Electronic Arts: FIFA, The Sims, Madden and More - [Business Breakdowns, EP. 106]

25:57So they're responsible for two -thirds of top -line growth over a little more than a decade. It's a very different story without Ultimate Teams. And what I find interesting is that the only other competing soccer title that had some licenses back in 2009, Pro Evolution Soccer. And in that year, FIFA sold something like 9 million units, console units for FIFA. Pro Evolution Soccer was about 7. so FIFA was bigger, but they were competing in the same ballpark. And today, FIFA is selling 20x Pro Evolution Soccer. So it's probably the combination of Ultimate Teams and exclusive licensing that led to this dominance in their most important franchise, but I think it's been the case for other sports.

26:39And what's interesting about Ultimate Teams is I think there's a social element to network effects that once that ball starts rolling, it makes it really hard to compete with. At a micro level, EA talks about these little atomic units of four to six people that play one to two hours a day together in some of these games like FIFA Ultimate teams. But at a macro level, like as you get more players into the fold, matchmaking liquidity improves, liquidity in the cross -platform transfer marketplace improves, and that's how you trade players and build your team. There are more tournaments and then a lot more content gets produced that gets consumed outside of the game, like on Twitch or YouTube.

27:16A little bit like professional real -world sports. If you think basketball, you think NBA, hockey, NHL, football, whatever. So I think EA is building something very similar with leagues and tournaments. So they have an E -NLS and E -Champions League. And a lot of these leagues are pretty new, but the tournaments are still getting 100 ,000 plus viewers per game. So I think that's a very important part of the sports franchise story. Yeah, I want to get into a lot of the revenue dynamics. If you just step back and look at EA's exposure to console, PC versus mobile, what does that look like today?

27:56Yeah, so console is about two -thirds of the total business, PCs. 20 % mobile is 15%. So console is the bread and butter. I assume that's different versus the industry? Yeah, so the industry split. It's changed a lot over time. But today, mobile is about 50 % of total industry revenue. I don't know the exact split, but we're talking maybe 25 -25. I know that's wrong by a small margin, but the rest is split between PC and console. So mobile is the biggest part of the market today. And have they ever made a big push into mobile or is there a reason why they haven't? They have tried via M &A multiple times.

28:31They tried, I think, under John Riccitello. Nothing really came of it. Most recently, under Andrew Wilson, they acquired two mobile studios. studios. This is 2021. I think this is peak hype in mobile. And they paid almost $3 .5 billion to buy these two mobile studios, which was something like 30 times trailing EBITDA. So they paid a lot to get exposure in this market. And to make that math work from an IR perspective, you just need really high organic growth or margin expansion or something like that. And that hasn't played out. So I think they spent a lot of money trying to get a stronger foothold here.

29:12It's maybe too early to judge, but I would guess those are bad acquisitions. But I think that goes to show how hard it is to organically build a mobile business. It almost forced them to try M &A. If you look at the other big publishers, Take -Two bought Zynga. I think it was another big mobile game. Activision had no mobile business. But years ago, before I think peak mobile hype, they bought King for some measly like five times So a lot of the big legacy PC console publishers bought their way into mobile. What's different about the mobile market from what I think are pretty well understood console and PC markets?

29:53Unlike console and PC, where if you're making a AAA game, the lead time is potentially years. The budgets are in the 100 million plus range. You and I could go out and start a mobile title. We could make one. It wouldn't be very good, but we could make it with like $10 ,000. Really big mobile titles cost some fraction to develop. These titles are distributed digitally. That's not hard to do if you're like a little indie studio. And because the budgets aren't that big, the reliance on a publisher is not as high. So you find there's just more indie mobile studios. And if you come up with a great game and you make some revenue, you can like bootstrap your way to becoming a big mobile studio.

