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General:
• Have we waited at least 3 months since we first developed our thesis and valuation expectations before deciding to buy the stock? • Have we bounced our investment thesis off of an industry expert, or someone capable of providing a dissenting opinion? • Have we conducted a pre-mortem? • Does reporting consistently change and/or is it opaque?
Value Proposition & Customer:
• What value is the business providing? o Create video game content for PC, console and mobile gaming platforms. They’re best known for their sport franchises that include FIFA, Madden, NHL, and PGA. Other titles worth mentioning include Battlefield, Star Wars, Sims, Need4Speed, Apex Legends, Command & Conquer, and Mass Effect. EA is also predominately geared toward console players. • How does the business make money? o There are three ways that EA monetizes their content: ▪ 1) Traditional paid games, where consumers pay a single upfront fee to acquire a game. A single customer interaction. • Note that physical video games have historically been purchased in- store (at Walmart, GameStop, etc.). Most games are now purchased through a digital medium (80-85% of PC games, 50-55% of console games, and ~100% of mobile games are sold digitally) ▪ 2) Microtransactions (MTX)/downloadable content (DLC). MTX are small in- game transactions, typically in the $1-$5 range. Free-to-play games (e.g. Apex Legends) can be very profitable with MTX, but paid-games can also benefit from higher ARPU through MTX. It’s worth noting that EA uses MTX in a pay-to-win strategy much more than the other two publishers. DLC is additional content (e.g. map expansion pack) that can be sold to existing user base. These tend to be repeat transactions. ▪ 3) Monetization through eSports (league rights, advertisement and merchandise revenue, etc). Ultimate Team mode and Apex Legends are examples of this. • Can we define exactly who the customer is? o The customer is anyone with access to a smart phone, computer, or console. Traditionally, the stereotypical gamer was an 18-35 year-old male, but those demographic boundaries are disappearing. ▪ PC/Console: customers are generally more enthusiastic gamers. Barriers-to- entry are higher than Mobile (cost of the console or PC), and PC/Console games typically require a large time commitment. ▪ Mobile: virtually anyone with a smartphone.
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o Is this a need-to-have, or a nice-to-have? Is this product or service critical to the customer? ▪ Video games are a nice-to-have. It’s worth mentioning that video games are 1) becoming more social, 2) a relatively cheap form of entertainment, and 3) very engaging. These three things make the customer base and ARPU relatively resilient. o What is the share of that customers wallet? Is this offering a small percentage of the customer budget? ▪ It’s difficult to get exact numbers on this, but our conclusion is that overall, it’s 1) generally a small part of the customers wallet; and 2) a cheaper form of media entertainment vs. many other options. ▪ Including hardware and content, our guess is that the cost of gaming on PC/Console is ~$150-$200/year. PC/Console gamers probably average >7 hr/week, which is then equivalent to a cost of well under $1.00/hr. ▪ Cost to play video games on mobile is much less than console/PC. The incremental hardware costs for mobile is essentially ~nil, and there are a lot of F2P mobile games. • Is there a substitute for the product or service? If it didn’t exist, what would the customers or users need to do instead? o Basically, any other form of entertainment can be viewed as a substitute, but the most direct competing service is television, which is a totally different experience. • Does any single customer represent more than 10% of revenue? o No (customer base is extremely fragmented). It’s worth mentioning that direct sales through Sony and Microsoft represented ~32% and ~17% of total net revenue in 2020, respectively (concentrated distribution). o It’s worth mentioning that EAs sport titles and Ultimate Teams generate close to 50% of EAs revenue (see Figure below):
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• Are any of their customers or customer cohorts ‘unhealthy’? o No. • How are the customer end-markets evolving? o See our Industry piece (Part 1) for details. In short, Free-to-play, improving social aspect of gaming, smart-phone penetration, and eSports are a few examples of how the customers interactions are evolving. • What is the customer life-cycle? Do you touch them once every twenty years, or is it a monthly or yearly recurring touch-point? o Most of EA’s sport games are released annually (e.g. FIFA, Madden), and most players seem to purchase each successive title. MTX and DLC revenue is more consistent throughout the year, and in-game purchases are becoming a larger chunk of EA revenue, specifically through Ultimate Teams mode. Besides some seasonality and some titles being released ever few years (instead of annually), EA’s revenue is fairly stable. • What is the customer retention rate? o On key franchises, we believe it to be very high, although we can’t really measure this. • Can we find any customer feedback or commentary? Are there any recurring themes? o We can read game reviews and pull Metacritic scores. See below for FIFA and Madden franchise scores. The Metacritic score for both franchises has significantly deteriorated over the past ~decade. o When we read critic and user reviews, two common themes emerge. ▪ First, consensus seems to be that the games “aren’t innovating enough” over time – EA is just pushing out the same game with new players. In other words, Madden 21 is basically the same thing as Madden 20, so customers feel cheated.
