Electronic Arts Valuation DD

Electronic Arts (EA) TLDR: Cash flows for an unregulated casino for underaged soccer fans need to be discounted Short Thesis $98 52 week Target $2.85 non-GAAP EPS 3Q22 Description Notable Electronic Arts properties include exclusive licensing for NFL Madden and FIFA through 2025 and 2022 respectively, Free to play (F2P) Apex Legends, the Battlefield franchise, other licensed sport IP’s, and a portfolio of mobile gaming developers. Additionally EA holds exclusive development licensing to Disney Star Wars through 2022 though exclusivity will not be extended. EA is known for introducing industry leading monetization mechanics and expanding one time sales to revenues over the life of the game through downloadable content (DLC) and in- game currencies. In recent years EA has struggled with development and commercial performance of first person shooter IPs, not limited to 2017 Battlefront II, 2018 Battlefield V, BioWare’s 2019 Anthem and 2021 Battlefield 2042 along with governmental scrutiny for monetization and RNG mechanics. Electronic Arts is headed by CEO Andrew Wilson, the former lead of EA Sports who was promoted in 2013. For FY21 EA posted $5,629m in revenues, $837m in net income and $2.9 GAAP EPS. Earnings for Electronic Arts along with other gaming/entertainment peers are reported in GAAP accordance. Non-GAAP earnings are preferred by industry analysts and management to recognize revenues of the current quarter without deferring for the length of service provided (DLC and Pre-Sales) and are used for analyst estimates. Electronic Arts fiscal years begin 1 April. Coming off strong EA Sports performance in 2Q22, the current market valuation and analyst targets rely on an extremely optimistic projection over the next 52 weeks and have not been revised to reflect significant struggles with a much anticipated flagship title launch in 3Q22 along with risks of losing exclusivity to FIFA at the end of calendar year 2022. Electronic Arts releases 3Q22 earnings on 1 February 2022 after market close with expectations to provide guidance on the recent Battlefield 2042 release and a possible update on FIFA licensing. Thesis Electronic Arts presents a compelling short opportunity over the next year with the failed launch of much anticipated title Battlefield 2042 driving an EPS miss in 3Q22 earnings, subsequent write down of live service revenue expectations and a possible loss of FIFA exclusivity end of year. Electronic Arts is obligated to continue development of Battlefield DLC for 1 year due to pre-sale bundles or will be required to entirely refund pre-sold “Season Passes” which are expected to the amount of $30m for the next calendar year. The development cost required to improve stability and provide content exceed possible revenue generation from the existing player base, creating a negative cash flow asset. Further, the risk of losing exclusive licensing to the FIFA franchise at end of year has not been discounted from FIFA derived cashflow projections which amount to 30% of overall bookings. Losing exclusivity to a competitor would prevent Electronic Arts from publishing FIFA games all together and extending licensing with FIFA will require paying an additional $1bn over calendar 2023-26 while simultaneously losing exclusivity. This threatens the viability of Ultimate Team monetization which have failed in titles with peer competition. With adjustments solely regarding Battlefield 2042 bookings, discounting of FIFA bookings starting calendar 2023 and a correction of Star Wars projections, revised FY22 revenues of $5,217m and $2.85 3Q22 EPS fall short of analyst expectations of $7,189m and $3.25 EPS respectively. On the basis of projected FY23/24 FCF and current market multiple, we reach a 52 week price target of $98, a -25% downside to the current market price of ~$130. In this case, long dated put options on Electronic Arts stock presents a unique risk/reward even if Electronic Arts is ultimately successful in these areas with asymmetric exposure and underestimation of tail risk on long dated contracts. While easy to borrow, outright shorting Electronic Arts stock is unattractive with the risk of acquisition. Bull Case for Electronic Arts Acquisition Value of Electronic Arts The video game industry has experienced a number of large acquisitions over 2021 and 2022 including the recent acquisition of Activision Blizzard by Microsoft in a record breaking $68.7bn all cash deal. The industry is experiencing consolidation of game publishers under technology conglomerates, Microsoft, Sony, and Chinese publisher Tencent. Sony and Microsoft are building out exclusive titles for competing subscription gaming platforms. The recent Activision Blizzard deal was struck at a premium to market value and a similar acquisition of Electronic Arts could occur. Outright shorting shares is unattractive with this risk because of the linear profile. Strength in EA Sports Segment and Mobile Gaming A strong outperformance of EA Sports titles over 3Q22 could cover financial weakness in Battlefield 2042. FIFA and Madden unit sales and live revenues compose roughly 35% of total revenues. Outperformance of up to 40% in earnings over 3Q22 would cover losses seen in the FPS/Shooter segment. Successful Release of Future Titles The financial struggles of recent FPS titles have been brought about by an aggressive development cycle and issues with management decision making within Electronic Arts and respective studios. An example of such is DICE’s Battlefront 2042 which was designed as a “Battle Royale” by EA management until being pivoted very late in an already short development cycle. Complexities with the Frostbite engine has exacerbated development struggles. Pivoting to a less complex engine such as Unreal comes with added licensing costs but has proved successful with the smooth launches of Respawn’s Jedi Fallen Order and Apex Legends and 2021s It Takes Two. While these segments contribute a small portion of income relative to Ultimate Team and EA Sports, a smoother development cycle would bolster performance of future titles. Business Summary and Drivers: FIFA and Madden (EA Sports) EA holds the exclusive licensing to FIFA and NFL branded games among other sports leagues including PGA and UFC. The EA Sports segment is the largest driver of revenue and profit earning, mainly through the Ultimate Team monetization scheme for FIFA, NFL Madden, and others which allows players to unlock and build a team through RNG packs which are bought with in-game currency or real currency. These revenues are booked as live services and subject to GAAP revenue deferrals. FIFA comprises the largest segment of Ultimate Team, generating approximately $1,300m in the trailing twelve months. Exclusive licensing for FIFA expires end of 2022 with the World Cup. Negotiations for an extension have been ongoing for 2 years with no deal reached to date. The terms sought by FIFA include a $1b cash payment over the period 2023-2026 and non-exclusive licensing. If exclusivity is lost and competitor titles are launched, the viability of aggressive Ultimate Team monetization is questionable. Apex Legends (Titanfall) In 3Q18 EA acquired the producer of the acclaimed Titanfall FPS series, Respawn Entertainment. While EA receives no royalties from sales of Titanfall units per the conditions of the acquisition, Respawn developed the F2P battle royal shooter Apex Legends which is a core revenue driver as a live service title. Apex Legends is projected to generate $960m in revenue for FY22, accounting for nearly 25% of live service revenues. A mobile port of the Apex title is under development and will be undergoing early player testing. The title was slated for a 3Q22 release but no further updates have been given. Battlefield Battlefield was an early FPS genre that defined characteristics of the genre and a core IP of Electronic Arts through the acquisition of DICE Studios. Battlefield is a multiplayer FPS focusing on squad based gameplay and realistic military settings. DICE Studios is responsible for the Frostbite engine used in DICE titles and EA Sports FIFA and Madden. The engine is known for industry leading graphic capabilities but complex to use. Recent titles of the franchise include commercial success 2016 Battlefield I and weaker 2018 Battlefield V. Flagship title Battlefield 2042 launched 19 November 2021. The commercial success of the title was widely anticipated in analyst coverage with 11m unit sales forecasted for $501m net bookings for 3Q22 and $80m in annual live service revenue through FY25. Online player population numbers published by distributer Steam suggests disappointing sales performance well under analyst projections with a loss of 92% of players by end of 3Q22 and an estimated 7.3m unit sales; a 34% miss of analyst projections. The to-date decline of 97% of players severely limits possible live service revenues. Under the same assumption of 20% capture and an estimation of active player baser, quarterly DLC would generate