30:32And so the dependence on publishers in the mobile space is just lower, which is obviously one reason why they've had a hard time organically growing those businesses. Barrier century or low. That makes sense. How much is replicable across the different mediums? So you were referencing some type of game engine software that they have within EA's walls, which they can use. I assume that breaks down once you transition over to a mobile platform. How much can you take from developing a game for an Xbox or a PlayStation and then just copy the code over and apply it to the mobile side or even the PC side?

31:12I think you're often just starting from scratch. I don't think there's a lot of synergies to be had necessarily from a development perspective. Is that between console and PC as well? Or just is it the mobile extension, which really breaks down? I'm not actually sure. Most games that are cross -platform like they're developed for PC and consoles simultaneously. So I'd imagine that's much more homogenous than console mobile pairing. Can you talk a little bit about that game development and what that looks like in terms of costs? I think you made some reference to it there. But what are the general economics like for a new title?

31:53And let's assume that you have some visibility in terms of what revenue will be, which I know is the big question, but just some general economics around the cost to develop a game and then what the goal is in terms of margins for a run rate mature game. I find it helpful to start the other way and go backwards. So if you started like $100 of gross revenue, the digital distribution platforms are clipping on average about 25%. And so just right out of the gates, if you have $100 in sales, you're left with $75. And then in EA's case, because they license so much IP, they obviously have to pay all these licensing fees.

32:32That probably works out to a billion and a billion and a half dollars for them. But in this hypothetical example, that's an extra $15 to $20. And so on $100 of sales after the platform fee and licensing, somebody like EA is left with $55 to $60 of gross profit. And then the costs to develop and market a game, all of that is expensed. And typically, it's a little more than half gross profit dollars, spending billions of dollars a year doing this. And then you layer in a little bit of SG &A. And on balance, these scaled franchises are generating something like $20 of EBITDA on that $100 of gross revenue.

33:10So call it 20 % EBITDA margins or 25 % EBITDA margins on net revenue, which is after the platform fee, which is what you'd see them report. So it's a very capital -white business. There's no CapEx involved. Everything involved in making a game is expensed. So it's relatively high margin, capital -white. You'd expect for any scaled business franchise that has enduring value, return on invest capital to be very good. And it generally has been. If you strip out the impact of M &A, return on invest capital at EA over the last decade, well north of 30%. So it's a very profitable business at scale. What's the expected lifespan of a game?

33:51I think 20 years ago, the titles were maybe shorter just in terms of how long they stayed atop the charts. What does that look like today? Has that changed much? Yeah, there's more. I don't know if you'd call them perpetual games, but a lot of this free to play stuff just persists for years and years and years. I think Fortnite, Apex Legends, since Call of Duty Warzone. So there's a lot of large franchises. We haven't seen some of these franchises expire yet. World of Warcraft was created decades ago, still running FIFA decades ago, Call of Duty decades ago. So a lot of these big franchises, the franchise life could be 40, 50, 60 years.

34:30We haven't seen some of these end yet. Those are the franchises, but you have seen new titles come out. There are new Call of Duty titles. Oh, right. So there's annual release cadence. Yeah. Yeah. So a lot of games still do the annual release in sports for sure. A lot of first person shooters have an annual or pretty regular release, but certainly there's more perpetual games. There's not really a full game sale and all the monetization is in game. And so the only reason you wouldn't have an annual release or a very frequent release is if you can generate more of your revenue from in game sales and then just drop in new content to keep people in there.

35:07And you referenced it before, but can you give that breakdown of in -game sales versus upfront sales? That's just such a massive shift in terms of business model and monetization. So in 2010, something like 90 % of total revenue was coming from physical full game sales, like you're buying a disc. And today, only 10 % of revenue is physical full game sales. maybe another 15 % is digital full game sales and then like a whopping three quarters is in -game sales and that is an enormous shift over the course of basically just a decade and so in -game sales like it can be dropping new downloadable content like maps or campaigns that people can pay for to unlock it's cosmetic items it's loot boxes it's all these other things and that has become the driving force behind a lot of these games.

