One of the largest American game entertainment companies, Electronic Arts, Inc. (NASDAQ: EA) has had its fate tied to the declining videogame industry, where users are trading in their controllers for simpler tech products like tablets and smartphones. In EA’s case, much of the blame falls on its overreliance on rehashing sequels to franchises like “Madden” and “Tiger Woods PGA Tour,” which is a result of the company’s uninspiring business model. While it is no doubt that these gloomy strategic decisions will continue to hurt EA’s stock price, there are darker clouds on the horizon. The stock has fallen 21 percent since the beginning of the year and insider and fundamental analysis will have investors taking cover sooner rather than later.
One of the most obvious of these clouds can be seen by looking at the buying and selling decisions of insiders within the company, and in Electronic Arts’ case, there hasn’t been much of the former. In fact, while there have been no insider purchases of EA stock within the last year, a total of 9 different officers have sold 324,993 shares for a combined market value of nearly $7 million. The most active of these insiders have been the Chief Financial Officer F. Eric Brown, Chief Operating Officer R. Peter Moore, and General Council member G. Stephen Bene. Hedge funds share a similar distaste for EA. As of the end of last year, 5 of the 6 funds with at least 2 percent of their holdings in the stock elected to downsize their positions. On average, this reduction was large – almost 30 percent. These five funds were Hawkshaw Capital Management, Castlerock Asset Management, JAT Capital Management, Platinum Asset Management, and Cavalry Asset Management. On the whole, 34 funds held long positions in EA in the fourth quarter of 2011, in comparison to 39 funds in the preceding quarter.
It is believable that the two parties with the best resources for analyzing EA – insiders and hedge funds – are seeing something fundamentally wrong with this stock. When looking at some valuation ratios, investors can have some immediate concerns. Let’s start with the Price-to-Cash Flow ratio, which measures the amount that investors are willing to pay for every dollar of cash flow generated by the company. In the videogame industry, cash flow is an important indicator of financial health because it measures the funding a company has for R&D and developer acquisitions, both of which have been paramount in the success of Electronic Arts.
For example, a new videogame can either be developed through internal development or through external procurement of an already-developed franchise. In EA’s case, its popular “Madden” franchise was developed in-house, while the “Mass Effect” franchise was absorbed after the developer BioWare was acquired. Getting to the metrics, EA’s P/CF is 22.1X, which is higher than the industry average of 14.6X, and higher than the company’s major competitor Activision Blizzard, Inc. (NASDAQ: ATVI) which is at 15.4X. Other competitors Take-Two Interactive Software, Inc. (NASDAQ: TTWO) and THQ, Inc. (NASDAQ: THQI) both have negative P/CF values due to high levels of debt, though this does not take away from the fact that EA is an overvalued investment.
Adding moldy icing to investors’ stale cake, EA is operating in an industry that has been battered to say the least. In the first quarter of 2012, videogame sales were down 20 percent from the same month one year earlier; a trend that has been unfortunately consistent. In fact, similar declines were reported in the last quarter of 2011, and this article aptly states how many hedge funds felt the burn specifically from their holdings in EA. These sales difficulties can be seen when analyzing the EA’s 3-year average revenue growth, which is a dismal -0.7 percent. Compare this with the industry average of 0.7%, ATVI at 16.3%, and TTWO at 4.4%, major problems can be seen. In fact, only THQI (-13.6%) has a lower 3-year revenue growth than EA. If all of these reasons are not enough to dissuade investors from EA, they need only look at its historical stock price to receive final justification. The stock’s return has been in the red since the financial crisis – it had lost 70 percent of its value since 2008 and has yet to regain its footing, retreating even further in recent months. From its negative insider and hedge fund sentiment, to its poor fundamentals, Electronic Arts, Inc. (EA) a definite sell.