Electronic Arts Needs to Remove the Chaff to Fatten Profits

I know there has been a bit of a video game slump due to various reasons, such as a drop in consumer spending or mobile gaming. For those in love with mobile gaming, the proliferation of these free games that only the passage of time and constant in-app purchases will not continue. Many of the games are low quality, even if they look nice. Great visuals do not make up for shallow game play and a lack of depth. The presence of other players does not make the game suddenly fun, at least not all 1000 of them. Making a similar free game with tons of in-app purchases after another one topped the charts is not a sustainable strategy, but we do need more Angry Birds.

Electronic Arts Inc. (Nasdaq: EA) is not resigned to history, because it makes regular video games. That is the same reason I think there is room for Take-Two Interactive Software Inc. (Nasdaq: TTWO) to turn itself around if it can control expenses. It is also in the mobile games space with the monstrously successful Simpsons Tapped Out. It does not matter how many notable video game franchises the company has if it cannot use them effectively. Normally, I like to call them intellectual properties, but some I call franchises. I like to treat properties with a bit more depth.

Dead Space is an Electronic Art’s property, but Madden is a franchise. The difference is semantic but not superficial, because properties get optioned for movies, licensed for TV, and occasionally have novels and comics. I do not think The Sims will be optioned for a movie. Even Activision-Blizzard, Inc.‘s (Nasdaq: ATVI) Call of Duty games could be fit into the mold of a mediocre movie. I hold Activision-Blizzard up as a paragon of video game companies, and one that EA should take notes from.

Heading into the holiday season there are a few titles that could see an uptick in sales. I am sure Madden is a popular stocking stuffer. The new Need for Speed game is out, though I think that series has a limited, but loyal, fan base. I do not think anyone I know has played a Need for Speed game since high school.

The future also looks bright with Dead Space 3, Battlefield 3: Aftermath, and Crysis 3. While those are shaping up to be critical successes and achieve great sales, I am unconvinced that records will break. Crysis 3 might manage it, but the second one felt nowhere near as good as the first. Crysis and Dead Space are properties while Battlefield is a franchise, for those keeping score. All in my opinion of course.

Reasonable minds can differ on the health of EA’s business. Some might think it strange that I do not consider Electronic Arts to be consistently profitable, because it depends on if you look at GAAP or non-GAAP. Accounting gives me a headache, but EA has had the deferred revenue issue for a while. The thing about recognizing revenues over time is that eventually you are recognizing so much revenue that even GAAP earnings start looking good. For example, EA’s net income ttm is $15M, while Activision-Blizzard’s is $892M. Even looking at the five year history net income ttm and EPS ttm at Activision-Blizzard grew and grew. World of WarCraft was all deferred revenue after a while. EA finally has a positive EPS ttm, even if it is just at 0.02.

Even assuming accounting magic, cash is at $1.3B maintaining the overall level with some slight decline. EA has a $500M share repurchase program, but I think I would rather see that go into development. The repurchase program is discussed in the earnings call. I understand that EA defers a lot of revenue under GAAP so the company does better than its savagely negative EPS would indicate. Perhaps the company’s fortunes are improving in a way that is readily discernible. Battlefield 3 has sold about 17M units and is still raking in revenue from add-on products and a premium subscription service.

Take-Two does not have any persistent deferred revenue issues that I can see. The company has an expense problem in my opinion, and the easiest place to fix that is in marketing. Also, looking past what we see and are told, I question the efficacy of some of the marketing campaigns. I think certain methods can be dropped to save cash.

Take-two’s Borderlands 2 required marketing expenses that were cited as a reason for the increase in expenses the last quarter. Borderlands 2 is a sequel to a very high-profile and successful game, and I do not think a company like Take-Two needs to burn so much cash raising awareness. I think Take-Two needs to consider a different advertising strategy. How much money do you think the company would need to spend marketing the next GTA game? Release videos and arrange for some sites to play demo versions, and it will spread across the internet like wildfire.

I make no secret about my preference for Activision-Blizzard. However, I have taken a closer look at a few other companies now. EA appeals more toward my riskier side, but Take-Two appeals even more. Electronic Arts is good if you want a big company with a safe cash position that has a chance at changing aspects of its business to drastically improve its results in the existing environment. I think Activision-Blizzard’s success counts on releasing huge hits, and it has been less active lately about exploring new properties. EA has its sprawl, but at least that gives it a chance to launch a new successful series. If costs are cut, and games are sold I think EA has a bit farther to go than Activision-Blizzard. Take-Two will benefit once the retail market for games recovers, but considering the titles under its belt I would consider buying at the first sign that expenses are shrinking rather than growing.