Why Electronic Arts Stock Desperately Needs a Catalyst

EA revenue and earnings have flattened out, which means the "old" bull case for EA stock isn't good enough

Electronic Arts (NASDAQ:EA) stock has basically done nothing for nine months now. Early optimism toward the company’s Apex Legends “battle royale” game sent the price of EA’s stock soaring back in February. But even after grinding higher in recent months, the stock still sits below that month’s highs.

Why Electronic Arts Stock Desperately Needs a Catalyst
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The sideways trading makes some sense. Apex Legends growth and usage both have moderated, leaving the game still a distant second to Epic Games’ Fortnite. Earnings, including last month’s third-quarter release, haven’t looked all that impressive.

The hoped-for catalysts for revenue and earnings largely have played out. Digital downloads, microtransactions and higher gaming usage all have gone mostly as planned. But, thanks in part to share gains from private companies like Epic Games, those tailwinds haven’t provided the boost to the industry that bulls projected.

Indeed, shares of all three major video game developers, including Activision Blizzard (NASDAQ:ATVI) and Take-Two Interactive (NASDAQ:TTWO), still trade below 2018 highs.

Admittedly, TTWO and ATVI have posted stronger rallies of late than EA. But that’s precisely the point. Take-Two’s Red Dead Redemption 2 was a massive hit. Activision Blizzard’s World of Warcraft Classic has driven optimism toward a rebirth of that franchise. Electronic Arts lacks any similar catalyst. And until it finds one, it’s hard to see how EA stock does more than maybe keep drifting in the right direction.

The Case for Electronic Arts Stock Below $100

To be fair, there’s an argument that the status quo should be enough for EA stock to rally at some point — or to at least outperform the market in the coming years. Based on analyst earnings-per-share estimates for fiscal 2020 (ending March), which appear to exclude acquisition expenses and changes in deferred revenue, Electronic Arts stock trades for about 21x earnings. Back out roughly $6.50 per share in cash net of debt, and the multiple drops below 20x.

Admittedly, growth isn’t all that impressive: consensus suggests a roughly 10% increase in earnings per share this year. But based on the company’s guidance, about half that EPS growth is coming from a lower share count driven by share repurchases. On its face, a roughly 20x multiple for ~5% underlying profit growth hardly seems attractive.

That said, in this market, it might be more attractive than it has been in years past; 5% growth is more valuable at a time when 10-year Treasury yields sit under 2%. And EA’s core franchises like Madden and FIFA can theoretically last for decades to come. Not only that, but the products might well be almost defensive at this point, with less sensitivity to macroeconomic factors than other forms of entertainment.

In a market where Microsoft (NASDAQ:MSFT) trades at 28x earnings and tax software developer Intuit (NASDAQ:INTU) 36x, there’s a case that 20x is somewhat cheap for a stable software play. If Electronic Arts can accelerate earnings at all, and its earnings multiple expands, even the existing portfolio might be able to drive double-digit annual gains for EA stock.

Not Enough for a Big Rally in the EA Stock Price

That said, grinding out 8% annual earnings growth and 10-12% share price appreciation isn’t exactly what EA bulls are looking for. Nor is it a particularly compelling investment case, even in a market trading at all-time highs.

And so we get back to the problem I’ve detailed relative to Electronic Arts stock in the past: it needs a new source of revenue and bookings growth. (The same holds true for Activision Blizzard as well, which has a worrisome reliance on old franchises.)

That new source probably has to be a new franchise. The financial engineering of microtransactions and “loot boxes” largely has played out. And it has left a number of angry gamers in its wake. Comment sections aren’t always the best source of accurate information, but I’d suggest investors check out the discussion on a Bloomberg article concerning rival Ubisoft (OTCMKTS:UBSFY, OTCMKTS:UBSFF).

The comments there echo those held by gamers across the world. Games aren’t unique enough, with the so-called AAA games largely being re-issues of existing IP or duplicates of other games. Microtransactions create a “pay to win” environment that prioritizes spending over skill in multi-player contests. Gamers pay $60 or more for a game only to serve as beta testers until new patches come out to fix a game that should have been delivered properly in the first place. One comment put it succinctly:

“I think we are getting to a breaking point with all AAA games. Gamers are tired of being treated like cash cows by ham fisted in game [sic] economies and pay to win micro transactions. I feel there is a big crash coming for all big developers.”

As a business, not just as a stock, there’s an increasing case that the status quo is not good enough, even if the numbers might suggest otherwise.

Where’s the Catalyst?

The reason Electronic Arts stock soared in February was that investors believed Apex Legends would be the catalyst. Fading numbers suggest it won’t be. A new Star Wars game has received good reviews, and perhaps EA has finally figured out the surprisingly difficult process of creating a popular game out of that franchise. (One reviewer said it was the first good Star Wars game from Electronic Arts since the company acquired the license from Disney (NYSE:DIS) six years ago.)

But the new Star Wars game, too, doesn’t seem like it moves the needle. And so what does? It’s going to be difficult, if not impossible, to wring much more gamer spending out of the existing franchises. New smaller games can add some growth here and there, but not enough to drive double-digit net income growth and a big rally in the EA stock price.

Electronic Arts stock has been stuck for nine months now, and in looking at the numbers and the business, that sideways trading makes some sense. It’s difficult to imagine what changes in that trading without a real change in growth. And that requires that EA deliver something new to gamers, and investors.

As of this writing, Vince Martin did not hold a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, https://investorplace.com/2019/11/why-electronic-arts-stock-desperately-needs-a-catalyst/.

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