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▪ The second reason is that the most popular game modes are becoming increasingly pay-to-win (Ultimate Team), which clearly irks users that give low scores.
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Competitive Advantage:
• Can we identify a competitive advantage like network effects, brands, patents, regulated monopolies, high switching costs, first mover benefits, or scale? o Competitive advantages include exclusive licenses, brands, high switching costs, and scale. ▪ A significant portion of EA’s revenue comes from games with third-party licenses. E.g. mostly all of their sport titles, Star Wars, Simpsons, etc. These licenses create major barriers to entry for competitors. They hurdle for a licensor to switch developers is also very high. A good example of this is FIFA: EA
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has over 420 licenses (some exclusive) with counterparties all over the world and with staggered terms: very difficult to replicate. ▪ Some of the core brands that EA has licenses with are extremely strong. E.g. the FIFA, Madden, and Star Wars brands have been built over decades, and are supported by other forms of entertainment (e.g. live sports, cinema, etc). This allows EA to tap into a large existing user base and social network. ▪ Scale has obvious benefits, but it’s worth noting that EA has consolidated the majority of its key franchises to a single game engine, which has helped EA reduce costs and improve flexibility. o If we can’t clearly identify a competitive advantage today, can we identify signs that the business might develop one? ▪ n/a o If the company’s CEO left tomorrow, how long would it take, if ever, to create a successful competitor? Are there any major barriers to new entrants? ▪ In our opinion, it would be extremely difficult, if not ~impossible for a new entrant to replicate this business model. FIFA has probably the strongest competitive moat out of any console/PC/mobile game that we have come across, given the multiple licenses and high switching costs to third-parties. EA’s IP can be hit or miss, but new IP would still need scale to be competitive, and this is very difficult to achieve. AAA games can also be quite costly. ▪ Note that mobile would be easier to compete in for new entrants, but is also much more competitive. • Who does the company compete with? Can their competitors copy/replace what the company is offering over time? o For console and PC, EA mainly competes with the other large content publishers – ATVI, TTWO, MSFT, Riot Games, Epic Games, etc… Great AAA content is really hard to create, and it’s extremely difficult for a competitor to copy EA’s success in any given franchise and/or out-bid on a third-party license agreement when those come due. o Mobile is much more fragmented, and much more competitive. But this is a smaller part of EA’s business (~10-15% of net revenue) • Does the company have pricing power? How elastic is demand? Can we find examples in the past to illustrate demand elasticity or lack thereof? o We believe that the publishers do have some pricing power, but they haven’t seemed to have exercised it until the roll out of the next generation of consoles. Both ATVI and TTWO are increasing pricing on some games, from $60 to $70/game. We expect EA may follow suit over the short-to-medium-term for select franchises, and don’t expect to see any notable hit to unit sales.
