Chit Chat Stocks - Why We Own Electronic Arts (Ticker: EA)

Episode Date: September 30, 2022

This is an Arch Capital Update episode, a monthly recurring series where we explore holdings and decisions made for our investment partnership. Electronic Arts (EA) develops and distributes games, content, and services. The company markets its products through digital distribution and retail channels. Brett and Ryan dive through EA and outline the investment thesis for why we own the company in our Arch Capital limited partnership. ------------------------------------------------------------------------------------------------------------------------------------ What is Arch Capital? Arch Capital is a concentrated, long-only equity fund aiming to compound capital at an above-market rate. Arch managers are perpetual learners with a long-term focus that strive to build wealth with our partners through intelligent capital allocation. Learn more here: https://www.archcapitalfund.com/ ------------------------------------------------------------------------------------------------------------------------------------ If you can't access this episode, you may want to subscribe to CCM+. Sign-up directly through Spotify or Apple Podcasts for $5 a month. If you listen on another podcast player, use this link and create a private RSS feed: https://anchor.fm/chitchatmoney/subscribe Need more information? Check out our launch newsletter: Here ------------------------------------------------------------------------------------------------------------------------------------ Timestamps Why we own EA (1:18) Competitive Advantages (22:46) Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. On this show, host Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or recommendation. Now, please enjoy this episode. Welcome in. This is the monthly Arch Capital episode for CCM Plus subscribers. I will describe what the Arch Capital episode is, but if you haven't listened to the others, there is one more

in the queue right now, and that is Spotify. But we plan on doing these once a month. But before we talk what it is and then what company we're talking about today, as a reminder, if you are on apple podcast email us at chit chat money podcast at gmail.com and let us know that you have subscribed the spelling is down in the show notes and we can get you on our mailing list for ccm plus subscribers you'll get show notes and other information charts that go along with each episode all right ryan today we're talking electronic arts um this is a company we own in the arch capital portfolio uh we've owned it since the beginning uh you know i guess it's been a holding for the entire time, although the fund has only been open for less than two years now.

But we're going to be talking about why we own it, what the company does, competitive advantages, some of the long-term growth trajectories, and why in general we like the stock at its current valuation. Anything else before we get into the details of what these type of episodes are? What should listeners expect from these monthly Arch Capital episodes? Well, for the time being, we are trying to encapsulate we've been doing these themes if you've been a ccm plus subscriber you know we've been doing these like themes so we did video gaming this last month so we try to wrap it up with the video game stock we're gonna try to do that as long as we can although we only have so many holdings in the arch capital portfolio so it just might not work out but um well yeah

we'll come up with something else different themes when the time comes yeah yeah and so we went through four or was it five video game companies over the last month for Capcom, Rovio, Ubisoft, Xbox, and now we're doing the fifth, which is a company we own electronic arts that kind of fits in with all those other ones. Yeah. And it's, uh, I recommend if you can listening to all those episodes after you listen to this one, because it gives you an idea of, And we're going to get to this, but it gives you an idea of the stability of EA versus some of the other developers. There's just lumpiness. Lumpy results is a part of being a gaming company.

And some of the more mature businesses have proven an ability to smooth out those results. And do what they say they're going to do. But like some of the other companies that we've studied, historically, they claim they're going to be doing stuff and they actually don't execute. Electronic Arts, as we'll kind of describe, has some competitive advantages that allow them just an easier time. Yeah, it's an easier time. But yeah, let's get into it. Yeah, let's start there. The way we're going to do this, we're just going to ask each other questions.

So I'll let you kind of explain for anyone that doesn't know what is Electronic Arts. Yeah, so Electronic Arts is a multinational video game publisher. They own many different game development studios, but they have a focus on the console and PC franchises, but they also have a growing presence in the mobile market. Over the last 12 months, just for reference, 61% of their sales came from consoles, and consoles just mean Xbox, PlayStation, and Nintendo Switches, although the vast majority of theirs will be the Xbox and the PlayStation systems. And then 22.5% is revenue coming from PC games.

And then 16.5% is from mobile and mobile mostly equates to smartphones. So think Android or iOS. The company owns and operates many different franchises. You likely know them for their EA sports brand, but they own much beyond that as well. The most important, and this is in descending order from most important from a revenue perspective to the least important, at least some of these might be an estimate, but generally these are the most important. So FIFA Soccer, which is soon to be EA Sports FC, Apex Legends, Madden NFL, The Sims, Battlefield.

Then I have a category here of other sports simulation franchises, which include hockey, golf, Formula One. These are more niche, you know, durable audiences, but a lot smaller than football or soccer. And then the Star Wars Jedi series, which they have a relationship with Lucasfilm and Disney to make a lot of games for the Star Wars brand. and then for a comprehensive list of studios we're gonna put out these notes most likely in the newsletter there's a nice graphic from one of their latest investor presentations and it shows all the different studios they have around the world that are operational and all the games that are under development now these are not all of the games that EA has under development there's some that are hidden they don't do everything released to the public and there are always

titles that are not formally announced I think we just had today one that got announced I didn't get a chance to see it on twitter but the big thing is that they have a lot of games in the pipeline they always do and that's you know the benefit and maybe you know you get that diversification as a large video game publisher now after building the games ea markets and distributes them it's pretty self-explanatory through both digital and physical versions an example of a digital version is download and add on content purchased through console smartphones or pc platforms like steam and then physical packages i think everyone knows and you know well they're the discs that are bought at retailers like best buy over the last 12 months

less than 10 of their sales came from packaged goods making the majority of ea's business now going through digital platforms like xbox ios and steam which have higher margins because of the packaged goods you have i think it's a it's about a six percent to ten percent gross margin advantage And that's 10% of total revenue, but of games sold. So keep in mind, there's two revenue streams here. Essentially, you've got revenue from microtransactions, so purchases within the game, and then the purchases of the actual game itself. Of the games being sold, 65% are digital.

