Electronic Arts Beats, Reaffirms

Electronic Arts Inc (ERTS) reported strong first quarter 2011 earnings and reaffirmed its full-year 2011 non-GAAP guidance. Electronic Arts reported a loss per share of 38 cents as compared with an estimated loss of 50 cents according to the Zacks Consensus. Loss per share includes stock-based compensation but excludes one-time items. Shares were up $0.74 (4.57%) after hours.

Electronic Arts reported GAAP earnings of 29 cents as compared with a loss of 72 cents in the first quarter of 2010, primarily driven by strong revenue growth and stringent cost controls.

Gross margin declined 160 basis points to 59.4% in the first quarter of 2011. The decline was primarily due to a greater mix of low-margin digital revenues. Operating loss, including stock-based compensation expense, was $156.0 million as compared with a loss of $44.0 million in the year-ago quarter.

Revenue Details

Revenues on a GAAP basis increased 26.6% year over year to $815.0 million in the first quarter of 2011. Revenue was below the Zacks Consensus Estimate of $744.0 million. However, excluding deferred net revenues of $276.0 million, revenues on a non-GAAP basis were $539.0 million, down 33.9% year over year from the prior-year period. Revenues on a non-GAAP basis were well above the company’s guidance range of $460.0 million to $500.0 million.

The year-over-year decline was primarily due to a lower number of title releases in the quarter, partially offset by a growth in digital revenues. Electronic Arts released six titles in the first quarter of 2011 as compared with ten in the prior-year period.

Sales from publishing (55.3% total revenue) plummeted 52.5% year over year, while revenues from Distribution (9.8% of total revenue) decreased 18.5% in the quarter. This was partially offset by strong growth in Digital revenues (Wireless, Internet-derived and advertising).

Digital revenues (34.9% of total revenue) spiked up 51.6% year over year to $188.0 million in the quarter, primarily driven by strong sales performance from Battlefield: Bad Company 2, FIFA Ultimate Team, Dragon Age, Mass Effect 2 and FIFA Online 2. At first quarter 2011 end, core registered users were 67 million, significantly up from 33 million reported the year-ago quarter.

Moreover, robust growth from titles played on Apple Inc.’s (AAPL) iPhone and iPad also drove revenue growth. In the quarter, Electronic Arts was the number one publisher across all platforms in Apple’s application store. Of the top ten games available in iPhone (launched in June 2010), nine were from Electronic Arts.

By geographical region, North American sales fell 40.5% year over year, Europe decreased 26.0% and Asia plunged 25.0% in the first quarter of 2011.

The company noted that its share in high definition consoles market increased 22.0% at the end of first quarter 2011 and Electronic Arts retained its number one publisher position. Electronic Arts also achieved significant market share gains in North America and Europe, and its market share increased 21.0% during the quarter.

In the quarter, three Electronic Arts games — 2010 FIFA World Cup South Africa (ranked 4), Battlefield: Bad Company 2 (ranked 7) and FIFA 10 (ranked 12) — were among the 15 top selling games in the North American and European markets. 2010 FIFA World Cup: South Africa, FIFA 10 and Battlefield: Bad Company 2 sold more than one million units in the first quarter 2011.

Balance Sheet

In the first quarter of 2011, cash used from operations was $148.0 million as compared with cash flow generation of $253.0 million in the prior quarter. The company ended the quarter with cash, short-term investments and marketable securities of $1.73 billion as compared with $2.0 billion at the end of March 31, 2010 and no long-term debt.

Outlook

For second quarter 2011, Electronic Arts expects revenues on a non-GAAP basis to be in the range of $775.0 million to $825.0 million. On a GAAP basis, revenues are expected to be in the range of $600.0 million to $650.0 million. Loss per share on a non-GAAP basis is expected to be in the range of 15 cents to 10 cents.

The company reiterated its full-year 2011 revenue and earnings guidance. Revenues on a GAAP basis are expected to be in the range of $3.35 billion to $3.60 billion, whereas on a non-GAAP basis revenues are projected to be in the range of $3.65 billion to $3.90 billion. Earnings on a non-GAAP are expected to be in the range of 50 cents to 70 cents per share for full-year 2011.

Electronic Arts projects a consistent revenue growth for the rest of the fiscal 2011 with approximately 21.0% of total revenue to come in the second quarter, 38.0% in the third quarter and 26% to 27% in the fourth quarter.

Management believes that 2011 will be a strong year, driven by quality titles and robust growth in the digital business. Management expects to release 7 titles in second quarter of 2011. The company continues to expect that its top 20 titles for fiscal year 2011 will generate approximately 80.0% of total packaged goods revenue.

Electronic Arts expects to release 36 titles for fiscal year 2011, with 15 titles in third quarter and 8 titles in fourth quarter. The company is expected to release its much awaited Medal of Honor on October 12, 2010, which we expect will provide a boost to the third quarter profitability.

However, the company could be hurt by pushing title releases. Electronic Arts has rescheduled the release of Crysis 2 to the fourth quarter 2011. Moreover, we believe Medal of Honor will face tough competition from Activision Blizzard Inc.’s (ATVI) Call of Duty: Black Ops, which is expected to be released in November 2010.

Recommendation

We maintain a Neutral rating on Electronic Arts on a long-term basis (6-12 months), primarily due to better-than-expected first quarter results, strong product pipeline and a debt-free balance sheet. However, sluggish video game industry trends, negative cash flow and increasing competition from Activision Blizzard, Take-Two Interactive Software Inc. (TTWO) will hurt profitability in the long term.

Currently, Electronic Arts has a Zacks #5 Rank, which implies a Sell rating on a short-term basis (1-3 months).

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