A lot of the buzz around the EA interregnum has focused on EA’s relevance in digital distribution, mobile gaming and free-to-play. Can EA win in these new markets? What should a 21st century EA look like? It is interesting to think about EA’s assets and the current state of the digital game economy in light of the challenges a new leader at EA might face.
By the way, I’m going to talk about “digital revenue” considerably more narrowly than EA typically does in their financial communications. EA counts as “digital” hundreds of millions of dollars of online sales of packaged goods products and “additional content” for console products. Some of this is legitimately “digital revenue,” as I’ll discuss below, but most of it is just an online substitute for a packaged good. I’m going to be talking about mobile, online subscription and virtual goods revenue, and a subset of the console “additional content” revenue when I talk about “digital revenue.”
In my experience, the incumbent packaged goods companies clearly see mobile, digital distribution and free-to-play models as inevitable. They know what’s coming and have known for some time. But within the senior management ranks of these companies there is still a lingering perception that digital doesn’t, in their words, “move the needle” sufficiently – meaning that the revenue generated from existing console franchises still far exceeds the revenue that can be generated, even in aggregate, on new platforms and through new business models. There is an appreciation that the higher-margin revenue from digital can enhance profits but not really produce top-line revenue growth for a company like EA or Activision, doing in excess of $4 billion in annual sales.
The problem with that perception is that it is simply not true any longer. There are games on the mobile and free-to-play PC platforms that are indeed capable of moving the needle. And for real next-generation publishers with customer acquisition leverage (i.e., not the hamster-on-a-treadmill LTV arbitrage kiddies that litter the iOS and social gaming charts), hit games can generate almost unimaginable profit margins, at least by packaged goods standards. One game I know well, Riot’s League of Legends, is poised to grow to World of Warcraft sized revenues in the near future, and is driving record profits for parent company Tencent. In the mobile space, Supercell’s one-two punch of Clash of Clans and Hay Day could together generate as much net revenue as a top 5 console game franchise. Wargaming’s World of Tanks on PC and NaturalMotion’s CSR Racing in mobile generate enough revenue and profit to be tentpole products for an old-school packaged goods company.
The good news for EA’s next CEO is that the company has not been sitting idly – in fact, you could argue that EA has been the most aggressive large publisher in pursuit of digital revenues. EA Mobile, the successor to my startup JAMDAT which they acquired back in 2006, is the largest market share player on iOS and probably on Android, too. They’ve had solid titles like The Simpsons: Tapped Out and the recently-released Real Racing 3, demonstrating that the company can produce top-quality products for the mobile platform. They haven’t been able to deliver a break-out hit – Real Racing 3 is currently lagging behind last summer’s CSR Racing in the top grossing charts – but with some strategic nous and studio leadership unafraid of the new business models, there’s no structural reason EA can’t create a mobile franchise that contributes $200MM a year in revenues and throws off $40MM in profit. If they can control production costs (always a problem for the company) and marketing spending, they should have a decent shot at a profitable billion dollar mobile business in a few years.
Similarly, in PC free-to-play, EA’s Battlefield franchise has been doing well. It is not in the same strata as packaged goods juggernauts like Activision’s Call of Duty or free-to-play hits like League of Legends and World of Tanks, but it is a solid contributor and certainly demonstrates that EA can be competitive in the space. Their Origin portal is no Steam, but it’s not bad, and the lack of recent Steam product innovation may open a window for deeper competition. That said, the Sim City server debacle suggests EA still has a ways to go building a stable, scalable internet presence.
One of the things EA doesn’t get enough credit for is the transformation of FIFA into a virtual goods engine. Without question, FIFA has become the global lynchpin franchise for the company bridging both the packaged goods and digital spheres. As of the end of 2012 the company said it sold 12 million FIFA ’13 units across all platforms. But the most impressive thing to me is that they’ve generated well over $150MM of virtual goods revenue from their FIFA Ultimate Team mod – a virtual goods engine that runs on top of the packaged goods product (this is in addition to the $70MM+ they are generating from the Asian online-only versions).
FIFA Ultimate Team is one of the coolest things the company has done recently – a trading card game masquerading as a management simulation with a fantastic compulsion loop that enhances the core FIFA product. It blows digital trading card games like Rage of Bahamut out of the water and has a passionate, engaged fan base. They should be trying to replicate Ultimate Team with all of their sports franchises. They need to migrate their sports businesses to subscription services, and Ultimate Team suggests that they can make good money with innovative new digital products.