So there's still plenty of upside in terms of more games being sold online. for anyone that's not understanding it, or if we have any listeners that aren't gamers, it really draws a perfect parallel to like the movie industry, Blockbuster versus Netflix. Bad home movie industry, yeah. And how everything kind of went on to streaming.

I think that's, you're probably going to see that same exact evolution. It feels very similar. So yeah, just keep going. Yep. And only a few notes here. It's a pretty simple business. But lastly, I think the other thing

investors should understand is that the majority of EA sales now come from these live services and other, which are the microtransactions that Ryan was talking about. They categorize it, if you're looking at their investor reports, as live services and other. This is everything that is in a full game purchase. Here's the full definition from EA's SEC filings. Live services and other net revenue include revenue from sales of extra content for console, PC, and mobile games, licensing revenue, subscriptions, advertising, and non-software licensing. So basically everything that isn't full game downloads and over the last 12 months 73 of ea sales have come from the live services

category which has grown as a percentage of revenue over the past decade um you know the majority of this is and again like i said fifa and apex are the most important franchises here and then on top of that there's madden nfl and sims um but it's a lot of add-on content for say the fifa soccer game where you're buying packs players all that good stuff or apex legends where you're buying skins um for your characters guns whatever it is for the shooter games um and this is the most important category to track because that has been the majority of growth for ea over the last decade now before we get into the investment we do need to give some more context so ryan can you give some history and important context for electronic arts with business because

it's a very not a very old business but one of the oldest gaming businesses out there yeah and there's some sometimes history is more important for certain companies uh but ea it's it's been i'd say the last 10 years or have sort of been it's a very different business today than it was 20 years ago um but to give some context anyways the the company was founded in 1982 by a man in trip hawkins so trip was an early apple employee i think he was there when there was like i want to say gosh i'm gonna get the early days tiny amount of employees when they went public though he had a whole bunch of stock sold it basically got this windfall of cash and he always wanted he'd always been and like loved the gaming business he wanted to start his own company

from even while he was at apple he knew he wanted to do this and so he went off launched his own which was basically just software for computer games um and early on i think they are he already had a relationship with Sequoia. So they got some funding from Sequoia Capital. I think it was $5 million in total funding. And for the time, that's a decent amount. So they were pretty well capitalized early on. And they got some office space in Sequoia's office park. That was kind of the really inception of the business. And it really became one of the early premier game publishers so and it's pretty much held that role for 40 years now it's they early on it was simply just pc games um or computer games i should say and then whatever console was out they would

build for that as well whatever console was popular at the time and often it was basically this war between sega um and nintendo there may have been some other ones as well but those were like the two yeah there was atari we don't need to really get going all the details for that And they became sort of the well-known publisher. And there was kind of this, I don't want to say iconic moment, but an important moment in their history that embodies the company that they still are today. So in the late 80s and the early 90s, Nintendo was really successful. They were the dominant console, and EA wasn't making games for them, which was a sacrifice in terms of revenue. But they said EA was unwilling to abide by Nintendo's conditions, which would have involved agreeing not to provide the same games to Nintendo's competitors, such as Sega. So by remaining platform agnostic, they took a risk on not receiving revenue up front.

But as the console ecosystem evolved, this ended up being the right decision because it allowed them to be more popular with a larger fan base, with different consoles, and kind of maintain a positive relationship and be that independent publisher. um and they an early employee who i believe was there for a long time basically said our basic competitive advantage is that we can publish games across multiple platforms simultaneously in a cost-effective way and in multiple languages and deploy it globally better and bigger than anybody else i think that really encapsulates what drove their success for the first 30 years of their business and probably even still today um size matters yeah in this industry as a publisher at least having the scale and the resources to build for different consumers and different geographies on different platforms isn't easy and nintendo's maintained that impact that advantage

for a while you mean ea yeah sorry well nintendo's and nintendo maybe but yeah yeah um and so i guess other important parts of the business was throughout the 90s they started landing a lot of big licenses um and so the ones that probably come to mind are fifa and madden but there was also a lot of other ones that they landed that kind of sparked or ignited the strategy so there was a one game cover that was like larry bird and dr j um they had some with james bond they had some with nhl the nhl players association uh pga they this is when they really started establishing their licenses and they would throw their this was really just it wasn't about having the rights to characters or some of the ip that those brands had it was more just for attracting consumers

because the games weren't that advanced at the time so by putting fifa on the cover by putting john madden football on the cover it really attracted consumers to the game and it kind of built up this sort of brand loyalty brand notoriety um it obviously became more important later on as live services became a component and you wanted the rights to the actual players that were uh under a lot of those brands but those really helped establish those relationships and it wasn't until um i think it was 2004 that sega had success with their espn nfl 2k5 game When they did that, they stole a bunch of market share from EA and EA realized, okay, we need to lock these in and signed super long-term exclusive agreements with a bunch of leagues. And that really helped them dominate the various sports that they were in.

