Electronic Arts’ fall from grace has been a slow motion train wreck that has been going on for almost 5 years. After reaching an all-time high of $71.16 on March 9, 2005, shares have collapsed to the current level of $16.39. The company’s operations have not been profitable in their last three fiscal years, having lost $2.08/share in their most recent fiscal year ended March, 31, 2010 (source EA Annual Report pg. 145). Shares have fallen 77% from their all-time high in 2005, but this does not necessarily make the stock cheap. So why on earth did PMC recommend buying shares of ERTS in our June 23 Game Trader article?
Wall Street hates this stock, with very few buy recommendations and a smattering of hold/neutral ratings. Any kind of good news could lead to a slew of upgrades, even if they are just from sell to hold. Standard & Poor’s recently rated them 1 star with a 12-month price target of $14.00. ERTS shares recently hit a 5-year low of $14.06 on July 1, 2010. Now there are technical and fundamental reasons for the recent 16.6% rally off of that July 1st low.
The daily ERTS chart had a DOJI candlestick pattern right at the end of a brutal downtrend that began on April 27, 2010 at the recent highs for the stock market. This also occurred at the lower Bollinger Band and at oversold Money Flow, Stochastic and RSI levels. It was a perfect confluence of technicals for the rally. The weekly ERTS chart also had two DOJI after a long downtrend followed by a bullish engulfing candle. The weekly chart’s Money Flow and Stochastic were also reading oversold.
From a fundamental standpoint, this stock is selling at very reasonable valuations. Trading at a price to book value around 1.9 is not out of the question for a company with such a vast catalog of intellectual property. The company also has a $2 billion cash account with no long term debt. Their market capitalization is only $5.2 billion, and we are hard pressed to find a better balance sheet in any industry. The company does spend quite a bit on research and development as well as other investments, but they do so with the focus on growth. In our recommendation last month, we cited earnings growth as a major risk to our call. Expectations remain low, but consensus estimates show 45% growth from fiscal 2010 to 2011 and 34% growth from fiscal 2011 to 2012 in earnings per share. This is not that bad considering the stock is trading at 25 times fiscal 2011 and 18.5 times fiscal 2012 earnings estimates. If the bearish analyst community turns slightly more optimistic, there is a chance that we could see some multiple expansion as they ratchet up their earnings expectations.
On April 2, 2007, John Riccitiello rejoined EA as CEO with a difficult task ahead. Lucky for him, the entire financial services industry was entering its worst collapse since the great depression. EA was not too big to fail, and earnings entered a nose dive with the rest of the economy. The share price has dropped 68% since the day he took over as CEO. These are the facts, and we are sure that this was not his plan. Electronic Arts is a very large company and it would take anyone a while to change its culture and direction.
PMC loves a good turn around story. Riccitiello and the rest of management seems to be really focused on what made EA successful to begin with. An anonymous source in the industry told us that independent developers are more inclined to work with Riccitiello than other more brash CEOs. This was apparent at E3 when the company announced that they will be distributing some great new games from Crytek, Insomniac, Valve, Respawn, Epic and Harmonix. The addition of Vince Zampella and Jason West from Infinity Ward adds to the deep bench of great developers working with Electronic Arts.
EA also has a war chest of intellectual property that they are dumping into mobile gaming. This will allow them to recycle old IP on new platforms at low costs. Just check out the top 10 grossing games on iPhone and iPad on any given day and you will see a few EA titles up there. Last November, EA jumped into the social gaming industry with two feet when they bought Playfish for $300 million with a $100 million earnout. There is no doubt that EA sees secular growth in both mobile and social gaming and this deal is hopefully just the beginning of a wave of consolidation in the industry.
Electronic Arts has a mountain of cash, but it is not out of the question for a larger cash-rich media or gaming company to swallow them up. We do not think this is likely. Even after being eviscerated in the capital markets, the company is still in a position of strength as the industry as a whole has been pulled down. They will also benefit from easy year-over-year comparisons going forward. Low expectations, their return to profitability and earnings growth over the next few years leads us to reiterate that ERTS is a buy. The stock has had a big relief rally off of its lows, and they report earnings after the market closes on August, 3. If they disappoint and the stock gets slammed, there could be a buying opportunity somewhere around $15-15.50. ERTS has rallied 7.2% since our buy recommendation on June 23, 2010. We continue to think this is a great long term investment and would recommend buying on any weakness.
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Investors should do their own research or consult their advisor before acting on this information. Panoptic Management Consultants, Inc. is a Registered Investment Advisor that was founded in 2008. Please go to our website www.panopticinvesting.com for more information about fundamental investing as well as technical analysis. For prospective client inquiries please contact us at panopticmc@gmail.com
Full Disclosure:
At the time of this article our CEO, Asif A. Khan, CPA, his family members and/or Virtue LLC had the following positions:
Long Electronic Arts
At the time of this article, clients of Panoptic Management Consultants Inc. had the following positions:
Long Electronic Arts