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Industry:
• What are the key drivers for the industry? o Essentially, the two top-line key drivers are: 1) total gamer growth/penetration; and 2) average revenue per user (ARPU). Total gamer growth is driven by: mobile and casual gaming (smart phone penetration); eSports and streaming; growth in international markets, where penetration is low; benefits from the social aspect of gaming; and demographic shifts. ARPU is a function of increasing video game popularity, and evolving monetization strategies (e.g. free-to-play and MTX/DLC). o Other drivers in the industry that will impact publisher profitability include the shift towards digitization and pressure on digital platform fees, subscription offerings, etc. ▪ See Industry piece (Part 1) for more in-depth discussing on industry drivers.
o How has the industry evolved over time? ▪ Video game popularity is increasing: gaming is becoming more social, and eSports/Streaming is becoming more popular. ▪ See Industry piece (Part 1) for more in-depth discussing on how industry has evolved over the past decade+. • Is the total addressable market (TAM) expanding or shrinking? o Expanding. See Industry piece (Part 1).
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o Are there long-term positive or negative secular themes that will change the opportunity set? ▪ Many positive secular trends that should improve the publisher’s profitability and support above-average growth. See Industry piece (Part 1). • What does the competitive landscape look like? o What is the businesses market share?
o Is there extreme fragmentation or concentration? ▪ Console and PC are much more concentrated among the top publishers (ATVI, EA, TTWO, MSFT, etc). Mobile is relatively fragmented. There has been some consolidation in console/PC over the last decade. o Is the same number of businesses competing in the space today as there was 5 and 10 years ago?
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▪ For PC/Console, it’s largely the same big publishers competing today as 10 years ago. Mobile is evolving very quickly, and new mobile developers pop up every year. There is some consolidation, but it remains competitive and evolving quickly. o Can we identify a business in this industry that has failed in the last 10 years, and why? ▪ Not really complete failures. There are some companies, like Amazon, that have really struggled to enter the business, but we can’t think of an established developer/publisher failure. o How do industry participants compete: capital, service, price, etc? ▪ Participants mostly compete on content quality. Price for game sales is typically homogenous. • Has there been a flood of new capital into the space? o No, besides some small mobile IP, and development of new third-party video game engines (Unreal and Unity). o Has there been an increase in IPO activity in the sector? ▪ No. o Are businesses issuing more equity than in the past? ▪ No. o Is leverage for the industry much higher than the 10Y historical average? ▪ No. • How cyclical is the industry? o Not cyclical. Revenue will fluctuate YoY given each publishers game slate for that year. E.g. TTWO has much higher revenue in years with GTA releases. However, video game revenue seems to be relatively stable through economic cycles. • Is this a profitable industry? o What has been the minimum and maximum ROIC for the industry over the last 20 years? What is the range of ROIC within the industry today? ▪ ROIC is not a perfect metric to use for this industry due to large off-balance sheet assets (e.g. brand and some R&D costs). However, ROIC does screen well, and seems to be improving for all participants, which we expect to continue.
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o What was peak-to-trough ROIC/margins/sales in previous recessions? ▪ Most of the publishers don’t seem to be impacted in a material way during recessions. Cost/hour of entertainment is low, and despite being more of a consumer discretionary offering, the customer base seems to be relatively sticky. We’re not worried about the impact to the publishers during recessions. o How do these characteristics compare to the overall market? ▪ Much better ROIC/ROE than market, much more resilient revenue stream, and exposure to secular themes that should support much higher growth than the market. o Has the rank order of relative profitability (ROIC) changed meaningfully in the last 5 and 10 years? ▪ Yes. EA has been generating higher ROE’s than the other publishers for a number of years now. • Does the company operate in any geographies with volatile legal, political, or regulatory environments? Do any of these represent more than 10% of sales? o No. Worth noting that Sony and Microsoft represented ~29% and ~16% of total net revenue in 2019, respectively. We expect that any regulatory pressure in this industry is likely to benefit the publishers. o Is there a regulatory body that can meaningfully impact industry profitability? ▪ No. o Are there any outstanding legal or political risks? ▪ No. • Is this a business that can pass on inflation to customers? o In some parts of the business, yes, but we haven’t seen much of that. Some new releases this year on console/PC are being sold at higher prices (e.g. $70/game vs $60/game). We imagine once the industry stops growing that the publishers will likely increase prices with inflation, but we don’t see that happening for a long time. • Are employees unionized or not? o Not unionized.