The only one that they really lost in was basketball. Which is, yeah, take two interactive. Well, there's three big categories, right? football american football soccer or international football and uh basketball and ba has two of them but nba 2k is produced by take two interactive now and nba chose to be uh chose to not have an exclusive deal so so ea had produced several basketball games yeah and they still could i guess right now but that kind of goes into the competitive advantages we'll talk about later it's not worth it for them to do basketball because 2k is just there's no way they can

compete with them but on the flip side can anyone compete with fifa and madden i guess we'll discuss that further right and so that that's why getting those sort of landmark licensing deals was really important at the time was even if you built like all right take two obviously has the big notable basketball game in nba 2k but ea 15 years ago could have built a basketball game and still had had a decent amount of sales. It wasn't like all the sales were skewed to one provider. Now, today with the live services, it's not worth the development costs unless you already have the name in that sport. And so that's why EA has been able to maintain for, I guess, what is it now, since the mid-90s, their prominence in football and soccer mostly.

there's also PGA Tour and stuff like that, but those games are pretty minuscule in terms of revenue for EA. I guess the only other parts of the history that I think are important, last 10 years, last 15 years, John Riccatello came in as the CEO in 2007. His big, I guess, accomplishment was that he reorganized the company into individual studios that operated autonomously. At the time, there was less creativity. That was kind of the knock on the company at the time. And so they said, we're going to separate these into independent studios. It was four major labels. I believe it may have changed since then, but there's four major labels. They all operated autonomously and it allowed them to be a little more creative and produce

more games. Then he was, to be honest, pretty underwhelming as a CEO. So Andrew Wilson came in, I think it was 2013. He's the current CEO today. The last 15 years, only real important the only other real important points as far as history goes they've made a lot of acquisitions a lot of mobile related acquisitions yeah and that was accelerated the last uh year if we look at their history when wilson took over he did not like he thought ridicello over acquired and then they only they really slowed down the acquisitions but the last year um which i guess we'll go through in our capital allocation discussion uh they they've re-accelerated the the acquisition spree yeah and then part of a big a big component of their success over the last decade has has

really it isn't it is not even credit to them i mean they've obviously had to play into it but it's just been how the industry evolved the games have become more interactive gaming today you want to play where other people are playing. And so that's created what is largely a winner-take-all market for most of these sports-based games. So I know I already alluded to it, but there's no real global competitor to FIFA. There's no real global competitor to Madden. That's because it's so interactive today. So much of the revenue comes from live services. So So that's really been a tailwind for them. And then also the move to digital has really increased margins.

I think gross margins have doubled over the last decade. So do you think I'm missing any important history? Okay, well, that's pretty much it as far as history goes. What about, let's talk about the revenue drivers today. So what are the dominant revenue lines for them? And then what are the biggest costs? Yeah, so to be clear, they don't put, most of the time they don't talk about the individual revenue

from each game but reading through the tea leaves and stuff we can kind of parse out what are the most important ones and they have give some notes from time to time so as discussed briefly above you know the two largest sales drivers are the full game sales and live services and we can separate the different franchises into those driven by live services and then those driven by full game downloads and remember the most important are these live services games so the big four live services games are fifa soccer apex legends madden nfl and the sims and they all sell a lot of these micro transactions in-game content and this also includes mobile for the majority of these i know apex legends just launched their mobile game fifa soccer just revamped their

mobile game we maybe we'll talk about that later in the risks section how they're investing heavily into the mobile market right now and how they really haven't executed well within that the last few basically the last decade as mobile has taken off and become the largest part of the gaming industry and on top of that again there's the niche sport games hockey golf racing and then the second category would be full game downloads the ones here you know you have battlefield star wars jedi mass effect dead space and then a lot of other smaller ones now battlefield if executed correctly should likely be in the live services category however they've really they've had some disappointing games the last couple of releases and there's been a reorganization there

um the company's executed well in spite of it but this has kind of been the one that's been disappointing out of all the franchises that could be live services now within the sports categories and then apex legends and the sims they executed well but within battlefield that's kind of the one they missed on now ea also owns a growing portfolio of other mobile games that are not attached to its core you know console or pc franchises um it has bolstered this portfolio the last few years through acquisitions of playdemic glue mobile and metalhead software In the show notes, we'll have a reference list here of all, I think, the 40 plus acquisitions they've done over the years.

You can kind of go through those and see when they were heavily acquiring companies, when they haven't. And then if we want to go through the cost and kind of show how they have the margin structure they do, there are three major costs outside of standard corporate and back office expenses. First one are fees paid to platforms like Xbox, Steam, and the smartphone makers, which take a cut on every dollar spent inside of EA's games, or I guess for the game, if you're on some of the platforms as well.

