Investments That Look Good (But Aren’t)

Over the past 25 years, Electronic Arts (EA) has been an excellent investment. It has compounded at 18.33% annually. A $10,000 investment would have grown into $725,000. The stock doesn’t pay a dividend, so even if you bought it through a taxable account you would have the full value sitting in your account with embedded capital gains. If you sold it, you’d net around $550,000.

By many measurements, it appears to be an exceptional company. After making $75 million in 1999, Electronic Arts is expected to make $1 billion in the next year. The research budget is immense–the company spends hundreds of millions of dollars each year developing new games–and it enjoys a solid stable of lucrative intellectual property that allows the whole company to maintain mouth-watering profit margins. Even in the near term, the skies appear bright as EA will be rolling out a “Star Wars Battlefront” game.

The balance sheet is nice. As is common with video game companies, there is no pension or preferred stock. There are no off-balance sheet liabilities. The debt load of $633 million is less than nine months of annual profits. It has $2.8 billion in cash, for a net surplus of $2.2 billion.

Usually, when a company has 27% operating margins, has raised profits ten-fold in sixteen years, a twenty-five year track record of 18.3% annual returns, and a surplus of $2.2 billion on the balance sheet, the firm is a worthy investment.

Those optics look nice, but cover up an underlying reality that is far worse.

The first thing you should consider is that most of the gains at Electronic Arts came in the first decade after the IPO. The creation of the EA Sports franchise, as well as video gaming for the masses, coupled with the bubble valuation of the tech boom era to create substantial (if ultimately ephemeral) wealth. Between 1990 and 2000, Electronic Arts compounded at 35% annually. You turned $10,000 in 1990 into $250,000 in 2000.

The long-term returns at EA are still heavily weighted towards the very significant outperformance during those early years. If you change your measurement period to the past twelve years, the results are much more modest. Since 2003, EA has only returned 5.2% compared to the 8.2% annual performance of the S&P 500 over the same time frame.

My second point is that even those disappointing returns from 2003 through 2015 are generous because the stock is probably overvalued with a P/E ratio of 28. In 2012, it traded at 17.5x earnings, the low end of what I would consider fair value. If you look at the performance of EA from 2003 through 2012, you will see that the stock returned a negative ten percent annualized. You would have seen $10,000 shrink into $3,500.

The issue is that the company’s business model hinges upon always creating something new–it does create franchises like SimCity that maintain extended interest and live on through sequels and updates, but it can never rest on its laurels and enter autopilot. Colgate can keep selling the same toothpaste over and over again, with only incremental improvements in anti-cavity protection along the way. The product is nearly timeless, and the profits that the company generates twenty years from now will be similar to the source of profits today.

With EA, the company must constantly produce new games. I have a strong presumption against that type of model because you are always one product launch away from witnessing the evaporation of earnings. If you are someone that looks to own things for 20+ years, you are only a few bad launches away from losing your market position and suffering catastrophic, permanent earnings impairment. True, there is a research budget in the hundreds of millions, but it is a tall burden to find the pulse on the zeitgeist of the gamer community over and over again.

Between 2005 and 2011, investors got a glimpse of what happens when poor product launches is met by a recession. Profits shrank from $1.64 to $0.24 before turning into a loss of $1.33 in 2008 Earnings didn’t improve above that $1.64 mark until 2013 when earnings clocked in at $1.69. That $1.33 loss in 2008 amounted to a loss of ~$500 million. The stock fell from $61 to $14, and much of it was deserved based on the fundamentals of the game at the time.

In the near term, Electronic Arts may very well perform well. It has its hand in the Star Wars cookie jar, and that could auger well for earnings in the near term. But with a P/E ratio near 30, I think investors are underestimating the cyclicity of the firm. Bad times come again, and they will come hard. I would in no way feel comfortable spending $71 per share today and holding for decades. It is a near certainty that EA will underperform the S&P 500 substantially over such a long time frame.

Originally posted 2015-11-19 23:31:11.

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