So, assuming EA had a focused next-gen management team with good product selection capabilities and good monetization/analytics skills, it’s not a huge stretch to imagine EA generating $2 billion in high-margin digital revenue (as I define it): three or four $100MM or better mobile franchises, three or four $150MM or better PC free-to-play franchises, $200MM or so from online (Pogo, casual and social gaming), and $500MM from digital sports products, on top of their other online and mobile activities. I think this business, if properly managed, could throw off between $1.00 to $1.50 in EPS.
That sort of business would be roughly 50% bigger than Zynga on the top line and much, much more profitable. So with Zynga as a current apples-to-apples comp, this should be good for $4 billion in market cap by itself, and, given the revenue and earnings growth potential, probably considerably more. Plus, the underlying platforms are all growing like weeds, so there’s a strong tailwind for EPS multiple expansion. When I say that EA could be a smaller, more focused, more profitable company without sacrificing current market cap, this is what I am talking about.
Which brings us to the console business. As counter-intuitive as it sounds, console is the wild card for the future of EA, the platform with the most risk. As everyone knows, the console business has been declining at double-digit percentage rates year-over-year for the last few years. At the same time, the option value ascribed to a possible re-invigoration of the console market from the launch of new hardware this Christmas has produced what some are calling a “dead cat bounce” for EA and Activision, who have the greatest exposure to the new consoles. In order to be a player on the new consoles, EA will need to greenlight a dozen titles, and they will be very, very expensive – given EA’s penchant for big spending, the need to support multiple hardware platforms simultaneously at launch, and online features, this could be close to a $1 billion R&D expense. And given the customary annual refresh in the sports genres, it’s necessary to keep spending year after year.
In a particularly telling interview, EA’s out-going CEO described the launch of new consoles as “the light at the end of the tunnel.” I’m worried it may instead be the headlights of an on-coming train. The console business, even digitally-enhanced, is just a completely different business than the mobile and online free-to-play businesses. The two businesses require different people, different infrastructure and logistics, different team sizes, different development cadences, different marketing strategies, and very different revenue recognition models. Despite the considerable differences in scale and scope, mobile and free-to-play PC are actually much more alike than either is like console.
Further, I think you could easily take the position that there will never be a return to the installed base level that Sony, Nintendo and Microsoft saw with their c. 2005 consoles. They’ve essentially lost the living room. I watch my own children, sitting on the couch, ignoring the massive HDTV hooked up to every game console in existence and broadband internet, playing Temple Run on the tiny screens of their mobile phones. To use the old parlance of by-gone console industry analysis, there is likely to be a massive fall off in peak-to-peak margins.
EA has a dilemma. By yoking their business to the new consoles, they hamstring the company with bloated teams, high production costs, and packaged goods marketing and merchandising that is not, in my opinion, additive to their other business opportunities. Console investment doesn’t position EA well for the future. There are few economies of scale on the audience aggregation side — unless you think like a feature film company and view the massive TV advertising spend on console games as having a “brand halo” that benefits the mobile and online games. The only way EA benefits is if console players come online and authenticate with EA rather than Sony, Microsoft, or Nintendo. Otherwise, EA can’t really do anything to leverage them cross-game or cross-platform. And the console manufacturers are not likely to be easily dis-intermediated.
But if EA doesn’t support the new consoles, they are going to feel strongly that they have missed an opportunity for quick, if ephemeral revenue growth. It’s super-seductive for their senior management, who see the console business as their wheelhouse and who are dubious about launching new franchise intellectual properties through mobile or online free-to-play. Because of this, if they go all-in on console, it’s going to get the lion’s share of the attention of management, and the big, talented teams of developers. It’s going to demand TV advertising and massive retail merchandising presence. It’s going to require sharing audience with Microsoft and Sony, who have their own online ambitions. It is fraught with peril and execution risk, and demands a nuanced long-term strategy. For me, EA Games needs the biggest re-think – that division has been pretty undisciplined about product selection, cost control and marketing spend in the past, and represents the biggest downside risk on the new platforms.
So, in the end, I think there is a lot to work with, but a lot of hard, cost-cutting work to be done to get EA back to greatness. They don’t have the management team to execute against all of these opportunities simultaneously, and recent management losses haven’t helped, leaving the old guard with greater power and stripping the company of some much-needed new thinking.
However, I’m more convinced than ever that traditional attributes like brand and quality can produce meaningful efficiencies in customer acquisition costs, which certainly aren’t negatives for EA. The sports business, while not as profitable as it once was, is still a global force and they’ve done a good job at the margins trying to modernize that business. There are certainly things to be optimistic about. On the other hand, EA is a very conservative company at its core, and will struggle to change in the dramatic way that the new market opportunity requires. EA’s current strategic situation suggests that the search for a new CEO could be very, very difficult.