These fees make up the majority of EA's cost of revenue. Last fiscal year, cost of revenue was 27% of net revenue. So I think when you're looking at, and there's some other stuff in the cost of revenue, like payment processing fees and some data center stuff, but most of it is that fee paid to the public, or excuse me, the platforms like Xbox or Steam. We would expect this to probably stay around the same level

and possibly go slightly lower, which would increase their gross margins this decade. but not much lower. I mean, a lot of juice on the gross margin has already been squeezed. Now, the second cost is game development expenses. So this is the vast majority of EA's R&D expenditures each year. Last fiscal year, they spent $2.19 billion on research and development, or 31% of revenue. Now, both numbers are up from fiscal year 2018, which ended in March of that years, so about five years ago, when they had $1.3 billion in R&D expenses at only 26% of net revenue. Now, that is important to note because our thesis here, and one of the theses on the

stock over the next three to five years, one of the reasons we own it, is we expect R&D as a percentage of net revenue to quickly decline over the next few years. Obviously not go to zero, but they're in a heavy games development period. And over the next couple of years, as these games release, hopefully do well. Revenue will go up and R&D won't go up by as much or maybe stay around the same level. Now, lastly, self-explanatory one, sales and marketing. As the publisher of the game,

EA is responsible for marketing its people, or excuse me, marketing it to people. And last fiscal year, marketing expenses were 14% of net revenue. So we got, just to sum it up, cost of revenue, 27% of net revenue. That is fees, R&D expenses, or game development expenses at 31% of net revenue

and then marketing, 14% of net revenue. And then obviously they'll have G&A expenses, but those should stay fairly stagnant over time. Although the salaries to some of their executive teams, they get talked about in the media sometimes as being a little exorbitant and that might be true. All right, next one. Why do we think EA has multiple competitive advantages?

this is the heart of any you know thesis we have so ryan why don't you go through it and maybe we'll discuss each of them yeah so the first one is what i talked about earlier it's it's that massive network effect within a lot of its largest brands so thanks to live services if you're a gamer you want to play where everyone else is kind of playing and in some cases certain games they actually have to reach a certain amount of scale to even function properly and so to kind of illustrate this point if you've if you don't think network effect or the the other player base is that big of a deal i recommend going and trying to play fifa or madden from past generations so go try to play fifa 18 and any of the live services and it's basically you can't find a

game you can't find a peer to play against um and then even within the current generation let's say someone built out a competing game um if it was split 50 50 a bunch of the functionality would be destroyed there's like it's hard to well there's tournaments different skill levels right yeah there's different skill levels the different tournaments there's different stages of different tournaments where everyone has to be playing concurrently in order to find a match to set up a match there's auctions you're trading cards literally with other players around the world if there isn't a certain level of players there's a certain level of scale that the game doesn't function properly and so i think ea's really locked that in um i also think

that uh well i guess i'll save this for another point but basically people are going to stay there because the best distribution point or the best distribution place for next year's game is this year's game. So if you're going to buy or you're going to upgrade to next year's version of FIFA or Madden or the next iteration or season of Apex Legends, you're going to get advertised to in the current season or the current game. And that's probably where you're going to make your purchase because you get discounts, you get different points, different incentives to sign there so it makes it so on top of the network effect iterating is more consistent and then your development is more predictable so so the development costs aren't quite as risky

yeah and then a lot of that even on non-sports this applies as well um and it can create well in sports it kind of creates winner takes all in non-sports um it's more of a winner takes most now i'll say an example to maybe the detriment of ea is call of duty that's been a winner takes most in the shooter franchises the traditional shooter franchises that um battlefield has turned into a more second you know it's been the more niche player within that space however if we look at battle royale um fortnite was the number one player there two other games from apex legends and uh gosh call of duty warzone have risen and become popular among their own right but um and what sorry pub g yeah i think that's yeah similar i might be forgetting some but either way there's

only been a few that have reached the necessary scale from a live services perspective which means you have enough people playing online you have it you know you're able to have the large enough development team to make it worthwhile um and with these battle royale or you know competition games where you're playing against people around the world even if it's non-sports you also need that benefit so that's why apex legends has been such a diamond you know since since it launched in, what, 2018 or 2019, it has grown so quickly is because it kind of caught fire with that user base.

They have this, you know, gigantic user base and the monetization is fairly simple, even if it's a free-to-play game. As Andrew Wilson quoted recently, they see from engagement to monetization, they basically see a one-to-one correlation. So if engagement rises, if their user base rises and their daily users and how much they're playing rises,

it correlates exactly to monetization. They kind of have that honed down as a very experienced games publisher on how to monetize properly, which also is probably an advantage that you're going to talk about as well with that scale. Yeah, I guess I'll save scale for later. But the second competitive advantage that I think is worth mentioning is that unlike some other industries, so you talked about the Battle Royale, that free-to-play mode, sports-based games are evergreen. And because of the ties to the actual sports themselves and the growth of the sports, you're always going to have a consistent fan base. So there's just less risk of losing that potential gamer base where you might have with Apex or Fortnite, stuff like that. Typically, now Apex has done a pretty good job since it first launched of maintaining its user base. but it's easier for those to stray away and those gamers to stray away and find different

