If a Tree Falls in the Woods, but Nobody Wants to Hear It…

A tree fell on Wall Street yesterday.

Specifically, Electronic Arts, which has managed its way through the vicious cycles caused by fickle teenagers and rotating game platforms better than any other video game maker such that it has been legitimately accorded “best-of-breed” status by Wall Street’s Finest, guided earnings down by a magnitude normally associated with far lesser breeds of companies.

Citing an “abrupt” shift in the “demand curve” for video games, ERTS management guided this quarter and next quarter revenue and earnings “well below” a forecast given just short of two months ago.

And they weren’t kidding about the “well below” part.

Back half fiscal 2006 earnings (ending next March) got whacked roughly 40%, from the $1.40 area to the 85c a share area.

And First Call earnings estimates for fiscal 2007 began the week at about $1.75 and, depending on whether you deduct stock compensation, are going to end the week anywhere from $1.20 to $1.40 a share.

But a look at the calendar reveals we are approaching year-end, when portfolio managers around the globe focus anxiously on their own performance as well as whatever benchmark (the S&P 500 index, the Russell 2000 index, the R-Tango-Delta Mid-Cap Value-Growth-Dividend-Momentum-Day-Trader index) they are attempting to beat.

Furthermore, a look at the ERTS shareholder’s list reveals 10 and 15 and 20 million share positions among the Janus Capitals and Legg Masons of the world.

And what good sell-side analyst wants to—let’s use the polite word—annoy one of their firm’s largest customers by beating up on a “best of breed” company like Electronic Arts, which, not for nothing, recently announced a large, fee-generating acquisition of Jamdat, this close to year-end?

Answer: none.

And so Wall Street’s Finest put on a good face, called the ERTS announcement a “buying opportunity” because (I am not making this up) of the “reduced uncertainty” now that the bad news—foreshadowed last week when Best Buy reported earnings in which video game sales were an area of notable weakness—was out.

One of them actually said it was time to step up to the plate and buy, because ERTS shares were now trading at their “trough valuation.”

Net result: ERTS shares closed up 35c yesterday, at $53.46 a share.

Precisely what is the “trough valuation” that makes ERTS shares so attractive?

Well, the shares now trade at 45 times the low-end of the forward earnings range. And this assumes sales grow all of 12% next year, with the help of the Jamdat acquisition.

Google, for what it’s worth, trades at 48x the high-end of next year’s earnings range, with a sales growth more than 5-times that of Electronic Arts. (Divide everything Google-related by 10: it becomes a $43 stock with 90c of earnings in 2006, compared to ERTS at $53 with $1.20 of earnings in the year ending March 2007.)

Yet the general consensus on Wall Street would no more describe Google’s PE as a “trough valuation” than my dog Lucy would accept a piece of broccoli in place of a dog biscuit.

Don’t get me wrong: Electronic Arts is a very very well run company in a very very cyclical, but growing industry.

The fact that a tree fell on Wall Street yesterday and nobody heard it fall, however, has more to do with the calendar on the wall than the fundamentals involved.

Jeff Matthews
I Am Not Making This Up

© 2005 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations.