Red-hot video game publisher Electronic Arts (NASDAQ:EA) is set to report first quarter numbers after the bell on Thursday, Jul. 26.
There is legitimate reason to believe the numbers will be quite good. The video game industry is red-hot. EA stock has been upgraded by several analysts heading into the print. Esports, something EA is very big in, has continued on its rapid growth trajectory. And the company just launched a subscription service which should boost revenue and cash flow stability.
But, there are also reasons to believe the numbers won’t be good enough to send EA stock that much higher.
EA stock has been on fire in 2018. It is up 38% year-to-date and up 11% since its last earnings report. Its valuation is also at five-year highs. Clearly, big expectations are priced in. Yet, the quarter was light on catalysts, and that could lend itself to light numbers which don’t really move EA stock all that much.
As such, I’m a long-term holder of EA stock but not a buyer into the print.
Here’s a deeper look.
EA’s Quarter Was Light on Catalysts
There is reason to believe EA will report very good numbers.
After all, everyone else is reporting really good numbers. Nearly 80% of companies have reported sales above expectations this quarter, while 90% have reported earnings above expectations. EA will likely be in the double-beat majority this quarter.
Also, the video game industry remains red-hot in terms of sales and growth potential. Video game sales were up in April and May, and EA’s FIFA 18 made a strong showing, likely owing to World Cup tailwinds.
Esports continues to morph into the next big thing. And EA continues to evolve its business model to a direct-to-consumer framework and recently launched a video game subscription service.
These are all positives for the EA growth narrative. That is why UBS, Needham and Baird have all upgraded EA stock over the past two months. The average price target on the stock is $150, and the average rating hovers between “Buy” and “Strong Buy.”
In other words, EA should report good numbers this quarter.
But, I don’t think they will be good enough to catalyze a big rally in EA stock. The quarter lacked catalysts, with FIFA 18 being the only title that made a big splash. A catalyst-light quarter won’t be the big upside driver for this stock, which has rallied to all-time high prices and all-time high valuation levels.
Thus, at best, I think you get sub-3% move higher in the stock on good numbers.
EA Stock Looks Good Long-Term
Long-term, EA stock looks like a solid multiyear investment.
The company is at the heart of three secular shifts in the video game industry, all three of which materially benefit EA’s business. Those three shifts are:
- Traditional gaming to AR/VR gaming, which will grow gamer engagement and mass consumer interest in EA video games.
- Legacy model to subscription model, which will lead to more predictable and higher-margin revenues.
- Isolated gaming to esports, which will grow consumer awareness and create new revenue opportunities through advertising and partnerships.
Put these three shifts together, and it is easy to see why EA over the next five years will do better than it has over the past five years.
Over the past five years, revenue growth has run around 6% per year. I think that accelerates to 8-9% over the next five years. Meanwhile, the shift to digital and subscription sales will boost margins in a meaningful way. Therefore, I see runway to 40% for adjusted operating margins.
Under those assumptions, I think EA can do about $8 in earnings per share in five years. A historically average 23X forward multiple on that implies a four-year forward price target of $184 on EA stock.
Bottom Line on EA Stock
Here and now, it looks like EA stock has had its big rally. I’m not expecting much upside in the near term.
But, in the longer term, as eSports and subscription tailwinds kick in, EA stock should head materially higher thanks to robust profit growth.
As of this writing, Luke Lango was long EA.