games. Whereas if you are dedicated to the sport of football, you're going to stick with Madden or you're going to stick with whatever the popular football game is at the time. And the growth of the sport overall just drives more adoption for EA's sports-based game. So that's another advantage. The other one here, licenses. EA has deals with literally hundreds of organizations. And in a lot of cases, those licenses are exclusive. So I believe La Liga now is literally called EA La Liga. Yeah. And the easiest one is the NFL, which is the one league. They have an exclusive deal. I think it's 2026, something around there. Don't quote me on that, where no one can make a simulation game until then. I mean,

that's a monopoly by definition. Right. And the other part is that as, So let's take FIFA for an example or EA Sports FC, whatever it's going to be called. There's hundreds of different deals that they've had to sign. So you have different agreements with different leagues, different teams. In some cases, you have to sign licensing agreements with stadiums in order to use the stadium in the game, that kind of thing. Their bargaining power in those agreements goes up as thanks to the network effect, thanks to them being the prominent place in gaming for soccer. So they can kind of get sweetheart deals because if those stadiums or those clubs decide, no, we're not going to do it, they're going to collect no gaming revenue. There's no other way for them to get soccer gaming revenue. So that kind of gives them more advantageous position in those negotiations. Last thing I'll say here, scale. We talked about it briefly, but if you look at commentary from gaming companies dating back to the 90s or the 80s, one of the biggest pain points for the industry is finding enough developers to release all the games that they want to release and to do so in a timely fashion. ea because they're so large is able to pay people more it's able to attract more employees

than your your smaller peers obviously there are some developers who will want to be in sort of those independent studios and build their own thing but more often than not if you're able to pay them more you're probably going to attract them yeah and then there's a de-risk the business through diversification because if we look at they acquired respawn entertainment in 2017 that is the maker of apex legends and star wars uh the jedi series among some other stuff they're kind of having them under development right now now the studio has been phenomenal like it's its execution has been fantastic for ea however if respawn was under its own on its own it would only have one game and then it was trying to come out with this new apex legends game based on the

titanfall franchise that risk of execution if it's just respawn launching this apex legends game is super high if they're on their own. But if it's under EA's umbrella, they can probably take higher risk because if the game fails, it's not as detrimental to EA. They can weather that storm and take more shots on goal without risk of going out of business. All right. Let's talk about their, I guess, financials. Why is cashflow, if you look at the business currently, you're going to see basically suppressed cashflow. Talk about why that is and why we expect it to change. Yeah. And this is another crux of the thesis. If we look at their five-year chart, which will be included in the notes that we send out, free cash flow has been stuck right above the $1.5 billion range, even though revenue has gone up by almost 50%. So if we look at the chart, revenue over the last five years is up 42% and free cash flow has barely budged. Now, at first, this game was paused. We were like, why is free cash flow not growing along with revenue? And as we thought about it, and we looked at their games pipeline and kind of the commentary they've had out and their R&D expenses, it all comes down to this game development and then the timing of game releases.

Now, when a game gets made, a ton of the expenses are spent up front. And what's strange is they're including operating expenses when they really should be capital expenditures. And I guess that wouldn't affect free cash flow, but just kind of a weird accounting. The gaming industry has strange accounting. Um, but all the revenue is going to be earned after launch. You're not going to get any before launch with live services. This even makes it more, uh, I use the word astute here, but I don't think that's the right word. It's even more dragged out where it takes many, many quarters and possible years for full monetization to kick into high gear. If you have a successful game, as opposed to that flat purchase of $60 while you pay

it up front. Now, EA has multiple games in development right now that are inflating R and D expenses and making its cashflow look weak. this year guidance for operating cash flow which translates fairly well into free cash flow is only 1.6 billion to 1.65 billion dollars these include the games under development include ncaa football which has i think the potential we both think the potential to be a live services cash cow uh and be the next you know probably the third biggest sports game under their franchise they have three new star wars games an iron man game a lord of the rings mobile game a battlefield

mobile game dead space remake mass effect need for speed and then a skating game and on top of this they're investing heavily into apex legends mobile which was released in 2022 quite recently it's doing well downloads wise but they have not turned on the monetization tools yet so again that's an example of they're investing all this in development right now but they're not going to get that return for a few years after i'm sure we're missing some on this list but they just have a huge amount of games coming down the line a lot of them are not going to get released this fiscal year but will come out over the next you know the next couple of years and are all these games going to be a commercial success no i can guarantee you not all of them are going to be a

commercial success but ea is getting a ton of shots on goal over the next few years um unless the majority of these titles perform poorly which i guess is a risk we think there's going to be major leverage on this r&d budget over the next two years likely driving operating cash flow to three billion dollars or more each year or annually and now there'll be some lumpiness in the games industry and it might go lower. But part of the thesis is we think there's going to be that inflection going forward. Anything to add there, Ryan,

or should we talk about cloud gaming and why we think that can be a great long-term tailwind, especially for electronic arts? Yeah, let's jump to cloud gaming. The thesis here is pretty simple. First of all, I personally believe, and I think Brett's in agreement, that cloud gaming is probably where

the majority of the gaming market is heading. I guess mobile is kind of its own thing. Mobile is almost already cloud, but just at a smaller scale, less graphical, less computationally intensive, as I'm trying to say. Yeah, what I mean by cloud gaming is that you have a Bluetooth connected controller and you have an internet connected device. And on that internet connected device, whether that's a smart TV, whether that's a PC or an iPad, you're able to basically click in to the Xbox app and play live console games without needing the console. All you need is that Bluetooth connected controller, or you could even have it on your phone. But and and you don't grip is important and you don't have to download the game to your specific hardware. It's all, you know, streamed in the cloud, just like think of it as the Netflix for games.