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Strategy: From fiscal 2014 to 2019, EA highlighted three core strategic pillars: Players First, Commitment to Digital, and One EA. In 2020, EA highlighted that their new strategy is “to create games and content, powered by services, delivered to a large, global audience”.
• How do they deliver on the value proposition? o Maintain high quality content and up-to-date sport games. Most titles, specifically sport games, are released annually, and some are released every few years. EA also releases new content (MTX and DLC) throughout the year, e.g. updated “play packs” in Ultimate Team. EA has effectively tapped into eSports through Ultimate Team, but can also most likely add eSport leagues to other titles like Battlefield and Apex Legends. o Is the business generating an upfront payment or recurring revenue stream? ▪ Historically it was an upfront payment for PC/Console: paid-games. With F2P and MTX/DLC, revenue is much less dependent on the release cycle – e.g. >25% of revenue comes from Ultimate Team alone, and >60% of revenue comes from Live Services and Mobile. o How do they try to understand their customer needs? ▪ Metacritic scores and other gaming reviews help them gauge customer satisfaction. MAU on streaming platforms like Twitch also help EA gauge the popularity of their content relative to peers. They also have droves of data and feedback from existing players to help update games (through patches/new seasons) to address their customer demands. o How do they think about strengthening their position? Can they build on their competitive advantage? ▪ Frostbite might help them better leverage independent publishers to create content through partnerships with EA, which is a unique offering for big publishers ▪ eSports will also improve some of their brands like Battlefield and Apex Legends, and help grow these communities. • How do they acquire customers? o Advertisement, which includes conventional advertisement (physical and digital), and through video game streamers. EA also offers Ultimate Team for free, which has probably led to better engagement. Ultimate team is effectively pay-to-win though, and has most likely led to higher ARPU rather than a significant uptick in MAU. o EA’s new subscription offering, EA Play, may also attract new users to EA’s suite of games. o Otherwise, brand value is so high that they don’t need to spend a lot to convince a player on FIFA 2020 to buy FIFA 2021. o Do they rely on an internal sales team? Partners? Do customers come to the business directly? ▪ EA has their own marketing and sales team and strategy. Customers technically buy the content through the distributors (physical/digital), but the customer acquisition responsibilities are mostly in the hands of EA. For the content that
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EA licenses from third-parties, e.g. all sport games, Star Wars, etc., EA also benefits from brand development from the third-party. • Note that video game streamers are becoming a larger part of EAs marketing strategy, and should be considered as partners. o How do they approach marketing? ▪ Commercials, advertisements, and, more recently, video game streaming (e.g. Twitch). o Do they offer customer incentives? ▪ No, but they do run sales, particularly on older content. EA also offers a subscription service, which might be a more cost effective solution for some gamers. • How do they operate the business? o How do they approach manufacturing? ▪ Sport games require licenses from third-parties, and most games are developed in house. Other content/IP is a mix of owned and licensed from third-parties. EA has also developed their own video game engine in-house, Frostbite. o How do they approach distribution? ▪ Through physical distribution (e.g. Walmart, GameStop, etc.) and digital distribution (Apple, Google, Sony, etc.). Similar to the other large publishers. But, they also have EA Play, which is a subscription service – and can selectively be DTC. o Can they reduce input costs by changing suppliers, bringing processes in-house, etc? Is there a road map to do so? ▪ EA One has been mostly executed – single game engine for all franchises, consolidated R&D, S&M, and back office resources, etc. There are likely further cost reduction initiatives (e.g. improvement in marketing through streamer services), but the low-hanging fruit is probably gone. ▪ In the very long-term, EA can push to sell more DTC (particularly PC). However, the move away from Steam to Origin originally proved to have a net negative impact on revenue and profitability, and is probably an unlikely part of the strategy mid-term (they reintroduced content to Steam and rebranded Origin as EA Play). o Is any single supplier their only option for a given input to the product or service? How do they manage procurement? ▪ The digital distributors for all types of video games (PC, console, and mobile) have ~oligopolies in distribution. • How do they manage risk? Do they use natural or financial hedges to reduce volatility in cash flows? o EA uses some currency hedges. Revenue/cash flow is relatively stable though, and therefore probably doesn’t need to think too much about this. • Capital allocation