just $0.5-3m. Under the unreasonable assumption of no repeated players or pre-sale players, turning over the entire player base each week with new purchasing customers in addition to the quoted 4.2m first week unit sales would fall short of analyst expectations by 1.2m unit sales and $33m net bookings. Since end of 3Q22 the title supported a lower player base than 2016 Battlefield I and 2018 Battlefield V. Further development of the title is required to add basic FPS features such as a scoreboard, in game voice chat, and player loadouts, in addition to producing 1 year of pre-sold DLC. Electronic Arts is reportedly considering converting the game to F2P or cutting support after the 1 year of pre-sold content similar to failed 2019 Anthem. No statements or guidance have been given since an unsuccessful software patch in mid-January. Star Wars Electronic Arts maintains the exclusive licensing for Disney Star Wars games through 2022 although no Star Wars titles are reported to launch until 3Q 24. Past titles include DICE’s Battlefront and Battlefront II FPS along with Respawn’s 2019 critically acclaimed Jedi Fallen Order. The exclusive licensing of the franchise has generated $3bn in revenues through FY21. The launch of 2017s Battlefront II was met with controversy around the aggressive implementation of monetization, largely RNG loot boxes. Initial sales were largely successful but further bookings from the titles struggled until the 3Q20 Celebration Edition which achieved 5.8m unit sales and approximately $230m in net bookings. Importantly, the title led to government scrutiny into EA , the broader industry’s use of monetization mechanics and becoming regulated in the European Union which likened the feature to gambling. Development of a third Battlefront title was turned down by EA management in late 2021 although in the last week of January 2022, EA announced three Star Wars titles in early development or concept phase led by Respawn Entertainment. Mobile Gaming Portfolio The Electronic Arts mobile gaming portfolio is comprised of F2P spinoffs of flagship titles. Mobile F2P games utilize a “free to anchor” model that relying on in game currency transactions to convert players into regular revenue after a free download. Major mobile titles include Madden Mobile, Star Wars Galaxy of Heroes, and FIFA Mobile. In FY21, the mobile segment contributed $783m in net bookings and is expected to reach $1100-1300m in bookings for FY22. Electronic Arts is developing mobile F2P titles of Apex Legends and Battlefield reportedly due for launch in calendar year although the Battlefield Mobile title may be delayed due to issues with the console/PC version. A spinoff of the Battlefield 2042 Hazard Zone mode was expected in the calendar year 2022 but the mode in the PC/Console platform commercially has been a failure. A new development cycle would be required to pivot; delaying any release. Valuation Adjustments to Revenue Drivers Three franchise adjustments to revenue drivers have been made from November 2021 analyst projections. $195m in annual bookings ($150m in 3Q22) attributed to Star Wars Battlefront II in an analyst model have been revised to reflect player numbers. The projections were based upon an average of FY21 sales however the title supported fewer than 10,000 players globally over FY22 and is unplayable on PC platforms. The title was made free over certain periods in the year, marking down the ASP. Adjustments to Battlefield 2042 unit sales and live service revenues for 3Q22 through FY24 were based on publicly available concurrent player numbers and reporting of internal decision regarding the future of the title. Player counts suggest few holiday sales and the ASP was marked down within two weeks of launch with 50% discounts. Using these figures (no change to ASP), we reach an estimate of 7.3m 3Q22 unit sales for $245m in net bookings. Live service revenues for the Battlefield 2042 title were projected as $80m annually through FY25. Based upon the performance of the title post launch and lack of EA/DICE guidance on DLC release, live service revenues have been guided down in accordance with estimates player count using the same average capture rate of 20% at a $10 ASP. A portion of this revenue was pre-sold with Ultimate Editions and will be recognized differently in GAAP and non-GAAP earnings. No adjustment to title 3Q22 DLC sales have been made. Unit sales revenues forecasted for FIFA titles past the expiration of licensing have been discounted for risk associated with losing licensing outright for FIFA titles. Further, Ultimate Team revenues have been discounted for losing development rights along with losing exclusivity which threatens viability of Ultimate team monetization. Electronic Arts is reportedly exploring launching a non-FIFA branded football title although no information has been made public. Free Cash Flow Valuation The revenue cycle of game development and deferred revenue contributes a significant difference in GAAP and non-GAAP reporting. Projected free cash flows are used for our valuation to reconcile differences of revenue recognition. Unlevered free cash flows for FY23 and FY24 less stock based compensation total $1,326m. At the current multiple of forecasted performance (20x), our enterprise value target is $26,522m. Enterprise value less net debt yield a $27,575 equity value with 281.1m shares outstanding. Our 52 week target price is $98, a downside of 25% from the current market valuation. ​ Other Risks Governmental Regulation of Microtransactions and Loot Box Mechanics EA monetization of Ultimate Team titles carry the risk of government scrutiny and regulation. The titles utilize RNG “Loot Boxes” that have been likened to gambling and removed from non EA Sports titles. Ultimate Team contributes 25% of Electronic Arts bookings but are entirely reliant on these mechanics. A British government committee is due to deliver a report in the next 6 months deciding whether these mechanics legally amount to gambling. Regulatory risks of monetization schemes have not been factored into the valuation but pose a tangible risk to the current business model. Investor Litigation for Misleading Statements Around Title Sales Guidance Electronic Arts management guidance and statements to investors regarding the development of Battlefield 2042 could result in investor litigation. This type of suit was brought during the 2013 launch of Battlefield 4 although the case was ultimately dismissed. During the 3Q21 investor call, Wilson stated the title was further along in the development cycle than previous titles and would avoid the history of game breaking bugs and lack of content from past titles. Further, during the November 2Q22 investors call, Electronic Arts maintained positive guidance for unit sales based on the open beta test of the title in October 2021. An example of such is the following from Andrew Wilson. “...the feedback from the beta was overwhelmingly positive. I think there was some conversation around some elements of the beta, which is not unnatural in a beta. And we've been able to take that feedback around those constructive elements and really implement that in the game. And I think what we had talked about with the community is, it was an earlier build of the game that we used for the beta as the team continued to work and tune and polish the final build for the game.” Two portions of this statement could be construed as materially false and basis for a similar lawsuit. Although the internal data from the open beta is not public, players publicly returned mixed reviews largely predicated Electronic Arts assuring certain features were added in more recent builds (reiterated in the investors call) such as a scoreboard along with polishing of bugs. This was largely untrue as the launch version delivered less than a month later was absent such improvements or any changes to criticized mechanics. While this is not a judgement whether legally credible, there is precedent and such a lawsuit is possible, especially within the context of CEO Andrew Wilson maintaining guidance while selling 10% of stock ownership within the same timeframe to the amount of $2.5m per SEC Form 4 filings. Disappointing sales figures well below guidance and investor ire could be a catalyst for similar attempts at legal action. Summary Electronic Arts provides a compelling short opportunity with unaccounted risks associated with a significant portion of revenues, a recently failed flagship title unaccounted in analyst expectations, and tangible regulatory and legal risks. Leap options give an investor a good risk/reward exposure to Electronic Arts stock with an asymmetric payout. Losing exclusivity to core IP over the next calendar year set up an unfavorable environment for long term performance. Catalysts Poor reception of 3Q22 Earnings and Investors Call Analyst Revisions of Live Service and Mobile Revenue Failure to Extend Exclusive Licensing for FIFA franchises Legal and Regulatory Risks of Monetization Schemes

