The sudden departure of Electronic Arts Inc. (NASDAQ:EA) CEO John Riccitiello occasioned Motley Fool’s own Rick Munarriz to offer the observation that EA’s problems were endemic to the video game industry as a whole. True, Electronic Arts has suffered along with the rest of the industry, but a closer comparison with EA’s principal rival Activision Blizzard, Inc. (NASDAQ:ATVI) reveals that EA’s essential problem is both simpler and less tractable: profitability.
Although both companies were impacted by the recession, both continued to post fairly robust revenues throughout. Activision Blizzard, Inc. (NASDAQ:ATVI) operating income was briefly impacted, but soon recovered, and its revenue has continued to grow. Electronic Arts Inc. (NASDAQ:EA) had already posted an operating loss for fiscal 2008, even before the recession began, and the losses continued almost unabated even as the economy began to recover in 2010-11. Unlike AB, EA’s revenues haven’t grown substantially over the past five years, but neither have they shrunk substantially. In the chart below, I plot annual revenue and operating income for both EA and AB.
A difference of perception
In searching for an answer to the question of Electronic Arts Inc. (NASDAQ:EA)’s relatively lower profitability, I sifted through many possible explanations, not the least of which have to do with consumer perceptions of the quality of EA products and of EA itself.
To assess consumer perceptions of product quality, I tabulated metacritic.com review data of key game franchises for both companies. For EA I used review data for Dragon Age, Mass Effect, Harry Potter, Madden, FIFA, and the Sims. For AB I used data for World of Warcraft, Star Craft, Guitar Hero, Transformers, Tony Hawk, and Call of Duty. I averaged the ratings over all the games for each succeeding sequel.
The lack of significant difference between the companies, especially for sequels, suggests that EA’s products are not viewed in general as being significantly better or worse than its competitor. EA’s image as a company is a different matter, judging by the vote by users of consumerist.com of Electronic Arts Inc. (NASDAQ:EA) as the “Worst Company of 2012.” How does a company whose products are well received manage to become so reviled? By doing dumb things that needlessly antagonize its customers.
EA has often fumbled badly in Public Relations, as when purchasers of Mass Effect 3 needed to make an immediate additional $10 purchase for a DLC (down loadable content) that most players felt should have been included in the original game. The launch of Sim City Online is just the most recent example of a PR headache, as users found themselves locked out of EA’s servers and unable to play the game they had bought. EA attributed this to server overload, and apologized profusely, even offering a free game as recompense.
Although the effect may be difficult to quantify, customer perceptions of EA may have a direct impact on EA’s bottom line by forcing EA to spend more for Marketing and Sales than its competitor AB. In the chart below, I compare Marketing and Sales cost as a percentage of total revenue.
Both in percentage of revenue, and in absolute terms, EA has spent much more than AB to market games that consumers give comparable ratings to.
A difference of technology
In 2008 Electronic Arts Inc. (NASDAQ:EA)’s rival AB was the undisputed master of the MMORPG (massively multiplayer online role playing game, MMO for short) through products such as World of Warcraft (WOW) and multiplayer versions of Call of Duty, and taking in a cool billion dollars a year in monthly subscription revenue. From a technical standpoint, MMOs represent the most sophisticated form of cloud computing that has ever been devised, in which participants from all over the globe can interact with each other and the game in a virtual world.
In order to achieve the high resolution graphics of today’s MMOs, the game developer manages a delicate balancing act between server-side and client-side (PC) processing that aims to minimize data flow while giving the player responsive control.
Keeping all the players entertained in a virtual world that behaves properly without constant system crashes isn’t easy, and in 2008, Electronic Arts Inc. (NASDAQ:EA) had not yet mastered that art, although it wanted very badly to do so. So it invested heavily in R&D towards the end of developing its own MMO capability. How much of EA’s R&D budget was devoted to MMOs is uncertain, but EA outspent its rival in R&D by a large margin, as the chart below shows.
EA’s R&D budget, together with M&S, was the main culprit in reducing EA’s profitability, and it must have been a difficult commitment to make year after year as the losses continued. The fruit of those R&D labors was to be Star Wars: the Old Republic (SWTOR), which debuted with high hopes in late 2011. All concerns about the expense of developing SWTOR would have been quickly forgotten if it had been a success, but it wasn’t, and by the end of 2012 SWTOR was shedding users. EA’s long expensive attempt to field a competitive MMO had ended in failure.
The denouement
The impact of the SWTOR collapse was devastating. Q4 2012 revenue dropped to $922 million, down 13% y/y for what is traditionally Electronic Arts Inc. (NASDAQ:EA)’s strongest quarter. Even though EA had started to roll back spending on R&D and Marketing, EA still ended up with an operating loss for the quarter of $39 million.
Was it fair to hold Riccitiello accountable for the state of the company? Yes. He approved every R&D and M&S budget during his tenure as CEO starting in 2007, knowing full well the impact to the company’s bottom line. What he probably didn’t understand, having a business degree and little knowledge of software or game development, was what he was getting for his R&D money.
Riccitiello’s successor will now have the difficult tasks of trimming the R&D and M&S budgets to manageable levels and salvaging what can be salvaged from the MMO development effort. Although SWTOR may have flopped, EA has built valuable MMO capability applicable to future games. With EA’s profitability hinging on the outcome of these endeavors, let’s hope that EA’s board finds someone from within the company who understands something about Electronic Arts Inc. (NASDAQ:EA)’s product development.
The article Electronic Arts vs. Activision/Blizzard: a Difference of Profitability originally appeared on Fool.com and is written by Mark Hibben.
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