and xbox is investing heavily in this sorry keep going potentially that becomes one subscription that you have to pay but even if it's just the xbox cloud app where you could directly play the games you just pay for the games you play them um it's still you're still getting similar economics but it could also be bundled into some sort of a subscription yeah the netflix subscription yeah it's not the subscription it's more of how the video gets the person yeah yeah but right now one of the largest barriers to access for customers is it costs $500, sometimes $600 if you're getting all the equipment with it to really become a console gamer. And then you also typically have to pay for Xbox Game Pass in order to have the live component, or you could pay just

for live, but you might as well pay for Game Pass now. And so it's a big cost in order to really become a console gamer i think that's part that plus the current sort of shortage of supply of consoles has driven sort of stagnation in the console market i should have included that in the cash flow too i forgot the cut that the console shortage is hurting ea's cash flow remember i'll give that note here 61 of their sales came from consoles so if less people are getting consoles less people are playing ea's games right so it's pretty simple as if playing via internet connected devices becomes more common it's much cheaper for consumers to access triple a games or the console games that have previously been very expensive to get um and in some cases

literally impossible to get if you wanted an xbox series x right now you may be yeah i i checked for research for the show on amazon it's by invitation only which basically means you have to be checking constantly and see when they get supply and then like someone like me who's more you know not even going to buy one uh is is just never going to get one until they have fully in stock right um but so obviously this benefits um this benefits the console developers because a lot of people want access to their games but can't get them so it clearly makes the pool larger but these are also the highest or the most immersive games um relative to a lot of the other platforms so So if you're thinking about like mobile, I guess PC could be pretty immersive too, but

these are the highest budget, most immersive, most people want to play these, can't get access. So that's going to benefit EA if that's where most of the gaming ends up happening. Additionally, it benefits EA because as I alluded to, 65% of the game sales were digital. So 35% are still physical cartridges, not cartridges, packages, CDs. If you're playing cloud gaming, it's impossible. There's nowhere to put a CD. So you're going to buy those games digitally. That's higher margin. It's not going to create significant operating leverage since we're already sort of reaching that level where most of the game sales are digital, but it's increasing, slightly increasing operating leverage for the business as well.

Am I missing anything there? I don't think so. All right. Let's talk about management capital allocation. Obviously, some people have, I guess, bears, people that are bearish on the stock would say that capital allocation has been pretty bad for management. I guess we kind of think otherwise. So do you want to talk about why you've liked the capital allocation decision so far and what you think of the CEO and executive team? Yeah, like you mentioned, just as reference again for listeners, Andrew Wilson has been the helm of EA since 2013. So almost a decade now. You know, we also understand and I think anyone that knows the company well listening to this, they know he gets a healthy salary that may happen and end up in the news quite a lot. But his execution has been top notch since he took the helm. So for the CEO of a games publisher, from an investor's perspective, we think the two most important categories are acquisitions and returning capital to shareholders. Specifically, acquisitions are very important because that's part of the nature of a large game publisher like EA. They're basically turning a roll up that has succeeded over the last few decades. Now, since Wilson took over, acquisitions have been small and less frequent, but have generally worked out well.

in 2017 as we mentioned EA acquired Respawn Entertainment for under 500 million dollars if you include all the earn out incentives which given the execution of that studio I think they hit all their earn outs since then the studio has made the hit Apex Legends game which does over 1 billion dollars in sales a year and is building out the hit narrative Star Wars Jedi game which is one of the top selling and it's a little bit smaller because it's mainly full game downloads but one of the top selling games it's going to have a sequel coming coming in 2023 In 2021, though, and this is where a lot of people got a bit nervous with EA, they accelerated their acquisition strategy and bought four companies, Codemasters, Glu Mobile, Playdemic,

and MedHod Software. There was around $4 billion in capital spent on the deals. However, what's nice is that EA is so cash generative that they didn't have to dilute shareholders and share count continue to go down. They're able to spend on buybacks, which I'll talk about next. i don't and i think ryan i can would agree with me there i don't think any of these will be as successful as respawn respawn was known to the best acquisitions in gaming i mean it's early but one of the best ever um we are optimistic that you know given how wilson has been a bit

more capital disciplined that they see a ton of opportunity within these studios for a reason and they wanted to acquire all this developmental talent for a reason they saw the opportunity here I mean, for Codemaster, it's pretty simple. They own the rights to the F1 game. F1's growing really, really quickly, and they've shown tremendous growth again. So they wanted to have that lock on and do that to be another one of their niche licenses.

