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Electronic Arts Inc.(EA - Analyst Report) reported third quarter 2012 non-GAAP earnings (excluding one-time items but including stock-based compensation) of 87 cents per share, which beat the Zacks Consensus Estimate of 83 cents. The reported EPS came in at the lower end of the management’s guided range of 85 cents to 95 cents.

Revenue

Revenues, including deferred revenue of $590.0 million, increased 17.0% year over year to $1.65 billion, way ahead of the Zacks Consensus Estimate of $1.15 billion and was in line with management’s high point of the guided range of $1.55 billion to $1.65 billion.

The strong year-over-year growth was driven by robust digital revenues and strong performances from Battlefield 3, Star Wars: The Old Republic (which were launched during the holiday season) and FIFA 12.

EA’s digital revenue surged 79.0% year over year to $377.0 million in the third quarter and contributed 23.0% of total revenue, significantly increasing from 15.0% reported in the year ago quarter. Strong growth from mobile and other handheld revenues and downloadable content (DLC) drove digital revenue growth in the reported quarter.

Mobile and other handheld digital revenue expanded 25.0% year over year to $85.0 million, driven by strong tablet and smartphone-related revenue. DLC and free-to-play micro transaction content spiked 86.0% year over year to $123.0 million in the third quarter. This increase was attributable to the continued strong performance from FIFA 12.

Full game downloads were $103.0 million, up by a staggering 442.0% on a year-over-year basis, driven by downloadable content from Origin, EA’s digital platform. Revenue from subscriptions, digital advertising and others increased 14.0% year over year to $67.0 million.

Sales from Publishing (74.0% of the total revenue) increased 10.6% year over year, while revenues from Distribution (3.0% of the total revenue) decreased 46.0% year over year.

Region wise, North American sales increased 16.2% year over year. Sales from Europe also increased 15.6%, while Asia achieved a growth of 38.4% in the reported quarter. 

Operating Performance

Non-GAAP gross profit increased 34.6% year over year to $1.11 billion. Gross margin increased 870 basis points from the previous year quarter to 67.4% on the back of higher revenues.

Total operating expenses on non-GAAP basis increased 15.1% year over year to $692.0 million in the quarter. Operating expense, as percentage of revenue, was relatively flat during the period.

The year-over-year growth in operating expense was primarily due to higher marketing & sales expenses (up 6.3% year over year), general & administrative (up 30.7% year over year) and research & development expenses (up 19.0% year over year).  

Non-GAAP operating profit in the reported quarter was $421.0 million compared with $226.0 million in the prior-year quarter. Net profit on a non-GAAP basis was $294.6 million compared with $154.6 million in the year-ago quarter.

Balance Sheet/Cash Flow

Exiting the third quarter, EA had $1.79 billion in cash, short-term investments and marketable securities, as compared with $1.50 billion in the previous quarter. Cash from operations increased from $211 million in the previous quarter to $ 475.0 million.

In the quarter, EA repurchased 1.8 million shares for $141.0 million. The company has $312 million remaining under its existing share repurchase authority.

Outlook

For the fourth quarter 2012, EA expects non-GAAP revenue to be in the range of $925.0 million to $975.0 million. Non-GAAP gross profit margin is expected between 66.0% and 67.0%. Operating expense is expected to be $560.0 million.

Moreover, EA forecasts Publishing and other revenue in the range of $500.0 million to $525.0 million for the fourth quarter. Distribution revenue is expected to be approximately $25.0 million and Digital revenue is projected in the range of $400.0 million to $425.0 million in the fourth quarter.

Earnings per share (EPS) on a non-GAAP basis are expected in the range of 10 cents to 20 cents in the current quarter. The Zacks Consensus Estimate is currently pegged at 23 cents for the quarter.

For fiscal 2012, management expects capital spending to be $140.0 million and non-GAAP digital revenue is expected to be $1.2 billion.

Our Take

EA has been shifting its focus to digital format and with its diversified portfolio coupled with a strong product pipeline it is expected to drive top-line growth going forward. We believe that high-quality titles along with increasing online exposure, social games guarantee market share gains over the long term.

However, the gloomy macro-economic environment, increasing competition and weak video game sales results over the last 12 months, compel us to remain cautious in the near term. Competition from Activision Blizzard Inc. (ATVI - Snapshot Report), Zynga Inc. (ZNGA - Snapshot Report) and new entrant International Game Technology (IGT - Analyst Report) may act as the other headwinds going forward.

We have a Neutral recommendation on Electronic Arts over the long term (for the next 6 to 12 months). Currently, Electronic Arts has a Zacks #3 Rank, which implies a Hold rating in the short term.

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