EA Management 'Lacks Transparency,' says Pachter

Electronic Arts yesterday posted results for a disappointing second quarter, which not only included a nearly $400 million loss but also the harsh news that the company is axing 1,500 employees and is canceling numerous projects while refocusing on core IP. Former EA employees need not be reminded that this is now the second major "cost reduction plan" at the company. The question has to be asked: is EA on the right path?

That's a difficult question to answer, but clearly the results aren't where EA needs them to be and investors are antsy, and management is starting to come under fire. 

"The reality is that EA remains a company in transition. As it tries to figure out how to right-size itself and execute, the timing and the form of the transition to digital are still unclear. Strategically, EA is clearly focused on digital as the key driver of the future; however, management needs to prove that it can execute against plan and most importantly, transform its margin structure," noted Broadpoint AmTech analyst Ben Schachter. "It is still too early to give this management team the benefit of the doubt around execution, but for the first time in quite a while we think they may be at least heading in the right direction."

Michael Pachter of Wedbush Morgan Securities also fired some shots at EA's management. "It is easy to understand why investors have not embraced this stock. After last year’s earnings debacle, management claimed to be focused on cutting cost, eliminating unprofitable games, and improving game quality. ... However, after claiming to recognize the problems it faced with unproductive investment, it appears that there are still potentially unprofitable games in the pipeline. The elimination of 900 R&D positions makes clear that the company intends to terminate the development of several games (management mentioned 'more than a dozen'). However, today’s action raises the question as to why the company’s management didn’t recognize the low revenue and profit potential of these games when it conducted its last deep soul searching in early 2009," Pachter commented.

He continued, "It is also difficult for us to explain to investors that they should have confidence in a management team that is so lacking in transparency. When asked about which games were being eliminated, the cavalier answer came back that the dozen or so games that were cancelled were games 'we hadn’t yet told you about.' One of the recurring complaints we have heard about Electronic Arts management is that they are dreamers rather than visionaries, and that they see profits in places that others don’t. If the company had a stellar track record in discovering heretofore undiscovered gems, its lack of transparency might be more palatable. As it stands, the company has provided very little transparency, continuing to lump disparate categories of revenue together and calling them 'digital.' It is hard for us (and for investors) to see how iPhone game revenues are related to Battlefield 1943 Xbox Live download revenues, and how either is related to Pogo.com subscription revenues or to Warhammer Age of Reckoning MMO subscription revenues. The company seems immensely pleased that it generated $138 million in revenue from these disparate sources during the quarter, and is confidently focused on growing these revenues by adding even more disparate lines of business."

Part of the aforementioned transition is clearly EA's big focus on digital and social gaming. The purchase of Playfish underscores EA's new direction. But even that's an area that's not 100% proven. EA is spending an awful lot on Playfish (potentially up to $400 million) and Pachter wonders if it's the best move for the company. "Today’s acquisition of PlayFish for $300 – 400 million has the potential to further confuse. It is not clear that the social games opportunity is immediate, and that buying is preferable to building," Pachter said. "We estimate that the entire social games space represents an annual revenue opportunity of $600 million – 1 billion, and that PlayFish, with its 16 million unique visitors, generates around $75 million annually. Industry leader Zynga likely generates revenues of around $200 million, largely through an entrenched user base on the Facebook network. It seems to us that EA would have had equal success in building its own social games, and in paying Facebook for slotting of its games in a preferable position to Zynga and PlayFish. However, the company chose to buy a private entity that is two years old, rather than building up its own presence."

He added, "We may be wrong about the digital opportunity, and may be particularly wrong about social gaming. We think that there are many opportunities (particularly in the MMO space), and think that EA’s leadership in any of the segments of the market could pay huge dividends in the future. For example, we’re not proposing that EA dump its mobile efforts, now that they have the size and scale to drive operating leverage going forward. However, we think that the company’s reputation for being dreamers rather than visionaries is reinforced with each acquisition in an unfamiliar area, and its reticence to provide greater transparency is an obstacle to gaining the trust and confidence of its investors."

Ultimately, it's not just EA that's in transition. The entire industry is grappling with the ever increasing presence of digital downloads, casual games, social games and the "freemium" phenomenon. Although we think EA probably overpaid for Playfish, we applaud the company for at least taking bold action in a relatively new space rather than standing still. The company could choose to be more conservative, double down and focus on the traditional console business, but risk becoming a dinosaur in a business model that's quickly proving to be at death's door.