Blue Hawk Investment Group, which manages long-short fund Blue Hawk Fundamental Growth Fund, recently published its Q2 investor letter – you can download a copy here. The letter included the fund’s investment thesis on Electronic Arts Inc. (NASDAQ: EA), a video game company headquartered in Redwood City, California. Blue Hawk believes that “The Street is materially underestimating EA’s earnings power over the next 4 quarters.” Let’s take a look at the fund’s thesis on EA.
Last month, the company presented at the E3 Expo, the major video game industry conference, in which the company provided an update on a few big initiatives that are atop of investors’ mind. Our takeaways, which we present below along with the announcements, are that the prospects for EA and the video game industry are as promising as they have been since I began covering the stock, which is saying something in the context of the industry growth the last 5 years. (1) Cloud Gaming aka Gaming as a Service (GaaS) – At the event, EA demoed their progress on video game streaming. Our takeaway is that viability is much further along than we previously believed and provides a glimpse into the future of gaming. What is cloud gaming?
“Traditional Gaming involves using your own Hardware to power your Gaming Experience. Your Computer or Game Console is actually rendering Graphics and making everything happen. The Computer or Game Console has to be attached to a non-mobile screen in order to be useful. Cloud Gaming is different. Instead of using your device to power your Gaming Experience, Cloud Gaming is powered by a server over the internet. The server does all of the heavy lifting, and your device is merely streaming audio and video. It’s almost like watching a movie on Netflix, but you’re playing a Video Game. This creates an advantage compared to Traditional Gaming.”
Streaming is important because it removes the need to purchase a console, a ~$500 barrier for all but the avid gamers and expands the Total Addressable Market from roughly 130 million gamers, the current number of avid PC/console gamers, to 700 million people, or the total number of people who play mobile games.
The development is significant for 3 reasons. First, from a cost perspective, streaming will decrease EA’s development costs as customization required to tailor each game to each platform (Xbox, PlayStation, Mobile, etc.) will greatly decrease. Customization will still exist for each platform, but the focus will be on increased monetization opportunities rather than purely extra developmental costs. Second, streaming will drive platform convergence, similar to what Microsoft has done with Microsoft Word, ensuring the same gaming experience across all devices. The convergence will lead to increased engagement and an overall better experience for gamers. Third, streaming and platform convergence will allow EA to greatly reduce the current friction limiting the conversion of mobiles gamers to the more profitable full-game experience – the experience currently available on console. If gamers can easily transition their mobile game Sims or Madden sessions to their living room TV with a device similar to a Chromecast or Fire Stick, “avid gamers”, engagement, and monetization will all increase.
All in all, streaming is an unequivocal positive for the industry and further along than Blue Hawk and consensus previously believed. We do not include the effects of streaming currently in our model and we view it as an upside to our current estimates.
(2) Subscription Expansion – the company announced the expansion of their existing EA Origin subscription program to title Origin Access Premier, a PC subscription service that features titles in addition to the non-premium titles (older games) offered on the existing service. In addition, the new service allows for early access to the newest releases before official launch date.
This move is important because it’s perceived as a test trial by the company for a full-on subscription service, which we know from software is a far superior business with superior economics. With subscription, both customer acquisition costs and year to year churn decrease significantly and the hit driven nature of video games, the bear thesis on the industry that has partially subsided but still exists as an overhang, is all but eliminated.
In addition, this move is the first in which EA is openly encouraging gamers to bypass retail and buy online. Historically, EA has been reliant on vendors such as GameStop to sell their games and thus they have been careful to manage the relationship, but with a current game sale mix of 70%/30% online to retail from a 50%/50% split a few years ago, the implication is that EA no longer feels this need. This is significant because the economics of online downloads are significantly better for EA than retail sales. To illustrate the magnitude of the difference in profitability, a 100%/0% online console mix would add roughly $6B in economic value to the stock per Blue Hawk estimates. And this estimate does not factor in the benefit from a reduction in marketing costs that occurs in a subscription model – a subscription model requires a periodic software update instead of the production of a new game each year with heavy promotional spend to sell units. The shift to Office 365 for Microsoft is an appropriate comparison.
(3) Modeling of Live Services by Wall Street – This point is more technical but is nonetheless a material source of short to medium term upside for the stock. There are different models to evaluate changes stock prices, one of which is results relative to investor expectations, or an Investor Expectations Model. Read directly below if you are unfamiliar with such a model.
In an Investor Expectations Model, stock prices are driven by changes in investor expectations and a major source of changing expectations are earnings surprises and disappointments. Better or worse than expected earnings cause investors to revise expectations. At Blue Hawk, we use an expectations model to determine if a stock we like over the long term has potential near term risk or potential near-term catalysts, which we place within the context of a more robust analysis. To say another way, earnings expectations matter for a stock in the near term.
We believe The Street is materially underestimating EA’s earnings power over the next 4 quarters. The first reason relates to how The Street models Live Services (Extra Content), which does not accurately reflect the drivers of the business. The Street oversimplifies and simply applies a growth rate to last year’s revenue. For example, revenue in EA’s Live Services was $2,189 last year and a 10-15% growth year over year and would yield $2,400 to $2,500 in Live Services Revenue. The correct method to model the segment is to multiply an attach rate to an installation base – also known as the razor blade model. Gillette’s razor blade sales, like EA’s Live Services, are dependent on the number of razors sold the last few years as EA’s extra content is dependent on the number of video game units sold. You are not going to buy a razor blade if you do not own a Gillette razor. The correct way to model this is with an installed base, or the total number of razors you estimate are currently in circulation and use, and an attach rate, or the number of razors purchased per year per razor in circulation.
The issue is exacerbated due to a one-time jump in unit sales. EA’s video game unit sales, presented to the right, are relatively steady except for last year, in which, as you may recall, an issue with their flagship title Battlefield caused unit sales to dip by 11.5%. As unit sales revert to normalized levels, as Blue Hawk and The Street both model, unit sales will grow greater than normal, estimated around 10-12%. In addition, the attach rate should continue to improve, we believe at a 20%+ better rate than last year. As the attach rate is multiplied by the installed base, an underestimated install base is compounded, increasing the differences in estimates. Crunching the numbers, the oversimplification causes The Street to meaningfully underestimate Live Services growth in Fiscal Year 2019 in the range of 10-20%.
(4) Conclusion – We have a 1-year Price Target of $170 and a 2-year Price Target of $206, implying the stock remains 14% and 39% undervalued over the respective time horizons, and we are incrementally more positive on the long-term prospects of the industry after the E3 Expo.
Electronic Arts Inc. (NASDAQ: EA) shares are up 7.21% since the start of the year. The stock has lost 16.02% over the past three months. Whereas over the past 12-month period, the company’s share price has moved up 2.14%. EA has a consensus average rating of ‘BUY’ and a consensus average target price of $140.23, according to analysts polled by FactSet. The stock was closed at $ 120.49 on Friday.
Meanwhile, Electronic Arts is a popular stock among hedge funds tracked by Insider Monkey. As of the end of the second quarter of 2018, there were 79 funds in our database with positions in the company. That compares to 61 funds as of the end of the first quarter of 2018.