EA Has Much More Upside Post Q3 2016 Earnings

  • EA Q3 2016 earnings were centered around Battlefront digital/physical mix.
  • EA fell short of its non-GAAP gross margin target, but it seems well positioned to beat Q4 2016 earnings estimates.
  • Furthermore, FY 2017 is shaping to be a promising year due to the strong line of AAA titles and on-going mix shift to digital.
  • As such I continue to reiterate my buy recommendation on EA and anticipate 10% additional upside by the next quarterly earnings date.

Electronic Arts (NASDAQ:EA) took a beating coming out of the quarter and it was partially due to the broad anticipation that the digital mix was going to be a lot higher. EA reported revenue of $1.8 billion versus consensus estimates of $1.810 billion. EA reported non-GAAP EPS of $1.83, which beat consensus expectations by $.02. I think buy side expectations were for $1.89 non-GAAP EPS with an incremental $.05 to $.10 in non-GAAP EPS driven by Battlefront assuming high enough digital sell through. However, the sales mix of Battlefront leaned more heavily to physical as opposed to digital. This negatively affected the non-GAAP gross margin as it fell below guidance by 110 basis points, which translated into the very nimble EPS beat.

Star Wars Battlefront got caught up in the usual gift giving frenzy, which was why the packaged format became a much larger portion of the sales mix, and while the Star Wars sell-through was higher than the broadly anticipated 13 million figure for FY’16, the profit metrics weren’t nearly as reassuring. As such investors started discounting assumptions on valuation going into the end of the year. Now whether this justified a 7.52% sell-off on Friday is up for debate, but when basing it on EA’s guidance for FY’16 the non-GAAP EPS figure was $3.05, which fell short of the $3.07 non-GAAP EPS estimate. While expectations on the sell side were high, the expectation among buy side analysts was even higher, hence the selloff.

Quoted from EA earnings call transcript:

So right now, I would say nothing would imply to us that the digital journey is slowing in anyway. And in fact, if we look at all of our non-Star Wars products, every one of them were up digitally in full game downloads and the digital engagement associated with them. You look at the Ultimate Team statistics we gave you, that's clear sign that people are playing and engaging longer and longer around the titles. In terms of guidance, guidance on Star Wars, we are not going to break out individual guidance. Obviously, we'll end up selling more than the 13 million units, as we've already gotten there. We did sell more in the third quarter, so we may ultimately sell less in the fourth quarter than we originally thought. But we will clearly sell more overall and that's built into our guidance for the fourth quarter.

For the most part, I’m not too concerned by the weakness in EA's sell-through figures for digital as it seemed more like a one-off event. Furthermore, if Battlefront reached 13 million in sell-through there’s potential upside to Battlefront sales once we enter into Q3 2016 despite weakness in seasonality.

Prior to Q4 2015 EA guided conservatively and as a result, EA beat the consensus average by 56% in terms of non-GAAP EPS (last year). I’m anticipating the conservatism in the non-GAAP EPS guidance of $.40 to translate into a bottom line beat, but perhaps not to the wide extent we had witnessed last year. Since Battlefront already reached 13 million, there’s upside to last quarter estimate especially on the digital front. While I know many aren’t anticipating Battlefront strength to carry into Q4’16, the holiday quarter was inclusive of some discounting, which resulted in pricing of $40 on some AAA titles. My guess is that we’ll roll into Q4’16 with healthier pricing dynamics in conjunction with 500k to 1 million in incremental units.

However, expectations on earnings/sales is the next major theme once EA reports its Q4’16 results in the March or early April time-frame.

The analysts over at Wedbush shared some interesting commentary in a recent sell-side note:

We believe there is plenty of reason for optimism going forward. Management confirmed that a Titanfall sequel will launch in FY:17, joining Battlefield 5, Mass Effect: Andromeda, Mirror’s Edge Catalyst, and potentially the next The Sims game as well. Prior to the print on Thursday, the Street had modeled FY:17 EPS growth of almost $0.50 to $3.57. We believe EA could print an EPS figure closer to $4.00 by year-end, with its incremental AAA titles providing incremental EPS of $0.55 and digital growth generating an additional $0.30.

While upside is limited over the near-term, I come away with impression that EA will continue to sustain a pattern of beats over the course of FY’17. Whereas Q4’16 could result in a beat, I’m anticipating that there’s a potential $.05 upside to consensus non-GAAP EPS in FY’16. So, I’m valuing EA at $70.85 (22.71x EPS) by end of FY’16 (3-month target). I will offer a FY’17 target upon Q4’16 results as management will provide full-year 2017 guidance in March. The company seems somewhat undervalued following the earnings announcement as I anticipate 9.7% upside by end of the fiscal year reporting period.

I continue to reaffirm my buy recommendation. While I acknowledge EA’s earnings miss in Q3’16, I anticipate investors to pile back into EA due to a better than expected earnings print in the next quarter. I also anticipate management's outlook for FY’17 to exceed $3.50 non-GAAP EPS given the strong line-up of games and on-going shift to digital.

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