It has a been a bumpy ride for stocks over the past several weeks, but the turbulence has been especially bad for video game publisher Electronic Arts (NASDAQ:EA). EA stock was once one of the most loved stocks in the market. It was a leader in a growth category with secular tailwinds, big revenue growth and healthy margin expansion. Investors couldn’t get enough of all that good stuff. From mid-2012 to mid-2018, EA stock skyrocketed from $10 to $150.
Then, the turbulence hit.
EA stock dropped big at the end of the July due to weak guidance which signaled that the company’s red-hot digital tailwinds were starting to cool. Management took that weak guide down even further at the end of August after deciding to push back a key game launch by four weeks and factoring in FX headwinds. Then, the markets started to freak out about interest rates, and selling pressure on growth stocks intensified.
All together, EA stock has dropped from $150 in July to around $95 today. That is a whopping 35%-plus drop in just a few months.
The bleeding could stop soon. The secular growth narrative supporting EA stock remains intact, and the fundamentals remain strong. The valuation was just ahead of itself at $150. But, down at $95, the valuation is much more reasonable. Assuming the video game industry continues to benefit from secular tailwinds, EA stock looks considerably cheap here.
Having said that, sell-offs don’t end easy. There needs to be a catalyst to spark a reversal. That catalyst could be EA’s second quarter earnings report, which is due after the bell on Tuesday. Those numbers should be pretty good. Importantly, they should be good enough to spark a reversal in beaten up EA stock.
The Fundamentals for EA Stock Remain Strong
EA stock went from $10 in 2012 to $150 in 2018 because of a robust growth narrative in the video game industry. Not much has changed about this growth narrative over the past few months. If anything, the narrative has improved. Thus, the recent sell-off in EA stock is not warranted by a deterioration in the fundamentals.
The video game industry has been on a broad uptrend over the past several years. As consumers have become more digitally engaged than ever, they have also upped video game consumption to peak levels. Moreover, video game publishers like EA have leveraged two key trends over the past few years to supercharge growth: digital downloads and micro-transactions.
The days of GameStop (NYSE:GME) are over. Consumers don’t buy physical games anymore. They buy a game through a digital marketplace, and download it from the cloud. This model of digital downloads is far more convenient for consumers. It requires very little effort. It is also far better for video game publishers. Digital downloads carry higher margins, so as the the digital download trend has gone mainstream over the past few years, video game publisher margins have marched higher.
Meanwhile, video game publishers have also figured out that one complex video game has multiple in-game monetization opportunities, and have started pushing micro-transactions in many of their games. Thus, as opposed to a video game generating $60 per player (actual game cost), video games can now generate upwards of $100 and often way more per player (actual game cost plus recurring micro-transactions).
Neither of these trends are disappearing anytime soon. There are signs that the digital downloads trend is slowing because digital now comprises a majority of the revenue pie. But, higher-margin digital downloads are here to stay. There were also signs last year that micro-transactions might be fading from mainstream popularity. But, video game spend as a percent of the male teenager wallet continues to rise, so there really isn’t any slowdown happening on the micro-transactions front.
Meanwhile, eSports is just starting to go mainstream. We are finally starting to eSports leagues like Overwatch League and ePremier League gain mainstream traction, while eSports advertisements are now airing frequently on ESPN during live sporting events like NBA games.
All together, the video game growth narrative remains robust. As do the fundamentals supporting EA stock. As such, this recent sell-off has nothing to do with fundamentals. It is all everything to do with sentiment, technicals, and valuation.
Set-Up Into Earnings Is Favorable
At the present moment, sentiment related to EA stock is poor, while the technicals are broken. But, valuation is attractive. Due to high margins, strong cash flows, a wide content moat with enduring demand and secular tailwinds in the gaming industry, EA stock has normally traded at a 23 forward earnings multiple over the past five years. Over the past year, the forward earnings multiple has spent most of its time above 25.
Today, EA stock’s forward earnings multiple is below 21.
That is a pretty favorable valuation for EA stock. Not only is the stock trading at a 10% discount to its five-year average valuation and a 15%-plus discount to its valuation over the past year, but EA stock is also trading at the same forward multiple as low-growth consumer facing giants Coca-Cola (NYSE:KO), McDonald’s (NYSE:MCD) and Proctor & Gamble (NYSE:PG).
That doesn’t make much sense, considering McDonald’s biggest growth catalyst is All-Day Breakfast, and EA’s biggest growth catalyst is a global eSports revolution.
Thus, heading into the Q2 print, the valuation on EA stock is attractive. Moreover, the stock is down more than 35% over the past few months, and is trading at its lowest levels since May 2017.
In other words, this stock is priced for disaster. But, disaster isn’t happening, and it shouldn’t show up in the Q2 report, either. As such, even normal results could spark a meaningful reversal in EA stock.
Bottom Line on EA Stock
At $150, EA stock needed to cool off. Over the past three months, it has cooled off. A lot. Now, with a potentially positive earnings catalyst on the horizon, it looks like it may be time to buy the dip.
As of this writing, Luke Lango was long EA and MCD.
