Thursday, December 22, 2005

If a Tree Falls in the Woods, but Nobody Wants to Hear It…


A tree fell on Wall Street yesterday.

Specifically, Electronic Arts, which has managed its way through the vicious cycles caused by fickle teenagers and rotating game platforms better than any other video game maker such that it has been legitimately accorded “best-of-breed” status by Wall Street’s Finest, guided earnings down by a magnitude normally associated with far lesser breeds of companies.

Citing an “abrupt” shift in the “demand curve” for video games, ERTS management guided this quarter and next quarter revenue and earnings “well below” a forecast given just short of two months ago.

And they weren’t kidding about the “well below” part.

Back half fiscal 2006 earnings (ending next March) got whacked roughly 40%, from the $1.40 area to the 85c a share area.

And First Call earnings estimates for fiscal 2007 began the week at about $1.75 and, depending on whether you deduct stock compensation, are going to end the week anywhere from $1.20 to $1.40 a share.

But a look at the calendar reveals we are approaching year-end, when portfolio managers around the globe focus anxiously on their own performance as well as whatever benchmark (the S&P 500 index, the Russell 2000 index, the R-Tango-Delta Mid-Cap Value-Growth-Dividend-Momentum-Day-Trader index) they are attempting to beat.

Furthermore, a look at the ERTS shareholder’s list reveals 10 and 15 and 20 million share positions among the Janus Capitals and Legg Masons of the world.

And what good sell-side analyst wants to—let’s use the polite word—annoy one of their firm’s largest customers by beating up on a “best of breed” company like Electronic Arts, which, not for nothing, recently announced a large, fee-generating acquisition of Jamdat, this close to year-end?

Answer: none.

And so Wall Street’s Finest put on a good face, called the ERTS announcement a “buying opportunity” because (I am not making this up) of the “reduced uncertainty” now that the bad news—foreshadowed last week when Best Buy reported earnings in which video game sales were an area of notable weakness—was out.

One of them actually said it was time to step up to the plate and buy, because ERTS shares were now trading at their “trough valuation.”

Net result: ERTS shares closed up 35c yesterday, at $53.46 a share.

Precisely what is the “trough valuation” that makes ERTS shares so attractive?

Well, the shares now trade at 45 times the low-end of the forward earnings range. And this assumes sales grow all of 12% next year, with the help of the Jamdat acquisition.

Google, for what it’s worth, trades at 48x the high-end of next year’s earnings range, with a sales growth more than 5-times that of Electronic Arts. (Divide everything Google-related by 10: it becomes a $43 stock with 90c of earnings in 2006, compared to ERTS at $53 with $1.20 of earnings in the year ending March 2007.)

Yet the general consensus on Wall Street would no more describe Google’s PE as a “trough valuation” than my dog Lucy would accept a piece of broccoli in place of a dog biscuit.

Don’t get me wrong: Electronic Arts is a very very well run company in a very very cyclical, but growing industry.

The fact that a tree fell on Wall Street yesterday and nobody heard it fall, however, has more to do with the calendar on the wall than the fundamentals involved.


Jeff Matthews
I Am Not Making This Up


© 2005 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations.

15 comments:

mamis said...

In August of this year I did a lot of research on NVDA. I concluded that (a) they would miss revenues, (b) they would lose market share, (c) the street would cut numbers, and (d) the stock would drop. So I went short.

When the earnings hit, (a) they missed revenues, (b) they lost share, (c) the street cut numbers, and (d) the stock jumped 10% (and hasn't stopped rising since). I covered immediately, thank God.

As the inimitable Joaquin Andujar once said, "there's just one word to describe this game, and that word is, 'you never know'".

Its_strange said...

Jim Cramer recently wrote a piece about Oppenheimer loading up on TTWO , a company whos failures are clear for all to see. But this is wallstreet and Oppenheimer uses other peoples money to play squeeze the silly shorts.

You will read 100 stories on ERTS over the next few months and maybe 2 will touch on the stuff Jeff did.

I got idea . Can we get blogs listed on the yahoo fiance site like many news stories and press releases are ? Like they say " If a Tree Falls in the Woods and Wallstreet holds the cards .... "

SellToWhom said...

Cramer is part of the problem, his manic proclamations of buy ATYT/GME/ERTS/ATVI/whatever for eeexxxxxbooooxxxx 360 launch are laughable. Why? Video games are both cyclical AND seasonal. The launch of a new system is a reason to SELL not BUY. Why? Simple. Money normally that would go to buy games, is now going to buy expensive hardware, or is being held on the sidelines as consumers await PS3 and Revolution. Too many investors fail to understand these important factors.

