What Electronic Arts is doing right

September 14, 2012: 11:14 AM ET

Electronic Arts is still a traditional game maker, but it has found a way to take advantage of a new, growing business model: digital.

Electronic Arts' "The Sims Social"

By Don Reisinger

FORTUNE -- Since the early days of gaming, Electronic Arts (EA) has established itself as one of the few "major" video game publishers. The company sits alongside Call of Duty creator Activision Blizzard (ATVI) and Grand Theft Auto maker Take-Two Interactive (TTWO) at the top of the video game heap. Those companies are at once beloved by gamers who enjoy their titles and despised by many in the so-called "hardcore" segment of players that distrust their big, brooding business models.

But EA is slowly but surely becoming, well, different. It's still a traditional game maker that pushes out titles for consoles and portables, but it has found a way to take advantage of a new, growing business model: digital.

Speaking in July with game news site GamesIndustry.biz, EA Games Label president Frank Gibeau said that it's only a matter of time before the company becomes a fully digital game provider.

"We're going to be a 100% digital company, period," Gibeau told GamesIndustry.biz in the interview. "It's going to be there someday. It's inevitable."

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Not only is it inevitable, but it's not that far off. In an earnings statement in July, Gibeau announced that EA generated over $1.3 billion in digital revenue during the 12-month period ended June 30. During the company's first fiscal quarter, two-thirds of its $955 million in sales were in digital.

EA's digital efforts span several areas. The company offers digital goods and add-ons for console titles, like its Madden NFL franchise. It also offers a digital-game delivery service, called Origin, that allows consumers to buy titles directly over the web.

The company's free-to-play games, however, have proven most successful.

During an earnings call in July, Gibeau reported that his company's free-to-play games, which run on social networks, PCs, consoles, and mobile devices, represent its "fastest-growing business model." Revenues during the quarter on free-to-play games, in fact, were up 156% year-over-year.

Free-to-play has become a hot trend in the gaming industry. In EA's case, free-to-play gamers are allowed to work their way through a large chunk (if not all) of a game at no charge. If they want to add more levels, get more in-game weapons or goods, or want to engage in other kinds of play, they need to pay a nominal fee to do so. The result? Less upfront revenue, but an opportunity to generate more cash over the long term.

The Sims Social is perhaps the best example of that. According to EA, the free game has 3 million daily active users and has generated $50 million in revenue since its launch last summer.

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So, why might a company like EA, which has relied so heavily on packaged video game sales over the years, jump so bravely into a new world? As Wedbush analyst Michael Pachter pointed out in a note to investors recently, it comes down to changing market trends.

"The video game industry continues to suffer, with packaged goods sales declining in 35 of the last 41 months, and expected to have declined again in August," Pachter wrote.

That stands in stark contrast to digital sales. In August, research firm NPD announced that consumer spending on digital gaming content during the second quarter hit $1.47 billion, representing a 17% gain over the same period last year. Consumers spent just $1 billion on new physical video and PC game software.

But that's not the only justification EA has. When EA sells a physical copy of a game that might cost millions to make, it needs to print discs, acquire packaging, and share a piece of the revenue with retailers selling the title. What's worse, when those games are then sold on the secondary market as used titles, EA doesn't get a dime.

The digital space fixes that problem. EA can offer its games for less, not worry about the high cost of physical packaging, and escape any troubles with the used-game market. It's a direct-to-consumer model. And it's profitable.

During its last fiscal year ended March 31, EA generated $4.1 billion in revenue and scored a slight $76 million profit. Digital propped the company's revenue up from the $3.6 billion it generated in the prior fiscal year. It also improved margins to help it emerge from the $276 million loss it posted in 2011.

During its last-reported quarter, EA, led by digital sales, posted a $201 million profit.

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EA's success has come despite rather disappointing recent performance from competitors. Game maker THQ (THQI) lost a whopping $243 million during its last fiscal year on $831 million in revenue. Take-Two Interactive lost $109 million on $826 million in revenue during the same period. Even Nintendo is having its fair share of troubles.

Only Activision Blizzard has followed EA's lead -- it posted a profit of $1.1 billion last year. But that's because it offers the two most popular game franchises in the world, Call of Duty and World of WarCraft.

So, what is EA doing right that its competitors are doing wrong? According to Pachter, it comes down to one, simple answer: EA is fully embracing the digital world.

"EA is far along with its diverse digital offering, with a strong mobile, social and MMO presence," he wrote recently in a research note.

So, perhaps EA is on to something. While the industry is on the decline, EA is on the rise. While customers ignore packaged games, they're flocking to digital. And all the while, it's EA that's ready and willing to accommodate them.

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