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Electronic Arts Valuation DD

bearish

Electronic Arts (EA)

TLDR: Cash flows for an unregulated casino for underaged soccer fans need to be discounted

Short Thesis

$98 52 week Target

$2.85 non-GAAP EPS 3Q22

Description

Notable Electronic Arts properties include exclusive licensing for NFL Madden and FIFA through 2025 and 2022 respectively, Free to play (F2P) Apex Legends, the Battlefield franchise, other licensed sport IP's, and a portfolio of mobile gaming developers. Additionally EA holds exclusive development licensing to Disney Star Wars through 2022 though exclusivity will not be extended.

EA is known for introducing industry leading monetization mechanics and expanding one time sales to revenues over the life of the game through downloadable content (DLC) and in- game currencies. In recent years EA has struggled with development and commercial performance of first person shooter IPs, not limited to 2017 Battlefront II, 2018 Battlefield V, BioWare's 2019 Anthem and 2021 Battlefield 2042 along with governmental scrutiny for monetization and RNG mechanics.

Electronic Arts is headed by CEO Andrew Wilson, the former lead of EA Sports who was promoted in 2013. For FY21 EA posted $5,629m in revenues, $837m in net income and $2.9 GAAP EPS. Earnings for Electronic Arts along with other gaming/entertainment peers are reported in GAAP accordance. Non-GAAP earnings are preferred by industry analysts and management to recognize revenues of the current quarter without deferring for the length of service provided (DLC and Pre-Sales) and are used for analyst estimates. Electronic Arts fiscal years begin 1 April.

Coming off strong EA Sports performance in 2Q22, the current market valuation and analyst targets rely on an extremely optimistic projection over the next 52 weeks and have not been revised to reflect significant struggles with a much anticipated flagship title launch in 3Q22 along with risks of losing exclusivity to FIFA at the end of calendar year 2022.

Electronic Arts releases 3Q22 earnings on 1 February 2022 after market close with expectations to provide guidance on the recent Battlefield 2042 release and a possible update on FIFA licensing.

Thesis

Electronic Arts presents a compelling short opportunity over the next year with the failed launch of much anticipated title Battlefield 2042 driving an EPS miss in 3Q22 earnings, subsequent write down of live service revenue expectations and a possible loss of FIFA exclusivity end of year.

Electronic Arts is obligated to continue development of Battlefield DLC for 1 year due to pre-sale bundles or will be required to entirely refund pre-sold “Season Passes” which are expected to the amount of $30m for the next calendar year. The development cost required to improve stability and provide content exceed possible revenue generation from the existing player base, creating a negative cash flow asset.

Further, the risk of losing exclusive licensing to the FIFA franchise at end of year has not been discounted from FIFA derived cashflow projections which amount to 30% of overall bookings. Losing exclusivity to a competitor would prevent Electronic Arts from publishing FIFA games all together and extending licensing with FIFA will require paying an additional $1bn over calendar 2023-26 while simultaneously losing exclusivity. This threatens the viability of Ultimate Team monetization which have failed in titles with peer competition.

With adjustments solely regarding Battlefield 2042 bookings, discounting of FIFA bookings starting calendar 2023 and a correction of Star Wars projections, revised FY22 revenues of $5,217m and $2.85 3Q22 EPS fall short of analyst expectations of $7,189m and $3.25 EPS respectively. On the basis of projected FY23/24 FCF and current market multiple, we reach a 52 week price target of $98, a -25% downside to the current market price of ~$130.

In this case, long dated put options on Electronic Arts stock presents a unique risk/reward even if Electronic Arts is ultimately successful in these areas with asymmetric exposure and underestimation of tail risk on long dated contracts. While easy to borrow, outright shorting Electronic Arts stock is unattractive with the risk of acquisition.

