Investing in Video Games Part 3: Electronic Arts… Avoid This Stock Like the Plague


Welcome to part 3 of Investing In Video Games. In parts 1 & 2 we covered the 5 basic investment rules, a few pointers on portfolio management, and how to select a discount broker for trading. As promised we will now delve into the nitty-gritty of making money including some basic terminology, and hedging with dividends however we are going to keep the section on options sidelined until part 4 because it is long and detailed. Hopefully, if you read parts 1 and 2, you will have gotten some small insight into what to look for in companies to determine what they are worth. Up to now, the criteria may seem random and even biased however there is a method to the madness and we will start looking at those methods now.

Investment Valuation Rules

  1. Invest as though you are buying the business.
  2. Income and Income Growth are the most important measures to consider.
  3. Money in your pocket is the ultimate hedge against incompetence and market volatility (especially crashes). Dividends are your best friend.
  4. Do not use DRIP (automatic Dividend Re-Investment Plans). Let the money accumulate and deploy it yourself.
  5. Stock buybacks can be better than dividends... sometimes.
  6. Options are your 2nd best friend. (Note we will cover this in part 4)
  7. Most of the time, a lot of debt sucks but a little bit of debt is good.
  8. Big companies are usually safer than small companies so look take advantage of it.
  9. Hard assets are better than imaginary assets (aka "intangible assets").


That is a long list... and honestly the list is not complete due to caveats in specific types of investments, but we need to start small since this is just primer.

Invest as though you are buying the business. You are not just a trader looking for a quick 'hit and run' payday. Its true that there are some successful day and swing traders however for every success there are 9 failures. Lets not play this game. Recall the 5 rules in part 1, and note that it is unwise to mess around in the playground of the rich and powerful who can afford to invest irrationally (as EA will prove below). When you look for a potential investment, be it a stock, bond, real estate or whatever, do so from the perspective of a potential business owner. Would you pay a huge premium for a business that has no proven track record? Maybe, but chances are you would not, unless you have money that you can afford to lose. When you buy an investment for a substantial amount of money, you generally want it to be profitable from the get go else you would not pay a premium for it. That does not mean that investors will never sell investments but investors should always enter an investment with the assumption that it is good for the long run.

Income and Income Growth are the most important measures to consider. I cannot stress enough that income is key. A lot of companies are valuated on revenue growth and future potential but you will be surprised how many times the "professionals" gets these valuations completely wrong and lose money. Remember the old saying "a bird in the hand is worth two in the bush." This is true in investing and is more important for someone just starting out and still building their savings. Once you have a lot of money, you can start taking more risks however you should not do that until you are more financially secure. I recommend that new investors wait until they have a stable, well paying job and at least $100k in their account/s before they start taking major risks. Now here is some terminology that you should learn and their significance.

EPS (Earning Per Share) - Is how much money the company is currently making divided by the number of shares available on the market. This is how much money you make indirectly on the shares you buy.

P/E (Price per Earnings) - IMPORTANT! P/E tells you how much you are paying for the income the company is generating. For instance, if a company makes $1/yr and the price of the stock is $10/share, then the P/E is 10. This can also be viewed as how long it will take you to recoup your money. P/E 10 means you get your investment dollars back every 10 years (most of the time this means you doubled your money). Note that this is not money in your pocket directly, but rather money the company made on your behalf and hopefully used to make even more money.

fP/E (Forward Price per Earning) - Is an estimate of what the Price per Earnings might be based on estimated income in the future and assuming the same stock price as today. This is not always accurate so be careful, but it will give you a general idea of how the company is expected to perform in the future based on statements made by the executives and number crunching done by analysts. You want fP/E to be lower than current P/E. Note that some CEO's are known to inflate or hype their future earnings to unreasonable amounts. They are the spin doctors of the financial world. Some are the opposite and always underestimate on the side of caution. Bobby Kotick of Activision is a good example of a well known spin doctor who is usually ignored by the financial community (until recently at least). Here is another example; Goldsman Sachs is a professional "spin doctor" firm and they makes money by selling their services to perspective businesses. They are essentially the use car salesmen of the financial world and they make a lot of money doing it. As you can see, the financial world is full of mines that we common investors have to navigate around or get blasted. Just remember, fP/E makes a lot of assumptions and many times it is wrong.

