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EA: Ready to Score Big

By Jonathan Rudy With Microsoft's (MSFT) release of Xbox 360 on Nov. 22, the next-generation hardware console cycle has begun (see BW Online, 11/18/05, "Get Ready for the Xbox Shootout"). We at Standard & Poor's Equity Research Services anticipate that Sony's PlayStation 3 (SNE) will follow next, with an expected spring, 2006 launch, and Nintendo's next-generation GameCube, code-named Revolution, is anticipated to launch in mid-2006.

These new platforms, in our opinion, will be the key driver for the video-game software companies. We believe that Electronic Arts (ERTS

; recent price, $59) will be a major beneficiary of the next-generation hardware console cycle, as the company has the strongest and most diversified interactive video-game software library in the industry, in our view.

NO. 1. POSITION. With these new hardware console launches, in addition to the growth in the handheld and wireless gaming markets, we believe that Electronic Arts will reap the benefits. We think that EA's financial results will bottom in the current fiscal year, ending Mar. 31, 2006, and earnings growth will accelerate going forward, as the company leverages its current investments in infrastructure as well as research and development.

Additionally, Electronic Arts has consistently generated strong free cash flow, and has a clean balance sheet, in our view, with more than $2.4 billion in cash and investments, with no debt. We view this market leader as an excellent way to participate in the secular growth in the video-game industry. The stock carries Standard & Poor's highest investment recommendation of 5 STARS, or strong buy.

Electronic Arts is the leading provider, in our view, of interactive entertainment, or video-game, software. It's currently the largest independent video-game software provider in the world, based on revenues and market capitalization. We project an annual revenue run rate of approximately $3.4 billion for fiscal 2006. EA's leading brand franchises include: Madden NFL, FIFA Soccer, NCAA Football, Need for Speed, Harry Potter, The Lord of the Rings, and The Sims.

DOMINANT PLAYER. The games that Electronic Arts develops internally are published under three major brands: EA SPORTS, which includes Madden NFL Football, NCAA Football, FIFA Soccer, NBA Live, NHL, NASCAR, and Tiger Woods Golf; EA GAMES, which includes The Lord of the Rings, James Bond, The Sims, Need for Speed, and Medal of Honor; and EA SPORTS BIG, which includes NFL Street, NBA Street, and FIFA Street.

In calendar 2004, the company had three of the top 10 selling titles in the U.S. -- Madden NFL 05, Need for Speed Underground 2, and NBA Live 05 -- according to The NPD Group, a market researcher.

In Electronic Arts' fiscal 2006 second quarter, according to company numbers, it had approximately 75% of the sports market in North America, a dominant market share, in our view. It also had an approximately 27% market share on Sony's PlayStation Portable (PSP) in North America, and a 16% share in Europe.

PRICE BOOST. In fiscal 2005, Electronic Arts developed or published products for 11 different hardware platforms. EA's revenues by platform included about 43% from PlayStation 2, 16% from Xbox, 7% from Nintendo's GameCube, 17% from the personal computer (PC), 2% from Nintendo's GameBoy Advance/Color, and about 1% each from Nintendo's DS and Sony's PSP. Its co-publishing and distribution revenues were about 9% of total revenues, and subscription revenue made up about 2% of revenue.

Electronic Arts generates approximately 53% of its revenue from North America, about 41% from Europe, and 6% from the Asia/Pacific region.

As planned, the company released five titles -- Madden NFL 06, FIFA Soccer 06, Tiger Woods Golf, NBA Live 06, and Need for Speed Most Wanted -- in time for the Xbox 360 launch. We believe that Electronic Arts will benefit notably from the $10 increase in retail prices of titles over the last cycle, to $59.99, as premium titles should be able to hold this price point, in our view.

R&D PAYING OFF. Other new growth opportunities include the wireless and handheld gaming markets. Sony's PSP and Nintendo's Dual Screen (DS) have helped to provide a more diversified revenue stream for the video-game software companies.

Company revenues bottomed in fiscal 2005, in our view, even though Electronic Arts still grew revenues 6% in the middle of a transition period to the next-generation hardware consoles. We see revenue growth accelerating to 8% in fiscal 2006, and a further 14% in fiscal 2007, as the installed base for the next-generation systems continues to build out.

Moreover, we believe that Electronic Arts will be able to significantly widen its operating margin in fiscal 2007, as the company benefits from investments in R&D made in fiscal 2005 and fiscal 2006 for the next generation of hardware consoles. Additionally, as EA is able to leverage its franchises across more stock keeping units (SKUs), we believe it has significant earnings leverage in its model over the next gaming cycle.

