Activision Blizzard and Electronic Arts Both Get Hit by Downgrades

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

Up to now, investors in Activision Blizzard (NASDAQ: ATVI) and Electronic Arts (NASDAQ: EA) had enjoyed a mostly unremarkable month in August. True, Activision suffered a distressing 4% drop after reporting Q2 earnings on Aug. 2 -- but the earnings were objectively good, and Activision soon recovered, while Electronic Arts stock just kept humming along nicely.

That changed yesterday, when EA announced it will be delaying release of its hotly anticipated Battlefield V video game by four weeks, pushing some of its expected fiscal 2019 revenue into fiscal 2020 instead. Electronic Arts stock suffered a steep 10% decline in response to the news.

And they're both about to get hit again.

Downgrading Electronic Arts...

In its press release yesterday, Electronic Arts slashed $350 million from its "fiscal year 2019 net bookings guidance." (Hint: EA uses a different calendar from most everybody else. In its timeline, we're currently in the middle of fiscal Q2 2019 right now.) Instead of the $5.55 billion it expected to book, it's now guiding toward something closer to $5.2 billion.

Arguably worse -- because the market hates uncertainty -- while the Battlefield news suggests there will be some impact on GAAP financial results such as fiscal 2019 revenue and earnings, EA declined to give investors any guidance on what effect they should expect to see. Instead, EA postponed the announcement of any advice on that score until "EA's next earnings call," which should take place on Oct. 30, 2018.

That forced investors to guess, and this morning, analysts at Merrill Lynch guessed we will be looking at a "back-end loaded year," as it explained in a note covered by TheFly.com. Between this prospect and continuing worries about a "'crowded' holiday title slate and continued Fortnite pressure" hurting sales, Merrill Lynch says it's downgrading EA stock to neutral and assigning the stock a $126 price target -- 21% below its previous target.

...and Activision Blizzard, too

That explains why Electronic Arts stock is taking another dive today (down 2.2% as of 10:30 a.m. EDT). But what about Activision Blizzard stock, which is down 3%? What's up with that?

As it turns out, the second verse is the same as the first: It's a Merrill Lynch downgrade that's killing Activision Blizzard, too.

Activision has its own big-budget first-person shooter coming out this holiday season. And although Activision managed to largely dodge the Fortnite bullet last quarter, reporting an uptick in sales to $1.6 billion and beating on earnings as well, its upcoming Black Ops 4 is joining a crowded field of major releases including not only Battlefield V, but Red Dead Redemption 2 and Assassin's Creed Odyssey, at the same time as it strives to fend off competition from Fortnite. These are the same factors that motivated Merrill Lynch to downgrade EA today.

What's more, Activision appeared to confirm the analyst's fears when it issued guidance earlier this month that fell well short of expectations. Now, perhaps spurred to action by EA's warning, Merrill Lynch is responding by cutting its rating on Activision stock to neutral as well, with a $77 share price target that's 8% below its previous target.

Crisis, or opportunity?

So how should investors react to these downgrades, and the cheaper stock prices on Activision and Electronic Arts they've given rise to? Here's how I look at it:

Priced at $72 per share after today's downgrade, Activision Blizzard has a market capitalization of just under $55 billion and sells for nearly 29 times its $1.9 billion in trailing free cash flow. Ordinarily, I'd want to see a stock growing at 30% annually or more when selling for such a high a multiple to FCF. Analysts surveyed by S&P Global Market Intelligence, however, currently anticipate that Activision Blizzard will grow earnings at only about 15% annually over the next five years.

(And that's the good news. Activision stock is even more expensive when valued on GAAP earnings, costing nearly 110 times trailing net profit.)

The situation at Electronic Arts is a little better. Priced just above $113 a share, EA stock has a market cap of just $34.6 billion and earnings of $692 million. That gives Electronic Arts stock a nice, round P/E ratio of 50. With a projected growth rate north of 16% (yes, even after the Battlefield delay), EA looks pretty expensive when valued on GAAP earnings -- but valued on its trailing free cash flow of $1.5 billion, it's a much more palatable 23 times FCF.

If forced to choose between the two, I think I'd be much more comfortable owning EA stock at today's prices than Activision Blizzard.

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Rich Smith has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Activision Blizzard. The Motley Fool recommends Electronic Arts. The Motley Fool has a disclosure policy.