Wednesday, January 19, 2005

Thoughts on the Future of EA

I've been thinking about Electronic Arts lately. Not them turning into The Borg, even though it appears that they are. What I've been thinking about are some of the oddities in their behavior over the last few weeks, and what those oddities might indicate about their future.

Here are the bits of information I'm working with.
1. Sports games provide 1/3 of EA's revenue (from a CNN article).
2. EA is buying up as many exclusive league licenses as they can, and paying outrageous prices for them.
3. EA just signed an agreement with ESPN for a 15-year deal to use the ESPN brand in their games.
4. EA said this week that they're looking to go "beyond" electronic entertainment and get into entertainment in general. A Sims 2 television show was mentioned.
5. EA's labor costs might go up in response to the class action suit now filed against them.

That's an odd jumble of moves. Historically, this is how EA generates its revenue:
1. Annual sports franchises
2. Licensed games like LOTR and Harry Potter
3. Buying developers after a smash hit, then flogging the sequels to death

I know that's incomplete, but I think it's the lay of the land, at least generally. Importantly, there's one thing missing, and it's the wave of the future: online games. EA has done a terrible job with online games, which is ironic, because Ultima Online was hugely successful. That was followed by disaster after disaster, culminating in The Sims Online, which was the equivalent of the Titanic sinking ten feet from the dock. The dock it embarked from. Yes, Battlefield is successful, but when was the last time you heard anyone talking about it?

Here's why I think EA has such a problem with online games. Marketing can definitely get people to buy a game, but it can't get them to keep playing. Online games generally succeed or fail on their own merits once the product has been purchased. Also, given the strange course of development for products like Motor City Online, it's clear that the online division has additional, structural issues. So in the online arena, EA's size is much less of an inherent advantage.

Regardless, EA is not participating as a primary player in online gaming, and given their status in gaming in general, that's quite surprising. Or maybe it's not so surprising. EA has a profitable map in the other three areas--they know how much a game will take to develop, how much they'll spend on marketing, and a general estimate of how many units they can sell. With online games, though, development costs are much harder to estimate, marketing is less effective, and it's very difficult to estimate how many subscribers will sign up--let alone how many will stay.

In the last two years, Electronic Arts stock (ticker symbol: ERTS) has climbed from $25 to $60, including a 50% increase in the last twelve months. Revenue, though, has only increased by 19% year-over-year. Earnings have skyrocketed, up 82%, but that's not sustainable--and in particular, their draconian overtime policies will likely be forced to change, increasing labor costs and putting more pressure on earnings. In the long term, without attractive revenue growth, a company like EA stops being sexy and starts being stodgy. Clearly, for the stock price to continue its march, revenue has to increase at an even greater pace, and once a company gets used to that rocketing stock price, it's very hard to give up.

So let's look at what they're doing. Are their recent moves reasonable in light of their need to grow the company at 20-25% a year? No. For starters, I think the sales of ESPN NFL2K5 deceived them in terms of market size. To some degree, I think they're looking at the six million in total unit sales between Madden and ESPN and, incredibly, concluding that they "lost" 2.5 million potential units because of ESPN. Any of us would know that's stupid--a large number of people bought both games, and nobody's buying two copies of Madden next year instead of one copy of each game--but companies can be amazingly short-sighted, because people inside the company have a set of common assumptions that they base their analysis on, and often those common assumptions are just wrong.

Then there's the potential move into television. Now let me get this straight--television ratings are declining every year because of the Internet (and, to some degree, online games), so EA wants to get into television? Bad, bad move. It's particularly bad to use The Sims 2 as the potential project. If The Sims Online proved anything, it's that EA really doesn't understand why The Sims was so successful. And if they don't understand that, they're not going to be able to capture it in a television show. Not that I'm sure they could, even if they understood it very well.

Here's another reason why the move into television looks disastrous to me. Remember Square? Great company, wonderful games, highly profitable. They wanted to make an animated feature (Final Fantasy: The Spirits Within). They knew how to control costs when making games. They had a profitable map. They had no map when it came to making a film. They poured a staggering amount of money into the film, and at some point the project just got totally out of control--they had put so much money into it that they couldn't back down. When it was finally released, it was a huge bomb (even though I thought it was better than the reviews). They spent twenty dollars for every dollar in revenue they made. That's revenue, not profit. It was the worst project in the company's history, and it took them years to recover. I'm not sure they've fully recovered yet.

When you have profitable maps of a process, it's easy to assume that some other, unknown process will be no more difficult. Bad assumption. Very bad assumption. EA is the big fish in gaming--in general entertainment, they wouldn't even be in the pond.

So these moves don't really make sense in terms of Electronic Arts growing the company. What if that's not what they're trying to do, though? There is an alternate scenario that I'm convinced has become far more plausible: EA wants to get bought.

Hold on before you say I'm crazy. EA can't keep growing at its current rate. It's much, much easier for a company to go from one billion to three billion in revenue than it is to go from three billion to nine billion. At some point, scale just eats you up. And as your growth goes down, so does your P/E, and as that happens, the stock price starts to deflate. I believe it's entirely possible that this $65 stock price might be as high as EA gets, at least for the next several years.
Sexy company, growing quickly but starting to strain, sees itself as vulnerable. What do they do? They sell. As fast as they can.

Madden as a franchise has value to a prospective suitor. What's much more valuable, though, is an exclusive NFL license for the next five years. And a fifteen-year deal with ESPN. In that context, overpaying for those deals doesn't matter, because they're designed to make the company more attractive as a buy-out target.

Television shows? Designed to demonstrate how easy it is to adapt games--EA games--to other entertainment mediums. And if a major media company believes that, think how attractive all those games would suddenly become. It's not just about games, then--it's about buying a company with attractive content that can be readily adapted to other mediums. It's about delivering a demographic that will then be willingly transported into other mediums. That would be the theory, anyway.

See? It's not so crazy. And I have to believe that Disney is the obvious choice for the suitor. Disney, through ESPN, is heavily into sports already. They're losing Pixar, which is a huge blow to their credibility, since Pixar has been responsible for whatever brilliance Disney has left. Who better to make a move on Electronic Arts and then claim that they're being "visionary" again?

I wouldn't be surprised at all if this happens in 2005. I would be very surprised if it doesn't happen by the end of 2006.

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