Its has been a tough run for video game publisher Electronic Arts Inc. (NASDAQ:EA). Owing largely to controversy over in-game purchases in its headline 2017 holiday title Battlefront II, EA stock is in the middle of its longest and sharpest downtrend in recent memory.
Since Halloween, EA stock has gone from $120 to $103. That is a pretty noticeable move downward for a stock that rose steadily from $10 in the summer of 2012 to $120 in the summer of 2017.
Is this recent weakness a sign of the times or is a rebound in Electronic Arts stock imminent?
I think the latter… but I don’t think that means buy EA stock now. Investors can afford to exercise patience with this recently beaten-up name.
I had a slightly bearish skew on EA stock even before the Battlefront II controversy.
The valuation simply felt too full.
While EA does find itself on the winning side of a shift towards downloadable content in the video game world, growth at the company isn’t that great. Revenues are expected to rise just 5% this year and 8% next year. This level of 5-10% revenue growth is good, but nothing special.
The margin expansion narrative is also good, but not great. Gross margins are trending up thanks to a higher mix of digital sales, but this margin expansion narrative can’t go on forever. Indeed, the fiscal 2018 guide implies that gross margin growth will start to moderate soon.
Somewhere between 5-10% revenue growth and moderating gross margin expansion gives EA stock good (but, again, not great) earnings growth prospects. The Street is modeling for around 15-16% earnings growth over the next several years. That feels about right to me.
EA isn’t a big tax payer, so I don’t see any reason why EA stock should trade in-line with the S&P 500, which is trading at a 100% premium to growth prospects (20 times 2017 earnings for roughly 10% growth) even with tax reform looming. The average effective tax rate for S&P 500 companies is 24%. EA’s effective tax rate last year was 20%, or about 17% lower (call it 20% lower to be conservative).
Consequently, I think EA stock’s growth premium should be more like 80% (or about 20% lower than the S&P 500’s growth premium). Applying that 80% premium to 15.5% growth prospects, you get a “fair” price-to-earnings multiple of about 28. A 28 multiple on this year’s estimated earnings of $4.20 implies a fair value of $118.
That is almost 15% higher than where Electronics Art stock languishes today.
But there is no need to rush in and buy EA stock now.
Historically, November through January is a tough time to own EA stock, thanks to (usually) conservative holiday sales guidance from management in early November. This year, that historically tough time is extra painful due to the Battlefront II headache.
These headwinds will keep investor sentiment depressed into the foreseeable future. Put simply: investor demand for EA stock won’t ramp back up until the Battlefront II headache is in the rearview mirror. That won’t happen until the next earnings report, at the earliest.
Until then, Electronics Art stock will likely remain depressed.
EA stock is approaching good value territory. The free cash flow yield has crept back up to 4.7%, a level which has historically signaled a good time to own the stock. Consequently, EA stock is on my potential buy radar.
But given depressed sentiment surrounding Battlefront II, I’m not pulling the trigger yet. Closer to the end of January 2018 looks like a more compelling time to buy back into EA stock.
As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.