How Electronic Arts Lost Its Way

EA is spending too much to make video games for systems that cost too much for consumers, and its new titles aren't hooking gamers. Is it takeover time?

Expectations ran high almost two years ago, when John Riccitiello took the helm of video game maker Electronic Arts (ERTS). Formerly operations chief for EA, Riccitiello had departed in 2004 to co-found private equity firm Elevation Partners. He came back with a clear mandate to slash costs, boost game quality, and distance EA from a risky strategy of overspending on titles based on big names such as Tiger Woods and James Bond.

But the turnaround has yet to materialize, investor patience is wearing thin, and speculation swirls that the company could fall prey to an acquirer. On Dec. 9, the Redwood City (Calif.) company said it will miss its profit and sales forecasts for the fiscal year that ends in March. Shares tumbled the following day, and almost every analyst who follows EA has downgraded the company's stock. "Just when investors began to believe that things couldn't get worse, they did," says Wedbush Morgan analyst Michael Pachter. "Investors remain skeptical that management is on the right track."

Wrong on Costs, Hardware, and Content

What's keeping EA off track is a nagging propensity to overspend on games, says Todd Greenwald, a senior analyst at Signal Hill. EA releases about 35 to 50 titles a year and spends 27% of sales on research and development. By comparison, chief rival Activision Blizzard (ATVI) backs just 15 titles and spends 10%. With both companies posting revenues of about $5 billion, Activision's profit margins per game are fatter. "EA just doesn't know how to make a game for less than $10 million to $20 million," adds Greenwald, noting that successful companies excel at creating a few key titles gamers feel they absolutely must have.

EA also overestimated demand for expensive machines like Sony's (SNE) PlayStation 3 and Microsoft's (MSFT) Xbox 360, which can cost as much as $500 apiece. Consumers have instead flocked to Nintendo's cheaper Wii, which has been outselling both those systems 2 to 1 heading into the holiday season. After ramping up the creation of games for other systems, EA is now scrambling to develop games for the Wii. "They made a strategic bet on the PlayStation and Xbox," says Colin Sebastian, an analyst at Lazard Capital . "It may have been logical, but it was the wrong bet."

Meanwhile, Riccitiello's plan to drum up best-selling original content isn't panning out. New games like the science fiction horror title Dead Space, which the company hoped would become a lucrative new franchise, were well received by critics but haven't sold in high numbers. Riccitiello declined to comment, but said on a conference call the company would shed 6% of its workforce, or about 600 jobs, and reduce research and development spending in 2009. He also promised to be more aggressive in canceling titles that lack "hit potential."

Takeover Speculation

EA is stumbling just as the game industry hits its stride. Despite the sour state of the economy, U.S. retail sales of video game hardware, software, and accessories jumped 10%, to $2.91 billion, in November from a year earlier, according to market researcher NPD Group. NPD analyst Anita Frazier says the industry remains likely to generate record sales of $22 billion this year, as games provide a relatively inexpensive form of stay-at-home entertainment.

With its stock so battered, EA could become a takeover target, some analysts and pundits have opined. Disney (DIS) has been rumored to be eyeing the company to expand its reach into video games. Disney's ESPN, for example, would make a natural fit with EA's sports division. But with lending scarce, analysts doubt Disney could raise the $15 billion it would need to clinch an EA takeover.

EA isn't without some successes. It scored a mild hit last month with an apocalyptic zombie game dubbed Left 4 Dead. Unless management can rein in costs and convince investors it can pick more winners, EA's turnaround efforts may be given the same epitaph.

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