Bull Case for Electronic Arts

Acquisition Value of Electronic Arts

The video game industry has experienced a number of large acquisitions over 2021 and 2022 including the recent acquisition of Activision Blizzard by Microsoft in a record breaking $68.7bn all cash deal. The industry is experiencing consolidation of game publishers under technology conglomerates, Microsoft, Sony, and Chinese publisher Tencent. Sony and Microsoft are building out exclusive titles for competing subscription gaming platforms. The recent Activision Blizzard deal was struck at a premium to market value and a similar acquisition of Electronic Arts could occur. Outright shorting shares is unattractive with this risk because of the linear profile.

Strength in EA Sports Segment and Mobile Gaming

A strong outperformance of EA Sports titles over 3Q22 could cover financial weakness in Battlefield 2042. FIFA and Madden unit sales and live revenues compose roughly 35% of total revenues. Outperformance of up to 40% in earnings over 3Q22 would cover losses seen in the FPS/Shooter segment.

Successful Release of Future Titles

The financial struggles of recent FPS titles have been brought about by an aggressive development cycle and issues with management decision making within Electronic Arts and respective studios. An example of such is DICE's Battlefront 2042 which was designed as a “Battle Royale” by EA management until being pivoted very late in an already short development cycle. Complexities with the Frostbite engine has exacerbated development struggles.

Pivoting to a less complex engine such as Unreal comes with added licensing costs but has proved successful with the smooth launches of Respawn's Jedi Fallen Order and Apex Legends and 2021s It Takes Two. While these segments contribute a small portion of income relative to Ultimate Team and EA Sports, a smoother development cycle would bolster performance of future titles.

Business Summary and Drivers:

FIFA and Madden (EA Sports)

EA holds the exclusive licensing to FIFA and NFL branded games among other sports leagues including PGA and UFC. The EA Sports segment is the largest driver of revenue and profit earning, mainly through the Ultimate Team monetization scheme for FIFA, NFL Madden, and others which allows players to unlock and build a team through RNG packs which are bought with in-game currency or real currency. These revenues are booked as live services and subject to GAAP revenue deferrals.

FIFA comprises the largest segment of Ultimate Team, generating approximately $1,300m in the trailing twelve months. Exclusive licensing for FIFA expires end of 2022 with the World Cup. Negotiations for an extension have been ongoing for 2 years with no deal reached to date. The terms sought by FIFA include a $1b cash payment over the period 2023-2026 and non-exclusive licensing. If exclusivity is lost and competitor titles are launched, the viability of aggressive Ultimate Team monetization is questionable.

Apex Legends (Titanfall)

In 3Q18 EA acquired the producer of the acclaimed Titanfall FPS series, Respawn Entertainment. While EA receives no royalties from sales of Titanfall units per the conditions of the acquisition, Respawn developed the F2P battle royal shooter Apex Legends which is a core revenue driver as a live service title. Apex Legends is projected to generate $960m in revenue for FY22, accounting for nearly 25% of live service revenues. A mobile port of the Apex title is under development and will be undergoing early player testing. The title was slated for a 3Q22 release but no further updates have been given.

Battlefield

Battlefield was an early FPS genre that defined characteristics of the genre and a core IP of Electronic Arts through the acquisition of DICE Studios. Battlefield is a multiplayer FPS focusing on squad based gameplay and realistic military settings. DICE Studios is responsible for the Frostbite engine used in DICE titles and EA Sports FIFA and Madden. The engine is known for industry leading graphic capabilities but complex to use.

Recent titles of the franchise include commercial success 2016 Battlefield I and weaker 2018 Battlefield V. Flagship title Battlefield 2042 launched 19 November 2021. The commercial success of the title was widely anticipated in analyst coverage with 11m unit sales forecasted for $501m net bookings for 3Q22 and $80m in annual live service revenue through FY25.

Online player population numbers published by distributer Steam suggests disappointing sales performance well under analyst projections with a loss of 92% of players by end of 3Q22 and an estimated 7.3m unit sales; a 34% miss of analyst projections. The to-date decline of 97% of players severely limits possible live service revenues. Under the same assumption of 20% capture and an estimation of active player baser, quarterly DLC would generate just $0.5-3m.