36:01And EA specifically, a lot of their monetization now comes from in -game sales. That's true of Apex Legends. It's true of most sports. So it's been a huge shift. What is the goal over the next five years? That's just such an insane shift in terms of monetization. Is that the goal just to continue to lean into more in -game monetization? I mean, do we get to a point where the upfront cost of the games is free? it just becomes an entirely free -to -play industry. I don't know if we'll ever get 99 % in -game sales. There are, I think, certain styles of games that don't lend themselves well to that, like stories.

36:42Whenever you're playing a single -player campaign game where there's a very intricate narrative, I don't think it lends itself well to in -game sales. But most titles that you play online with other people, i think yeah the majority of revenue will push that way over time what does madden cost now or console or pc no i haven't checked recently console games were 60 for the longest time that's what i was wondering yeah with the next gen shift i don't know if madden specifically has changed but a bunch of titles had increased that for the first time in like a decade by ten dollars or something but it's still like relatively cheap if you inflation adjust that all this stuff has gotten cheaper over time.

37:23Yeah. I mean, it was $50 back in like 2000. So if it was still anywhere close to that, it's pretty crazy. When you do see a new generation of graphics driven by PCs or consoles, you would often hear about app developers. And it was like, whoa, when we see an iOS change, all hands on deck, overnight work, just to make sure everything is working properly. How do the actual publishers coordinate that in terms of the step up, developing games that work on these new systems? How much of an overhaul is it? And does that shift economics significantly in terms of having to keep up with the technology?

38:00Yeah, I think historically, when there's been a change in console generation, development costs go up. That should be capitalized, honestly. They should capitalize it. It's a console generation last 10 years, the 10 year investment. But yeah, so it's generally more expensive. But that's really also the only time you can justify increasing the headline price on games. And to the extent that full game sales still exist in the future, that's offsetting factor, but certainly more expensive. And a lot of studios would just lease a game engine from somebody else, or maybe they'll develop it themselves, but it's just used within the studio.

38:39But EA does this unique thing with the game engine, where they try to have the same engine power as many of their games as possible. So trying to get economies of scale on that front. In theory, if you can do that, if you can have multiple studios using the same engine, then when there's a console generation jump, you're just updating one thing and cross your fingers and hope that it works for all the different titles that you're making games for with that engine. EA may, like you can make an argument that they've navigated that a little easier than they might have otherwise. Can you talk about that engine a little bit?

39:13If I am a game developer and I don't sit under the EA umbrella, what does it cost me in terms of do I create my own game engine? Can I outsource that in some way? You have two choices as a studio, whether you're indie or not, whatever, you have two choices. And that's to lease or to pay a royalty to a third party to use their engine like an Unreal or a Unity where you can build it in -house. Typically, building it in -house is very expensive. Cost estimates of 100 million plus. It's very expensive. So if you're an indie developer, you most likely are just renting an engine from somebody else. If you're a large publisher and you're making huge games, particularly if there's an annual release cadence, you'll just develop an engine in -house.

39:57So EA had this engine called Frostbite, and it was being used by the studio Dice to make Battlefield. And a little more than 10 years ago, they said, you know what, we should probably experiment with rolling this out to other games. So I think they started that rollout in 2010 or 2011 with this Frostbite engine. eventually it got picked up by the studios making FIFA, Madden, NHL, PGA, some Star Wars games, Mass Effect, Need for Speed. It's a long list. And it's difficult to know, to measure for sure, if there's been an improvement in margins, like if there has been scale economies. But you can see that R &D intensity has fallen.

40:35So I think it's a good argument to be made that the shift to moving multiple studios to the same engine was margin accretive. But it's also been a very challenging, more than 10 -year journey. So the first game to use Frostbite was outside of Battlefield, was Need for Speed. And they apparently had to spend an entire year repurposing this engine that was made for first -person shooters to do driving. The same thing happened if they're building a big open -world role -playing game, they had to repurpose the engine. Your publisher gave you two years to make a game, or three, and you spent a whole year just repurposing this engine.

