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The Fine Art of Buying Hated Stocks

Value investors typically gravitate toward hated companies. The more a company is hated, the cheaper its stock and the better the potential opportunity.

Electronic Arts is hated with a vengeance. The Redwood City, California–based game maker’s stock is trading at 13-year lows as investors grouse that EA’s sales have stagnated for years and its earnings, though rising, are still below their 2003 level. A falloff in industrywide sales of packaged video games — down four months in a row, including an apocalyptic 25 percent drop in March — have added to the rancor. To top it off, EA was recently named the worst company in America for 2012 by the Consumerist, a blog operated by the same company that publishes Consumer Reports.

Although these might seem like very reasonable concerns, they really aren’t.

Stagnant sales. On the surface, it looks like EA’s sales have been in the doldrums for years, but they haven’t. The company has been winding down the distribution of games made by other publishers; this low-margin revenue declined from more than $600 million annually a few years ago to about $200 million today, masking healthy growth in EA’s core games business.

The games industry is going out of business. A four-month decline in packaged-game sales sends shivers through investors, but it shouldn’t. The bulk of the falloff is happening in handheld devices that have been losing market share to smartphones (sales of Nintendo Co.’s DS software were down 78 percent in March). Nintendo Wii sales were down 47 percent; its console has been rapidly losing market share to Microsoft Corp.’s Xbox, which has a much more powerful processor, more-advanced graphics and a camera that reads gestures, so there’s no need to wave around the bulky Wii remote. Of course, these statistics cover only packaged games and don’t count those distributed digitally, a fast-growing segment.

Worst company in America. What did EA do to be named the worst company in America in a poll of more than 250,000 Consumerist readers? It created Mass Effect 3, a role-playing game in which players battle to defend the world in a war against the Reapers. Mass Effect 3 has been a huge commercial success, but gamers were outraged by the game’s ending: Independent of the player’s decision, the world is destroyed. EA has promised to release an alternative, happier ending to Mass Effect 3; in any case, the game maker hardly compares with the truly villainous companies that topped the Consumerist’s list the previous three years: American International Group, Bank of America Corp. and BP.

Investors are also worried that smartphones will plunge a dagger into the heart of EA’s core business as people discard their Game Boys and other handheld devices for iPhones. Wrong! The iPhone and other smartphones have removed the social stigma of adults playing games in public and in so doing have created a whole new market for EA. Gaming is not exclusive to rotten kids, not anymore. Plus, nobody knows whether you are playing a game, texting or e-mailing when you’re using a smartphone.

Adults are a perfect demographic for games: We do a lot of waiting, and because the smartphone is always with us, we kill time playing games. The smartphone gaming industry is still in its infancy; it has captured only a third of the total market.

And then there is Facebook, which is arguably the best time-wasting website known to man (and woman). It presents another opportunity for game makers, opening up a time slot that was previously unavailable to most adults: office hours (when they are supposed to be working). This market was virtually nonexistent before.

EA will capitalize on both smartphones and Facebook. The company is no Zynga when it comes to social network games (nor does it have Zynga’s sky-high valuation), but it has an impressive slate of brands. It bought game makers Playfish and PopCap, which have expertise in social and casual games and plenty of hits of their own.

In addition to its exciting new revenue opportunities, EA can significantly improve its profit margins as consumers increasingly download games in digital format rather than purchase packaged software. The company’s full-game downloads doubled over the past year. Digital games come with profit margins 10 to 25 percentage points higher than those of packaged games, and their sales are growing at a much faster rate. Today they represent about 25 percent of EA’s sales. In a few years they should approach 50 percent. The margin-­expansion opportunity is significant for EA, which recently traded at $15 a share and could earn north of $2.00 a share within the next few years.

There’s nothing to hate about that.  •  •

Vitaliy Katsenelson (vk@imausa.com) is CIO at Investment ­Management Associates in Denver and author of    The Little Book of Sideways Markets.

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