Fitch Rates Electronic Arts' Sr Unsecured Notes & Existing Sr Unsecured Revolver 'BBB'
OREANDA-NEWS. Fitch Ratings has assigned a 'BBB' rating to Electronic Arts Inc.'s (EA) announced benchmark-sized senior unsecured notes and published a 'BBB' rating for EA's existing senior unsecured revolver. A full list of ratings follows at the end of this release.
Proceeds from the offering are expected to be used for general corporate purposes, including the payments of amounts due on EA's existing convertible notes and share repurchases, including the new $500 million share repurchase program announced concurrently with this offering. Pro forma for the note issuance, Fitch expects total leverage to remain within its sensitivities at the 'BBB' Issuer Default Rating (IDR) level. Adjusted gross leverage, calculated using funds from operations (FFO) as described below, was 0.8x as of Dec. 31, 2015.
Fitch previously assigned a first-time 'BBB' IDR to EA on Feb. 4, 2016. The Rating Outlook is Stable.
The rating reflects EA's solid credit profile and conservative balance sheet, as well as profitability tailwinds in the video game industry, as a greater percentage of revenue is being derived from digital distribution. These strengths are partially offset by revenue concentration in key franchises and the competitive and hit-driven nature of the video game industry.
KEY RATING DRIVERS
EA's strong credit profile consists of abundant liquidity, with $2.3 billion in cash (EA does not break out domestic and international cash balances in their press release), $966 million in short-term investments, $500 million of revolver availability, $930 million of free cash flow (FCF) for the last 12 months (LTM) ended Dec. 31, 2015, and conservative FFO-adjusted gross leverage of 0.8x as of Dec. 31, 2015. Fitch believes FFO-based metrics are more appropriate than GAAP-based EBITDA metrics given GAAP treatment of the digital revenues generated by EA's online-enabled games.
EA's digital experience is in line with the video game industry's overall shift away from physically-shipped, packaged goods towards digitally-distributed games and content. EA's digital revenues comprised 53% of LTM ended Dec. 31, 2015 total revenues, up from 45% one year ago. A majority of EA's revenue shift will be to full-game downloads, as games can now be downloaded directly to a player's console, computer, or phone.
Digital revenue is more profitable than packaged goods revenue and this shift has caused upward momentum in video game company margins. Fitch expects EA's operating margin to increase from the mid-20% range to the mid-30% range over the next five years due primarily to this ongoing shift.
The shift to digital revenue, coupled with the company's ongoing efforts at a more disciplined operating cost structure has materially increased EA's free cash flow (FCF) generating ability. For LTM Dec. 31, 2015, Fitch-defined FCF was $930 million, compared to $105 million in FY2012 before the digital shift commenced. Fitch-defined FCF is expected to be sufficient to fund some level of share repurchases going forward and is projected to grow from $1.1 billion in FY2016 to $1.4 billion in FY2019 due primarily to digital revenue growth. EA's FCF exhibits seasonality around the holiday season, with the majority being derived in the quarter ended Dec. 31 (EA's fiscal third quarter).
Partially offsetting this secular tailwind is the fact that over 50% of total revenue is derived from EA's top three franchises. This level of concentration is less than some of EA's peers, but still represents a risk in Fitch's view. FIFA is one of EA's top-ranking franchises, with full-game sales comprising 15% of total revenue over the past two years (excludes live services and extra content revenue). To combat this, EA, as do most video game companies, dedicates material R&D spend to develop new franchises and expand existing mid-tier franchises (around 5 million players) into mega-franchises (around 15 million players plus) in an effort to diversify its revenue concentration.
A number of EA's core franchises (e.g. FIFA, Madden NFL, Star Wars) represent licensed intellectual property (IP) which can have weaker unit economics than wholly-owned IP due to the underlying royalty rates and/or minimum guarantees. Competition for key licenses is intense and the inability to extend or renew a core franchise license could materially impact EA's cash flows. This risk is partially offset by staggering license agreement terms and increasing the switching costs for individual users by developing large online communities for specific franchises.
The video game industry is inherently hit-driven and highly competitive, which increases the potential volatility of future cash flow. Some of this risk is mitigated by the video game franchise model, which has increased the cash-generating lifespan of certain games and creates some form of recurring cash flow, depending on the franchise strength. However, video game companies must keep publishing new and expansionary content for key franchises to keep customers engaged, which makes franchises still hit-driven to some extent.
Fitch expects traditional video gaming will continue to be a significant part of the overall gaming segment. The introduction of next-generation game consoles from Microsoft and Sony in late 2013 reinvigorated demand for console hardware and software, and the current installed base is outpacing prior-generation trends at this point in the cycle. Nonetheless, Fitch believes that traditional video gaming is a mature market with industry revenues fluctuating based on next-generation console introductions and high-profile software releases.
Additional growth in the sector will be driven by the continued emergence of mobile and social network gaming. The proliferation and technological advances in smartphones and tablets has led to superior growth in the mobile gaming market compared to traditional PCs, consoles, and handhelds. EA has successfully transitioned a number of its core franchises over to the mobile platform, which has helped contribute to its success in the space.
--GAAP-based revenues decrease by low single-digits in FY2016 due to effects of revenue deferral for online-enabled games. Thereafter, overall growth is in the mid-single-digits, driven by continued 10%-20% growth in the digital segment. Packaged goods revenue declines are in the 5%-10% range as a greater percentage of games and content are distributed digitally.
--Gross margins expand by around 100 bps a year due to shift toward more profitable digital revenue. SG&A and R&D costs are managed at a fixed percentage of revenue.
--Capex is consistent with recent trends at approximately 2% of revenues.
--Domestic FCF is used primarily to fund share repurchases.
Positive: Positive rating action will likely be forestalled for the foreseeable future due to minimal business considerations to support the company maintaining a rating above 'BBB' and secular factors such as competition and the hit-driven nature of video games. Future upgrades could be considered if there is an increase in wholly-owned IP as a percentage of total revenue, increased franchise revenue diversification driven by strength in new or smaller existing franchises, and/or operating margin expansion exceeds Fitch's expectations.
Negative: Negative rating actions are more likely to coincide with a material shift in financial policy including, but not limited to, the company managing toward a more aggressive financial strategy or event-driven merger and acquisition activity that drive FFO adjusted leverage beyond 2x in the absence of a credible de-leveraging plan. Additionally, negative rating actions could result if shareholder-friendly activities materially exceed domestic cash flow generation and drain domestic liquidity, and/or the shift to digital revenue is weaker than expected.
At Dec. 31, 2015, EA had $2.3 billion in cash and cash equivalents, $966 million of short-term investments, and full availability under its $500 million revolver. For LTM Dec. 31, 2015, EA generated $930 million of FCF. The primary use of cash through Fitch's forecast is expected to be share repurchases; however, there is $340 million in convertible notes maturing in July 2016 (the company received notices for $177 million to settle in fourth quarter 2016) which can be fully funded by cash on hand and projected FCF generation. Fitch expects EA's overseas cash balances to grow in lieu of repatriation and as the company utilizes domestic FCF to fund its share repurchases.
FULL LIST OF RATING ACTIONS
Fitch has assigned the following ratings:
Electronic Arts Inc.
--Senior unsecured bank credit facility 'BBB';
--Senior unsecured notes 'BBB'.
Fitch currently rates EA as follows:
The Rating Outlook is Stable.