41:09that can really hamper game quality. And I think we've seen many examples of that. Once you get past those growing pains and you build the second driving game or the second big open world game, you should spend less time repurposing. And if you can make that 10 year commitment to get through it all, you get to the other side and you can end up with a more profitable business. And this is something that would be, again, not impossible, but very difficult to replicate anywhere else. Yeah, there's a certain irony that Need for Speed was the one that had to go through the thrilling long pain of going through that switch.

41:45Do other publishers also have in -house engines that are used across different games? As far as I'm aware, like I've only looked at the big franchises and for the most part, they're all using a dedicated in -studio engine. And even at EA, not every studio is using an engine like this. Respawn, which is outside of EA Sports, it's probably the most important studio. They specifically are not using Frostbite for Apex Legends. They're not using it for the Star Wars games they create. So yeah, it's not used everywhere. Some big franchises at the other publishers are just stuck with their own little thing, their own big thing.

42:27It sounds like something that would make sense to investors as being this great unlock in terms of value, but it doesn't seem like they necessarily disclose how much value it's created. So is the value of frostbite, is it clear or is it more conceptual in nature? Like I said, it's hard to measure improvements in R &D intensity. You can see it's maybe like a few percentage points improvement to margin, which is not immaterial, like that's hundreds of millions of dollars. But yeah, it is hard to measure. They have referenced it in calls in the past, but nobody's ever come out and said, hey, Look at this thing saving us $500 million a year.

43:05I think there's some indication there where if management has any chance to point to sizable savings or sizable gains, they usually don't miss that opportunity. But it's interesting. And it's one of those things where it would make all the sense in the world in terms of a synergy. And is it truly just software type application? Is that the right way to be thinking about it? It's like a toolbox. There's like a renderer and there's spatial and audio tools. So like if you were, say, for like a role -playing game, you had a scene. So you wrote in a character and the character is moving. You could like pause it and then change what they're going to say.

43:41You can drop in a bush. It's like a toolbox for somebody, for anybody who's participating in making the game come to life. Super interesting. An interesting development and differentiation for sure. In terms of the in -game monetization, you referenced loot boxes. I know there's some risk around this development and how it's being treated and regulation. Can you touch a little bit on that? And again, reference just how big of a percentage of growth that's been for the business? Yeah. So loot boxes, if you don't know what they are, it's just something you can purchase in a game that produces a random assortment of items for players.

44:21You don't know what you're going to get. Basically, all of Ultimate Teams is monetized with loot boxes. Player packs that you buy is a loot box. You don't know where you're going to get distribution of probability based on how rare something is. All of Ultimate Teams, which is more than 30 % of the business, different games of theirs have experimented with this, like Star Wars, whatever. So I would say you're approaching 40%, maybe more percent of total revenue is coming from loot boxes. Pretty large exposure to this unique monetization mechanism. The concern would be that it constitutes gambling.

44:56And if it constitutes gambling, then it should be regulated under gambling law, which would obviously be very detrimental to EA. So this has been part of the regulatory conversation for maybe since 2018, really been part of the conversation. And since then, in the most extreme case, we've seen places like Belgium deem loot boxes illegal. And so today you can't play ultimate teams in Belgium. You just can't. And then moving down the spectrum, you have other places like the Netherlands where the Dutch Gaming Authority, they just sued EA for using loot boxes in FIFA. But then EA appealed and won.

45:35And the appeals court said Ultimate Team packs for part of the larger game of skill. Being technical, it's not gambling. so they're really flirting with this line but i think what's important is that there's no expectation for financial reward and this was a stance that the uk took so you can pay real world money to buy a player pack but if you get a really rare player you can't sell it back into the world for real currency they've been very careful to to make sure that's not the case because if it was i'd almost certainly would be considered gambling so in most countries you know after talking about this for five or six years.

46:12I think it's been established under case law that loot boxes aren't technically gambling, but there's the concern that it stokes gambling behavior in kids. And that's a totally fair concern. And so a lot of politicians are trying to get the industry to self -regulate. Can you do stuff to protect children before we actually bother stepping in to take legislative action? So you can add better parental controls, not just at the console level, but at the game level to make sure kids can't spend money on the stuff. You can adjust game ratings. You can be more transparent so you can show the probability of receiving certain things.

