• Bocconi Students Options Club

Electronic Arts : Long Butterfly

Updated: May 2

DISCLAIMER:

This association and its publications are solely intended for academic purposes and should not be used as investment advice or be interpreted as such.








Company Presentation


Introduction:

Electronic Arts Inc. was founded in 1982 and is headquartered in Redwood City, California. It is one of the largest companies worldwide that develops, markets, publishes, and distributes games, content, and services for game consoles, PCs, and mobiles. It also diversifies its revenues by providing advertising services; and licenses its games to third parties to distribute and host its games (as in the case of their most popular game, FIFA). The firm markets and sells its games and services through digital distribution and retail channels, as well as directly to mass market retailers, specialty stores, and distribution arrangements.

Some of the qualities attributable to EA’s success are their strategic marketing, heavy investments in R&D and strategic partnerships in growing sub-industries. EA has received a lot of criticism due to its focus on profitability rather than the users/clients. EA’s current CEO, Andrew Wilson, states that the company’s mission is focusing on the players, however this does not reflect how the public perceives them.


The video gaming industry is volatile and subject to constant innovation.When the market evolves so rapidly, it is essential for suppliers to be flexible. Software flexibility is an important strength of EA. EA operates in a growing industry, that according to Newzoo (leading e-sports analytics firm) will grow to 189 billion in 2021, from 175 in 2020. Its market Cap is 40.57 billion$, less than its main competitor, Activision Blizzard (74.748 billion$).


The global pandemic did not affect EA’s revenues significantly, but it crashed their Earnings (from a 54.9% profit margin in Q1 2020, to a 20.8% in Q4 2020). That being said, EA’s liquidity is healthy, and its S-T assets are more than double the S-T liabilities.


Acquisitions and partnerships:

EA recently acquired Codemasters for 1,2 billion, launching the new F1 game. This acquisition is helping them expand their presence in the sport video-game genre. EA also has a strategic partnership with KLab Inc. for game development and operation. This partnership mainly concerns the desire for EA to develop their presence in mobile gaming, a sector that has been growing fast since its conception in 2007. Also in this same context, EA is acquiring Glu mobile for 2.4 billion.

Market presence:

EA is a leading game developer in the gaming industry for PC and Consoles, and is growing in mobile gaming.They currently serve 450 million registered players around the world.It is a leader in sports games and capitalized on it.The company introduced EA sports in 1991.Its international expansion was lead with the acquisitions of Distinctive Software, Canada and Origin Systems, Inc. of Austin,Texas and other strategic partnerships.This allowed them to gain entrance to Asian and other European markets. Also, in the early 1990s diversified by creating educational software for children ages 3 to 14 and it was marketed under EA Kids which was used in schools and at home.


Its main competitor is Activision Blizzard, developer of the world renown Call of Duty, followed by Take Two Interactive, creator of Fortnite. According to Morningstar analysts, EA’s economics moat is significantly larger than its competitors, signifying its competitive advantage.

Fundamental analysis


The P/E ratio of the Electronic Arts stock is high indicating an expensive stock price in relation to earnings. However, among its peer group of video game developers, this is an average rating due to the exceptionally high growth expectations in the esports and gaming industry. Profitability is higher than average which is underlined by a successful track record of EPS growth. However, historic sales growth of Electronic Arts shows a relative weakness compared to peers. Recent quarterly sales growth in Q4-2020 amounts to approx. 5% YOY. The low levels of debt indicate healthy financing. Annual dividend per share recently amounted to 0.68$ resulting in a dividend yield of approx. 0.5%, far below the average value of the S&P 500. Given a payout ratio of approx. 4%, there is room for further growth.


