It was the best of times, it was the worst of times. Video game maker Take Two Interactive Software Inc (NASDAQ:TTWO) is exploding to all-time highs following another beat-and-raise quarter. Meanwhile, competitor Electronic Arts Inc. (NASDAQ:EA) has trickled lower after EA stock reported unexciting second quarter results while delivering a disappointing guide for the all-important holiday quarter.
This divergence in EA and TTWO, though, is nothing new. While both stocks are up big on the year, TTWO stock is up more than 25% over the past three months, while EA stock is actually down 4% during that time.
This divergence will likely continue into the holiday season.
Investors are excited about TTWO stock heading into a huge 2019 release slate headlined by Red Dead Redemption 2. But investors are sour on EA stock because it looks like its big launch, Star Wars Battlefront II, won’t live up to the hype.
I think that means buy TTWO stock and sell EA stock.
EA Stock Is Supported by a Good Growth Narrative
Good news first.
EA stock has exploded higher this year (up more than 30% year-to-date) because the company is successfully leveraging the massive digital shift in the video game industry to squeeze tons of high-margin revenue out of its strong content portfolio. Simply, as video games go digital, that means EA is now selling digital games, not physical games, and those sales are higher margin.
Therefore, it is bullish to see that high-margin digital net bookings growth is actually accelerating. Over the past four quarters, the digital net bookings growth rate has ticked up from 18% to 20% to 23% to 26%. That has dragged the gross profit margin higher. So far this year, gross profit margins are up more than 400 basis points year-over-year.
Breaking down EA’s content portfolio, the Sims franchise is doing really well. Sims 4 just had its best quarter in recent memory in terms of monthly active user growth. A new console game is launching soon, and that should build on this already strong momentum for Sims.
Battlefield 1 is also doing very well as is the Madden franchise. The new Battlefront game should do quite well, but search-interest trends do indicate that demand for this game will be noticeably weaker than demand for the Battlefront game released two years ago.
All in all, though, EA stock has a solid top-line growth narrative with strong gross margin drivers and a healthy earnings growth outlook.
But EA Stock Is Also Tough to Own Right Now
But growth isn’t that big.
Revenues are expected to inch up just 5% this year. Next year, revenue growth is supposed to look like 8-9%. Overall, over the next several years, revenue growth will look a lot like how it has over the past several years (up roughly 6% per year since 2013).
Gross margins should continue to move higher as the digital shift accelerates, but the fiscal 2018 guide implies that gross margin growth will start to moderate. Overall, then, the Street’s forecast for roughly 15% earnings growth over the next several years seems about right.
EA stock is trading at 26.3x this year’s earnings for that 15% growth.
That isn’t all that great. Its a price-to-earnings/growth (PEG) ratio of about 1.8. The market is at 1.9, while TTWO stock is at 1.5.
Plus, the free cash flow yield is at 4.3%. That is pretty low for this stock. At the beginning of the year, the free cash flow yield was above 4.7%. A year ago, it was around 4.8%.
Then there is the whole fact that November through January is historically a tough time for EA stock. Management almost always gives a conservative guide for the holiday quarter, and that hangs over the stock until the next earnings report at the end of January.
Bottom Line on EA Stock
I’m not a buyer here. I like the growth story, but the stock feels maxed out from a valuation standpoint. Plus, sentiment should remain dour so long as the negative holiday guide hangs over the stock.
As of this writing, Luke Lango was long TTWO.
