Is the video game console dead? Perhaps Electronic Arts Inc. (NASDAQ:EA) may no longer have the long-term potential with its hard-core video game franchising. Despite the weak performance, I’m a little more optimistic than the rest of the street. Let’s uncover this opportunity?
In the first quarter of 2013 Electronic Arts Inc. (NASDAQ:EA) reported a decline in revenue. The company’s revenue declined from $1.368 billion in 2012 to $1.209 billion in 2013. The decline in revenue was driven by the falling demand in anticipation of the console refresh cycle. In classical economic theory, demand for a product goes down in anticipation of future price declines. It has been historically proven that when a console is refreshed with a better version, the older-generation console experiences a significant decline in value. In anticipation of that, it is likely that consumers are saving up to upgrade or are avoiding the purchase of video games in order to buy video games for the PlayStation 4 or Xbox 720.
The company’s decline in revenue wasn’t that terrible of news as the company was able to report strength in its gross profit margin. The gross margin improved from 72.7% to 74.4% and was driven by digital downloads.
The digital media division is projected to report an increase in its revenue. Electronic Arts Inc. (NASDAQ:EA) anticipated $1.7 billion in sales for 2014 (guidance) from digital downloads. The company’s growth in downloads from fiscal year 2012 to 2013 from $1.227 billion to $1.663 billion is what led to the significant increase in its gross margin year-over-year. The improving bottom-line performance is the primary reason for the sudden upwards surge in the valuation of the stock. The company may experience further improvement in gross margin as the next generation of consoles will be switching to a download-only format for purchasing digital content.
Guidance
Guidance was strong; the primary catalyst in the stock price was the operating cash flow improvement. The company anticipates that cash flows will improve to $400 million in fiscal year 2014 from $324 million in fiscal year 2013 (remember the fiscal year 2013 ended on Mar. 31). The company projects its cash flow to grow 23.45% over the next fiscal year. This was what led to the 29.4% rally in the value of the stock. Some of the valuation premium is also attributable to the console refresh cycle along with Electronic Arts Inc. (NASDAQ:EA)’s attempt at growing its market presence in the mobile space.
Landscape is changing
Sony Corporation (ADR) (NYSE:SNE) is expecting sales and operating income to grow by 10.3% during fiscal year 2013. Some of this is driven by the launch of the PlayStation 4 console. Sony Corporation (ADR) (NYSE:SNE) anticipates the demand for its PlayStation 3 to decline from 16.5 million units in 2012 to 10 million units in 2013. This is all in anticipation of the PlayStation 4 launch, which will bring about a significant decrease in the demand for PlayStation 3 consoles.
PlayStation 4 will result in an increase, in digital downloads. This will improve the overall profitability of video game developers that sell content in the packaged format.
GameStop Corp. (NYSE:GME) could be a bigger loser. GameStop Corp. (NYSE:GME) believes that it can potentially compete in the market place even after the transfer to digital content. The problem with digital is that it no longer requires the physical presence of specialized brick and mortar retailers like GameStop Corp. (NYSE:GME). GameStop Corp. (NYSE:GME)’s response to digital media content is the development of a power-up reward program that encourages video gamers to buy digital content through its network of services. The loyalty program, while good, cannot overcome the convenience of buying content directly to a PlayStation 4 or Xbox 720.
Console sales alone are not enough to cover the costs of operating a brick and mortar shop like GameStop Corp. (NYSE:GME). GameStop Corp. (NYSE:GME)’s growth has slowed, with revenue at $9.473 billion in 2011 to $9.55 billion, in 2012. GameStop grew its revenue by 1% year-over-year in the previous fiscal year, implying that the underlying business is becoming a legacy business model (decelerating growth).
Take a closer look at the digital media business and you see that digital media only represents $453 million in revenue compared to the company’s total revenue of $9.55 billion. The company’s revenues are primarily composed of selling video games and consoles within its brick and mortar locations. The digital media division doesn’t contribute enough to the company’s performance, leaving me underwhelmed about the future growth of GameStop.
Let’s not forget that Sony Corporation (ADR) (NYSE:SNE) anticipates console sales of the PlayStation 3 to decline from 10 million units to 5 million units. Assuming a 50% decline in demand for packaged video game content over time and you can say that the brick and mortar business model of GameStop is more or less done. GameStop will rapidly shore up its business by cutting costs. GameStop’s cost cutting will result in a rapid reduction, in the number of stores. This will at least protect the shareholders from any unnecessary loss of equity.
Conclusion
The console wars are heating up again. Electronic Arts Inc. (NASDAQ:EA) should experience added gains in its margins due to the adoption of purely digital content downloads. The same trend will negatively impact GameStop. That being the case I am optimistic of Electronic Arts Inc. (NASDAQ:EA) and its future as the company provided strong guidance despite the console refresh.
The article Electronic Arts’ Gross Margin Improves at the Expense of GameStop originally appeared on Fool.com and is written by Alexander Cho.
Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.
