I first thought about EA when i was looking into WWE and gaining a better understanding of the value that sports have in terms of content. Basically with sports you have content that is only really relevant in real time and a passionate fan base. A great combination.

I started thinking about how this content was distributed, and remembered the EA Sports video games like Madden Football and NHL Hockey. I reasoned that these were strong franchises with dedicated customers that likely upgraded every few years if not every year to keep their gaming experience relevant to real world sports. For example, players being traded, new rookies making a splash in the league, and other changes to real world sports will all motivate consumers to purchase the new game each year regardless of technological advances in the games themselves.

Now, I have to admit i haven’t played video games in probably 15 years, and I have a lot of catching up to do in terms of how the industry works etc.

However, the other initial thoughts that I had were that as games go digital, the economics of the industry should really improve. For starters, margins should expand due to reduced packaging and shipping costs. If the game is simply down loaded by the user, there is obviously no need for cover art, the box, the plastic wrap, and the physical disk or cartridge that the game traditionally came on. (This also means no blowing into the game original nintendo style… if you don’t know what i mean you are at least 5 years younger than me.) Secondly, with digital games, there is an opportunity to move toward a “barbie” model. Users buy the game, and then buy further add ons like extra levels, or extra weapons, or whatever the case may be. This is most applicable in roll playing type games, and could create somewhat of a recurring revenue stream.

The preceding thoughts were enough to get me to take a brief look at the chart, and was happy to see that the stock had been murdered over the last several years – not surprising their seeming inability to actually make any money dyring this period. I was also happy to see from a brief review of recent conference calls that the company has identified the changing market place and the above mentioned opportunities and is moving to embrace them.

EA was also written up on VIC on Friday, and the writer opined that the growth of smart phones has made it more socially acceptable for adults to play video games, which expands the audience. The author’s reasoning is that with a smart phone no one else knows if you are playing a game. For example, if you are in a waiting room somewhere, you can take out your smartphone and play a video game while the people around you think you are just checking emails or texting. An obvious addition to the “adult gamer” thesis is that for the first time really, adults in their 30s to maybe 4os grew up playing video games in some form, so would not be embarrassed to be seen playing a video game as say an adult in his 50s or 60s who never had a video game experience when he or she was a kid.

Short version, the stock has dropped from $70 at its peak in 2005 to around $15 today because it missed a few changes in the business (the success of Wii) and got over aggressive and started making too many games (something like 50 a year at one point!) which squeezed margins. The first problem is/was temporary, and the second one is/has been addressable/addressed as evidenced by reduced inventory and headcount. Now investors focus on the decline in sales of packaged games, which isn’t surprising given that this includes non digital games for hand held devices. To be honest, I think the market for “GameBoy” type devices is on its way out, so the decline in games for these devices is expected. Think about it – if you are a 10 year old kid, do you want a handheld gaming system that only serves one function, or do you want an iPad or similar that can serve multiple functions? Maybe if we see SP 2000 we’ll see parents shelling out for both an iPad and a gaming system, but for the mean time, most kids are going to be limited to one or the other, and it seems like a pretty simple choice.

EA is positioned to capture this move away from handheld gaming and into smart phones. For starters, in addition to their more complicated games like the EA Sports franchises, they also own several well known brands that are tailor made for smart phones such as Tetris, Monopoly, Trivial Pursuit and others. Given the popularity of Words With Friends, it isn’t hard to picture Trivial Pursuit or something similar slipping into that niche. Additionally, EA has made a few acquisitions in the last 2-3 years, picking up companies that have experience in designing online / smart phone games.

There is of course the risk of these smart phone sales for cheaper games having a negative impact on the more expensive games meant for play on an X Box or Play Station. However I am inclined to think that this risk is overstated by the market as I think that hand held gamers and console gamers are probably fairly unique segments. The hand held gamer is likely a more casual time killer, while the console gamer is likely more passionate.. the hand held gamer is playing for a few minutes while waiting for the bus or for a meeting, or as a way to socialize… I realize I am going out on a limb here, but in many cases the console gamer is playing as a way to interact with an alternative reality… possibly (probably?) because he has an underdeveloped social life. Certainly this is not true of all gamers, but there is definitely a subsect of gamers that fall into that “weirdo fan” arena that also follows Star Trek and the WWE. Weirdo fans are great – they are very sticky.

I also hate to admit it, but the sad truth seems to be that the trend is away from kids riding bikes, playing tackle football, and climbing trees, and toward living in a safety first, the world is dangerous, “you’ll get skin cancer!” world where playing video games and staying out of trouble is encouraged. Making it even easier for parents to justify their incantations to stay of trouble is the fact that each of the major video game consoles now has some kind of functionality that encourages physical activity like the Wii does. Parents can simultaneously keep their kids in a bubble while pretending that they can stay just as fit playing video games as they can riding their bike or playing at the park with their friends.

One other thing worth mentioning is the Star Wars Old Republic MMO (massive multiplayer online) game. This is notable for a few reasons. 1) star wars is about as strong a brand as there is 2) players pay on a monthly basis, creating a recurring revenue stream 3) the game can be and is modified as time goes on keeping players engaged and 4) it is rumored that the game took somewhere around $150M to develop – now that the lion’s share of development is done, expenses should come down. The game launched right before Christmas, and early indications are that it is a big success.

Quarterly revenue data seems to indicate that the decline has halted, and the uptick in the liability for deferred net revenue offers some evidence that revenue going forward will improve as this deferred revenue for future use of online gaming services and the likes is converted to revenue. Not exactly accounting wizadry there, but something to be aware of as the prepaid revenue will fool some screeners into thinking that current liabilities are higher than they really are. Additionally, with no debt due until 2016, the company has some time to perform now that it has right sized itself and moved to embrace the changing face of gaming.

What I don’t like is the lack of insider buying, although this doesn’t surprise me given the “techiness” of the company and the fact that many tech employees probably feel they’ll get their exposure via options rather than buying in the open market. The company did announce a $600M buyback in early February of 2011, and as of 12/31/11 they had repurchased $230M worth of shares. In its original incarnation the buyback expires in August of 2012, so it is worth watching if they continue to use it and or extend it.

These are just my initial thoughts – there are also significant growth aspects worth discussing, as well as significant branding opportunities across multiple distribution platforms. For now I am watching the stock – I will write more about these other points if and when i start a position.

…and one last thing – the stock has popped a bit the last few days on a rumor that Nexon – a japanese company – may be interested in buying AE. I don’t know anything about Nexon, potential financing, potential synergies etc.