'Questionable Games Quality' Threatening EA's Stock

'Questionable Games Quality' Threatening EA's Stock

A few days ago, EA released its preliminary financial results for the second quarter ended September 30, 2007 revealing the giant publisher has suffered a net loss for the quarter totaling $195 million (compared with net income of $22 million for the prior year) and that its gross profit was also down 45 percent to $245 million.

EA also announced a reorganization plan that will lead to a number of changes over the next two years including: "(a) closing certain facilities, including EA's facility in Chertsey, England, (b) relocating and/or eliminating certain job positions, (c) incurring costs in connection with lease and other contract terminations, and (d) incurring IT and consulting costs to assist in the reorganization of business support functions."

In spite of the aforementioned losses, EA provided guidance of net revenue between $1.325 and $1.575 billion for the third quarter ending December 31, and for the full year ending March 31, 2008 EA is expecting between $3.35 and $3.65 billion in net revenue, which is up $150 million from the company's previous guidance.

Following those revelations, some analysts maintained EA's stock rating at "But" and "Strong Buy", others didn't feel so optimistic about the publisher's future.

Deutsche Bank analyst Jeetil Patel downgraded the stock (ERTS) to "Sell" and issued a price target of $45. He commented that while "Electronic Arts delivered 3Q upside... we think that the company still appears to be losing share (on a sellthrough basis) in the video game industry."

Patel's main concern is EA's questionable games quality: "Our investment thesis on Electronic Arts remains unchanged in that amidst solid growth industrywide, EA's game quality remains questionable, which in turn could translate into ongoing market share losses and limit operating margin expansion to historical levels (seen in the previous cycle). In our opinion, the lack of major outperformance on unit volumes among a majority of EA's titles, especially with a growing fixed R&D expense base, represents the single most important hurdle for the company."

Patel then pointed out that EA couldn't achieve similar profits during this console cycle compared to the previous one.
"We estimate EA will generate almost $400mn in operating profit in fiscal 2008, vs. $633mn in year 2 of the last cycle (FY 2003). As the company progress into years 1-3 of the current cycle, it appears profit dollars generated will be much lower in this cycle, underperforming its previous period by an average of $165mn in profits. In other words, the previous cycle was more profitable, yet it does not make sense to us why we are paying a premium for a less profitable business."

The Deutsche analyst also revealed that EA shipped too much units that sell too slow: "The company shipped in 2mn units each of Command & Conquer and Harry Potter. Assuming a 50/50 int'l./domestic mix split and 50% of C&C on the PC, it may take EA 70-100 weeks to sell-through existing channel inventories on these titles, based on current NPD sell-through vs. units in the channel".

"Additionally, we highlight that retail pricing for several of the next-gen versions (Xbox 360, PS3, Wii) of the two titles have been already marked down to $30-$40 within 4-6 months of release. We think this could become a more widespread problem considering lackluster product quality, weak sell-through thus far (even on major franchises), and a crowded holiday selling season that should favor a handful of titles (Call of Duty 4, Halo 3, Super Mario, Guitar Hero to name a few)."

Ultimately, Patel concluded that the world's biggest third-party publisher will be losing market share next year: " we think EA will grow by ~9% in FY08 in the core video game operations. With industry growth of 15% for North America and Europe, the underlying data suggests that the company stands to lose 4-6 points of market share."