Watch as this Market Leader Regains its Mojo

For many years, there were two camps in the video game world: Electronic Arts (Nasdaq: ERTS), and everyone else. The company’s annual sales grew so large that they equaled the revenue base of the next three public players — combined.

But corporate bloat set in, and Electronic Arts lost its mojo. Sales, which were already challenged by secular headwinds, fell even faster than at key rivals, leading to eroding market share. New management took the helm more than two years ago, and as Electronic Arts continued to struggle, investors lost hope that a turnaround could be implemented. It may have taken awhile, but that turnaround is now at hand.

Electronic Arts lost boatloads of money in fiscal 2008 and again in fiscal 2009. In order to right the ship, management first needed to sharply shrink costs to at least generate break-even results. Mission accomplished: General & Administrative expenses fell roughly -8% in the just ended fiscal year, while R&D spending fell by nearly $200 million from a year ago.

Those R&D cuts were simply a reflection that Electronic Arts was developing too many new game titles, many of which generated very little revenue. Instead, the company is now focusing on fewer titles (35 are slated to be released in the fiscal year that just began, down from 54 in fiscal 2010). The company is making sure that those titles have a greater chance of success by improving the quality of each game. And don’t be too alarmed about the R&D cuts: Electronic Arts still spends an industry-leading $1.2 billion each year.

Management also realized that many of the released titles did not receive sufficient marketing support. As a result, spending on sales and marketing is modestly rising , which translates into a much greater marketing spend per title.

Those efforts are starting to bear fruit. Titles released in the fiscal fourth quarter ended March are off to a good start, according to just-released data from market research firm NPD. Electronic Arts’ Mass Effect 2 title zoomed out of the gate, selling more than two million copies — good enough for fourth best in the industry in March. Battlefield: Bad Company 2, which Electronic Arts markets and distributes, debuted at the number eight position. Three other Electronic Arts titles released this winter are also off to a strong start.

Long-time observers of the video game industry have seen the Electronic Arts’ demise noted many times over. During the past year, as sales turned negative, the obituary was written anew, sending share prices down to multi-year lows. Increasing competition from other forms of entertainment is usually cited as the key industry risk. Yet historically, the timing of upgraded gaming consoles has been the real factor behind the volatile stock moves in the sector. That factor may be diminishing as new gaming platforms such as Apple’s (Nasdaq: AAPL) iPad, and similar tablet devices soon to be released from companies such as Nokia (NYSE: NOK), Google (Nasdaq: GOOG), and Microsoft (Nasdaq: MSFT) hit the market. These mobile large-screen handheld devices could be just the catalyst the industry needs.

Shares of Electronic Arts now trade below $20 these days, well below the $60 levels seen throughout most of the second half of the last decade. It would likely take sustained double-digit sales growth to boost shares back up to that level. Instead, investors should expect more moderate top-line results as the company puts greater weight behind fewer new titles. (Note that consensus expectations call for sales to drop nearly -10% in fiscal 2011, though that forecast now looks far too conservative in light of the fresh improvements in recent sales data).

More importantly, the deep cost cuts during the past year should propel earnings higher at a faster pace, perhaps in the +10% to +20% range. By fiscal 2012, non-GAAP profits should be back in the $1.00 a share range. If you back out the roughly $5.50 a share in cash sitting on the company’s balance sheet, shares trade at a reasonable 14 times projected earnings. That’s a far cry from the multiple this stock historically garnered. As investors come to see that the sales erosion has ended and the lower cost base can turn Electronic Arts into a nice profit grower once again, investors are likely to bid shares back toward a multiple of 20 (excluding cash), putting shares past the $25 mark. If the new devices noted above indeed turn out to be a new leg of growth for the industry, then a $30 price target isn’t out of the question. For this former highflyer, that would prove to be a panacea for long-suffering investors.