MORE MOBILE GAMERS. In addition to the five titles released in time for the Xbox 360 launch, Electronic Arts plans to release an additional three titles for this platform by the end of calendar 2006. Plus, it has approximately 35 SKUs in development for the Xbox 360.

We believe that Electronic Arts will benefit over the long term from growth in the online and wireless gaming markets. In its most recently reported quarter, it experienced strong growth in its mobile segment, which was up more than fivefold, to approximately $62 million, and its Club Pogo online venture grew about 75%, to one million subscribers.

The current installed base of hardware consoles includes approximately 83.2 million units of the PlayStation 2, 24 million units of the Xbox, and 21.5 million units of the GameCube. We believe that the installed base of the next-generation hardware consoles could grow approximately 12%-15% from these levels, as these platforms continue to attract a broader and more diverse range of gamers.

BEATING ITS PEERS. Based on Standard & Poor's Core Earnings methodology, our fiscal 2006 and fiscal 2007 operating Earnings Per Share estimates are $1.36 and $1.86, respectively; each includes approximately 24 cents of stock-options expense. We estimate that the impact of expensing stock options should lower EPS by about 15% in fiscal 2006, and 11% in fiscal 2007. We believe that Electronic Arts has a higher quality of earnings, and lower negative impact from the expensing of stock options, relative to the broader software industry based on this methodology.

The stock trades at approximately 32 times our fiscal 2007 EPS estimate of $1.86 (including 24 cents in stock-options expense), at the lower end of its historical range. We believe that Electronic Arts can grow at a five-year compound annual rate of about 20% over the next cycle, as we anticipate it to grow faster than the rest of the video-game software market. This results in a p-e to growth (PEG) ratio of approximately 1.6 times, a slight discount to the company's peers.

In our opinion, the challenging aspect of valuing a cyclical company is that as a new cycle approaches, the earnings leverage in a business model such as Electronic Arts can be quite substantial. Thus, perhaps somewhat counterintuitively, we believe that investors should look to buy shares when they appear to be expensive on an earnings basis.

STRONG GOVERNANCE. On a price-to-sales and enterprise value-to-sales basis, the stock trades at a premium to peers at approximately 5.3 times and 4.6 times, respectively. However, this premium is warranted due to what we see as EA's strong, diversified brand library, which reduces its dependence on one or two hit titles, in our view. Additionally, given Electronic Arts' market leadership in the sports genre, annual releases of popular titles such as Madden NFL, NCAA Football, or FIFA Soccer, create steady revenue streams, in our view.

Based on our

discounted cash-flow valuation analysis, we arrive at an intrinsic value of about $70 per share. Blending our relative PEG and enterprise value-to-sales metrics and our DCF model, our 12-month target price is $70.

Concerning corporate-governance practices, Electronic Arts compares favorably with other companies in the software industry, we believe. Regarding the company's board of directors, positive corporate-governance policies, in our view, include that the board is controlled by a supermajority of independent outsiders (independent outsiders comprise over 75% of the board), the company's compensation committee is comprised solely of independent outside directors, the full board of directors is elected annually, and no related party transactions were found involving the CEO.

A WINNING CONSOLE? In the takeover defenses category, we like that the company does not have a poison pill in place, a simple majority vote of shareholders is required to approve a merger, and there is no dual class capital structure in place. As for compensation and ownership, we view positively that all directors with more than one year of service own stock, and that all stock-based incentive plans have been approved by shareholders. In addition, we view favorably that the company's audit committee is comprised solely of independent outside directors, and non-audit related and other fees represent 10% or less of the total fees paid to the audit firm.

However, we view somewhat unfavorably the combination of the chairman and CEO roles, and a $2 million outstanding loan to the CFO that the company has indicated it will forgive in June, 2006.

We believe there are several risks to our recommendation and target price. One particular risk at the beginning of a new hardware console cycle is that the acceptance of new platforms could prove to be a disappointment as investor expectations tend to grow significantly with the approach of the new cycle. This could lead to possible pricing or inventory issues. Also, as with any technology company, rapid technological change could notably impact Electronic Arts and its cost of developing or licensing titles for new technology platforms. There is also intense competition in the video-game industry as larger companies, such as Microsoft, have entered the industry in recent years.

Analyst Rudy follows shares of software companies for Standard & Poor's Equity Research Services

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