Common P/E's in the Business World

  1. P/E 1 to 5: Brick and mortar business that you can buy and operate yourself. Requires a lot of your time but offer large returns.
  2. P/E 10 to 20: Most real estate investments. Corresponds to 4% to 9% cap rates plus minimal capital gains based on inflation rate.
  3. P/E 33 to 62: Treasury bonds, corresponding to 30 year notes and 5 year notes respectively. Note how high the P/E is. It reflects the safety of the investment.
  4. P/E 12 to 62: Corporate bonds & municipal bonds. Note that large range.
  5. P/E 10 to 15: Stocks that are not growing very fast or have some internal problems. Many powerful companies enter this range during stagnant years. For small companies, this is worrisome.
  6. P/E 15 to 20: Stocks that are currently growing income fairly well at a rate of between 6% and 10% per year.
  7. P/E 20 to 30: Stocks that are currently growing income very fast, at a clip greater than 10% per year.
  8. P/E 15 or less: Is a key P/E that usually signals a market is too cheap. This is in reference to the S&P 500 index as a whole. Keep a close eye on this. If the S&P 500 index hits a P/E of 15 or less at any point, its time to get aggressive and buy like a madman. This will remain true as long as our government maintains current tax rates on the wealthy; The lower the tax rate, the higher the threshold and vice-versa.
  9. P/E 25 or more: Is a key P/E that usually signals a market bubble and an impeding market correct or even a market crash. This is in reference to the S&P 500 index as a whole. Keep a close eye on this. If the S&P 500 index hits a P/E of 25 at any point, its time to stop any and all purchases and hedge to high hell. Note that as of today, the S&P 500 is currently sitting at about P/E 20. This will remain true as long as our government maintains current tax rates on the wealthy; The lower the tax rate, the higher the threshold and vice-versa.

Money in your pocket is the ultimate hedge against incompetence and market volatility (especially crashes). Dividends are your best friend. This is the catalyst that will put you over the top and is exactly how I got through the great recession with insane returns. Dividends and distributions are the ultimate hedge against corporate lunacy and incompetence as well as market manipulation by investment firms and speculators. Case and point; assume you own 1 share of MSFT which pays about $0.25 a share in dividends every 3 months. Now lets assume that some big wig at Morgan Stanley got his fortune told at the local Turkish coffee house and decided that he wants to crash the MSFT stock price to make a few bucks on panicking fools. Even if Morgan Stanley was able to crash MSFT stock to $0.01 a share, there is absolutely nothing they can do to prevent you from collecting your $0.25 dividend every 3 months because the stock price itself has nothing to do with the business operations. Yes you read that right, the stock price has nothing to do with the business. Think of it in terms of a house. Lets say you own a house that you rent out for $1000 a month. If the housing markets crash and your house was now worth $1, does that mean your house no longer exists? No that would be silly. The house is obviously still there and you own it. Further, even if the house is $1, you will still collect your monthly rent of $1000 so really, nothing changed except how much your house is worth. Both of these examples are purposely absurd to prove a point. The point is that dividends shield you from extreme market fluctuations. Even if the markets crash like they did in 2008 or 2009, your dividend income is not likely to change especially if you selected safe stocks. There are a lot of stocks out there that can be considered fairly safe in terms of business operation (as opposed to valuation which is never safe), and many of them provide a good stable dividend (which usually increases over time) even if the general markets crash.

Yet another reason to love dividends is because one should never fully trust strangers with their money. Do you have a personal relationship with the CEO's of the companies you invest in? Probably not. So why do you think they are trustworthy? Because someone else told you so? Assumption is the mother of all screw ups so it is always wise to take some money off the table, away from them and in your own pocket. Just ask anyone who invested in Enron, Nokia, KB Toys, Woolworth, Circuit City, Mervyns, Bennigans, GM, Midway Games, THQ or 95% of banks in the last 10 years, whether executives and analysts should be trusted or not... Obviously they shouldn't be trusted. But with a dividend, you can mitigate a lot of these problems because you take those profits away from them and once in your pocket, you get to decide how to use it rather than them. This way, even if a company goes under or does poorly, you at least got some of your money back (if not all of it), hence this "a hedge against incompetence" and believe me, CEO's and executives are no different than most anyone else in the working middle class. They are not smarter, stronger, more ethical or more moral and many will sell you out if they can get away with it. This is why we have so many regulations in place because back when there was no regulation, it led to disaster because people tend to abuse power. Our founding fathers knew this which is why they separated the government into branches. Unfortunately, they didn't do the same to big business because back then, they did not anticipate businesses to get so big and powerful. But anyway, we are here today and we need to deal with reality.

