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"Electronic Arts has missed the current hardware cycle" - analyst

Cowen Research sceptical over publisher's guidance, Wii focus and new IPs

EA has "missed the current hardware cycle" and is unlikely to return to historical operating income margin levels "anytime soon", according to a new report by analysts at Cowen Research.

In an occasionally damning critique of EA's plans and guidance the report states that: "We believe that following serial earnings disappointments, Electronic Arts now deserves a lower valuation premium than the company has historically enjoyed."

"Since management first laid out its initial full year 2010 guidance and full year 2011 long-term guidance in February 2008, the company has failed to deliver on its earnings targets and has been forced to repeatedly revise down its guidance. Given this historical record, we do not think investors should place too much faith in management's current guidance."

The report suggests that EA's guidance for the next financial year is "fairly aggressive" but that its targets could still be met. EA's revenue targets currently stand at USD 4.3 billion, but the report suggests this can only be achieved via further cost cutting - which is likely to be damaging in the long term.

The report points out that publishing revenue growth will need to outperform overall industry figures by a considerable margin, despite a "pared back" release schedule and currently difficult global economic conditions.

Growth in digital distribution is seen as a key factor, with EA aiming for a 100 per cent increase over the course of the year - which the report again characterises as achievable but with considerable downside risk.

Despite considerable scepticism over EA's business model and guidance the report is not entirely critical, maintaining a share rating advice level of "neutral".

Indeed, the report suggests that EA's own expectations for its first quarter may be unnecessary low, with a strong line-up including EA Sports Active and Bloom Blox: Bash Party on the Wii. First year sales in the US are estimated at 1.4 million and 350,000, respectively.

Although this would make EA Sports Active one of the most successful third party titles on the Wii, the report is general sceptical about the ability of any third party publisher to thrive on the format.

The report is particularly despondent about third party sales when revenues for Guitar Hero and Rock Band are ignored, where the top 5 per cent of third party titles for the Wii sold an average of 860,000 units, compared to 2.5 million on the Xbox 360 and 1.2 million on the PlayStation 3.

These top 5 per cent of titles accounted for only 31.8 per cent of total market share on the Wii, compared to 41.2 per cent on the 360 and 34.2 per cent on the PS3. The figures also suggest that quality and critical reaction are far less import on the Wii, making successful titles even harder to predict.

The report is also sceptical over the impact EA's increase in unlicensed new intellectual properties will have, with only 36.5 per cent of sales expected to come from unlicensed titles in the next financial year. Estimated first year US sales for selected EA-owned titles stand at 1.5 million for The Sims 3, 0.4 million for Brutal Legend, 0.63 million for The Saboteur, 1.3 million for Army of Two: The 40th Day, 2.1 million for Dragon Age: Origins, 1.1 million for Battlefield: Bad Company 2, 1.1 million for Mass Effect 2 and 0.8 million for Dante's Inferno.

In a final comment on the company's future for the next 12 months, a potential buyout is mentioned - especially given EA's current share price is currently significantly below its historical valuation. The report hints that Disney and Time Warner may be the most likely suitors - although the latter suggestion seems to have been made before the recent move for Midway.

Although Cowen Research's expectations for 2010 are only a little below that of EA's it is significantly lowering its 2011 estimates, from a year-on-year earnings per share increase of 48.7 per cent to just 24.0 per cent. The firm's analysts suggest that "further margin gains will be difficult without significant new hit games". However, little is currently known about EA's publishing schedule for that period.

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David Jenkins