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Electronic Arts Creates Value Through Timely Releases

Summary

  • EA is coming off a record-setting fiscal year in which the company created significant value for its shareholders.
  • Revenue fell in the first quarter, but the firm's shares are still near 52-week highs.
  • EA is building momentum after material hype surrounding future releases at this year's E3 gaming expo.
  • Let's take a look at EA's recent performance, as well as derive our fair value estimate for shares.

By Paul Tait

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In Electronic Arts' (NASDAQ:EA) fiscal 2015 ended March 31, the firm reported record numbers in revenue and cash flow, and significant margin expansion. The firm announced that it is one year ahead of schedule in its three-year plan to double its non-GAAP operating margins to 20%. EA's stellar performance on the new generation of gaming consoles that were released in November 2013 was the main driver of its record numbers. The company was the number one publisher on Sony's (NYSE:SNE) PlayStation 4 and Microsoft's (NASDAQ:MSFT) Xbox One.

However, EA's performance is often hit-or-miss, as evidenced in its first quarter of fiscal 2016, in which the company experienced declines near 10% in some metrics, including revenue. Top and bottom line growth declined in the quarter, but the firm's stock price continues to soar and is pushing its 52-week highs. Since the start of calendar 2015 alone, EA's share price has advanced over 60%, and is trading above our fair value range as of August 6. Though we are confident in the company's ability to continue to release successful games, we note that lumpy quarterly results are to be expected.

EA shone in the esteemed annual video gaming conference E3 as the firm announced a number of new games and received over 132 awards. The most notable release of E3 was Star Wars™ Battlefront™, which won Best Action Game and Best Online Multi-player Game. It plays like EA's highly successful Battlefield games, with the exception that it is in the Star Wars™ universe. The game is set to release about a month before the seventh Star Wars™ movie comes out. Previous releases of Star Wars Battlefront have been fan favorites and remain relevant among the gaming community.

EA's ability to connect with its consumers, particularly in calendar 2014, has enhanced the magnitude of its value creation and has earned it one of the highest-rated Economic Castles in our coverage universe. Let's dig deeper into some of Electronic Arts' other investment considerations and derive a fair value estimate for shares. We'll say this now - the shares aren't cheap.

Electronic Arts' Investment Considerations

Investment Highlights

  • Electronic Arts develops, markets, publishes and distributes game software content and services that can be played by consumers on a variety of video game machines and electronic devices, such as the PS3/4, Xbox 360, and Wii. Some of its titles include Battlefield 4, UFC, and EA Sports offerings for nearly every major American sport.
  • EA's revenue from mobile has grown considerably in recent years and is a great opportunity for future growth. The segment's gains have more than offset negative PC trends. The firm's console segment reported tremendous growth in fiscal 2015.
  • Electronic Arts earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. We expect the firm's return on invested capital (excluding goodwill) to expand to 291.1% from 137.1% during the next two years.
  • New consoles tend to drive growth at EA, so investors should pay close attention to the strategies of Nintendo (OTCPK:NTDOY) (Wii), Microsoft (Xbox One) and Sony (PS). Digital's share (mobile/handhelds, extra content, full game downloads) of overall interactive entertainment industry spending has advanced to 70% of the total in recent years.
  • The company's portfolio of brands includes wholly-owned brands, such as Battlefield, Mass Effect, Need for Speed, The Sims, Bejeweled, and Plants vs. Zombies. We like EA's considerable brand recognition and strength.

Business Quality

Economic Profit Analysis

In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Electronic Arts' 3-year historical return on invested capital (without goodwill) is 59%, which is above the estimate of its cost of capital of 10.6%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.

In the chart to the below, we show the probable path of ROIC in the years ahead, based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate. The company's record performance in 2014 led to significant value creation for shareholders.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Electronic Arts' free cash flow margin has averaged about 19.3% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.

The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures, and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Electronic Arts, cash flow from operations increased about 27% from levels registered two years ago, while capital expenditures fell about 10% over the same time period.

In the first quarter of fiscal 2016, the company reported cash provided by (used in) operating activities of ($71) million and capital expenditures of $24 million, resulting in free cash flow of negative $95 million in the period.

Valuation Analysis

There's no playing around here. This is the culmination of our analysis. Below, we outline our valuation assumptions and derive a fair value estimate for the shares.

Our discounted cash flow model indicates that Electronic Arts' shares are worth between $39 and $73 each. The shares are currently trading at ~$74, just above the upper bound of our fair value range. This indicates that there is significant downside risk associated with the shares at this time.

The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $56 per share represents a price-to-earnings (P/E) ratio of about 20.8 times last year's earnings and an implied EV/EBITDA multiple of about 13.6 times last year's EBITDA.

Our model reflects a compound annual revenue growth rate of 4.7% during the next five years - a pace that is higher than the firm's 3-year historical compound annual growth rate of 2.9%. The model reflects a 5-year projected average operating margin of 29%, which is above Electronic Arts' trailing 3-year average.

Beyond year 5, we assume free cash flow will grow at an annual rate of 2.5% for the next 15 years and 3% in perpetuity. For Electronic Arts, we use a 10.6% weighted-average cost of capital to discount future free cash flows.

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Margin of Safety Analysis

Each fair value estimate that we provide comes with a margin of safety within which we feel the company is fairly valued. Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $56 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets, as stocks would trade precisely at their known fair values.

Our ValueRisk™ rating sets the margin of safety, or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Electronic Arts. We think the firm is attractive below $39 per share (the green line), but quite expensive above $73 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Electronic Arts' fair value at this point in time to be about $56 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Electronic Arts' expected equity value per share over the next three years, assuming our long-term projections prove accurate.

The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.

The expected fair value of $76 per share in Year 3 represents our existing fair value per share of $56 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Wrapping Things Up

Electronic Arts has its share of investment merits.

The company boasts some of the most popular video games, as was clear from its record financial performance of calendar 2014. We don't doubt that the firm will be able to continue to release popular games, but as was evidenced by fiscal 2016 first-quarter results, its quarterly results are likely to be volatile based on consumers' opinion of recent releases. It is important to keep from putting too much emphasis on one quarter's results in either direction, however.

All things considered, we're huge fans of the company's highly-rated Economic Castle, but EA holds a lot of risk, with its shares trading "up here." It is trading at unattractive earnings multiples, and we would need to see shares trading at a significant discount to our fair value estimate before considering a position in the company. Electronic Arts currently registers a 6 on the Valuentum Buying Index.

Disclaimer: This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice. For more information about Valuentum and the products and services it offers, please contact us at info@valuentum.com.

Additional disclosure: MSFT is included in the Dividend Growth Newsletter portfolio.


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