Article: Lord of the Games
Article for The Motley Fool (Spring, 2005)

If you had to choose, would you rather be James Bond, Gandalf, or David Beckham? I know it’s hard to decide, but these are the questions the creators of Electronic Arts ask themselves as they sit down and plan which video games to create.

Located in Redwood City, California, Electronic Arts (NASDAQ: ERTS), is the world’s leading independent developer and publisher of interactive games for personal computers, hand held devices and home entertainment systems. Since the company’s start in 1982, they’ve won over 700 awards for outstanding software in the US and Europe, and in 2004 had 27 platinum titles including Lord of the Rings and Harry Potter.

But they are more than a company full of gamers and graphic artists. With revenues of $3 billion for the 2004 fiscal, Electronics Arts has the upper hand in negotiations when it comes to obtaining licenses from movie studios, record companies, and sports leagues.

Making the big bucks

Electronic Arts markets their products worldwide under four brand logos (EA Games, EA Sports, EA Big Sports and Pogo). Their 2004 fiscal was a record year for the company. In addition to a 19% increase in their net revenue, gross margin was at all time high at 63% and so was their return on invested capital at 70%.

Most of their success in 2004 came from growing their existing business: producing new and expanding established franchised games. Twenty-seven of the 43 games released in 2004 sold more than a million units. In addition, six of their franchised games, including The Sims, Need for Speed, FIFA Soccer, and Lord of the Rings, sold more than five million units each.

But the good news doesn’t stop there. Gamers are not only fanatic, but loyal. To keep their fan-base happy, in 2004 Electronic Arts launched updates of the games they love for a steady stream of sales. With Harry Potter Quidditch World Cup and James Bond 007: Everything or Nothing both selling games over a million units each, Electronic Arts proved they didn’t need a movie tie-in to be successful, and will continue this trend into 2005 with the launch a new Lord of the Rings and another James Bond title.

Obtaining extended play cards

The 2005 fiscal year is off to a good start. In December 2004, Electronic Arts signed an exclusive five year deal with the NFL knocking out all competition in the sports video category and strengthening their long term leadership position. There is also the long awaited summer release of Warner Brothers’ Harry Potter and the Prisoner of Azkaban to which they own video license.

New technology platforms will also help maintain sales in 2005. One of Electronic Arts’ strengths is the ability to publish games on multiple platforms. They have been working closely with Sony on their Playstation Portable (PSP) and are committed to having games available in time for the launch later this year.

High scoring financials

Overall Electronic Arts doesn’t seem to be doing too bad. With a gross profit increase of 32%, 2004 was nothing to complain about.

Electronic Arts’ Annual Results ($000)

	2004	2003	2002	2001	% change
Revenue	2957	2482	1724	1322	19%
Cost of Goods Sold	1102	1072	814	664	3%
Gross Profit	1854	1409	909	657	32%
R&D	510	400	380	376	28%
Amort, of intangibles	27	74	254	193	(63%)
Restructuring Exp.	9708	1510	7485	0	(16%)
Total Oper. Expense	1078	953	774	687	13%
Net Income	577	317	101	(11)	82%
Operating Cash Flow	669	714			7%

Important to note from the above numbers is the 28% increase in research and development. Much of this had to do with an increase in their employee headcount and the cost of external development on new games. As Electronic Arts continues to outsource more and more games to third party developers, this percentage will likely continue to grow.

A couple other important things to note are the 63% decrease to the amortization of intangibles and the 16% restructuring decrease. Both will not be reoccurring reductions in the following year and their temporary inflation to the net income percentage for 2004 must be considered when valuing the potential growth of the stock.

Pitfalls and challenges

Life is currently good for Electronic Arts, but like the games they create, there are some challenges that can stop them from getting to the next level. Besides the obvious risk of creating a game that sucks, key areas to watch out for are:

• Piracy threats: Although Electronic Arts’ Asian business has doubled in the last five years, things are not growing as fast as they would have hoped. Piracy of packaged games is a big issue in this region and they are currently experimenting with online fire-walled versions, but with little success. Unless a solution is found, this stream of revenue may not viable.

• Console licensing fluctuations: Electronic Arts excels at predicting which videogame platforms will be successful and developing games for those platforms. But it’s not all fun and games. They pay a licensing fee to have their products played on consoles such as X-Box and Nintendo. The licensing fee is subject to the provider’s discretion and there is always a chance the fee will be raised.

• Demand for entertainment licenses: Electronic Arts’ is currently big enough to purchase the popular entertainment and movie licenses. However, this may change as more and more entertainment companies are diversifying their media. Already, Time Warner and Disney have announced their intent to expand their own software game publishing divisions. If other companies follow, the platinum licensed sellers Electronic Arts depend on will be gone.

• Increased development costs: As the cost of the console prices decrease, the pressure is on for software prices to also lower. This is not unexpected, but when combined with the demand for greater and flashier games that cost more to produce, lowering the end cost will negatively impact their gross margin.

Cutting to the chase

With the acquisition of the NFL brand and the Harry Potter, Lord of the Rings, and Sims franchises, I’m sure Electronic Arts will continue to produce million-unit sellers for the next year with the hope of retaining a flat profit line. This falls in step with their recent predictions. With sales already falling short of what they expected for the first quarter of 2005, the company has reduced their estimated net revenue to $3.1 billion, as compared to their previous estimate of $3.3 billion.

Keeping this in mind, along with the increasing cost of producing videos, their obtainable market already reaching saturation and the potential growth in Asian still not resolved, a major rise in their fairly constant $53 stock is highly unlikely. I love interactive companies, but would need to do more research before putting my money on this one.

Although she sometimes is reluctant to admit it, Fool contributor Michelle Ponto is an X-box junkie, but she does not have stocks in any of the above mentioned companies.