Can Electronic Arts Keep on Clicking?


By Jane Black

What a kickoff! On Sept. 2, video-game publisher Electronic Arts (ERTS) announced that the latest version of Madden NFL had sold more than 2 million units in its first three weeks and that nearly 1 million copies NCAA Football 2004 were snapped up. Specialty-game retailers Electronic Boutique Holdings (ELBO) and GameStop (GME) proclaimed Madden their fastest-selling title ever, surpassing even last year's top title, TakeTwo's (TTWO) Grand Theft Auto: Vice City.

Investors rewarded Redwood City (Calif.)-based Electronic Arts (EA) by sending its stock to an all-time high of $91.12. But they were cheering EA long before the Madden launch. Over the last six months, its shares have skyrocketed 72% in anticipation of another winning Christmas season (see BW Online, 3/21/03, "EA Gets Its Game On"). Top-selling names, including the latest installments of games based on Harry Potter, James Bond, Nightfire, and The Lord of the Rings, are all expected to have another bang-up year. In the December quarter, analysts expect EA to rack up $1.4 billion in sales and $487 million in operating income. That's just shy of the $537 million in profits that EA earned in its entire fiscal 2003.

However, even its biggest fans are quietly beginning to wonder whether EA shares can keep up the astonishing pace. The industry's three-year, 19% compound annual growth is already priced into the stock, says Michael Pachter, an analyst at Wedbush Morgan Securities, who recently downgraded EA from buy to hold. At a premium multiple of 25 times forward earnings -- EA's competitors trade from 10 times to 20 times earnings -- the shares are worth $93, giving the stock only a 2.4% upside. No doubt EA is a good stock to own, but investors seeking a repeat of its recent returns might be better off with smaller game makers, such as Activision (ATVI) and TakeTwo, whose shares likely have not yet peaked.

INSIDER SALES. Certainly, EA is probably far less risky than any other video-game publisher. Over the last decade, it has developed and perfected a strategy for delivering hits. This is key because, like Hollywood and the Big Five music labels, video-game publishers have high fixed costs. They rely on best-sellers to deliver profits to investors and generate the cash needed to develop new games.

Thanks to its success with sports and high-profile franchises such as James Bond, EA is better positioned than smaller publishers, which tend to rely on single smash hits to make their numbers. "EA has so many good franchises that no one will make them or break them," says David Farina, an analyst at Chicago-based investment firm William Blair & Co. In fiscal 2003, 22 different EA titles sold more than 1 million units each.

About 80% of EA's revenue comes from existing franchises. And this year is expected to be no different. Besides Madden and NCAA Football, EA will roll out the third title in The Lord of The Rings trilogy and a new James Bond, called Everything or Nothing. Last year, each title sold around 3 million copies. Tiger Woods PGA Tour 2004, FIFA Soccer 2004, and NBA Live 2004 also are expected to see record sales. "It's hard to find another company that's performing better," says Edward Williams, a game analyst at Harris Nesbitt Gerard. "EA is the premier content company in the world."

On the investing front, there's one possible cause for concern: A string of insider stock sales. According to Securities & Exchange Commission documents filed Sept. 2, John Riccitiello, EA's president, dumped 43,200 shares for a net profit of $2.6 million, while Executive Vice-President Bruce McMillan sold 15,000 shares, earning $896,035. The sales came less than a week after CEO Larry Probst unloaded 24,600 shares for a profit of $1.9 million. It was Probst's eighth sale since May 27. All told, Probst's stock sales have reaped him nearly $17 million in profits.

LOTS OF OPTIONS. EA says the stock sales are routine. Probst has been with EA for 19 years and must sell stock according to vesting schedules. But at least one analyst, Wedbush's Pachter, sees a disturbing pattern emerging. Each year for the last three years, EA has issued an increasing number of stock options. In 2001, it granted 5.9 million options. In 2002, it distributed 6.3 million. In 2003, 6.9 million.

Huge options grants run the risk of diluting the stock, but they also raise questions about corporate excess: "Executives are giving themselves an increasing number of options and exercising at a record pace. That means one of two things: Either they think it's fully valued, or they believe that there's more coming to them," says Pachter. "Either way, you have to worry."

Still, EA's performance certainly merits some reward for execs. For its fiscal year 2004, which ends next March, analysts expect a revenue jump of 19.7%, to $2.97 billion, and operating profits of $768.2 million, a 43% rise over a year ago. But EA's 72% stock run-up raises a red flag about whether the shares will continue to soar. Risk-loving investors might prefer other game stocks -- ones that could deliver more bang for the invested buck. Black writes for BusinessWeek Online in New York


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