Frankly, the fact that the screaming moron on TV hates TTWO, adds to its charm.

Gone to the blogs said...

Whether or not the sell-sider expressly stated it, his or her "trough valuation" argument is probably based on normalized earnings (normalized to exclude the temporary effect of the console transition cycle). While it's somewhat foolhardy to try and pick the bottom in such a fashion, I think the sell side is mostly correct in that the current sales pushout and consequent downward estimate revision cycle (both caused by the aforementioned console transition) is much closer to its end that its beginning.

westcoast said...

Demand is going to be horrible through and into the initial launch of PS3, at which point it will definitely pick up (sorry msft but it looks like you blew your attempt at taking over the console world...maybe in 6 years). The question is when demand arrives will it come with the vengeance many are banking on?

Sure this cyclical industry is growing, but also growing is huge athlete/franchise license costs and huge development costs. To pursue more growth, the industry is starting to look more and more like the big bet world of movie studios...

Either way I think for once investors are collectively viewing the longer term prospects for a company (forgetting about this and the likely next couple quarters). Having said that.....Jeff you nailed it re: the ridiculous valuation.

Its_strange said...

Think what you want of Cramer but don't buy TTWO cause he doesn't like it. TTWO simply doesn't tell the truth . The people running it are no good.

shortseller said...

I play the video game market through Chartered Semiconductor. I don't think anyone has heard of them.

I'd love to see a web site dedicated to recommendations by Wall St. analysts. I'll bet these guys were aggressively reducing their forward revenue forecasts while complying to their institutional clients' requests to re-iterate a buy.

The Value Guy said...

Jeff said it best. The tree fell and Wall Street is choosing not to listen to it. Gee, what a surprise.
Why? Because Wall Street, and even Mr. Cramer can afford to be wrong.
Take Cramer for instance. The guy is worth millions so he can afford to be wrong about anything he says (it helps ofcourse that CNBC has plenty of legal disclaimers) Cramer makes his so called "predictions" about stocks and tech stocks in general not to help people...no...not at all. He does it so he can "look" and "be" right if the prediction goes his way. Thats is what happens when your TV ego takes over your sensible ego. If he is wrong. Hey, no money out of his pocket.
I'll say it once and I will say it again, the couple month tech rally we have seen is being fueled by speculation, and TV hyping, nothing more. There is no end demand, no matter how much rationalization goes on in the media.

Tim Knows How to Make Stuff Up said...

Because of comments like those above, re: Cramer and his show, I accumulated a nice position in TSCM last summer. Please keep watching MadMoney. Someone might as well make some money from his celebrity, eh?

The Value Guy said...

Re: the post above:

Spoken like a true gambler.

Congrats. Just dont forget to sell before the stock (TSCM) falls back to earth.
I mean the stock is up only 80% or so in the past month for no apparant reason whatsoever. Plenty of gamblers out there. Usually those gamblers are the very same ones that lost 80% of their net worth from 2000 - 2003.
Might as well have another go at it. Maybe lady luck will smile this time.

muckdog said...

I think folks are waiting for better XBOX 360 games and also Playstation 3 to launch. Nobody wants to fork out cash today for games when the next generation games are here from XBOX 360 and coming from Sony very shortly.

I think pullbacks could make an interesting buying opportunity. I haven't looked into them, but I'd take a look at what the development teams are working on, and what could be the blockbusters for these new systems.

Something to do over the long weekend.

Its_strange said...

Piper Jaffray reiterates outperform on TTWO , THQI , GME , ERTS ..You know i have never seen anything like it. For years TTWO has missed, lied , parked games , manipulated while insiders have sold boat loads of share and Piper and others just smile and come back for more. Its as odd as this battered woman syndrome . Wallstreet should be ashamed . But i guess getting invited to the Hamptons is what its all about.

Jeff D said...

EA should see a big pop when the new systems get out there. PS3 is supposedly coming in March so I'd be we see an uptick in their stock 2nd quarter.

Its_strange said...

Kotaku.com reports delays in ps3

http://www.kotaku.com/gaming/ps3/more-dirt-on-the-ps3-problems-145977.php

delays in ps3 and arrival of David Jones's ( creator of GTA ) " All Points Bulletin" could cause serious trouble for ttwo. All Points Bullentin will be published by Webzen

Its_strange said...

Looks like Herb was right again. And it looks like TTWO ain't worth a dime. ..And TTWO can't file thier 10K after 2 months ? I smell a rat