46:45There's all these steps you can take, but it's really difficult to know how this will shake out. My personal view is that this is a very low probability, but extremely high consequence risk to their model. And they're working on addressing this self -regulating, you'd say. They've introduced preview packs to FIFA Ultimate teams, which before you open a pack like you would their traditional packs, but instead of having to pay for it up front, you pay for it after you see what's in there. Kind of like a weird dynamic to me. Kind of defeats the purpose. But unlike regular packs, that's clearly on side.

47:23It's not in the gray zone. And according to FIFA, it hasn't changed the cadence of monetization or engagement. I mean, there's still probably more they'll need to do, but I think the loot box regulation risk is the biggest risk -facing business today. The next question I was going to ask was on M &A. And you have these headlines with Microsoft and Activision. It's a very unique case going on, a lot of it being done publicly through the media. If you just looked at that in a vacuum, there's some obvious step which says, okay, if that deal happens, then Sony might have to come out and buy EA. But putting that aside, if Microsoft does acquire Activision, is that positive, negative in terms of how it would impact EA?

48:07So you're right. Sony would almost certainly look at somebody, whether it's EA or Take -Two, like there's not many options. That's definitely on the table. In the event that EA wasn't acquired though, let's just say that didn't happen. Would this Microsoft Activision thing be bad for EA? And I think it depends. Probably not, but it depends. So what would happen if those two console behemoths, Sony, Microsoft, consolidated the rest of the console industry. So they bought Take -Two and Ubisoft, whatever. Or EA is the last man standing outside of these two behemoths. And these two big companies, Sony and Microsoft, just bundle all of this content into their subscription services, like PlayStation Plus and Game Pass.

48:45Say they didn't change price a ton either. The relative value proposition of just signing up for a Game Pass or a PlayStation Plus would improve dramatically over paying the $70 for a full game. So the concern would be big competitors effectively bundle and that hurts EA's full game sales. But at the same time, the beautiful thing about their competitive position is that it doesn't matter how many businesses Sony and Microsoft acquire, they're not going to have any sports content. Maybe if they acquire Take -Two, they'll have basketball, but they're not going to have any soccer or football or hockey content.

49:17So for players that want to play that stuff, you won't have a choice. So on balance, it's not positive if they don't get acquired, but I don't think it would be meaningfully negative. You referenced a bit there about the subscription models for gameplay. I think this exists in various different forms, but how has it changed the economic model for EA in terms of various forms of Game Pass and other offerings that are out there? What do the economics look like for that? And does EA license any of its games through those type of offerings? So EA has their own very small subscription offering, and it's basically treated as an add -on to some of these other larger subscriptions.

50:01So you can pay the additional, I actually forget exactly what the number is, $30 a year. And then you get access to the EA catalog. This catalog, though, it largely includes dated games. The week that they released FIFA 23, they're not including FIFA 23 in the subscription bundle. So to the extent that they're not cannibalizing full game sales, which granted have already fallen as a percentage of total revenue anyway, they're really just unlocking value from the old catalog. So net net, I think it's probably modestly positive if you can do that. And then generally just over time, if you're not cannibalizing a full game sale, because you're now largely monetizing with in -game sales, it actually would make a lot of sense to throw stuff into a subscription because it doesn't really matter to you.

50:48So why not get it into Game Pass? But it's currently not there today. If you look at this business and the next three years, what is the bold story or the optimistic the case for owning this? Is it margin expansion? Is it just overall sales growth? What does top line growth look like for this industry right now? And where do you, from an investor standpoint, get excited when you see a name and have a bull thesis on it? Hard to pin it down any particular year. But generally, over time, console PC markets grow at mid -single digits. That industry tailwind. Mobile was 2x that for a long time. Lower now.