Glue Mobile, I think they wanted to get the mobile developers. I think they acquired 500 mobile developers to accelerate that development. Yeah, I was going to say, a lot of this, some of the thinking here was probably just acquihires. It's easier to buy all those developers, and they already have the continuity and the team. They already know how to work together

and to generate, create really good games together that you can basically just buy the team in one. Yep, and we haven't talked about it much, but a lot of EA's thinking around where they can find more growth this decade is to invest smarter into having some of their historical franchises come to mobile. So they've invested heavily

in revamping the FIFA Soccer mobile. They're coming out with Battlefield mobile that might be on, we don't know when that's going to be released, but it's in development apparently um and then apex legend so yeah those are what the acquisitions are for um yeah it adds risk and it was a lot of money being spent we don't know there's a lot of unknowns of how if whether these will be successful but given how disciplined wilson has been we think there's a lot of opportunity there um it's not the highest part of the it's not the most important

part of the thesis but lastly on capital returns um since wilson took over ea has turned into a heavy share, excuse me, repurchaser with shares that's standing down around 11% in the past 10 years. That might not seem like much to compare to a lot of share cannibals, but we think highly of management teams that consistently buy back their own stock, especially if valuations become depressed as they are right now. And we expect, you know, as cashflow and flex higher, the dollar amounts flowing into share repurchases to accelerate over the next few years. You know, I mean, if you look at anything that's after acquisitions, right, but they generate their free cash flow and then their definition of free cash flow you know doesn't go into acquisitions

after they spend money on acquisitions almost all of it i mean they have a small dividend but almost all of it goes into buybacks we like that the game their you know franchises especially the sports ones are so predictable that they have the lean balance sheet they're i mean compared to someone like activision blizzard who was just and obviously a good business that kind of ran into some tough times over the last year, who was just stacking up cash on the balance sheet and what had like $10 billion in cash. We like EA's strategy of returning the cash to shareholders is they can grow, say, revenue at a 10% rate, but they're reducing share count as well, and free cash flow at a 10%

rate or something like that. This can be really beneficial, especially with the durability of these franchises. Now, lastly, I think this is the last question. Oh, no. We talk about acquisition as well. Okay. Last question for you, Ryan. What are the main risks we are watching?

What could go wrong here? How will we know if the thesis is busted? Yeah, I'll try to go through these pretty quick because I know we're running maybe slightly long for listeners. So the first one that I think about personally is the loss of relevance of APEX. So it doesn't seem to be happening yet. But as we kind of alluded to earlier, the free-to-play kind of battle royale market has been changing pretty quickly. Consumers have kind of hopped from game to game.

There's been a lot of different successes as well. PUBG, Fortnite, Apex, Call of Duty. Is that Warzone? I mean, Apex has only been around for a few years. Who knows whether it's a fad and it's over a billion dollars in the revenue. For reference, they're guiding for about $8 billion in revenue. So it wouldn't kill the business, but it's a large part. But reading through all of the games that EA has released over the years, I was kind

of looking through the history. It shows how hard it is to get a franchise that really sticks for more than 10 years. So even though Apex feels like a huge hit right now, there's just always durability concerns there, just given that we haven't seen it stick around for long enough. So that's what I'm watching. Second one, this is more of a short-term issue, but just foreign exchange headwinds. I know a lot of companies are going through this, but 57% of EA's revenue last year came from outside the US, it's going to be, there's going to be quite the headwind on bookings

for this year. FIFA's big in Europe. Yeah. Management's projecting that bookings growth in constant currency would be 8% to 11%, but in actual revenue or actual bookings, it's going to be 5% to 8%. So that'll be a headwind. And they said that last quarter, and I think things have gotten worse. So it might even, they may even have to revise that guidance as well.

The last one, or I guess maybe there's two more, but the big one that I really, really think about is just the mobile investments not paying off. EA has invested a ton into their mobile business over the last decade, not only through the billions of dollars in acquisitions, which Brett mentioned, Glue Mobile, Playdenic, PopCap Games was like 2011, but still it's, that was one of the acquisitions. That was John Riccatello. That was kind of a failed one. Right. So, you know, people look at that and say, okay, they bought, spent $4 billion on these other companies. Why are those not going to fail as well? Yeah. And then they've also poured a ton of money into internal development for mobile games, Apex mobile, FIFA mobile. Well, they had a FIFA mobile, but they really revamped it. You can, you can see that in the development costs. And if you look through management's commentary on the conference calls, they've talked about spending a lot in trying to develop those games.

that's included there as well and frankly i kind of as an investor hate the mobile market i have a hard time seeing what's successful like if someone pitches a game to me let's we just looked at rovio if someone pitched angry birds to me i would have no way of knowing oh that's going to be a hit yet it's generated cash for a decade um i think some of ea's franchises don't lend themselves that well to the mobile landscape i think fifa the sports the sports yeah really are better played on a console and you could even make the same case for apex it's a better experience on console that doesn't mean they can't well the the review there to be fair the reviews on apex mobile have been fantastic uh but yeah exactly and on the flip side the mobile here like the risk of their

franchise not being for mobile mobile's been the big growth driver in the entire gaming market If cloud gaming is going to be as big as we think, and we're not basing it off of our own research, we're kind of going off of the industry experts saying that cloud gaming is the next big thing, that could kind of reverse the tide and give a little bit of resurgence for basically consumer adoption among the, you know, the more, we have a hard time describing them, the more graphically intensive games that EA develops. yeah it just and so mobile tends to be i found that like gaming on mobile tends to be more trendy it's harder to establish a durable franchise and so when when ea acquires a company for not just for the development talent but because they have a franchise that's successful it kind of worries me just because habits can change so quickly and and gamer sentiment on mobile can change so fast so that's kind of something i monitor i want to keep an eye on mobile revenue they break it out so you better track it well any investor can track it every quarter it's done well

so far but again needs to keep doing well right and then the last one is just and i don't think this will happen but the failure to adapt to new platforms so if if the whole world goes to vr and ea doesn't shift well that could be detrimental but we don't even think that like we this has been ea strength yeah they've been able to adopt or adapt their intellectual property of their franchises to every new successful console and that has been their bread and butter since except except nintendo because they seem to hate but yeah uh i think that's more on nintendo nintendo seems to have uh difficult relationships with all publishers but um let's let's hit the last question there's been a lot of acquisition rumors lately how do you think about that