Under the unreasonable assumption of no repeated players or pre-sale players, turning over the entire player base each week with new purchasing customers in addition to the quoted 4.2m first week unit sales would fall short of analyst expectations by 1.2m unit sales and $33m net bookings. Since end of 3Q22 the title supported a lower player base than 2016 Battlefield I and 2018 Battlefield V.

Further development of the title is required to add basic FPS features such as a scoreboard, in game voice chat, and player loadouts, in addition to producing 1 year of pre-sold DLC. Electronic Arts is reportedly considering converting the game to F2P or cutting support after the 1 year of pre-sold content similar to failed 2019 Anthem. No statements or guidance have been given since an unsuccessful software patch in mid-January.

Star Wars

Electronic Arts maintains the exclusive licensing for Disney Star Wars games through 2022 although no Star Wars titles are reported to launch until 3Q 24. Past titles include DICE's Battlefront and Battlefront II FPS along with Respawn's 2019 critically acclaimed Jedi Fallen Order. The exclusive licensing of the franchise has generated $3bn in revenues through FY21.

The launch of 2017s Battlefront II was met with controversy around the aggressive implementation of monetization, largely RNG loot boxes. Initial sales were largely successful but further bookings from the titles struggled until the 3Q20 Celebration Edition which achieved 5.8m unit sales and approximately $230m in net bookings. Importantly, the title led to government scrutiny into EA , the broader industry's use of monetization mechanics and becoming regulated in the European Union which likened the feature to gambling.

Development of a third Battlefront title was turned down by EA management in late 2021 although in the last week of January 2022, EA announced three Star Wars titles in early development or concept phase led by Respawn Entertainment.

Mobile Gaming Portfolio

The Electronic Arts mobile gaming portfolio is comprised of F2P spinoffs of flagship titles. Mobile F2P games utilize a “free to anchor” model that relying on in game currency transactions to convert players into regular revenue after a free download. Major mobile titles include Madden Mobile, Star Wars Galaxy of Heroes, and FIFA Mobile.

In FY21, the mobile segment contributed $783m in net bookings and is expected to reach $1100-1300m in bookings for FY22.

Electronic Arts is developing mobile F2P titles of Apex Legends and Battlefield reportedly due for launch in calendar year although the Battlefield Mobile title may be delayed due to issues with the console/PC version. A spinoff of the Battlefield 2042 Hazard Zone mode was expected in the calendar year 2022 but the mode in the PC/Console platform commercially has been a failure. A new development cycle would be required to pivot; delaying any release.

Valuation

Adjustments to Revenue Drivers

Three franchise adjustments to revenue drivers have been made from November 2021 analyst projections.

$195m in annual bookings ($150m in 3Q22) attributed to Star Wars Battlefront II in an analyst model have been revised to reflect player numbers. The projections were based upon an average of FY21 sales however the title supported fewer than 10,000 players globally over FY22 and is unplayable on PC platforms. The title was made free over certain periods in the year, marking down the ASP.

Adjustments to Battlefield 2042 unit sales and live service revenues for 3Q22 through FY24 were based on publicly available concurrent player numbers and reporting of internal decision regarding the future of the title. Player counts suggest few holiday sales and the ASP was marked down within two weeks of launch with 50% discounts. Using these figures (no change to ASP), we reach an estimate of 7.3m 3Q22 unit sales for $245m in net bookings.

Live service revenues for the Battlefield 2042 title were projected as $80m annually through FY25. Based upon the performance of the title post launch and lack of EA/DICE guidance on DLC release, live service revenues have been guided down in accordance with estimates player count using the same average capture rate of 20% at a $10 ASP. A portion of this revenue was pre-sold with Ultimate Editions and will be recognized differently in GAAP and non-GAAP earnings. No adjustment to title 3Q22 DLC sales have been made.

