EA's Miss

After the bell today, EA announced a massive miss for their fiscal year, reducing revenue and earnings per share expectations. CFO Eric Brown also said in a conference call that they expect the packaged goods business to be flat to down for Fiscal 2011.

For anyone paying attention to the larger trends in the video game market, this could hardly have come as a surprise. A few days ago, Gamestop, a key packaged goods distributor for EA, announced a similar miss. While Activision was setting sales records with Call of Duty: Modern Warfare 2, EA had no major hits -- although, in fairness the COD:MW2 revenue was probably just filling in a sinkhole at Activision created by a music game business that has fallen off a cliff. EA is in the wrong business, with the wrong cost structure and the wrong team, but somehow they seem to think that it is going to be a smooth, two-year transition from packaged goods to digital. Think again.

John Riccitiello, the EA CEO, took over the reins of the company almost exactly 3 years ago. I was a senior executive at EA just prior to JR's return, and had a number of conversations with then-CEO Larry Probst about strategy at that time. As those who follow my blog know, I believed that the video game business had experienced a sea-change beginning in 2004, one that required immediate and decisive action.

My argument to Probst in February of 2007 was to reduce expenses immediately by a minimum of $200MM annually by reducing headcount and cutting back on ridiculous expenditures on risky titles (during my tenure, Spore and Godfather budgets had ballooned to ridiculous levels, and even spending on middle of the road products like The Simpsons and Superman had reached appalling heights). Meanwhile, I advocated hyper-aggressive R&D investment and acquisitions in a transition to digital distribution and games-as-service; combined with an approach to Wall Street that would position EA as a smaller but significantly more profitable company in the near term, with substantially improved long-term prospects when the digital future arrived.

This suggestion was derided by EA execs at the time -- they literally couldn't imagine going to Wall Street with a message of increased profitability rather than top-line revenue growth. They wanted to make the transition to digital while continuing to grow the packaged goods business. Ironically, they saw their looming innovator's dilemma as clearly as any company in the video game business back in 2006. They just weren't bold enough to act on that knowledge.

The old EA model was a basically a three-legged stool: 1) a profitable, recurring sports business (Madden, FIFA); 2) franchise games that produced big hits on a less frequent basis (The Sims, Need for Speed, Command & Conquer); and 3) a collection of digital assets (e.g.: Pogo & JAMDAT, and now Playfish) and distribution/partnership titles (e.g.: Rock Band & Left 4 Dead). Of those, the only stool leg left intact is the third one. Without the digital assets and the EA Distribution titles, they'd be in even more serious hot water.

EA's sports business has been hamstrung by vastly increased licensing costs (as I've discussed before) and failure to transition to a subscription/variable pricing model. This has substantially reduced the profitability of a business that EA used to rely on to fund other, riskier bets.

But by far the greatest failure of Riccitiello's strategy has been the EA Games division. JR bet his tenure on EA's ability to "grow their way through the transition" to digital/online with hit packaged goods titles. They honestly believed that they had a decade to make this transition (I think it's more like 2-3 years). Since the recurring-revenue sports titles were already "booked" (i.e., fully accounted for in the Wall Street estimates) it fell to EA Games to make hits that could move the needle. It's been a very ugly scene, indeed. From Spore, to Dead Space, to Mirror's Edge, to Need for Speed: Undercover, it's been one expensive commercial disappointment for EA Games after another. Not to mention the shut-down of Pandemic, half of the justification for EA's $850MM acquisition of Bioware-Pandemic. And don't think that Dante's Inferno, or Knights of the Old Republic, is going to make it all better. It's a bankrupt strategy.

So now, a couple of months after the board granted JR another $7 million worth of restricted stock units in addition to 140,000 options and EA Games president Frank Gibeau another $2 million in RSU's, EA cuts financial estimates to the bone. And don't believe this is the end of the bleeding. This latest stock drop, if consistent with the after-hours trading, will wipe out virtually all of the gain from 2009. Unfortunately, the loss comes after one of my favorite EA execs, business warrior John Schappert, returned from Microsoft to take over as COO and started firing 15% of the workforce to reduce costs.

With EA's enterprise value down below $4 billion, it's remarkable that nobody has stepped in to put them out of their misery with an acquisition. Certainly, Disney has been looking at them since I was at the house of the mouse back in the early 90's. And there are Chinese companies, like TenCent, that could easily swallow EA whole.

It's equally amazing that the board continues to support the existing management team through this debacle. Since JR took over, the company has destroyed over $11 billion in market value. Certainly, some of that was the economy and the general erosion of value on NASDAQ, but Activision (the blue line below, vs. EA's red line) has experienced far milder effects from the recession:

It's remarkably hard to kill a company doing $4 billion in revenues. But with flat or down stock performance since Q3 2003, how long are the institutional investors going to continue to hope against hope for a turn-around?