How likely do you think an acquisition is? Is that setting some sort of a floor for the business? Yeah. So sum it up. I think this is a nice little cherry on top for the EA investment. Rumors have been flowing around the last year that EA has been shopping itself to potential acquisition candidates, likely because they saw the Microsoft Activision Blizzard deal and the premium Microsoft paid for those assets.

Now, if the Activision Blizzard deal goes through, which will hopefully get approved in 2023, that's kind of the timeline those companies laid out. we kind of see the potential for multiple companies to bid for EA. And the most important thing is multiple companies, because then there can be a potential bidding war here where you get a nice little premium for EA's assets. Now the two most likely would be D would be Disney or Amazon. Disney already has a relationship and Amazon is trying to get into the

entertainment business. And they're building out a cloud gaming thing, which is or something within gaming that is just really, really small right now. However, you know, any of the tech giants on top of Disney or Amazon could kind of get in the mix. Probably not Apple

given their acquisition philosophy, but you know, Meta could acquire them, which is Facebook for anyone that's forgotten. Google has been trying to do gaming, although they kind of scaled back a bit. Microsoft probably no, just because

of the Activision Blizzard, and who am I forgetting? The other thing I'll add here, I mean, Apple's in gaming. Yeah, but they don't do big acquisitions, so it's probably out, but yeah. I would say the lines between linear entertainment companies and interactive entertainment companies are starting to blur. Yeah, Netflix could be here too, but EA, they don't. Comcast is a good one too, I forgot about them.

Disney, I don't know if you mentioned Disney. I did, yeah. I mean, for the two that seem the most likely to be in the mirror, Disney or Amazon, just because Amazon is trying to get into sports and they're also trying to get into gaming. they have a gaming division and disney already has you know they have sports and a great relationship with uh electronic arts yeah they both seem possible and you can kind of piggyback right now i think there's that's why yeah if that would be regulatory approval if microsoft yeah if

microsoft the largest you know microsoft and activision those are can team up i think yeah people will be able to acquire ea now on the upside you know this could be beneficial to shareholders um we'd probably like to see a 30 to 40 percent premium at least on ea sure ea's current share price given that we think the stock is pretty under you know really undervalued versus the cash flow that's coming over the next five years however on the downside also presents a risk if ea stocks goes down even further um you know just because of broad market stuff or whatever they have a bad quarter um a potential suitor could swoop in and take the company out for less than it's worth uh and you know we as shareholders who bought at slightly higher prices than where

it is right now would make little money as common stockholders um in the deal so that's a risk but on the whole we do think is you know it is likely enough given the rumors that have been out there to consider as a part of our thesis again nice little cherry on top um that you know we could get some accelerated returns here over the next uh say year or so there's the potential there hard to put a number on it maybe 20 chance something like that hard to put a range but it's high enough to warrant consideration all right that's going to do it should we sum things up um or anything else before we head on yeah i mean live services competitive advantages cheap valuation if you look forward and good capital allocation maybe something we didn't

mention that's probably the most important is the overall industry oh yeah sure growth of gaming broadly and the growth of gamers globally continues to continues to rise and even if you say well the console market hasn't changed that much mobile or you say mobile is not a big part of their strategy you can almost use it as just a marketing funnel to the brand i think a lot of people that play ea mobile or apex mobile will probably want to have a more immersive experience too exactly yeah they're almost it's really nice when you have that combination of mobile games with your AAA franchises. And I should mention,

we didn't talk about like their market cap or stuff like that. Look it up. It's pretty simple, but just the cashflow numbers we're talking about and part of our thesis, if you look at their market cap, it's kind of self-explanatory.

We think they can get to a 10% free cashflow yield fairly quickly. And that's kind of, you know, the core reason why we own it. All right. That's going to do it. If you have any questions, email us. We'd love to chat with any of the people

that have questions on electronic arts. Thank you all for listening. We're going to go into the housing theme for next month. October is going to be housing month. Check out the Twitter if you want any info on that. Remember, we are not financial advisors. Anything we say on the show is not formal advice or recommendation. We are general partners at Arch Capital,

and clients may hold securities discussed in this podcast. For the Arch Capital episodes, we should disclose that as of this recording, clients do hold securities discussed in this podcast, Electronic Arts. And if you want to check the fund holdings, go to archcapitalfund.com. I'm sure since it's the Arch Capital episode, we will include that in the show notes and you can check out our holdings. We update them monthly. We like to be very public about those and get on our mailing list if you want that.

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