Lastly, >> VERY IMPORTANT <<, cash is what will make you rich when markets are crashing. This is where most people go wrong. They do not keep enough cash on the sidelines to take advantage of market crashes and market crashes happen often due to our current tax policy. Since the rich are allowed to make a lot of money on investments, this results in a lot of speculation and market inflation. This started happening when President Reagan was in office back in the 70's. Note, I am not here to argue the merits of Reagan's policies (aka Reaganomics) but I am trying to teach you how to deal with it. Reaganomics, or "supply side economics" have been instituted in the USA since the 70's in response to "stagflation." When they implemented these changed, it undid the laws that were created during the great depression to prevent another depression. What Reagan ultimately did, is allow rich people to get richer more quickly by lowering their taxes on the upper end thus creating a snowball effect that has been ongoing to this day. If you look at the price of real estate and stocks since the 70's, you will notice that they have skyrocketed and this is due to the fact that the rich are making more rapidly than and they keep reinvesting it pushing valuations higher. This snowball effect eventually leads to over-valuation when the economy slows down and we call these periods "bubbles." We have already had several of these doozies since Reagan including the S&L crisis, the .com crash, and the recent Great Recession crash. The key then is to be ready for these crashes which seem to happen at a 8 to 12 year interval. Since the way to capitalize on crashes is to have cash, it only makes sense that receiving cash is a good things and dividends do just that. If you play your cards right and stockpile cash into a market craash, you could easily double or triple your money in a year or two. You could make even more than that depending on the severity of the crash. For example, I had a 100% return in 2008, 400% return in 2009, another 100% return in 2010, about 50% return in 2011, and another 50% return in 2012. Dividends allow you to accumulate cash before and during crashes and you never have to worry about selling assets at low prices during a crash to get that money. Thus, it is recommended that you invest in dividend stocks, and let cash accumulate. Once you have a lot of cashed saved, take a look at the P/E of the S&P 500 (which you should be monitoring frequently anyway). If the P/E is getting near the danger zone of 25, keep the money stashed and hedge with options (we will cover this in part 4). If the P/E is notably lower, it might be wise to re-invest it into something. My recommendation it to stick to dividend growth stocks that pay a minimum 2.5% dividend yield.

Do not use DRIP (automated Dividend Re-Investment Plans). Let the money accumulate and deploy it yourself. This was explained in the section above. Since you want to accumulate cash and deploy it yourself, it makes no sense to use DRIP which puts the money right back into the company that just paid you a dividend. It simply is not worth the savings. You are better off having control of your money and buying what you want when you want than saving $5 every month to buy stocks at prices that may not be favorable.

Stock buybacks can be better than dividends... sometimes. This one is a bit complicated to explain. Stock buybacks are almost the same thing as dividends because, they give you more equity in the company you own and they increase dividends linearly if the company offers dividends (since there are fewer shares to split the dividends between). There are times when buybacks are better than dividends but two things need to be true for that to be the case. #1, the stock price needs to be cheap or fairly valued and thus worth buying else the company is buying back their stock at too high of a price and just wasting your money & #2, the company is structured in such a way that income to investors is double taxed which is the case with most companies. Microsoft, Activision, EA, and Sony are all normal c-corp entities and are double taxed on dividends, however they are not double taxed on share buybacks and this is why it is sometimes an advantage to buy back stock rather than give money out as dividends. Some companies are structured as partnerships or regulated trusts which avoid taxation altogether but that is a lesson for another time. Now remember, that we like dividends... we do not want to lose our cash payments so it is a matter of personal preference how much dividend we are willing to give up in favor of buybacks. I personally like stocks that do a combination of both dividends and buybacks and fortunately, most blue chip stocks (large mature companies) do just that. My recommendation it to stick to stocks that pay a minimum 2.5% dividend yield with a combination of stock buybacks of about 2.5% per year (for a total of 5% combined). I will show you how to find this information in another article but if want the information immediately you can get it at Morningstar.com by entering enter a stock symbol into the search bar (like MSFT), and then selecting the "key ratios" menu item.

