Electronic Arts Inc
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Raiders Investment Associates Software: Electronic Arts Inc. (NASDAQ, ERTS) November 05, 2004 Analysis Team Members: Norman Chow: [email protected] David Timmons: [email protected] Justin Key: [email protected] Kyle Lock: [email protected] 1 Table of Contents Page 1. Executive Summary 4 1.1 Company, Industry Overview & Analysis 5 1.2 Accounting Analysis 5 1.3 Forecasting & Methodology 6 1.4 Derived Market Valuations 6 1.5 Recommendation 7 2. Business & Industry Analysis 8 2.1 Company Overview 8 2.2 Industry Overview 8 2.2.1 Trends 9 2.3 Five Forces 9 2.3.1 Current Competitors 9 2.3.2 New Entrants 10 2.3.3 Alternative Products 11 2.3.4 Customer Bargaining Power 11 2.3.5 Supplier Bargaining Power 12 2.4 Classification of Industry 12 2.5 Key Success Factors (KSF) 13 2.5.1 Competitive Advantage 13 2.5.2 Revenue 14 2.6 KSF: Degree of Attainment & Continuation 15 2.6.1 Customers 15 2.6.2 Distribution 16 2.6.3 Management 16 2.6.4 Facilities 17 2.6.5 Risks 17 2.6.6 Growth 18 2.7 Company & Industry Conclusions 19 2 3. Accounting Analysis 20 3.1 Key Accounting Polices 20 3.2 Accounting Flexibility 22 3.3 Accounting Strategy 23 3.4 Quality of Disclosure 26 3.5 Potential “Red Flags” 27 a. Appendix 3.1.1 53 b. Appendix 3.1.2 54 3.6 Quantitative Measures & Indicators: Explanation 28 3.6.1 Sales Manipulation Diagnostics 28 3.6.2 Core Expense Manipulation Diagnostics 29 3.7 Accounting Distortion 30 4. Ratio Analysis & Forecast 30 4.1 Analysis & Forecasting Overview 30 4.2 Financial Ratio Analysis 31 4.2.1 Time Series Analysis 32 a. Appendix 4.1 55 b. Appendix 4.2 56 c. Appendix 4.3 58 4.2.2 Cross-Sectional Analysis 33 a. Appendix 4.4 59 b. Appendix 4.5 60 c. Appendix 4.6 62 d. Appendix 4.7 64 e. Appendix 4.8 66 4.3 Financial Statement Forecasting: Methods & Assumptions 34 a. Appendix 4.2 56 4.4 Analysis & Forecasting Conclusions 36 3 5. Valuation Analysis 37 5.1 Valuation Segment Preface 37 5.2 Valuation of Electronic Arts, Inc. 38 5.2.1 Method of Comparables Valuation 38 a. Appendix 5.1 69 5.2.2 Intrinsic Valuation Method 40 5.2.2.1 Calculations of Beta (β), Cost of 40 Equity (Ke) and Debt (Kd), Sustainable Growth Rate (SGR), Effective Tax Rate Z-Score 5.2.2.2 Discounted Free Cash Flows 43 a. Appendix 5.2 70 5.2.2.3 Discounted Residual Income 45 a. Appendix 5.3 72 5.2.2.4 Discounted Abnormal Earnings Growth 46 a. Appendix 5.4 73 5.2.2.5 Long-Run Average Residual Income 47 Perpetuity Based on the P/B Ratio a. Appendix 5.5 74 5.3 Electronic Arts Valuation Synopsis 49 6. Financial Statements 75 6.1 Balance Sheet 75 6.2 Income Statement 76 6.3 Statement of Cash Flows 77 7. Sources 78 4 Analysis of Electronic Arts Inc. Investment recommendation: Buy (November 05, 2004) ERTS – NASDAQ (11/05/04) $ 47.88 EPS Forecast 52 Week Range $ 40.60 - 55.91 FYE 11/04 2004 2005 2006 2007 2008 Daily Range $ 50.01 – 53.17 EPS 1.92 2.13 2.36 2.62 2.91 Fiscal Year-End March 2004 Sales (mil) $2,957.1 Ratios EA Average of Competitor 1- Year Sales Growth 19.1% P/E 24.94 17.74 2004 Net Income (mil) $577.3 M/B 4.24 9.7 1- Year Net Income Growth 82.1% P/S 4.88 3.4 2004 Number of Employees 4,800 Valuation Prediction Dividend Yield 0 Actual Current Price $47.88 3-Month Avg Daily Trading 4,646,515 Long Run Avg. RI Valuation $42.08 Volume (Mil) P/E Valuation $34.06 Residual income Valuation $40.80 Book Value per Share 11.29 M/B Valuation $109.51 Return on Equity 21.6 % EBO (Abnormal Earnings Valuation) $38.86 Return on Asset 17% DCF Valuation $49.10 P/S Valuation $33.35 Key-Variables Beta (est.) .591 Cost-of-equity (est.) 9.04% Wacc (est.) 9.0% Cost-of-Debt .19% Rating System: BUY: A strong purchase recommendation with above average long term potential OUTPERFORM: A purchase recommendation that is expected to marginally outperform the return of the market PERFORM: A purchase recommendation to maintain current position with returns to match the market SELL: A recommendation to sell the security as it is expected to decrease in price in the medium term 5 1.0 EXECUTIVE SUMMARY 1.1 Company, Industry Overview & Analysis Electronic Arts, Inc. (EA) is one of the largest companies in the North American home electronic entertainment industry who both publishes and develops interactive games for computers and consoles alike. It operates within an industry that has steadily grown since the early 1980’s with the advent of notable console systems such as various Atari models and the original Nintendo Entertainment System. As such, the average consumer age in this industry is in the early to late 20’s, although frequently updated console generations and the computer age continue to bring younger consumers into the market. EA currently operates with weighty competitive advantages including a size large enough to deter new entrants to the industry, while the industry itself can be favorable toward companies due to factors such as extremely low supplier bargaining power. EA has and continues to exhibit steady growth throughout its domestic and global operations. 