Electronic Arts — A Risky Game Play, But Potentially Profitable

by Lawrence Meyers | October 10, 2011 7:30 am

Electronic Arts — A Risky Game Play, But Potentially Profitable

I really don’t play video games, even though I have kids. That’s mostly because, if I purchased a video game system, I would spend all my time playing video games. So I’m abstaining in an effort to save myself. The safer way to play video games is in the stock market, where I can potentially invest in a video game company and make money off other people’s addictions and squandered time.

That leads me to Electronic Arts (NASDAQ:ERTS[1]). The company doesn’t just develop, market, publish and distribute its own games — it distributes games developed by other companies. It also offers online games. Some of the more notable titles and series include the Madden NFL video-game franchise, the James Bond series, Harry Potter and the Order of the Phoenix, The Sims series, and first-person shooters such as Crysis and the Medal of Honor series.

Some of you investors might not get what the whole video game thing is all about, but it’s not just Pac-Man anymore. Today, it’s about creating an entertaining, unique and immersive interactive experience. Sure, some games are just shoot-’em-ups. But for the most part, gaming companies recognize that their players are seeking something extraordinary, so they take great time, pride and care in developing each new game. It isn’t just a cynical excuse to bilk kids out of their newspaper-route money.

The business also is changing because the five-year console cycle, in which game developers take time to adapt to each new technological advance, is slowly going away.

Digital sales are the fastest-growing revenue stream on every gaming platform. It is these new platforms — the Apple (NASDAQ:AAPL[2]) iPad and Google (NASDAQ:GOOG[3]) Android mobile devices — that are disrupting the business of gaming. Now, gaming companies can continue to focus on their core group of customers — the console players — while shifting resources heavily into digital platforms.

Electronic Arts’ success depends not only on successfully moving into this digital space, but on the single-most important aspect of gaming: making great games. The company has a good track record so far.

Electronic Arts’ financials are mixed. It holds $1.85 billion in cash with no debt. However, thanks to competition and the weak economy, the company has not posted a profit in any of the past three years. Losses are declining (from $1.08 billion in FY 2008 to $276 million in FY 2011), and the company has posted a profit the past two quarters. Free cash flow was negative in FY 2008 and 2009, but a positive $260 million in FY 2011. The company has $120 million in free cash flow in the trailing 12 months.

Conclusion

Backing out the $5.50 per share in cash, Electronic Arts is trading at $17 per share, against FY 2012 projected earnings of 90 cents per share, giving it a P/E of 19. For FY 2013, $1.20 in earnings yield a 14 P/E. Analysts see a five-year annualized growth rate of 15.7%.

It’s difficult to say how the company will perform because everything depends on the quality of its games. With all the new revenue streams available — particularly digital ones that do not require as much expense for hardware creation — the company is well positioned. I’d say that investing in Electronic Arts is not for the faint of heart, and the stock appears fully valued at the moment. It’s a “buy” for aggressive investors, while others may want to wait for a pullback to increase their margin of safety.

Lawrence Meyers does not own shares of Electronic Arts.

Endnotes:
  1. ERTS: http://studio-5.financialcontent.com/investplace/quote?Symbol=ERTS
  2. AAPL: http://studio-5.financialcontent.com/investplace/quote?Symbol=AAPL
  3. GOOG: http://studio-5.financialcontent.com/investplace/quote?Symbol=GOOG

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