Electronic Arts (EA) – It’s In the M&A Game?

by Dan November 29, 2017 3:10 pm • Trade Ideas

There has been a lot of talk of late about m&a in the media space, specifically the acquisition of content. Earlier in the month, CNBC reported that Disney (DIS) had held talks to buy most of Twenty-First Century Fox’s (FOXA) media assets. While it appeared that DIS’s talks had halted, it appeared the rumors attracted other potential buyers (including Comcast & Sony), possibly leaving DIS as the odd man out in a bidding war. While these potential combinations might look like a doubling down against the existing competition, it makes sense that traditional media companies like the ones listed above are attempting to create wider content moats for the oncoming assault from new media companies like Apple, Alphabet, Amazon, Facebook, and Netflix. The real challenge is the combination of these companies’ massive war chests of cash on their balance sheets (most of which might soon be repatriated) and equities that are at all-time highs (up on the year between 30% and 50%) allowing any or all to set off an arms race for their already outsized distribution channels.

While original programming content makes sense for companies like DIS and CMCSA to double down on, I suspect that others forms of media assets may soon also be on the block, possibly video game makers, especially those who have made inroads into the growing phenomenon of eSports. PJ Dallman of Factset recently defined eSports as “the rapidly expanding community of professional, competitive video games” in a research note on the investment opportunities surrounding this nascent trend. To put the viewership in perspective Dallman highlighted the following:

Last year’s League of Legends World Championship sold out the Los Angeles Staples Center in less than an hour. While the arena seats only 21,000, an additional 43 million tuned in online—for context, the 2016 NBA Finals Game 7 broke records with 30 million viewers—with past eSports events broadcast in more than 15 languages for viewers around the world. In another corner of the eSports arena, Activision Blizzard’s (ATVI) game Overwatch has inspired a minimum-salary, professional league with city-based teams, the first of its kind.

Readers might recall Amazon’s move into eSports in 2014, paying nearly $1 billion for Twitch, which last year Matt Weinberger of Business Insider suggested the purchase was a way to bolster their fast-growing and very profitable cloud computing division AWS, which is starting to attract sizable competition from other tech behemoths:

This is intensely desirable for developers: Twitch has 100 million users and counting, with over 7.5 billion minutes of video watched. Getting that massive community engaged with a game can mean the difference between success and failure.

With Facebook, Google, Microsoft, and the like all gunning to get developers to host their games in their clouds, Twitch could be a huge competitive advantage for Amazon Web Services. Microsoft may have the Xbox, but it doesn’t own the massive force multiplier that is Twitch’s rabid fans.

And with AWS facing intense competitive pressure from Microsoft Azure, a deep integration with Twitch becomes a strategic move to attract as many developers from the lucrative games market as it can.

The two largest game publishers also with footholds in eSports are Activision Blizzard (ATVI) who’s stock is up a whopping 75% year to date sporting a $47.6 billion market cap with expected 2017 sales of just shy of $7 billion, and trading 24.5x expected 2018 eps growth of 6%. And the other Electronic Arts (EA) who’s stock is up 36% ytd, sporting a $33 billion market cap with expected fiscal 2018 sales of $5.2 billion trading at 21.5x expected fiscal 2019 eps growth of ~5%. Neither stock is exactly cheap relative to expected growth, but EA has a solid balance sheet with $3.4 billion in net cash on their balance sheet, or about 11% of their market cap, while ATVI is quite a bit more levered with $3.5 billion in cash vs $4.4 billion in debt.

Given EA’s heavier reliance on sports game franchises like Madden & Fifa (and recent esports announcements with the NFL and Fifa, here & here), their exceptional balance sheet and the stock’s relative underperformance in 2017, I want to take a look at this one for a potential takeout in 2018 from either an old or new media player.

But first I think it makes sense to address the reason for the stock’s recent weakness, down 11% since the company’s soft guide on their October 31st fiscal Q2 report, and then the player revolt following the realization of in-game monetization of their Star Wars Battlefront II game released Nov 17th, leaving some to question the company’s micro-transaction business in other franchises, per CNBC.com:

EA chief financial officer Blake Jorgensen told investors in February its “Ultimate Team” sports micro-transactions business generated $800 million in high-profit margin sales for the company during the previous year. He added EA intended to extend a “similar mechanic” to its other franchises such as “Battlefield” and “Battlefront.”

Now that whole strategy is at risk.

Leading gaming YouTube personalities believe EA will be forced to change its practices after the “Star Wars Battlefront II” micro-transaction controversy.

“After the communal and political backlash EA received over Battlefront II, the industry at large is going to have to walk back its loot box plans a little,” Jim Sterling wrote in an email.

It all sounds a bit uncertain in the near term, but the relative underperformance of EA of late, related to fixable problems, and the prospects of upside from eSports in 2018 leads me to believe that this company could be on many potential content acquirers’ shortlists.

So what’s the trade?

If I were inclined to play for upside in the new year I might consider selling short-dated out of the money calls helping to finance the purchase of out of the money long dated calls. The next identifiable catalyst for shares of EA will be fiscal Q3 earnings on Jan 30th, so we want to target call sale before the event and own longer dated calls that capture earnings and gives more time for this speculative thesis to play out.

For instance:

TRADE IDEA: EA ($106.50) BUY JAN / MARCH 110 CALL CALENDAR FOR $3

-Sell to open 1 Jan 110 call at $2.75

-Buy to open 1 March 110 call for $5.75

Break-Even on Jan expiration: This trade performs best with a gradual move towards the 110 strike over the next couple weeks in Jan expiration. If the stock is below 110 on Jan expiration the short Jan 110 call will expire worthless and the and the trade will be left naked long the March 110 call. If the stock is close to $110 then the March 110 call should have appreciated as it will have picked up deltas. At that point it might make sense to further reduce the premium at risk by selling a higher strike call in March turning the trade into a vertical call spread. The max risk f this trade is the $3 premium paid, and would be at risk with a large move below the current level, or well above the 110 strike.

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