1/12/2010
By Brian Sozzi, Research Analyst

The troubles for Electronic Arts Inc. (ERTS) did not correct themselves in the holiday quarter as was painfully evident in an earnings warning January 11.  In short, the company lacked the big name content to entice nervous nelly retailers to place robust initial orders.  Additionally, sell through was soft for the products that did find their way to the shelves as consumers were tight-fisted on holiday purchases, meaning retailers had no impetus to reorder what Electronic Arts had in its stock room.  It was a disappointing quarter, nonetheless, though one that lacks an uber surprise component as we have watched Electronic Arts struggle mightily the last two years amid updates to tired franchises, changing dynamics in how gamers ingest content, and retailers adopting a more disciplined approach to building software inventory.

Citing industry and company-specific weaknesses, Electronic Arts' management outlined 3Q10 non-GAAP net revenue of $1.33-$1.35 billion and EPS on this same basis of $0.29-$0.33.  FY10 net revenue guidance is now $4.12-$4.20 billion non-GAAP and $0.40-$0.55 P/S, implying 4Q10 revenue in the range of $832.0-$887.0 million and $0.07-$0.18 P/S.  The ranges for 4Q10 appear conservative as Electronic Arts will have Mass Effect 2, Army of Two: 40th Day, and Dante's Inferno in the marketplace.  However, in light of Electronic Arts' frequent missteps, market conditions, and competitive slate of titles by other publishers in the first calendar quarter we are guarded in our financial assumptions.

That said, the current console cycle that began in 2005 with the arrival of Microsoft's (MSFT) Xbox 360 has been a severe letdown for third-party game publishers.  Electronic Arts is well along in its restructuring process yet continues to fall victim to marketplace evolution, first and foremost.  While acknowledging the troubles inflicting the company are fundamental in nature and raise the risk to forward earnings, it's our view that FY11 (begins in April) will mark one of significant change for the good at Electronic Arts.

The company's title release schedule is chock full of margin favorable internally developed games that will be comparing to outsized growth in low margin distribution sales in FY10.  Moreover, the addition of Playfish to the digital segment will help to counteract the weakness in packaged goods sales if they indeed arise to a strong degree.  Importantly, though, the titles on the horizon pack the punch needed to gain share in a crowded marketplace.  At present valuation, we believe the stock has discounted a fair amount of the risk and zero of the upside potential that exists in the form of pro margin new releases, among other factors.

Key FY11 Title Releases

Medal of Honor
* Comments: Title will wage a war with Activision Blizzard's (ATVI) Call of Duty franchise.  Early buzz suggests the title is a worthy contender.

FIFA World Cup
* Comments: Already a share leader, game could receive a unit sales boost from the FIFA World Cup tournament that starts in June of this year.

Madden NFL ‘11
* Comments:  The company recently signed a former Midway Games executive to the Madden development team, the same executive who designed arcade type sports titles.  Look for the popular football franchise, under pressure in recent years from gamer fatigue on the title and many being turned off by the steep learning curve, to get a mass market friendly makeover.

EA Sports MMA:
* Comments: Title will rival THQ Inc.'s (THQI) runaway 2009 hit UFC Undisputed.  A number of high profile MMA fighters have been signed to appear in the title, and my sense is the gameplay will be more technical and graphic than THQ's version.

Star Wars: The Old Republic
* Comments: There is still uncertainty as to whether this potential online juggernaut title will be released in FY11, but if it is, be worried World of Warcraft.

Brian Sozzi
Wall Street Strategies