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o Is the company willing to return cash to shareholders if they can’t find accretive ways to deploy it? ▪ EA carries a significant amount of cash on their balance sheet, but have systematically and consistently bought back shares over the past ~decade, and have recently instituted a small dividend. Despite this, and excluding the most recent acquisition of Codemasters, cash has been building on their balance sheet over the past ~decade, and has consistently been a drag on EA. We believe that if cash on the balance sheet continues to grow, and accretive M&A opportunities aren’t present, that EA will likely initiate a larger NCIB program, or meaningfully increase their dividend. ▪ Has the company repurchased stock in the past, and if so has it been opportunistic or mechanical? • EA’s strategy has been to systematically buy back shares, and have bought back ~10% of their outstanding shares between 2016 and 2020. There have recently been some excellent opportunities to buy back shares, which EA did not take advantage of. Going forward, we expect EA to maintain this systematic strategy. o Is M&A a likely contributor to future growth? If so, what criteria does the management team use to evaluate transactions? ▪ What type of M&A are they pursuing (roll-ups, transformational, etc)? • M&A has not been a major part of the strategy under this CEO, Andrew Wilson (2013-now), until very recently with Codemasters – it’s been more than a decade since they pursued any large transactions. • We expect EA to focus on their core franchises, experiment with some new titles in-house and through their partner network, and pursue small tuck-in acquisitions as opportunities arise. ▪ What drives synergies: costs or revenue? Can competing acquirers achieve the same synergies, or do they have other advantages? • Synergies are likely on both the cost and revenue side of the equation. On costs: conversion to the Frostbite game engine, consolidate back- office, and commercial and marketing functions. On revenue: better S&M reach/data, subscription platform, resources to improve game quality. ▪ What is their M&A track record? • Pre-AW, the M&A track record looks quite poor (lots of impairments). No notable track record to evaluate during AW’s tenor. At first blush, Codemasters looks like a good use of cash. ▪ Does the company look to retain key people at the entities that they acquire? • Yes. One of the most valuable asset in these acquisitions are the people.
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o How does the business rank order investment opportunities, organic or otherwise? Is it clear that they rank opportunities on the best performance metrics, like life-cycle ROIC instead of cash on cash yield in year one? ▪ Management clearly weighs ROE heavily vs. near-term cash/cash impact – they also seem to weigh opportunities over time, not just point-in-time (hence building cash balances). • Is their approach to any of the above points consistent? Or have they pivoted in the past? o John Riccitello was Andrew’s predecessor from 2007 to 2013, and under his leadership the company pursued a lot of M&A – in fact, nearly 100% of EA’s operating cash flow was spent on acquisitions during his tenor, versus <5% of operating cash flow under Andrew. Codemasters was the first significant acquisition under Andrew, and we think this cautious approach to M&A is prudent.
Performance:
• Is there a sufficient historical track record to evaluate? o Yes. Generally speaking adequate disclosure and sufficiently long-track record for us to evaluate EA performance. • Does, or has, the company earned a ROIC or ROE in excess of their cost of capital? o ROIC/ROE is not a perfect metric to use for this industry due to large off-balance sheet assets (e.g. brand and some R&D costs). However, when we look at EA’s trailing ROE/ROIC, we’re comfortable with the direction that it’s heading, and believe that EA has earned well in excess of their cost of capital.
