Description

I believe EA today presents investors with an opportunity to buy into a well-positioned compounder at a low valuation (around 15x P/E ex cash) that will also see limited headwinds (maybe even tailwinds) from the Coronavirus. As I detail below, I see the video game industry as enjoying 1) LT margin tailwinds from the transition to digital gaming, 2) a very cost efficient entertainment product that should enable strong medium term growth and 3) favorable gamer demographics that will enable longer-term growth. We particularly like EA (see 30%-40% upside to the stock today at 20x P/E adj for cash) as we favor its durable sports franchise with associated growth opportunities.

Why the Video Game Industry is Well Positioned

1. Gaming industry has gotten notably more profitable and stable for publishers (EA, ATVI, TTWO)

Over the last ~10 years, the videogame publishing industry has seen its profitability improve as the gaming industry has shifted to digital. Today, around 50% of the console gaming unit sales are digital (with the digital mix increasing ~5% per year). By comparison, 90%+ of the PC gaming industry is digital.

The first order benefit of digital gaming is obvious, packaging costs of ~$12 per game go away with digital sales. However, with the rise of digital gaming, we have also seen publishers monetize their games via microtransactions and downloadable content. In both cases, players are able purchase new gaming content and/or features after a game purchase with publishers keeping around 70% of the revenue. Not only are these revenue streams highly profitable but they have also pushed the gaming industry away from the boom/bust cycles of the 2000s to a more stable, compounding sector. 

2. Videogames are 1) among the cheapest forms of entertainment that will support continued sector growth in the near-to-medium term and 2) enjoy favorable demographics trends as we are seeing the average gaming get older.

Console/PC games are a fairly inexpensive form of entertainment per hour. The cost of entertainment is most comparable to OTT video. 

As a result of gaming’s cheap entertainment value per hour, we have seen an increase in consumer time playing video games. The rate of revenue increase for video games has come just under OTT video. 

While the below chart is a bit dated, it shows that has been also been a trend toward gamers being older. This is likely as a result of the rise of Nintendo in the late 80s (which created a first generation of gamers). This further implies more near-term upside to gaming growth if the “Nintendo generation” of gamers keeps player (and older, non-gaming generations are replaced with younger gamers). This trend will be discussed more below.

3. Over the long run, the rotation to cloud-based gaming looks poised to support longer-term sector growth with additional potential for margin expansion

Over the next 5-10 years, the future of gaming is likely on the cloud. Cloud-based gaming effectively just replaces the console with a cloud server. Today, cloud based gaming is small. For example, Sony offers PS Now which only had ~700k subscribers in March 2019. The services are still small because no one offers a seamless cloud service yet. However, the likes of Microsoft and Google are working to leverage their cloud platforms to develop this technology. The question is more likely when rather than if. 

When cloud-based gaming becomes mainstream, it will likely significantly reduce the barrier to trial for the consumer (after all, he/she will no longer need to spend the $400 required to buy a console). With the below analysis is highly illustrative, if we think that 1) cloud gaming increases gamer penetration in the 5-9 age cohort from 60% to 80% and 2) those new gamers are 75% as sticky through their life as current gamers, it’s easy to underwrite ~4% gaming growth for decades to come.  

Final note is that cloud gaming is also likely to be benefit to MTX take-rates for the publishers. More platform competition means there will be fighting over quality AAA content. While the savings are difficult to exactly quantify, we can look to the PC space where new entrants are undercutting incumbents on tax rates down to as low as 12-15%.

4. Barriers to entry in the gaming space are increasing as AAA games are increasingly in favor

Gamers are increasingly playing the same games for a longer period of time that has dramatically increased game development costs as publishers 1) try to attract gamers to purchase their titles for longer game play and 2) develop add on products/features for future purchase.

Budgets for flagship games can now exceed $100mm (Destiny and GTA5). This was further echoed by Ubisoft’s CEO who explicitly has said the usual cost of developing AAA game is over $90mm. 

As a result of these high development costs, we have seen the market share of each of the major publisher’s flagship games increase (crowding out other smaller studios). 

Game concentration with a select few publisher incumbents helps to prevent the industry from being invaded in a way that Netflix did to the TV networks. Disrupters in gaming cannot access compelling content because the publishers simply won’t license to them if the economics are not compelling. It also helps that all of the big three gaming companies are also extremely profitable with net cash positions.

5. Gaming industry appears to be a (relative) Coronavirus winner again supported by its cheap entertainment price and convenience compared to alternatives. 

Recent indications are that the Coronavirus has been a positive for videogame usage. Twitch hours were up 66% in Italy and Verizon CEO noted that internet traffic related to gaming was up 75%. Steam has also seen a marked pick up in hours of gameplay since the world went into quarantine.  

This year was shaping up to be a very quiet year in the gaming industry as publishers waited until the new Xbox and Play Station were released in late 2020 before releasing new games. Thus, if there had to be a year when the Coronavirus would shut down the global economy, 2020 isn’t a terrible year for the gaming industry. Finally, while I’m not sure I subscribe to the view that gaming stocks need to outperform upon the release of new game consoles (particularly now with the new consoles supporting legacy games), the stocks have historically at least modestly outperformed the NASDAQ in these time periods. 

Electric Arts (“EA”) Overview

EA is a $24bn TEV video game publisher and the second largest US video game company behind Activision Blizzard. They are predominantly a Console/PC business (~85% of revenue) and Sporting Games (FIFA/Madden) make up the majority of the business’s revenue.

EA revenue has historically grown at a MSD rate (a bit below industry average rates likely from EA’s focus on more stable sports platforms- more detail below). EPS/margins for the business have compounded up as the industry structure as improved as discussed above.  