Unit sales revenues forecasted for FIFA titles past the expiration of licensing have been discounted for risk associated with losing licensing outright for FIFA titles. Further, Ultimate Team revenues have been discounted for losing development rights along with losing exclusivity which threatens viability of Ultimate team monetization. Electronic Arts is reportedly exploring launching a non-FIFA branded football title although no information has been made public.

Free Cash Flow Valuation

The revenue cycle of game development and deferred revenue contributes a significant difference in GAAP and non-GAAP reporting. Projected free cash flows are used for our valuation to reconcile differences of revenue recognition. Unlevered free cash flows for FY23 and FY24 less stock based compensation total $1,326m. At the current multiple of forecasted performance (20x), our enterprise value target is $26,522m. Enterprise value less net debt yield a $27,575 equity value with 281.1m shares outstanding. Our 52 week target price is $98, a downside of 25% from the current market valuation.

Other Risks

Governmental Regulation of Microtransactions and Loot Box Mechanics

EA monetization of Ultimate Team titles carry the risk of government scrutiny and regulation. The titles utilize RNG “Loot Boxes” that have been likened to gambling and removed from non EA Sports titles. Ultimate Team contributes 25% of Electronic Arts bookings but are entirely reliant on these mechanics. A British government committee is due to deliver a report in the next 6 months deciding whether these mechanics legally amount to gambling.

Regulatory risks of monetization schemes have not been factored into the valuation but pose a tangible risk to the current business model.

Investor Litigation for Misleading Statements Around Title Sales Guidance

Electronic Arts management guidance and statements to investors regarding the development of Battlefield 2042 could result in investor litigation. This type of suit was brought during the 2013 launch of Battlefield 4 although the case was ultimately dismissed.

During the 3Q21 investor call, Wilson stated the title was further along in the development cycle than previous titles and would avoid the history of game breaking bugs and lack of content from past titles. Further, during the November 2Q22 investors call, Electronic Arts maintained positive guidance for unit sales based on the open beta test of the title in October 2021. An example of such is the following from Andrew Wilson.

“...the feedback from the beta was overwhelmingly positive. I think there was some conversation around some elements of the beta, which is not unnatural in a beta. And we've been able to take that feedback around those constructive elements and really implement that in the game. And I think what we had talked about with the community is, it was an earlier build of the game that we used for the beta as the team continued to work and tune and polish the final build for the game.”

Two portions of this statement could be construed as materially false and basis for a similar lawsuit. Although the internal data from the open beta is not public, players publicly returned mixed reviews largely predicated Electronic Arts assuring certain features were added in more recent builds (reiterated in the investors call) such as a scoreboard along with polishing of bugs. This was largely untrue as the launch version delivered less than a month later was absent such improvements or any changes to criticized mechanics.

While this is not a judgement whether legally credible, there is precedent and such a lawsuit is possible, especially within the context of CEO Andrew Wilson maintaining guidance while selling 10% of stock ownership within the same timeframe to the amount of $2.5m per SEC Form 4 filings. Disappointing sales figures well below guidance and investor ire could be a catalyst for similar attempts at legal action.

Summary

Electronic Arts provides a compelling short opportunity with unaccounted risks associated with a significant portion of revenues, a recently failed flagship title unaccounted in analyst expectations, and tangible regulatory and legal risks. Leap options give an investor a good risk/reward exposure to Electronic Arts stock with an asymmetric payout. Losing exclusivity to core IP over the next calendar year set up an unfavorable environment for long term performance.

Catalysts

Poor reception of 3Q22 Earnings and Investors Call

Analyst Revisions of Live Service and Mobile Revenue

Failure to Extend Exclusive Licensing for FIFA franchises

Legal and Regulatory Risks of Monetization Schemes

read-time
11 min
98.00
Target Price
8/ 10
Confidence
1-3 Years
Timeframe
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Earnings Release
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News
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SEC
Filing
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