Electronic Arts Stock Analysis

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It’s annual portfolio analysis time!

Electronic Arts (ERTS) is a stock that I have given little attention to this year. It may be time to sell off the shares, given that the stock spiked and is heading south from its $60 52-week high.

Electronic Arts Stock Performance

  • Purchase Price on July 25, 2006 – $46.61
  • Current Stock price(12/20/06) – $51.73

Total Gain: 10.78%

Electronics Arts Company Report

Electronic Arts Inc. develops, markets, publishes and distributes interactive software games (titles) that are playable by consumers on devices, such as in-home video game players (such as the Sony PlayStation 2, Microsoft Xbox and Xbox 360 and Nintendo GameCube (consoles); personal computers (PCs); mobile platforms, including handheld video game players (such as the PlayStation Portable (PSP), Nintendo DS and Game Boy Advance) and cellular handsets, and online, over the Internet and other online networks. The Company publishes interactive software games for multiple platforms. It makes investments in facilities and equipment that allow the Company to create and edit video and audio recordings that are used in its games. In August 2006, the Company acquired Phenomic Game Development. In October 2006, Electronic Arts completed the acquisition of Digital Illusions CE (DICE), development team and creators of the Battlefield game franchise. (Source: MSN Money)

Electronic Arts Fundamentals

The company presents some impressive margins when compared to the multimedia and graphics industry.

  • 60% Gross Margins – Electronic arts is above industry averages of 53%, so they’re taking in more money from revenue than most graphics companies.
  • 60% 5 Year Gross Margins – A better indicator of margins health is the 5 year trend. EA has managed to keep gross margins stable over the past 5 years.
  • 13% 5 Year Net Profit Margins – EA takes in 13 cents from every 1 dollar of revenue. How did the industry perform over the last 5 years? They lost 4 cents of every dollar of revenue, and struggled with negative Pretax and net profit margins. ERTS has significantly outperformed their competitors, making EA shares a best of breed stock.

Growth Rates

  • 17% 5 year Sales Growth – Growth of product sales is 3 percentage points above the industry average. Sales growth should continue due to the arrival of next generation gaming systems Nintendo Wii, and Sony Playstation 3.
  • Negative Year over year EPS growth rate – One negative feature of ERTS stock is their negative EPS growth trends. The company produced negative EPS growth the past 2 quarters, signaling a red flag for growth investors.
  • 0% Dividend rate – Electronic Arts reinvests their income, instead of paying out a dividend.
  • 16% 5 Year Earnings Growth – ERTS shows substantial growth, but is heavily outweighed by their high 90 times earnings ratio.

Price Ratios

Normally I would discuss P/E ratios, but Price over Earnings gives insight to short term stock signals. We must look for long-term signals and indicators, so we use the PEG ratio instead.

  • 4.92 PEG Ratio – this is a very bearish stock signal, and usually means the stock is significantly overvalued. I like holding stocks with PEG ratios of 1.5 or less.
  • 52 Times Cash Flow – Price over Cash flow for the trailing 12 months stands at nearly double the industry average. This stock is coming down because the market is realizing its weaknesses. Hopefully ERTS will break sales records this holiday season or the ratio will continue to increase.

Financial Condition
Electronic Arts Inc. is 100% debt-free. No lenders to worry about!

Investment Returns
Return on Investment is another huge concern of mine when it comes to ERTS shares.

  • 5.30% Return on Investment – This number is significantly below the industry average of 22.16%. ERTS has done a poor job of returning value to shareholders. Their competitors returned on average nearly 5 times the value I’ve received from Electronic Arts stock in the past 12 months.


Electronic Arts earnings performance

The current SmartEstimate trend is rising, and I agree with analysts on this one. Earnings will improve once more consoles hit the market, forcing video gamers to purchase game titles for their video game console.

Balance Sheet

Electronic Arts holds $2.5 billion in cash and short term investments. An added bonus is their zero long term debt. The company can do a number of things with their cash: acquire acquisitions, return value to shareholders, buy back stock, pursue alternative investments, or simply hold onto the cash. We shareholders would love to see a dividend from ERTS in the near future.

Catalysts for 2007

1. Sony PS3 and Nintendo Wii sales should drive Ea title sales upwards.
2. EA Publishers are toying with new cellular phone games and plan to release a full line of titles within the next year.
3. Release of iPod games should drive media gaming sales higher. This is an area of gaming that EA is currently exploring since there is a multi-million dollar market for iPod compatible gaming.

Obstacles for 2007

The video gaming industry is becoming more expensive to operate in. game publishers only take in about $1 or 1.5% from the game retail price. Next generation games list for $60, but retail, design, and game engineering eats up a lot of the profits.

Final Decision: Buy or Sell?

To determine the value of ERTS shares, I will use a discounted cash flow model with a 10% discount rate.

First, I’ll calculate the Average EPS over the past 3 years, instead of the trailing 12 months EPS, because a long term trend is more precise estimate number to work with.

Then we plug in the 5 years earnings growth rate of 16.5%, and set the growth rate after 5 years to 0%. I set my long term rate to 0% because investors should only evaluate what’s already been determined. Assuming a long-term growth rate for the future is an error in judgment.

What if sales fall off? What if the company incurs debt? What if growth stalls? By using a conservative estimate, we limit our risk threshold.

I entered the 10% discount rate, and the calculator returned a $27 stock value. The shares are highly overvalued, nearly twice its current day value, so I may either let go of the shares or refrain from purchasing more.

There is one reason why I’m still interested in Electronic Arts shares: they hold $2.5 billion in cash, and have no long-term debt.

What attracted me to Electronics Arts stock initially was their competitive edge on the video gaming industry. They are the market leader in video gaming, and have broken sales records on popular titles such as Madden ’07 and Fifa World Cup 2006, but costs of production are beginning to strip profits.

Video gaming costs are increasing, but Electronic Arts is pursuing media gaming as well as digital gaming on phones, iPod, Blackberrys, etc. Media gaming is cheaper than console gaming, so EA’s margins may show signs of improvement if consumers enjoy downloading and playing EA titles.

Even if margins remain unchanged, EA has tons of cash and zero debt. Who likes cash? I do!

Decision: Hold

Where do you see Electronic Arts heading in the next 5 years?

How will the release of Sony PS3 and Nintendo Wii impact EA sales?

I’m looking forward to the comments on this analysis.

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