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New Strategy for Game Publisher Will Pay Off for Shareholders

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The last few years have been unexpectedly difficult for Electronic Arts (NASDAQ: EA) and other game publishers. The console cycle has lasted longer than most industry insiders expected, which has resulted in fewer sales for the industry.

But Electronic Arts has suffered from more than just overdue console releases; many of its top franchises, including its top-selling Madden NFL franchise, have been unable to significantly grow sales over the last few years. In addition, The Consumerist named Electronic Arts the Worst Company in America in 2012 for what gamers called a terrible ending to Mass Effect 3 (the world ended no matter what the user did). All of this bad news has resulted in a multi-decade low for the company's stock price. However, there is reason to believe that Electronic Arts represents a good investment as it streamlines its development strategy.

Poor past performance

Despite developing several blockbuster game franchises, Electronic Arts still lags Activision Blizzard (NASDAQ: ATVI) in profitability. The two companies have similar levels of sales and gross margins, yet Activision Blizzard routinely earns a higher operating margin than Electronic Arts. This suggests that Electronic Arts is not as efficient as Activision in developing its games.

<img src="/media/images/user_13490/atvi-revenue_large.png" />

<img src="/media/images/user_13490/ea-ebit-margin_large.png" />

Instead of earning high margins like Activision, Electronic Arts earns margins similar to its much smaller rival Take-Two Interactive (NASDAQ: TTWO). Like Electronic Arts, Take-Two has also suffered from an inefficient cost structure in recent years.

New strategy could turn company around

However, Electronic Arts is taking steps to streamline game development. In the earlier part of the decade, the company lost focus on its core franchises due to its enormous success. It added all sorts of titles to its library and essentially diversified away from its hit games. Realizing its mistake, Electronic Arts has decided to concentrate its development efforts on only a few titles and focus on making high-quality games for multiple consoles. Margins should increase as a result of this development concentration.

Electronic Arts also has an opportunity to expand into online and mobile gaming. Its long-awaited massive multiplayer online game, Star Wars: The Old Republic, is a big step toward achieving a defensible foothold in the online gaming industry. However, its biggest opportunity may be in mobile games, where it can port existing franchises to smart phones. Both of these opportunities present the company with a long runway for revenue growth over the next decade.

Finally, the company has a lot of cash on its balance sheet, which affords it the financial flexibility to invest heavily in its new development strategy while maintaining enough cash on the books to undergo another recession.

Valuation

It's not hard to see the value in Electronic Arts. From 2002 to 2006, the company turned every $1 of sales into $0.17 of free cash flow. However, it has since turned each dollar of sales into barely $0.02 of free cash flow. If the company earned a 17% free cash flow margin on its last four quarters of sales, it would have produced almost $700 million in free cash flow. At a 10x multiple, the stock would trade for $22 per share. At a 15x multiple, it would trade at nearly $33 per share.

The company is unlikely to achieve a 17% margin any time soon, but a 10% free cash margin is well within its grasp if the streamlined development process improves profitability. At a 10% margin on TTM sales, the company would produce $409 million in free cash flow. Using the same multiples as before, we get values of $12.86 to $19.29. At a recent price of $14.24 per share, the market is offering the shares at the lower end of the company's no-growth valuation.

 


titans8904 has no position in any stocks mentioned. The Motley Fool recommends Activision Blizzard and Take-Two Interactive . The Motley Fool owns shares of Activision Blizzard. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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