What Lies Ahead for EA Sports and the Video Game Publishers?

Every fall EA Sports (NASDAQ: EA) releases its latest game in the Madden series and the other video game developers prepare for the holiday season.  These stocks have all outperformed the market this year.

Both Take-Two Interactive (NASDAQ: TTWO) and Activision Blizzard (NASDAQ: ATVI) are up 32% year-to-date while EA Sports is up over 60%.  The stocks have all done well behind higher than expected console sales, but which if any of these stocks is the best way to play the current console cycle and for the long-term.

Console Sales Exceed Initial Forecasts

The new console cycles for Sony’s PlayStation4 and Microsoft’s (NASDAQ: MSFT) Xbox One have exceeded expectations and acted as the key positive catalyst for the video game sector.  Sony’s PS4 especially has beat expectorations.  Console sales have far outpaced previous new introductions, and the timing of the peak of the cycle is still uncertain.  So far these two consoles have outpaced the initial sales of their predecessors, the Xbox 360 and PS3, by 80% according to data from NPD Group.  The Sony PS4 global sales exceed 10 million while the Xbox One currently exceed 5 million.

If console sales continue to surpass forecasts, and the installed base increases, it is positive for video game manufacturers and the stocks.   Along these lines, Microsoft has announced it will start selling Xbox One in a total of 41 markets this September.  Currently it is sold in just 13 markets compared to Sony’s PS4 sold in 72.

It is noteworthy that an unexpected slowdown in sales would be a negative.  This would not be without precedent with the Wii U as the most recent example.

EA Sports has been the best performer YTD

Initial reviews of the new Madden NFL 15 game are positive and better than those for the previous version of Madden.  The graphics improved again and increased attention was paid to defense, which has been received will by players of Madden.  Based on online commentary and reviews, sales of the Madden should outperform those of last year.

In addition to Madden, the upcoming release of NHL 15, FIFA 15, and Dragon Age: Inquisition are keys to sales in 2H14.  Also, 2015 will bring the release of Star Wars: Battlefront, and Battlefield: Hardline.  The release date was delayed for Star Wars in July and further delays are downside risks for the stock.  Battlefield: Hardline, the latest update to the successful series, was originally slated for a fall 2014 launch but delays pushed it back to early 2015.  Further delays here also represent a potential negative for the stock.

Digital Transition is Key to the Long-term Story

EA Sports has successfully positioned its online/digital business to offset declining sales of packaged games.  Just like print media, consumers are increasingly looking to buy their content digitally.   Digital revenues have accounted for 46% of sales in 2014 compared to 23% in 2011.   EA Sports has established a direct to consumer platform that provides some advantages.

First, it decreases the cost of its game to consumers, this can increase sales volumes.  Also, margins are higher for EA on digital content, and over long-term could result in 30% margins versus the 21.5% currently.   Digital also removes used game stores from the equation, and their impact on sales of games will soften.  It is noteworthy, that the shift to digital is a looming threat to that business model.  Stores like Gamestop (NYSE: GME) could see significant sales pressure or even end up like Blockbuster video if current trends continue.

In digital, the company announced EA Access for Xbox One.  This is a subscription service that will provide digital access to its older games at a flat rate.  This program allows the company to realize additional revenues where it historically could not.  This will also weigh on the used game retailers.   In addition, the margins on the product should be very high since the games are already developed, and the variable cost is likely low.   Subscribers also get a 10% discount on new digital purchases, another way to push consumers to digital.  Currently it is not available for Sony PS4, and Sony has explicitly banned its use.

EA Sports is near-higher, but the valuation is not unreasonable

The Madden news and other positive data points around its strong product pipeline all could be a near-term catalyst.  The shift to digital can improve margins in a big way over the long-term as well.  The valuation is not cheap and the stock is currently trading near 52 week highs.  That said, it trades at 19.8x and 16.6x FY15 and FY16 earnings (March year-end), relatively. For a stock with a forecast for 20% earnings growth, it is not expensive.  In addition, there is earnings upside given the higher than expected console sales, healthy product pipeline, and improving margins.

In our next piece, we will take a look at Take-Two Interactive and Activision Blizzard.