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Video games developer and publisher, Electronic Arts Inc. (EA - Analyst Report) reported EPS of 57 cents in the third quarter of 2013, which was significantly down from 99 cents posted in the year-ago quarter.  However, quarterly EPS was much better than 15 cents reported in the previous quarter.

Including stock-based compensation, EPS was 44 cents, which exceeded the Zacks Consensus Estimate by 3 cents in the reported quarter.

Revenues

Revenues (including deferred revenue of $260.0 million) decreased 28.0% year over year to $1.18 billion, which missed the management’s guided range of $1.25 billion to $1.35 billion. Revenue was also well short of the Zacks Consensus Estimate of $1.29 billion. The year-over-year downside was primarily due to weaker-than-expected performance of Medal of Honor Warfighter and continued headwinds for the packaged goods segment.

Both publishing and distribution revenue declined massively in the reported quarter. Publishing and Other (62% of total revenue) segment plunged 39.0% year over year in the quarter to $742.0 million. Distribution (3% of total revenue) revenues fell 33.0% from the year-ago quarter to $33.0 million.

This weak performance from publishing and distribution was partially offset by 8% increase in digital revenue (35.0% of total revenue), which reached $407.0 million in the quarter. The growth was fueled by a 50.0% year-over-year jump in revenues generated from extra-content and free-to-play games. This was driven by strong performance from FIFA, Madden Ultimate and Star Wars: The Old Republic.

Revenues from mobile and other handheld devices increased 18.0% year over year to $99.0 million. Smartphones and tablets revenues were up 36% year over year to $79.0 million. Subscriptions, advertising and other digital revenues grew 18% from the year-ago period, driven by Star Wars: The Old Republic. This strong growth fully offset a 57% year-over-year decline in full game downloads.

On a sequential basis, revenues increased 9.4% year over year, primarily driven by a 29.6% jump in digital revenues. Distribution revenue also surged 50% over the previous quarter.

Region wise, North American sales (44% of total revenue) decreased 40% year over year to $489.0 million. Sales from Europe (51% of total revenue) declined 15.0% year over year to $630.0 million. Asia (5% of total revenue) plunged 38% from the year-ago quarter to reach $63.0 million in the reported quarter.

Margins

Gross margin expanded 600 basis points (“bps”) from the prior-year quarter to 53.0% due to favorable product mix. EA has started its own digital distribution business, which replaced third-party vendors. This also helped in driving gross margin growth.

Operating expenses as a percentage of revenue, jumped to 48.0% in the fourth quarter from 41.9% in the year-ago quarter. As a result, operating margin (including stock-based compensation expense) declined sharply from 25.5% in the year-ago quarter to 17.6% in the fourth quarter.

EA reported net income (excluding stock-based compensation and other one-time items) of $176.0 million compared with $334.0 million in the year-ago quarter. Including stock based compensation, net income was $135.5 million in the third quarter.

Balance Sheet & Cash Flow

EA exited the quarter with $1.43 billion in cash, short-term investments and marketable securities, compared with $1.22 billion in the previous quarter. Cash flow from operations was $363.0 million compared with cash outflow of $28.0 million in the previous quarter. During the reported quarter, EA repurchased 12.2 million shares for $157.0 million.

Outlook

For the fourth quarter 2013, EA expects non-GAAP revenues to be in the range of $1.025 billion to $1.125 billion. EA forecasts EPS in the range of 57 cents to 72 cents per share on a non-GAAP basis. Non-GAAP operating expense is expected to be greater than $525.0 million.

For fiscal 2013, management lowered its revenue guidance. EA now expects non-GAAP revenue to be in the range of $3.778 billion to $3.878 billion (down from $4.05 to $4.20 billion). EA forecasts operating expenses of approximately $2.2 billion. Non-GAAP EPS is expected to be in the range of 86 cents – $1.00 (down from $1.00–$1.15) per share for fiscal 2013.

EA expects operating cash flow of $350.0 million for fiscal 2013.

Our Take

We believe that EA’s strong digital portfolio and continuing growth in the free-to-play and online segment will drive top-line growth going forward. Reportedly, both Microsoft (MSFT - Analyst Report) and Sony (SNE - Snapshot Report) are expected to launch their next generation consoles this year, which will be a significant growth catalyst going forward.

However, we believe that EA’s lowered guidance reflects soft video game industry outlook in the near term, particularly due to weakness in retail sales amid an aging console system lifecycle. Moreover, the cannibalizing effect of free-to-play games and tough competition from Activision Blizzard Inc. (ATVI - Snapshot Report) remains a concern.

Currently, EA has a Zacks Rank #4 (Sell).

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