51:29Now, mobile industry is having a bad year. But generally, I think you can expect as a publisher, mid single digit organic growth. Not that sexy. But for EA in particular, I think there are four things over the medium term. You could call that three years that I'm excited to see how they play out. And so the first is EA has ended their relationship, their partnership with FIFA. So they're rebranding the FIFA game to EA Sports FC. and all they're losing is the FIFA name. And FIFA, their only choice now is to find another partner to try to make a simulation soccer game to pay for the FIFA name. And so far, there's been no announcement.

52:10So I would be shocked if the new competitor did step in. But the implication of that is that EA is not spending $150 million a year on the FIFA license. And $150 million a year, that's more than 10 % of free cash flow. So I would expect at least immediately next year is the first EA Sports FC title, they'll probably spend all of that money marketing, maybe on new content, whatever. You really have to make sure that the rebrand goes well. So first year, it's probably all gone, maybe, and then some. Second year, maybe do it again. By year three or four, if the rebrand has gone okay and engagement's still there and there's no competing FIFA title, I think it's very likely that that $150 million just flows through to the bottom line.

52:54You revert to business as usual. x that licensing fee i think well it'll be interesting to see how that plays out there was a recent development the second thing where and i don't know if it's because disney was so happy with respawn and their star wars game but disney just signed an agreement with ea to make three new marvel video games i think there's a lot of potential there just like there was with star wars so that's exciting i'm curious to see so the studio that was making star wars and Battlefield was DICE, and they dropped the ball on both of those things. And then with the Respawn studio that made Apex Legends, which is arguably one of their most important franchises, can absolutely hit.

53:33That studio and the guy in charge of that studio, Vince, they're now taking over for Battlefield and Star Wars. So there's a Star Wars game coming out literally in like four weeks that Respawn developed. And so I think there's a lot of potential there. So again, it's just organic stuff where I would say there's a lot more risk to the upside than not. and the final thing is in the next three four years what happens with mobile can they do more organically they had been working on an apex legends and battlefield mobile title they even released the apex legends title but they since pulled it so what they're trying to do is create an experience that crosses platforms so the difficult thing with mobile is it's so casual it's hard to monetize whatever but if you could somehow tie the console apex legends game to mobile.

54:17So maybe you can just like watch your friends play. Maybe it's you can play some mini games that unlock content on console. So if you can do this stuff, well, I actually think there is a lot of potential to leverage that console PC IP in mobile. And so I think three, four years would be enough time to see them do something. And they're clearly working on it. So that's the medium term both thesis is they execute on multiple franchises, and there's a lot lined up. And if they don't, then it'll be sort of business as usual. Connecting the dots, getting a bridge from console, PC to mobile feels like such a...

54:51It's a tough nut to crack. Yeah, it's absolutely hard. But if you can pull it off, it seems incredibly valuable. We close out these conversations with lessons that can be applied elsewhere. Are there any lessons from looking at EA, its history, its current state today that you think you can pull out and say, this is an interesting theme, which I'll think about when looking at other investments? So EA has experimented with a lot of different things over the last 20 years, many of which have failed, like that origin platform. But some of these experiments have defined most of their success. Two or three experiments have defined most of their success over 30 years.

55:28And the lesson to me is that if you have a profitable core business with big moats and you can afford to take lots of calculated risks, then you should, because one of those is bound to have an extreme retail outcome. So that would be the takeaway for me. like a venture model, but sitting within a game publisher. Yeah. And I guess in this case, that's the job of the capital allocators to take these risks, and that's the publisher for you. It's fitting that it was Don Valentine and Sequoia who funded EA at the very origins. And there's some similarities there and overlap in terms of the businesses.

56:01Well, thank you very much. It's been a pleasure talking about it. Lots of interesting stuff in this space. EA really stands out. Thank you for joining us. Thanks for having me. To find more episodes of Breakdowns ranging from Costco to Visa to Moderna, or to sign up for our weekly summary, check out JoinColossus .com. That's J -O -I -N -C -O -L -O -S -S -U -S dot com.