February 21, 2017 / 9:31 PM / 5 months ago

Fitch Affirms Electronic Arts' IDR at 'BBB'; Outlook Stable

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(The following statement was released by the rating agency) NEW YORK, February 21 (Fitch) Fitch Ratings has affirmed Electronic Arts Inc.'s (EA) Issuer Default Rating (IDR) at 'BBB'. Fitch has also affirmed the issue specific ratings for EA's unsecured credit facility and unsecured notes at 'BBB'. The Rating Outlook is Stable. A full list of ratings follows at the end of this release. The affirmation takes into account EA's solid credit metrics and conservative balance sheet, robust free cash flow (FCF) generation, and the forecasted growth in profitability and cash flow driven by the industry shift towards more digitally-distributed content. 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 credit metrics are strong for the 'BBB' rating level and have some degree of cushion at the current levels. Fitch calculates EA's funds from operations (FFO) gross adjusted leverage at 1.1x as of Dec. 31, 2016. Fitch believes FFO-based leverage metrics are more appropriate than traditional debt/EBITDA leverage metrics given U.S. GAAP treatment of the digital revenues generated by EA's online-enabled games. Fitch also analyzes EA on an adjusted EBITDA leverage basis for peer comparison purposes due to differing treatment of online-enabled revenues and expenses within the industry. Fitch adjusts EA's EBITDA for the net effect of revenue deferral from online-enabled games and calculates debt/adjusted EBITDA leverage at 0.6x, also strong for the current IDR. EA's FCF generating ability has increased materially over the last five years as the video game industry has shifted away from physically-shipped, packaged goods towards more profitable digitally-distributed games and content. This benefit has been consistent across the video game industry. EA also successfully executed its efforts for a more disciplined operating cost structure, which has increased margins. For the LTM ended Dec. 31, 2016, Fitch-defined FCF was $1.25 billion, compared to $105 million in FY2012 before the operating cost structure was improved. Fitch-defined FCF is expected to continue to grow through the forecast horizon, to $1.9 billion in FY2021, due to the continued shift to more digital revenue, and as operating costs and capital expenditures remain stable as fixed percentages of revenue. EA's fiscal year ends March 31. EA's digital revenues comprised 60% of LTM (ended Dec. 31, 2016) total revenues, up from 53% and 30% one year ago and three years ago, respectively. The growth has come primarily from EA's Extra Content segment, which includes in-game micro transactions, and FIFA Ultimate Team. A majority of EA's future digital revenue shift will be to full-game downloads, as games are downloadable directly to a player's console, computer, or phone. Currently, full-game downloads represent around 25% of total console sales. Fitch expects this figure to grow over the forecast period toward 50%. Partially offsetting this digital 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. To combat this, EA, as do most video game companies, dedicates material R&D spend to develop new intellectual property (IP) and expand existing smaller franchises in an effort to diversify its revenue concentration. EA is underrepresented in the action game genre and Fitch expects the development of new organic IP to include this genre. A number of EA's core franchises (e.g. FIFA, Madden NFL, Star Wars) represent licensed 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 the 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. The release of Nintendo's next-generation console could also support the current cycle; however, its last console did not resonate as well with consumers as previous generations. In addition, EA's transition to a single-engine development process reduces inefficiencies and risk regarding game development for new platforms and consoles. Overall, 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. The mobile gaming market will supplement growth in the sector and provide additional tailwinds to margins given the digital distribution of content. Mobile revenue was 13% of total revenue for EA in the LTM period ended Dec. 31, 2016, up from 12% a year ago. 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. The mobile gaming space is highly fragmented and very competitive due to low barriers of entry and minimal capital needed to create a game. Mobile games mostly operate under a free-to-play business model to bring in new customers, with in-game micro transactions providing a majority of the revenue. The mobile market has transitioned primarily to this "freemium" model over the past three years after initially resembling the traditional console market, with one upfront purchase price. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer include: --GAAP revenues grow in the mid-single digits, driven by continued 10%-15% growth in the digital segment. Packaged goods revenue declines in the 5%-10% range as a greater percentage of games and content are distributed digitally. The Extra Content and Mobile segments also exhibit healthy growth in the 5%-10% range; --Gross margins expand by roughly 100bps a year due to a shift towards more profitable digital revenue. SG&A and R&D costs are managed at a fixed percentage of revenue; --Capex levels are consistent with recent years, though slightly elevated in the near term due to new studio build-out; --$750 million-$1 billion in annual share repurchases funded by domestic cash flow generation, with no incremental debt issuance assumed. RATING SENSITIVITIES Positive: Future upgrades could be considered if there is an increase in wholly-owned intellectual property 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, or adjusted EBITDA leverage beyond 1.5x, in the absence of a credible deleveraging plan. In addition, 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. LIQUIDITY EA has strong liquidity between its ample cash balances, robust FCF generation, and full availability of its $500 million revolver. EA also maintains a sizeable amount of short-term investments, primarily in government and corporate fixed income securities. At Dec. 31, 2016, EA had $2.5 billion in cash and cash equivalents, $1.7 billion of short-term investments, and generated $1.25 billion of Fitch-defined FCF over the last 12 months. The primary use of cash through Fitch's forecast is expected to be share repurchases. 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 affirmed the following ratings: Electronic Arts Inc. --IDR at 'BBB'; --Senior unsecured bank credit facility at 'BBB'; --Senior unsecured notes at 'BBB'. The Rating Outlook is Stable. Contact: Primary Analyst Jack Kranefuss Senior Director +1-212-908-0791 Fitch Ratings, Inc. 33 Whitehall Street New York, NY 10004 Secondary Analyst Colin Mansfield, CFA Associate Director +1-212-908-0899 Committee Chairperson Alex Bumazhny, CFA Senior Director +1-212-908-9179 Media Relations: Alyssa Castelli, New York, Tel: +1 (212) 908 0540, Email: alyssa.castelli@fitchratings.com. Date of Relevant Rating Committee: Feb. 21, 2017 Summary of Financial Statement Adjustments -EBITDA: Fitch adds back the net effect of revenue deferrals for online-enabled games to EBITDA for calculating leverage. Additional information is available on www.fitchratings.com. Applicable Criteria Criteria for Rating Non-Financial Corporates (pub. 27 Sep 2016) here Additional Disclosures Dodd-Frank Rating Information Disclosure Form here _id=1019334 Solicitation Status here Endorsement Policy here ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. 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