1.2 Accounting Analysis A major December sales season and resulting January returns causes EA to mark its fiscal year end at March 31. The company owes roughly half of its revenues to foreign activities, and it uses a combination of straight-line and double-declining balance methods to account for deprecation on its assets. Due to the intangible nature of R&D and intellectual property development, EA has considerable flexibility in its accounting policies. Therefore, it has numerous opportunities to illegally hide business shortfalls with accounting tricks, yet the only obvious red flag is a $4 million loan to one of its executives that was not duly and obviously represented on EA’s financial statements. KPMG LLP, EA’s current auditing firm, did not report any problems during the last audit. 6 The retail nature of the industry necessitates large outlays for marketing activities and allowance for doubtful accounts. This may be partly why EA hosts a range of helpful SEC filings and investor information on the official EA website. 1.3 Forecasting & Methodology EA and three of its domestic competitors were broken apart for analysis into four sections: liquidity, profitability, capital structure, and additional ratios. Results indicate a growth industry that EA operates extremely well within, managing to establish steady expansion patterns in most areas of its business. Comparatively, other firms had extremely volatile or low earnings. This steady growth carries into EA’s ten-year forecast. Assumptions for the forecasting include a continuance of this growth trend within a steadily recovering economy. Additionally, it is assumed that due to EA’s late fiscal year end that also falls before its primary sales season, fiscal 2005 can be treated the same as fiscal 2006 and so forth with very little distortion in resultant valuations. 1.4 Derived Market Valuations Of immediate interest is the fact that EA’s capital structure does not contain any debt, nor does the company pay out any dividends to investors. This places EA’s WACC very close to its cost of equity and SGR at its ROE value. SGR averages 11.7% for the previous five years, several points higher than the estimated WACC. Taking all assumptions and facts into consideration, EA was valued for November 5, 2004. Out of the four models utilized for this (Discounted Cash Flows, Discounted Residual Income, Abnormal Earnings Growth, and Long Run Average Residual Perpetuity), the range of estimated values fall between $42.13 and $62.18, although $49.16 is a price ceiling more consistent with the other valuations. 7 1.5 Recommendation EA’s November 5, 2004 market share price is $47.88, which falls much higher than valuations derived with the Value Line beta. If this beta is more accurate, EA’s stock price is severely overvalued. However, it is more likely that the much higher Value Line beta implies EA is more affected by movements in the market than what it actually is, most likely caused by computing it with a longer period of time before economically damaging events such as 9/11 and the tech crash. Using the much lower derived beta, EA’s estimated stock price falls in the lower middle range of the valuations. In this case the company is most likely valued fairly or slightly undervalued, so that, combined with positive future growth prospects, leads to a recommendation of buy. 8 2.0 BUSINESS & INDUSTRY ANALYSIS 2.1 COMPANY OVERVIEW Electronic Arts, Inc (ERTS) “develops, markets, publishes and distributes interactive games that are playable by consumers on home video game machines (such as Sony Playstation 2, Microsoft XBOX, and Nintendo Gamecube consoles), personal computers, handheld game machines (such as Game Boy Advance), and online.” Electronic Arts was founded in 1982 at Redwood, California and has since become one of the leading producers in home entertainment software, operating worldwide in over 100 countries; however, historically 50% of EA’s total revenue has come from within the North American market.