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o If so, for how long have they generated excess returns? ▪ On conventional metrics, since 2015. o If not, do we see a path to that happening? ▪ n/a.
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o How does this return compare to the peer group? ▪ Slightly above peers over the past 5+ years, but generally in-line.
▪ • What has the cash conversion ratio been for the last five years? o Much higher than 1.0x, not worried about this. • Is there a history of asset impairments/write-downs? o Not recently. • Is there any capital that is a drag on returns, and should have been utilized differently? o Probably. The large cash balance might enable EA to pursue very accretive buybacks and M&A. However, EA’s is very systematic with its buybacks, and we haven’t seen much M&A over the past few years. This presents an opportunity today, particularly given the tangible steps taken recently to deploy cash. • Do asset-specific KPI’s meet expectations? o Mixed. Game reviews for some sport franchises have been poor, and EA has flopped on a few titles (Anthem, for example). But, console growth has still been strong with growing ARPU on sports, and new successful titles in recent years like Star Wars and Apex Legends. • Have they historically managed their financial position well? o Yes, in the sense that they have never come anywhere close to a solvency or liquidity issue. No, in the sense that they’ve let all this cash accumulate.
Financial Position:
• How do their debt metrics compare to their peer group and to history? o n/a. EA and peers have net positive cash positions, and are all mostly in the same position.
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o o Is leverage higher then peers, or average levels for the business? ▪ Immaterial. o Are their financial covenants the business must maintain? Will the company breach those covenants in a recessionary environment? ▪ Immaterial. o What is the rating agency outlook? Is it likely that the company will need new external equity? ▪ S&P has EA at BBB+ credit rating. Will not require additional equity. o Are debt maturities staggered? If not, is there a looming refinancing, and how will the company manage it? ▪ Immaterial. • Are there any off-balance sheet liabilities? o Immaterial. • Does the company have any long-term contracted obligations? o Immaterial. • Is there a dual class share structure? o No. o Are there any obligations to other holders, like Incentive Distribution Rights? ▪ No • Does the company have preferred share and/or hybrid capacity? o No. • What is the potential impact from dilutive securities? o Immaterial • Is non-cash NWC a big part of the business? ▪ It’s about -25% of revenue. A big part of this is deferred revenue. o Is it large as a percentage of revenue? Is it shrinking or growing as a percentage of revenue? ▪ The negative NWC balance had been growing from 2005-2014, but has shrunk from -45% to -23% since then (largely on lower deferred revenue).
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o If it is negative, is there a large potential cash outflow if revenue falls? ▪ Probably not. Totally NWC is -$1.3 bln, so even if revenue fell meaningfully it would be a couple hundred million in potential draw. Easily covered by EA. • Do they pay a dividend, and if so, what is the payout ratio? ▪ Annual dividend of $0.68/share, ~10-15% DPS/EPS payout ratio. o Do they have a DRIP? ▪ No. o Have they been funding the dividend through asset sales or increased leverage? Ultimately, is it sustainable with internally generated cash flow? ▪ Dividend is sustainable, but is relatively insignificant anyway. • Are sustaining capital requirements in-line with DD&A? Is there a reason they might be different? Can they meet these spending requirements in a recession? o Sustaining capital requirements are ~in-line with DD&A, which is negligible anyway. EA can easily meet their spending requirements in a recession. • Is the business capital intensive? How do they plan to fund incremental capital expenditures? o Not really. Most of the R&D and brand spend is expensed. All incremental organic capital can be easily funded with cash flow from operations in any environment.