Why I favor EA’s position in the Video Game Space

1. Sport franchise gaming has the highest moat in the space

FIFA (~45% of EA revenue)’s dispersed contracts makes competition from rival gaming companies almost impossible

In creating FIFA, EA has a wide set of agreements that includes over 400 licensing agreements each negotiated independently and expiring at different times. EA’s near universal coverage of larger leagues gives them a nearly impenetrable moat as soccer fans care most about playing with their favorite clubs. Rival publishers simply cannot amass a comparable number of leagues. For example, notable rival PES doesn’t have even close to FIFA’s team roster (likely due to individual club exclusivity agreements) and sells a modest sliver of FIFAs ~20mm in unit sales. 

Madden (~10% of EA revenue) has over 16 years as the only mainstream football game in the market with incumbency only further entrenched with the proliferation of multiplayer mode

Videogame publishers negotiate a contract with the league/players association once every 7 years for US sports (NBA, NFL). The contract that EA has with the NFL is exclusive (and has been since 2005). While there is some risk of a deep pocked bidder coming in and stealing the NFL licensing rights from EA, the complications around creating a AAA sports game makes this an incredibly hard feat. EA developers have spent decades getting the exact details of each NFL player (along with the sports stadiums, commentators, etc) right. We have directly seen just how big the incumbency moat is with the NBA (which has similar concentrated, exclusive licensing rights). EA tried to re-enter the NBA franchise with NBA Elite 2011, but it flopped against the incumbent NBA 2K (which outsells it 20:1). Moreover, incumbency positions have likely only become more entrenched with the expansion of multiplayer/live services. 

While there is some concern over the recent NFL contract renewal for EA, I see little reason to worry. There has literally not been a rival NFL game launched in over 16 years. Additionally, TTWO recently renewed its NBA2K contract with the NBA whereby it said it didn’t expect margins to be meaningfully impacted (and here, there is an active competitor in EA’s NBA Live)

2. Live Service Revenue has been a tailwind for years driven by Ultimate Team. Ultimate Team revenue (estimated to be half of live services revenue) looks set to keep growing. 

As shown below, EA live service revenue has grown at around 20% per year for almost a decade. Ultimate Teams, a multi-player game mode on FIFA/Madden where players can purchase packs of characters to use in-game, has been a huge component of that growth. 

While Company disclosure around components of live service revenue isn’t great, we know that in 3Q’20, Ultimate Team Live Service Revenue was up double digits while FIFA Ultimate Team Matches were up 40% in 3Q’20. Madden/FIFA Ulitmate Team players were also up 20%/22% YoY in 2Q’20.  On the 3Q’20 earnings call, the EA CFO noted that its not ARPU increases that are driving Ultimate Team growth; rather, it is user engagement. 

“Team, really has benefited from more people and more engagement versus, once again, trying to change the ARPU in some fashion. We're very conscious about not trying to get people to spend beyond what their spend levels are. And so the best way to get people is to -- get people to spend in that is to engage them in better and more events that they'reexcited in.” EA CFO on 3Q’20 Earnings Call

I believe this sets Ultimate Teams up very well to grow given the large improvement in user experience that will come with new game console launches at the endof this year. As you can see from the specs below, computing rates in the new consoles are twice as good along with big improvements to memory/display.

3. Gaming Portfolio is resilient with optionality for business to surprise on new releases

EA expects revenue and EPS growth in FY2021 (even as game launches are light ahead of new console launches) with growth than accelerating in 2022 as new games (Battlefield) are launched. In part, this likely again speaks to the positive trends around live service/Ultimate Team revenue. However, it also supports my belief that the EA ex-sports franchises aren’t terrible. 

Many people would probably rate the ex-sports EA portfolio as “B-” at best. However, the Company does have some other reliable cash cows such as Sims. Sims business generates $300-$400mm of revenue and has grown basically every year since launch. The Star Wars franchise (which has seen more misses than hits) also still does generate good revenue for the company with its latest launch (Last Jedi) poised to sell at least 6mm copies this year. 

While the below chart isn’t exactly apples to apples (ATVI for example capitalizes some of its R&D), the basic message is EA does spend a ton of money on R&D. While product cycles can definitely surprise to the downside (Battlefield V in 2019), what you don’t know about in a publisher’s portfolio is normally your friend. For example, Apex legends basically showed up out of the blue and now generates $300-$400mm of revenue for EA (with further monetization likely).

Valuation

1. Company looks poised to sustainably generate a 14% TSR compared to its ~10% WACC (implying 40% upside to the stock)

Recent incremental margins have been around 60% (with 9 year average a bit higher than that). Again, I believe the longer-term trends (more MTX, DLC; more competition among platform operators; higher game moats) will continue to support incrementals in this 60% zip code. As outlined above, I don’t think underwriting 5% annual revenue growth seems crazy in light of longer-term favorable trends in gaming (cloud computing opening up TAM, inherently young population of gamers who will continue to play as they get older, etc). 

Given net income margins today are around 30%, a 5% increase in revenue at 60% incrementals will allow EPS to compound at 8-10% growth rate. The company also will generate around $1.3bn of equity FCF (where I deduct SBC) in FY2020. This is around a 6% FCF yield on the current market cap of EA (after removing cash). Thus, the business generates a sustainable ~14% TSR annually compared to a WACC of around 10%.  Thus, I see around 40% upside to EA today (14% TSR divided by WACC of 10%). 

2. Another way to look at EA is on P/E. Today, you can buy EA at ~15x P/E (adj for cash) and a modest (~.3x premium to the market multiple) when it has recently averaged a 2-3x premium. If you assume the stock should trade near its 2018 average P/E of 20x, it implies 26% upside to the stock.

Catalyst

-LT compounding