Technical Analysis

Due to the close maturity of our position, we decided to look at the weekly technical indicators for EA. 10 out of 11 indicators are showing a buy signal for the stock and the only indicator that says otherwise is the rate-of-change (ROC) indicator (Figure[3]). The ROC indicator, often referred to as simply momentum, is flashing a sell signal because the stock has been increasing at a slower rate than before. However, this could be explained by the current turmoil in the markets as people start to speculate that the stock market is overvalued. This increased fear in investors has resulted in lower purchasing activity and therefore a decrease in momentum for the stock, which can also be seen by the 14 day average true ratio (ATR) indicating low volatility. Nevertheless, we are still confident that EA stock will perform well in the upcoming financial release because of our previously mentioned reasoning and the fact that the weekly technical indicators show that the stock is a strong buy.


Looking at the Fibonacci pivot points (Figure[4]) for the next weeks, EA stock will likely remain between $139.98 and $143.68 because they are the most near support and resistance line. Furthermore, these pivot points let us safely assume that the stock price will reach a maximum of $150.42 and that the price can fall up to $135.21. A price bigger or smaller than the one mentioned before would be extremely unlikely during the upcoming weeks.


The Play


I. Description

Considering the recent economic factors, market trend (especially in the tech sector), and upcoming earnings for EA, we expect a growth rate of ≈ 5%. Taking this into account, we think a butterfly strategy would fit perfectly this stock and the upcoming trends.


The date and price at which we implement this strategy 30.04.2021 and ≈ 142$.


We would start off by buying 1 call option at 130$. Then, 20 points higher, at 150$, we would sell 2 call options. Finally, at 170$, buy again another call. The play can also be summarized in the following table:

Our entry cost will be 1039$, which also represents our maximum loss that we can incur. This can happen only if the price stays at 130$ at expiry date. We would break even at expiry at both 159.61$ and 140.39$. The peak of our possible returns is achieved when the stock hits a value close to 150$, and we would have a revenue of ≈ 2610$. This would mean a profit of 961$— 92.5% of your initial investment. From this price onwards, returns start to decline, eventually hitting the red zone again at > 159.61$.


II. Estimated Return


Our entry cost will be 1039$, which also represents our maximum loss that we can incur. This can happen only if the price stays at 130$ at expiry date. We would break even at expiry at both 159.61$ and 140.39$. The peak of our possible returns is achieved when the stock hits a value close to 150$, and we would have a revenue of ≈ 2610$. This would mean a profit of 961$— 92.5% of your initial investment. From this price onwards, returns start to decline, eventually hitting the red zone again at > 159.61$.



III. Positive and Negative Aspects


On the plus side, this play is suitable for us as we expect its price to go up by a modest amount (5%) and remain in this price range. No risk is involved (apart from the entry cost of course) and as we chose to buy and sell 2 calls this will help us a lot with the margin on a brokerage account.

On the downside, as things stand, the IV Rank of EA is quite high (33.4) and it will continue to go up because of the upcoming positive earnings call. However, a drop in the IV Rank after the earnings could really affect our prices.

*Disclaimer: Profits are calculated as if we assume we wait until the maturity is over and the price falls in the specified range for each case. If we want to close any of the plays before the maturity we will have different pricings then the ones specified.


Motivation and Recap


EA is a leader in the gaming industry which is full of opportunities for growth, especially with their focus on next-gen consoles and mobile gaming. EA has formed partnerships and acquisitions that strengthen their position at the top and help them pursue their goal of constant growth.

Given a P/E ratio of approx. 35, the fundamental valuation of EA is on industry average. A successful track record of EPS growth underlines an above average profitability. The only downside is that historic sales growth is lower than its competitors, nevertheless they are still positive sales growths. The technical indicators are flashing strong buy signals which strengthen our belief that the EA stock will continue to do well for the upcoming months. In addition, we can be confident that the price will remain between a certain threshold because they lay within the Fibonacci pivot points.

At this moment in the calendar year, the EA stock is really attractive as it has its Q2 earnings coming up in May. Our Butterfly strategy exploits the possible small increase in price (5%) but also has a limited risk attached to it, overall offering us an exceptional return on our investment of a maximum of 92.5%.