Sterne Agee analyst Arvind Bhatia comments on the delay of Electronic Arts Inc. (NASDAQ:EA)’s Titanfall for Xbox 360, saying that it suggests overperformance from Xbox One and PC versions, in a report dated March 6, 2014.
We are raising our target price on Electronic Arts Inc. (NASDAQ:EA) to $33 from $29 based on our revised estimates. We think the margin expansion story remains on track and see potential for 400 bps to 600 bps of operating margin expansion over the next two years and EPS CAGR of nearly 20% over that same period.
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We are raising our FY15/FY16 EPS to $1.41/$1.84 from $1.39/$1.65, respectively. While our revised FY16 estimate is essentially in line with consensus, our FY15 estimate is $0.12 or approximately 8% below consensus.
Two Key Near-Term Events
In the near term, there are at least two key events likely to impact the stock’s performance: 1) Titanfall (releasing next Tuesday, 3/11/14) and the company’s FY15 guidance (early May). Titanfall could prove neutral to the stock given expectations are already high while initial FY15 guidance could be below consensus and prove to be a slightly negative catalyst, as discussed later in the note. However, we recommend looking past these events and using any pullbacks as buying opportunities. Beyond a possible near-term pullback, we think the stock could perform well. We discuss both of these key near-term events in more detail on the next page.
Given our view above, we think investors should (and those with longer-term horizons probably will) look past FY15 guidance. We believe longer-term investors are focused on at least three key drivers of Electronic Arts Inc. (NASDAQ:EA)’s results: 1) the ongoing next-gen console cycle; 2) the ongoing revenue mix-shift at Electronic Arts toward the higher-margin digital segment; and 3) Electronic Arts’s strong focus on cost management. The last two should prove particularly beneficial as margin drivers over the next several years. Overall, we believe the margin expansion story at Electronic Arts may even prove more powerful than the console cycle story.
Electronic Arts’ Valuation
Our revised target price of $33 is based on slightly more than a cash adjusted PE of 15x our FY16 estimate of $1.84. At current prices, Electronic Arts Inc. (NASDAQ:EA) is trading at a cash-adjusted PE of 13x our FY16 estimate.
With numerous awards, strong early reviews and the recent beta launch, this upcoming title has continued to generate strong buzz. As a reminder, Titanfall is exclusive to Xbox One/Xbox 360 and PC platforms and Microsoft will be supporting it heavily. In fact, Microsoft (MSFT, $38.11, Neutral–Breza) has been positioning this title as a system seller. Our sense is sell-side expectation for the initial ship-in is around 2.5M units for the March quarter (F4Q), with roughly half of those units expected on the Xbox One platform. Furthermore, we think unit expectation for the first 12 months is around 6M units. These expectations, while reasonable, aren’t necessarily conservative either given this is a brand new title and will not be available on PS4/PS3. Since investors are already expecting positive results from Titanfall, we wouldn’t be too surprised if there is “sell on the news.”
In early May, management will provide their initial FY15 (March 2015) guidance and we think there is potential for initial guidance to be below current consensus. We think some of the key factors likely to drive management’s thinking while developing FY15 guidance will include: 1) current gen software performance (which has been trending lower than expected); 2) the initial sell-through performance of Titanfall; 3) tough comparisons to FY14 (due to the success of Battlefield 3); and 4) management’s own desire for conservatism. Currently, FY15 revenue/EPS consensus is $4.1B/$1.53, representing 5% / 13% growth, respectively. While consensus is not unreasonable, we don’t think it’s a cinch either, given the above factors. We note that our FY15 EPS estimate of $1.41 is $0.12 or 8% below consensus. We do not assume a new Battlefield title in the fiscal year and we suspect some of the sell-side estimates likely do.
As a reminder, we note that with respect to FY15 guidance, CFO Blake Jorgensen provided broad preliminary guidance on the most recent earnings conference call as follows: “… (FY15) will be a continuation of our multi-year plan of improving operating profits and cash flow.”
Margin Expansion Sources
We expect Electronic Arts Inc. (NASDAQ:EA)’s non-GAAP operating margins to improve 450 bps over the next two years from an estimated 14.2% in FY14 (ending March 31, 2014) to 18.7% in FY16. We expect gross margin improvement to contribute 220 bps, leverage on marketing costs to contribute 130 bps, R&D costs to contribute 80 bps, and G&A to contribute 20 bps of improvement over the next two years. In the upside case, we see operating margins expanding to 20% by FY16 (versus 18.7% modeled currently), with potential additional upside coming from gross margins and leverage on marketing and R&D costs.