Management & Governance:
• Does the management team have some competitive advantage, as people? Do they bring unique experience? Can we identify any shortcomings? o Marginally. Andrew Wilson joined EA in 2000 and became CEO in 2013. He’s been with EA for a long time, and is probably very familiar with the industry. o The rest of management has relatively diverse experience, but nothing overly unique in our opinion. ▪ Blake Jorgensen has been CFO and COO since 2012 and 2018, respectively. He previously served as CFO at Levi Strauss & Co. from 2009-2012, and as CFO at Yahoo! from 2007-2009. ▪ Ken Moss has been in the Chief Technology Officer role at EA since 2006, and previously worked at eBay. o What is their previous track record running a business or business unit? ▪ Relatively good. From fiscal 2014-2019, EA highlighted three core strategic pillars: Players First, Commitment to Digital, and One EA. Under Andrew, EA has seemed to fall short on putting Players First, but executed well on the other two pillars. With strong revenue growth, massive success on Ultimate teams, excellent execution on One EA and cost reduction initiatives, and improving ROE over that time period, we believe that Andrew can point to a relatively successful track record. o What is the consensus view of management? ▪ Generally a positive view of management team and board, but some commentary suggests that investors prefer ATVI/TTWO leadership.
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▪ Glass door has an 87% approval rating of Andrew Wilson, much higher than Robert Kotick at ATVI (50% approval rating). • Are they more comfortable with succeeding unconventionally than failing conventionally? o A bit of both. EA has focused most of their efforts on growing their existing sport franchises. However, over the past decade, EA has added new some new content (e.g. Apex Legends), and took on some relatively unconventional cost reduction initiatives (e.g. consolidation to a single game engine, Frostbite) that have paid off quite well. o Can we observe behavior that sacrifices on near-term profitability for the long-term benefit of the business? ▪ Consolidating their game catalog to use a single game engine was costly and had its drawbacks. However, this has seemed to pay off quite well. • What metrics are management compensated on? Are these appropriate drivers of shareholder value? If ROIC/ROE/EPS growth aren’t one of those metrics, are we confident that management has an incentive to most efficiently allocate capital?
o Performance cash bonus is based on revenue, gross profit, operating expenses, diluted EPS, operating cash flow, and non-GAAP net income, as well as strategic objectives. o PRSUs are based on Total Stock Return (TSR)
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o Do insiders own a significant amount of stock? ▪ All current directors and executive officers own ~1.0% of outstanding shares.
o Have insiders sold any stock in the last year? More broadly, how has insider ownership changed over time? Can we find good justifications for insider selling? If not, this is a brown M&M? ▪ No. Insider ownership for key executives has marginally increased over the past few years. o Does management use non-GAAP metrics in guidance, and if so, is that reasonable? ▪ Revenue largely GAAP-based, or easily understandable (revenue/net bookings) • How does the management team allocate their time? o Are they obsessed with stock price and constantly meeting with investors? Or; ▪ No evidence of this o Are they intently focused on running their business? ▪ Andrew Wilson has been with EA for ~two decades, and seems to be passionate about the business and products.
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• Is the founder still running the business or on the board? Is this a good or bad thing? o No, but Lawrence F. Probst III (`70 years old) has been EAs Chairman since 1994. He joined EA in 1984 (EA was founded in 1982), and was CEO from 1991 to 2007. He was even Interim CEO for a brief period in 2013. He clearly has been with EA for a long time, and probably has a very good understanding of how the business works. We don’t view this as a bad thing. • Is the business run in a centralized or decentralized way, both financially and operationally? o A little bit of both. Most development teams seem to have autonomy on content creation. Ancillary functions are much more centralized though, e.g. single game engine across all franchises, but the core “creative” functions are being left alone. Capital allocation/budgeting etc all seem to be managed centrally, which is a good thing – we don’t think that creative teams care as much about optimizing ROIC as they do about creating the best game (and vice versa). o What are employee incentives? ▪ Development studios share in game success (bonuses), which is important. SBC is also a fairly large line-item, so many employees share in total EA success as well. • Is there “key man” risk? o We like the strategy that EA has executed on with Andrew Wilson as CEO. There might be some risk to EA if Andrew were to leave – a new CEO may pursue M&A more aggressively. But overall, we don’t see this as a huge risk. • Can we gauge employee turnover? What about management turnover? Board turnover? o Management/Board turnover is relatively low. Hard to gauge employee turnover – recent restructuring would have meaningfully reduced headcount in some areas.
