Wednesday, October 20, 2021

Electronic Arts: An Expensive Cash Cow

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(C) Reuters. Electronic Arts: An Expensive Cash Cow

Electronic Arts (NASDAQ:EA) is a worldwide leader in digital interactive entertainment, specifically specializing in developing, marketing, and publishing video games.

Electronic Arts produces and holds the rights to some of the most well-known and highest-selling franchises, such as FIFA, Madden NFL, Battlefield, The Sims, and various others.

The company has grown into a $38.1-billion giant, while management has recently started accelerating capital returns towards shareholders. I am bullish on the stock. (See EA stock charts on TipRanks)

A Cash Flow Machine

Electronic Arts manages a diversified portfolio of franchises, each engaging with different audiences, which unlocks multiple sources of cash flow for the company.

This enables a spread-out timeframe for publishing its games, which means consistent revenues. The gaming industry is subject to seasonalities, which the company has managed to alleviate.

In addition, economies of scale work significantly in favor of Electronic Arts, which results in substantial profitability. Costs remain fixed for a studio, whether a game sells a few thousand or a few million copies.

As Electronic Arts’ player base has been expanding over the years, the company has been gradually expanding its gross margins, currently resting at around 73.4%. Margins are also assisted by the trend of retail sales shifting to digital, saving the in-between retail-related costs.

With such high gross margins, the company has been consistently highly profitable, which along with its ability to generate consistent sales, makes it a cash cow amongst its peers.

The company is able to scale its current titles while maintaining a steady and relatively cheap CAPEX. For this reason, the majority of its cash from operations drops down to become free cash flow.

The business model is non-capital-intensive, so management can leverage the company’s large free cash flow generation to develop a healthy balance sheet, while also returning a notable portion to stockholders.

Capital Returns, Valuation

Electronic Arts management has gradually started returning an increasing amount of its excess cash flow back to its shareholders. Over the past four quarters, the company has repurchased around $1.16 billion of its common stock.

Further, around a year ago, Electronic Arts initiated a quarterly dividend, currently yielding a tiny 0.5%. The yield is not that meaningful now, but the dividend has the potential to grow considerably moving forward.

At an annual rate of $0.68, it implies a payout ratio of just over 10% based on consensus EPS estimates of $6.61 for the year.

With revenues set to keep growing as the video-game industry continues to expand, the stock seems very reasonably valued.

With a forward P/E of 18 attached, the stock is trading at the lower-end of its historical range. Hence, it likely offers an enticing entry point for investors.

After all, the company reported $6.1 billion in bookings in its latest results, which indicates that revenues, and profits, should keep growing as we advance.

Wall Street’s Take

Turning to Wall Street, Electronic Arts has a Strong Buy consensus rating, based on 16 Buys, three Holds, and zero Sells assigned in the past three months. At $173.13, the average EA price target implies 29.4% upside potential.

Disclosure: At the time of publication, Nikolaos Sismanis did not have a position in any of the securities mentioned in this article.

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