How on Earth can EA afford PopCap?
Despite being one of the largest videogame companies in the world, EA has been consistently loss-making in recent times, yet earlier this week it announced the acquisition of PopCap in a deal that could eventually cost $1.3 billion. It's an eye-watering sum, put in context by EA's annual revenues of over $3.5 billion, but rather than fund the deal from its own pocket, EA has carefully structured it to avoid upsetting investors. Here, we examine exactly how the publisher has secured the services of the world's most beloved developer of casual games without wrecking its share price.
Does EA have the means?
It is four years since EA last posted an annual profit, a slender 2007 surplus of $76 million. Its increased focus on growing its digital business helped it reduce losses by over $400 million in its last financial year, despite a slight drop in revenue. Profitability and cashflow, however, are two very different things, and the same set of financial results revealed that EA was, on March 31, sitting on cash assets of $1.58 billion. Almost four months on, that will likely be closer to $2 billion.
EA's immediate commitment to PopCap is $650 million in cash, and $100 million in stock: EA could easily finance the deal itself. But instead it has chosen to fund the acquisition by other means, either to avoid scaring investors – who presumably didn't expect EA's drive towards a billion-dollar digital business to involve a billion-dollar acquisition – or because it foresees the need for that cash to be spent elsewhere.
Where will the money come from?
When it announced its intention to acquire PopCap on Tuesday, EA said it had arranged a senior unsecured bridge facility of $550 million from financiers including Morgan Stanley, JP Morgan and UBS. This is a short-term loan agreement, and the debt is not secured by any assets. Instead, it guarantees priority to the lender in the event of a company's liquidation to ensure the debt is repaid. However, EA did not commit to the loan, merely saying it "may choose to draw upon" the agreed funding.
Why? We don't know, because since then, EA has announced an offering of convertible senior notes: essentially loans that are either repaid or converted into shares at a later date. It's a canny move that will see it raise around $500 million in cash, and not have to deal with repayment or conversion to stock until 2016.
In addition to $100 million of EA shares, the publisher has pledged $50 million in long-term equity retention awards, stock options that do not mature for several years, aimed at retaining senior executives. EA will spread these awards over four years.
Can PopCap meet its targets?
That just leaves the earnings payouts. If PopCap generates less than $91 million in earnings before interest and tax (EBIT), there will be no payout; at $110 million, $100 million will be paid; at $200 million, $275 million; and if earnings exceed $343 million, the award will rise to $550 million.
It is hard to give an accurate assessment of how much revenue PopCap is likely to generate in the first two years of the deal. Firstly because, as a hitherto private company, PopCap has never published its finances; secondly because it remains to be seen how quickly its operations will expand with EA's backing.
Wedbush Securities analyst Michael Pachter puts PopCap's 2010 EBIT at just $20 million, but, remarkably, expects it to deliver between $130 million and $140 million this year. PopCap would therefore have to expand dramatically and earn $200 million in its second year for the deal to cost EA the full $1.3 billion. Pachter only foresees a large-scale investor backlash if no earnings targets are met; if PopCap secures the full payout, he expects EA's share price to increase.
Has the strategy worked so far?
Despite this, and EA's other efforts to mitigate for investor concerns, the publisher's share price has fallen by more than four per cent since it announced the deal on Tuesday. This is a common reaction to large-scale acquisitions, but also reflects EA's failure to immediately deliver to shareholders in the form of dividends: it will be 2013 before EA expects the acquisition to impact on earnings per share.
But it clearly sees merit in the acquisition, whatever the outcome. PopCap's games are low-cost, enormously popular and already available virtually everywhere; marrying the studio's talent to EA's distribution and publishing capabilities will help greatly in the publisher's drive towards a billion-dollar digital business. As Pachter puts it: "PopCap is a great strategic fit, and there are limited acquisition opportunities for EA that have the potential to add as much to EA's top and bottom lines."
Overall, the complex machinations of the deal go some way to vindicating PopCap's decision not to go public itself. Until sources revealed last month that EA was circling, chequebook in hand, PopCap had been expected to file an IPO of its own; the manner in which EA has had to structure the deal is an object lesson in the pitfalls of operating at the behest of jumpy investors.