EA adjusts earnings downward

Share price stumbles, recovers on warning of lower-than-expected income for the megapublisher's next two quarters.


The Godfather

Jittery investors panicked yesterday, selling off shares of industry giant Electronic Arts after it warned of an expected shortfall of revenues for the quarter ending December 31, 2005. After closing up 86 cents on the day Tuesday, the stock shed almost 4 percent of value after hours.

However, unlike some of its competitors, who saw their share price slammed following earnings warnings, EA's stock quickly recovered. In trading today, the publisher's shares ended up $0.35 from their previous closing price of $53.11. Volume was 14.7 million shares, almost five times its average of 3.4 million shares.

EA's earnings update comes on the heels of weak sales figures across the board for the game industry. Last week, research group NPD reported that November 2005 sales were down 18 percent from November 2004. But news that the number one third-party publisher would not meet its income targets put the industry-wide downturn--sparked by Xbox 360 shortages and the absence of 2004's holiday blockbusters Grand Theft Auto: San Andreas and Halo 2--into sharp focus.

In a post-bell conference call with analysts, EA's chief financial officer Warren Jenson said, "We expect our third quarter results to come in well below both the previous low end of our guidance range and current consensus estimates." He added that they should expect a sharp decline to revenues, a "mid-teens percentage decline on the top line."

"At the time of our last earnings call, we estimated industry numbers to be lightly up against last year given the introduction of two new platforms," Jenson told analysts. "It now appears that the overall market will be down in the double digits. The demand curve has shifted abruptly."

Focusing again on his own company, he added, "As we discussed in late November and early December, our sales have been below our expectations. Unfortunately, we have seen no improvement in the last 12 days, and sales have, in fact, further weakened in North America." The publisher had previously expected a third-quarter revenue of $1.48 to $1.58 billion.

Looking ahead, Jenson said, "we also expect these market trends to impact our fourth quarter and full year results."

While analysts across the board adjusted their own forecasts after EA clarified its sales outlook, few seemed outwardly shocked. "This preannouncement was not a total surprise," Mike Wallace of UBS said. "We had already lowered our numbers twice over the past 2 weeks."

"For the third time in three weeks we are reducing our EPS estimates," a weary-sounding Tony Gikas of PiperJaffray said in a morning memo, "Long-term growth trends remain in question, as does our valuation analysis on EA."

Wedbush Morgan's Michael Pachter echoed his colleague's statements, saying "It appears that revenue and earnings growth will remain challenged through the next fiscal year." He reiterated a Buy rating on the stock, but lowered his price target from $66 to $60.

Shawn Milne of Friedman, Billings, Ramsey was more optimistic, but his outlook was long, long term: "We maintain Outperform based on expectations for a significant snap back in earnings in FY08."

A few of the more interesting questions posed of Jenson and EA CEO Larry Probst during yesterday's conference call are as follows:

Analyst question: [Is there] any way of letting us know that this is a temporary problem versus a longer term industry problem? Has this transition been worse than previous transitions for any specific reasons that you can point to?

Probst: I would say that we're still very bullish about the upside potential on the next generation platforms and future growth opportunities for the company. A combination of things have occurred this quarter that have caused the results to be below expectations.

And I would include in that that the Xbox 360 launch, although it's gone extremely well in North America and Europe, we don't see them getting to the installed base numbers that we had anticipated when we provided guidance previously. The introduction of that platform has caused the Xbox 1 business to slow down dramatically. There's a rumor out there that the PlayStation 3 may be launching in the springtime of next year, and I think that's causing some people to stay on the sidelines and perhaps postpone purchases.

Analyst question: Do you think that we're seeing some fundamental changes in terms of consumer preferences, industry-wide, not EA specific? Mainly they're looking for some new brands or more distinctive games?

Probst: I would agree with you that if you take a look at the assortment of titles across the industry that are out there during this holiday season, it's probably not as compelling a portfolio of product as we saw last year. Last year we had Halo 2 and San Andreas on the PC. We had Half-Life 2 and World of Warcraft. The lineup this year is arguably not as compelling, but again I don't think that's a long-term indicator. I think that's this holiday season relative to last.

Analyst question: If you don't expect a pickup in Q4--and I'm going to assume probably throughout calendar 2006--do you think any brand-new games on the PS2 can hold $49.99 out of the gate, or are we likely to see most everything come out at $39.99?

Probst: We've got two significant titles shipping on the PlayStation 2 platform in our March quarter. One is Black, the other is Godfather. We haven't made any final determination on the pricing. We will assess the situation and at the appropriate time announce pricing. But I would expect that going forward the majority of new titles in the industry on PlayStation 2 are going to be launched at $39.99.

Analyst question: Is there anything you can do in terms of the outback spending to respond to this? Sales and marketing, maybe curtail R and D a little bit? Or is it just something where you bite the bullet for the next couple of quarters until we get back to a normal industry again?

Jenson: I would tell you as we move into our detailed planning for the next fiscal year, there really are three things that are top of mind for us: The first one is, we continue to believe in the industry, and we will continue to prepare for PS3 and to build the best titles we possibly can, because it is the corner of our company and we will continue to do that. The second thing that we will do is we want to support our brand value and the brand value of those titles with the best and the biggest--the widest breadth of marketing we possibly can.

That said, the third thing we will do as a team, is we're going to go through every aspect of the company, where we have opportunities to reduce spending, we will take advantage of those opportunities. When we come out of this transition, we want to come out of it stronger, we want to come out of it faster, and able to take advantage of the opportunities that lie ahead.

Analyst question: You made a comment about rumor that PS3, or reports that PS3 is coming out in the springtime frame. Your own viewpoint, it's a second-half launch. Do you think that causes a transitory kind of head fake in terms of the consumer buying over the next several quarters if you're looking at a second-half launch of the PS3, just like we saw with 360 here--folks delaying purchases in general in anticipation of next gen?

Probst: I would say, yes, that the possibility exists that people will postpone purchases in anticipation of getting their hands on a PlayStation 3. And if the belief is that that's going to happen in the first half of the year, then clearly that would have some impact on the March quarter, and if they believe it's in the second half of the year, I think the impact is not as great.

But people are going to be giving some consideration to that future purchase event. And the other rumor that's out there is that the price point is going to be lower on the PlayStation 3 than some people previously expected. And, so, that will be part of the equation as well.

Analyst question: Can you talk specifically to the Godfather, which has obviously been expecting to come out in the first half of next year? Is that something that you're committed to?

Probst: Yeah, we absolutely are committed to building that franchise over the long term. We are still expecting to launch that in the fourth quarter of this fiscal year, and we have high expectations for that title. And that will be a key part of our content portfolio going forward.

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