Options are your 2nd best friend. We already covered a lot in this article so I am going to push this forward to part 4 since it will take a few paragraphs to explain. The final 3 points should be self explanatory.

Most of the time, a lot of debt suck but a little bit of debt is good. Too much debt becomes a problem when a business struggles which happens to every business at some point. Having less debt than cash on hand it usually a good thing. But debt is good when you can get it at a low interest rate to help grow your business, thus some debt is usually good, especially interest rates are low (like now).

Big companies are usually safer than small companies. This is a no brainer. Not all big companies are good investments but in general, large corporations like 'blue chip' stocks are more stable than small companies. Of course, that also means that big companies have to work harder to increase income significantly whereas a small company can double income over a few short years if they are innovative. I personally recommend you stick to the big boys when you are starting and look at risky stuff once you have $100k in your account.

Hard assets are better than imaginary assets (aka "intangible assets"). Again this should be self explanatory. Many businesses have something called "intangible assets" which they value at whatever they think they are worth. If a company does poorly, they will need to liquidate assets to pay back debt and other obligations. If these assets are all "intangible" then odds are they cannot sell them easily if at all thus they really are not worth much in the real world. There are exceptions to this such as highly sought after patents but most of the time, companies greatly inflate their intangible assets value. Thus it is better when a company has "hard assets" because hard assets are real and generally always have good value. Hard assets are usually things like real estate, IT equipment, furniture, and vehicles. Real estate, especially, is a great asset because it usually holds its value very well, but once again, there are always exceptions. Just make a note of this when you go off to invest in video game companies because as you might suspect, they usually don't have much in hard assets which makes them a little risky if they have a lot of debt or big running costs. Look what happened to THQ. They were unable to sell their franchises and were forced into bankruptcy where their franchises sold at huge discounts to what they had them valued at. In the end, their investors basically got nothing from the sales because they could not even pay back their debtors.



Pew... that was a long primer... That's enough for today. I have updated the list of topics to reflect the fact that we are moving options to part 4:

  1. Part 1: Basic Investing Rules
  2. Part 2: How to Select a Broker Account
  3. Part 3: How to Determine Investment Value and Dividends
  4. Part 4: Hedging with Options
  5. Part 5: Best Websites for Researching Investments
  6. Part 6: Risks Associated With Video Game Stocks
  7. Part 7: tbd

At some point I will create a page with a summary of all the stocks covered. Lets look another game (related) company.


Electronic Arts

GTan Rating: 1/5 (run away)
Morningstar Rating: 2 star (out of 5)
S&P Capital IQ Rating: 3 star (out of 5)
Reuters Rating: Neutral
Smart Consensus Rating: Hold

Share Price: $37.89
Valuation: $11.85 billion
Cash on hand: $2.32 billion
Debt: $586 million
Yearly Revenue: $3.84 billion
Yearly Net Profit: $121 million
Earning Per Share: $0.23
Price/Earnings: 164.4
Dividend Yield: 0%
Dividend/Share: $0.00
3 Year Performance: Only growing because 2011 was a loss (loss of over $250 million)
5 Year Performance: Only growing because 2009 was horrifying (loss of over $1 billion in 2009)
10 Year Performance: Alarming Shrinkage (-35% per year)
Earning Consistency: Extremely Volitile
Risk Level: Extreme
Total Executive Compensation (2012): $23.7m (24% of company profit) (wow!)
Total Executive Compensation (2013): $43.0m (30% of company profit) (wow!!)

There is very little good to say about EA so lets start there. First, they dont have much debt and they have a lot more cash than debt. This is a good thing. Next, they are finally in the green and making money again... it isn't much for their size, but it is progress after a disastrous decade. But you need to take note of how they were able to turn a profit... it was not through new games and improved sales rather they fired a lot of people and that saved them a lot of money. In 2008 they laid off 1700 people or 17% of their work force. And in 2009 they laid off another 1500 people or another 17% of their work force. That is how they became profitable. As a business owner myself I am not against layoffs when they are needed but lets get real, EA is not improving on the top line, which is revenue which means no new income, just the same income with less expenses. That said, they are maintaining the same revenue with less people so that is a good sign.

