Electronic Arts Pushing Digital

The gaming industry is going through a turmoil: demand is there, but margins seem to be disappearing. Higher sales are driven by price cuts, and profitability is an issue. The industry is looking for a new idea or a game console that will shake up the gaming world. Sony seems to be planning to release such a console in 2010. In a recent interview, Shuhei Yoshida, president of Sony Worldwide Studios, said that we’ll see some new ideas coming out of Sony Japan in 2010 and indicated that a console could be launched next year. This could have a positive impact for the industry and invigorate the gaming companies. As for now, the gorillas of the gaming world are barely surviving.

Electronic Arts Inc. (NASDAQ: ERTS) announced its Q210 financial results on November 9. Non-GAAP net revenue for Q210 was $1.147 billion, up 2% compared to $1.126 billion in Q209.  Sales were driven by the launches of FIFA 10, Madden NFL 10, The Beatles Rock Band, Need for Speed SHIFT, and NCAA Football 10. Non-GAAP net income was $19 million, compared to a non-GAAP net loss of $20 million in Q209. Non-GAAP EPS in Q210 was $0.06 compared to a loss per share of $0.06 inQ209.

EA was the #1 publisher in both North America and Europe for the fiscal year to date, with a 21% segment share of those two markets combined, up four percentage points from last year. EA had four of the top ten games on both continents, and it is the #1 publisher of games on the iPhone, also with four of the top ten games, including The Sims 3, Need for Speed Undercover, Madden NFL 10, and Tiger Woods PGA Tour. The company has signed five new advertising partners, Johnson & Johnson, Doritos, Apple, Pfizer, and Renault for a total of $7 million in incremental advertising bookings. In-game advertising will bring in additional revenues as the company tries to transform itself from being packaged-goods dependent to being a leading player on the digital direct side of the industry.

The company has taken tough decisions related to cost cutting in targeted areas, and the exercise will result in the closure of several facilities and the elimination of 1,500 positions. The restructuring is expected to be mostly completed by March 31, 2010, and management says it should result in annual cost savings of at least $100 million and restructuring charges of $130 million to $150 million. The company is also narrowing its product portfolio and plans to invest more in higher margin games.

Management believes that the recent price reductions are driving higher console sales, but the improvement is not enough to get the industry back to flat software sales for the calendar year. Calendar year-to-date, packaged good software sales are down 12% in North America and 13% in Europe. Though packaged sales have been down due to the recession, the digital side of the business has been doing well.

There were rumors that EA would be taken over by Microsoft, but in September Microsoft’s management categorically denied these rumors, saying that it has no plans to acquire the company. Is Microsoft having to rethink, or does it want the stock to cool down before it makes a formal offer or does the software company want EA to make progress on the cost-cutting steps described above before it makes a bid? Right now there is no way to know.

In October 2009, EA signed a deal with IDW Publishing to expand Army of Two and Dragon Age into comics under a new EA Comics imprint, with IDW beginning in January 2010. EA and IDW will launch monthly, ongoing series for both comics. Print versions will be available nationally at comic book outlets, while the digital versions will be released for iPhone and iPod Touch and other emerging digital platforms. I think this is a good way of monetizing the intellectual property that the company owns. It may be coming a bit late in the day, but it has come.

EA estimates that the interactive gaming industry will be worth $44 billion by 2010. Of this, online gaming is expected to be $17 billion and mobile phone gaming is estimated at $3 billion. Packaged goods is expected to make up the rest. EA realizes that the future is in the digital space. Online gaming, mobile phone gaming are picking up and the company plans to focus on them. To take advantage of the rapid growth in the digital gaming arena, the company has formed focused operating groups to accelerate digital business growth, which was apparent in the recent results: Digital non-GAAP net revenue in Q210 was $138 million, up 23% Y-o-Y. EA Mobile, the company’s publisher of games for phones, delivered $50 million of non-GAAP net revenue in Q210, up 9% Y-o-Y. In the Q2 conference call, management did not give any names but made it clear that it will look at M&A in the digital side of the business to establish itself as a leading player in this space.

In fact, EA has already made a significant investment in digital gaming when n early November 2009, it acquired Playfish, a creator of social network games, for approximately $275 million in cash and $25 million in equity retention arrangements. The sellers are entitled to up to an additional $100 million in consideration upon the achievement of certain performance milestones. Playfish is the number 2 position in Facebook apps and has built a reputation for making the best games among competitors in the social gamingspace. Playfish will operate within EA Interactive, a division of the company. The acquisition accelerates EA’s growth in social entertainment by giving it immediate access to some of the top games in the social media space, significant market share and a sharper focus on the transition to digital and social gaming.

EA launched a VISA-branded EA SPORTS prepaid debit card that will allow loyal gamers to buy their favorite EA SPORTS titles and save on them.

The company also launched “Foto Face: The Face Stealer Strikes,” a new Nintendo DSiWare title that gives players the ability to put themselves into the game and sends them on a wild, adventurous quest to reclaim their own stolen identity. This I feel is a good approach to increase the involvement of the gamers and provide them with an unique experience. EA seems to be pushing the boundaries here and drawing deep into its creative resources. We need to see how much of it the company is able to monetize and expand this creativity to other projects, but it is clearly a sign of good things to come.

EA expects FY2010 Non-GAAP net revenue to be approximately $4.2 billion to $4.4 billion. Non-GAAP diluted EPS is expected to be between $0.70 and $1.00. EA expects to be profitable in both Q3 and Q4. EA may be profitable in the next two quarters, but to really make the stock move it has to do much more than just cut costs: It has to aggressively deliver on the social gaming and the online gaming fronts. The company seems to be getting its act together, but it will take a few more quarters before the effect of the cost cutting, the Playfish acquisition, and other initiatives on the digital front start reflecting [having an impact? MB – yes – SB] on the financials of the company.

With digital revenues expected to rise faster than the packaged goods the future is digital gaming. Different types of online games including MMORPGs (Massively Multi-player Online Role Playing Games), social gaming, smart phone gaming will be the future and what remains to be seen is whom EA acquires and when. Will it be another social gaming company next quarter or will it be an iPhone application this time? Let’s wait and watch.

The stock is trading at $16.36 with a market cap of $5.32 billion. It hit a 52-week high of $23.76 on June 1.