Description
I believe EA today presents investors with an opportunity to buy into a well-positioned compounder at a low valuation (around 15x P/E ex cash) that will also see limited headwinds (maybe even tailwinds) from the Coronavirus. As I detail below, I see the video game industry as enjoying 1) LT margin tailwinds from the transition to digital gaming, 2) a very cost efficient entertainment product that should enable strong medium term growth and 3) favorable gamer demographics that will enable longer-term growth. We particularly like EA (see 30%-40% upside to the stock today at 20x P/E adj for cash) as we favor its durable sports franchise with associated growth opportunities.
Why the Video Game Industry is Well Positioned
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Gaming industry has gotten notably more profitable and stable for publishers (EA, ATVI, TTWO)
Over the last ~10 years, the videogame publishing industry has seen its profitability improve as the gaming industry has shifted to digital. Today, around 50% of the console gaming unit sales are digital (with the digital mix increasing ~5% per year). By comparison, 90%+ of the PC gaming industry is digital.
The first order benefit of digital gaming is obvious, packaging costs of ~$12 per game go away with digital sales. However, with the rise of digital gaming, we have also seen publishers monetize their games via microtransactions and downloadable content. In both cases, players are able purchase new gaming content and/or features after a game purchase with publishers keeping around 70% of the revenue. Not only are these revenue streams highly profitable but they have also pushed the gaming industry away from the boom/bust cycles of the 2000s to a more stable, compounding sector.
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Videogames are 1) among the cheapest forms of entertainment that will support continued sector growth in the near-to-medium term and 2) enjoy favorable demographics trends as we are seeing the average gaming get older.
Console/PC games are a fairly inexpensive form of entertainment per hour. The cost of entertainment is most comparable to OTT video.
As a result of gaming’s cheap entertainment value per hour, we have seen an increase in consumer time playing video games. The rate of revenue increase for video games has come just under OTT video.
While the below chart is a bit dated, it shows that has been also been a trend toward gamers being older. This is likely as a result of the rise of Nintendo in the late 80s (which created a first generation of gamers). This further implies more near-term upside to gaming growth if the “Nintendo generation” of gamers keeps player (and older, non-gaming generations are replaced with younger gamers). This trend will be discussed more below.
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Over the long run, the rotation to cloud-based gaming looks poised to support longer-term sector growth with additional potential for margin expansion
Over the next 5-10 years, the future of gaming is likely on the cloud. Cloud-based gaming effectively just replaces the console with a cloud server. Today, cloud based gaming is small. For example, Sony offers PS Now which only had ~700k subscribers in March 2019. The services are still small because no one offers a seamless cloud service yet. However, the likes of Microsoft and Google are working to leverage their cloud platforms to develop this technology. The question is more likely when rather than if.
When cloud-based gaming becomes mainstream, it will likely significantly reduce the barrier to trial for the consumer (after all, he/she will no longer need to spend the $400 required to buy a console). With the below analysis is highly illustrative, if we think that 1) cloud gaming increases gamer penetration in the 5-9 age cohort from 60% to 80% and 2) those new gamers are 75% as sticky through their life as current gamers, it’s easy to underwrite ~4% gaming growth for decades to come.
Final note is that cloud gaming is also likely to be benefit to MTX take-rates for the publishers. More platform competition means there will be fighting over quality AAA content. While the savings are difficult to exactly quantify, we can look to the PC space where new entrants are undercutting incumbents on tax rates down to as low as 12-15%.
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Barriers to entry in the gaming space are increasing as AAA games are increasingly in favor
Gamers are increasingly playing the same games for a longer period of time that has dramatically increased game development costs as publishers 1) try to attract gamers to purchase their titles for longer game play and 2) develop add on products/features for future purchase.
Budgets for flagship games can now exceed $100mm (Destiny and GTA5). This was further echoed by Ubisoft’s CEO who explicitly has said the usual cost of developing AAA game is over $90mm.
As a result of these high development costs, we have seen the market share of each of the major publisher’s flagship games increase (crowding out other smaller studios).
Game concentration with a select few publisher incumbents helps to prevent the industry from being invaded in a way that Netflix did to the TV networks. Disrupters in gaming cannot access compelling content because the publishers simply won’t license to them if the economics are not compelling. It also helps that all of the big three gaming companies are also extremely profitable with net cash positions.
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Gaming industry appears to be a (relative) Coronavirus winner again supported by its cheap entertainment price and convenience compared to alternatives.
Recent indications are that the Coronavirus has been a positive for videogame usage. Twitch hours were up 66% in Italy and Verizon CEO noted that internet traffic related to gaming was up 75%. Steam has also seen a marked pick up in hours of gameplay since the world went into quarantine.
This year was shaping up to be a very quiet year in the gaming industry as publishers waited until the new Xbox and Play Station were released in late 2020 before releasing new games. Thus, if there had to be a year when the Coronavirus would shut down the global economy, 2020 isn’t a terrible year for the gaming industry. Finally, while I’m not sure I subscribe to the view that gaming stocks need to outperform upon the release of new game consoles (particularly now with the new consoles supporting legacy games), the stocks have historically at least modestly outperformed the NASDAQ in these time periods.
Electric Arts (“EA”) Overview
EA is a $24bn TEV video game publisher and the second largest US video game company behind Activision Blizzard. They are predominantly a Console/PC business (~85% of revenue) and Sporting Games (FIFA/Madden) make up the majority of the business’s revenue.
EA revenue has historically grown at a MSD rate (a bit below industry average rates likely from EA’s focus on more stable sports platforms- more detail below). EPS/margins for the business have compounded up as the industry structure as improved as discussed above. 
Why I favor EA’s position in the Video Game Space
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Sport franchise gaming has the highest moat in the space
FIFA (~45% of EA revenue)’s dispersed contracts makes competition from rival gaming companies almost impossible