• What do employees have to say about the company through Glassdoor or other channels? Can we gauge company culture through another channel?
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o Glassdoor ratings for EA and Andrew Wilson are 76% and 87%, respectively. It’s worth noting that EA laid off 350 employees in FY 2019, similar to ATVI. However, the entire executive team decided to forego their non-equity performances for that year, and instead paid that sum back into the bonus pool for all other employees. As a result, Glassdoor reviews for EA didn’t deteriorate over this time period, in contrast to ATVI and Robert Koticks reviews that fell in the same time period. o Other than these reviews from Glassdoor, It has been difficult to gauge this. • Are the skills and diversity matrices for the board of directors appropriate? o Yes. • Do board directors have sufficient financial interests in the company? o Yes. Nothing extraordinary here though. Lawrence (Chairman) owns the most stock out of any of the other insiders, and owns ~18 bps of outstanding shares. • Are board directors distracted by too many other professional endeavors? o Three out of the nine board members have a fair amount of other commitments, but generally we aren’t too concerned about this. • Is there an unhealthy relationship between any board directors and management? o No reason to believe that governance is a problem here.
Valuation:
• Have we identified the key drivers? o Top-line industry growth (console takes share, PC/mobile lose share), physical to digital distribution driving gross margin improvement, modest uptick from decrease in platform take-rates on PC/mobile, leverage on S&M/R&D/G&A, and deployment of excess cash. o Where do our expectations differ from what we think the market price implies? ▪ We are less pessimistic about loot box regulation, long-term console revenue growth, margin expansion, and cash drag . o Why do we think we have an edge, and/or can we understand why the market is wrong? ▪ Really difficult to tell. We suspect that many investors anchor to headlines that rage about the latest Madden or FIFA Metacritic scores (and therefore worry about EA losing licenses), without fully understanding EA’s competitive position and international growth runway. The margin-expansion narrative is also multi- pronged and likely difficult to understand – it’s also a very long-term theme which is hard for lots of investors to underwrite without that time horizon. Lastly, concerns about loot box regulation seem short-term (in the sense that EA can adapt quickly). o Are any of the key drivers impossible to forecast, ie. is uncertainty incredibly high? ▪ Top-line growth and margin expansion is difficult to gauge but we feel comfortable with the goal posts. Likewise, range of outcomes are wide for what EA might do with excess cash, but the range is understood.
The 10th Man
o What is the source of the data that impacts our view of the key drivers? Is that source reliable? ▪ Industry data is sometimes conflicting, but generally good. We mostly care about changes, and less so the absolute values anyway. • Have we done a bear and bull case scenario analysis? Is risk skewed to the upside? o Yes, for reasonable bear/bull cases, risk seems significantly skewed to the upside • Is the business fully cash taxable? If not, when will they be? o Yes they are close to fully cash taxable • Are there any unusual accounting policies? • Does the business expense anything that in principal is actually a capital item? Is this well understood by the market? o Yes, they expense many things that we view as growth capital, but we think this should be well understood by the market. • What percentage of costs are fixed? Is operating leverage high? o Effectively all of EA’s COGS are variable, while a significant portion (>50%) of R&D, S&M, and G&A are variable. • What is FCF conversion? Is it consistently above or below 100%? o Consistently at or above 100% • Is there a capital expenditure cycle, and if so, where are we in the cycle? How does this compare to their peers? o n/a • Is there any large unfunded liabilities, like pensions? o n/a