Everything else is damning. First, you will probably note the extremely high P/E. This is due to the fact that EA is in "recovery" mode and investors (especially those who bought long ago) believe that EA will some day return to their old levels of income and thus are investing in the "future." How they believe such a thing is beyond my understanding especially given how many people have been laid off reducing potential productivity. On top of that, it is not as if EA had stellar income 10 years ago. Even back in those good old day, they barely made $500m a year which is still not enough to maintain todays stock price without huge amounts of growth every year thereafter. Even if they were making $500m a year today, their P/E would still be around 23 which is only justified when a company is growing income at a 10% or more rate every year for a few years straight. How could we possible expect EA to perform that way when they managed to actually lose money during the most profitable decade in video gaming in history? The recent performance of EA has given investors hope that things are turning around but as a gamer with vast knowledge in gaming and gaming trends and as a investment professional, I would run the other way as fast I as I can.

To add salt to the wound, things are not looking good in their product pipeline either. The latest release of Sims 4 is receiving a lot of negative reviews from players mostly due to missing features they had in Sims 3. Battlefield is a great game and their best seller but they are so big (~$12b company) that they cannot depend on just 1 mega hit game, as the last 3 years of earnings proves. They really need Sims 4 to become a mega hit but it is not going to happen... not just because of reviews but because the target audience has changed and is playing other games. I think that Sims is going to get reduced to a medium hit. On top of that, they pretty much killed off the SimCity franchise with the last iteration (SimCity 5 was abysmal) which will probably reduce that franchise from medium hit to small scale hit. Their sports franchises have not done very well all decade long except maybe for Fifa due to worldwide soccer hysteria. Then again, sports games have lower profit margin due to licensing. This leaves a list of medium hits. We have Mass Effect and Dragon Age, both of which I like, but they seem to be losing steam. Next we have Titanfall which was hyped to be a blockbuster hit but was not. Further it will probably not do as well next iteration due to its restrictive demographics (multi-player only). Need For Speed and Medal of Honor are both good games but again they are medium hits. Realistically, EA needs either one or two more mega hits like Battlefield or they need ten to twelve smaller 1m-2m copy medium hits like Need For Speed, Mass Effect, and Medal of Honor but remember it costs a lot more to create ten to twelve medium hit games than one or two blockbusters. Alternatively they need to continue to reduce their workforce and cut expenses and if it were me, I would fire the entire executive staff and replace the board of directors with new representatives. Which brings me to the next important point.

How can anyone in their right mind, trust the executive staff and board of directors at EA to be faithful to shareholders given their history the last 10 years? These guys are taking high salaries & bonuses for extremely poor performance and they were collecting salaries even during the layoffs and the huge losing years not so long ago. At the same time, they have actually diluted their stock rather than reduce it with buybacks, they do not pay a dividend, and we all know that their book value is insanely inflated with "intangible" assets. How can investors have faith in a bunch of executives who managed to lose money during the greatest video game boom in history while still collecting massive salaries and bonuses? How can executive keep a straight face and accept such huge compensation when their shareholders are yet to see a profit 10 years running? In fact, their earnings are about the same as they were back in the early 90's... I would never give these people my money to invest and I recommend you avoid them completely as well. They are horrible business men.

Summary:
- Earnings need to climb about 8 times higher and they need to continue growing at a blistering 10% yearly net growth to justify the current share price valuation.
- Pipeline is extremely weak at this time.
- The only way to increase earnings at this point seems to be more layoffs and cost cutting.
- Executives are scum of the earth based on total pay vs earnings.
- Largely negative reputation among the gamer fan base. They need to do some serious public relation repairs to regain customer faith in their products.
- They get sued a lot for a video game company...
+ Revenue is steady despite workforce reduction and cutbacks
+ They have some good franchises under their flag.
+ Digital sales are growing (however most of the shift has already happened and growth is tapering off).

The only thing EA is good for at this point in time is straddles, an option strategy that assumes great volatility and given its huge valuation it is posed for a big move. Either they blow away estimates in every way the next 2-4 quarters of their stock is going to plummet. It cannot sustain the current level without something big happening. I would avoid EA stock like the plague.




Thank you for reading part 3. See you in article #4.

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