e10vq
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
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QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the Quarterly Period Ended December 31, 2006
OR
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o |
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TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the Transition Period from to
Commission File No. 0-17948
ELECTRONIC ARTS INC.
(Exact name of registrant as specified in its charter)
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Delaware
(State or other jurisdiction of
incorporation or organization)
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94-2838567
(I.R.S. Employer
Identification No.) |
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209 Redwood Shores Parkway
Redwood City, California
(Address of principal executive offices)
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94065
(Zip Code) |
(650) 628-1500
(Registrants telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by
Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for
such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. YES þ NO o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer,
or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in
Rule 12b-2 of the Exchange Act. (Check one):
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Large accelerated filer þ
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Accelerated filer o
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Non-accelerated filer o |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the
Exchange Act). YES o NO þ
As of
February 1, 2007, there were 310,042,832 shares of the Registrants Common Stock, par value
$0.01 per share, outstanding.
ELECTRONIC ARTS INC.
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2006
Table of Contents
2
PART I FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements (Unaudited)
ELECTRONIC ARTS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
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(Unaudited) |
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December 31, |
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March 31, |
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(In millions, except par value data) |
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2006 |
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2006 (a) |
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ASSETS |
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Current assets: |
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Cash and cash equivalents |
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$ |
1,199 |
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$ |
1,242 |
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Short-term investments |
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1,212 |
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1,030 |
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Marketable equity securities |
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235 |
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160 |
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Receivables, net of allowances of $228 and $232, respectively |
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551 |
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199 |
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Inventories |
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72 |
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61 |
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Deferred income taxes, net |
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92 |
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86 |
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Other current assets |
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170 |
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234 |
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Total current assets |
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3,531 |
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3,012 |
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Property and equipment, net |
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451 |
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392 |
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Investments in affiliates |
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6 |
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11 |
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Goodwill |
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730 |
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647 |
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Other intangibles, net |
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221 |
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232 |
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Other assets |
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104 |
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92 |
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TOTAL ASSETS |
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$ |
5,043 |
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$ |
4,386 |
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LIABILITIES, MINORITY INTEREST AND STOCKHOLDERS EQUITY |
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Current liabilities: |
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Accounts payable |
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$ |
170 |
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$ |
163 |
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Accrued and other current liabilities |
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851 |
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654 |
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Deferred net revenue |
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75 |
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52 |
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Total current liabilities |
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1,096 |
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869 |
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Deferred income taxes, net |
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6 |
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29 |
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Other liabilities |
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63 |
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68 |
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Total liabilities |
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1,165 |
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966 |
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Commitments and contingencies (See Note 9) |
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Minority interest |
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12 |
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Stockholders equity: |
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Preferred stock, $0.01 par value. 10 shares authorized |
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Common stock, $0.01 par value. 1,000 shares authorized; 310 and
305 shares issued and outstanding, respectively |
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3 |
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3 |
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Paid-in capital |
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1,345 |
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1,081 |
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Retained earnings |
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2,342 |
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2,241 |
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Accumulated other comprehensive income |
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188 |
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83 |
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Total stockholders equity |
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3,878 |
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3,408 |
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TOTAL LIABILITIES, MINORITY INTEREST AND STOCKHOLDERS EQUITY |
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$ |
5,043 |
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$ |
4,386 |
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See accompanying Notes to Condensed Consolidated Financial Statements.
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(a) |
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Derived from audited financial statements. |
3
ELECTRONIC ARTS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
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Three Months Ended |
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Nine Months Ended |
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(Unaudited) |
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December 31, |
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December 31, |
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(In millions, except per share data) |
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2006 |
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2005 |
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2006 |
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2005 |
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Net revenue |
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$ |
1,281 |
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$ |
1,270 |
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$ |
2,478 |
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$ |
2,310 |
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Cost of goods sold |
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470 |
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502 |
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977 |
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937 |
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Gross profit |
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811 |
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768 |
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1,501 |
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1,373 |
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Operating expenses: |
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Marketing and sales |
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165 |
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147 |
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350 |
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329 |
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General and administrative |
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91 |
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58 |
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222 |
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160 |
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Research and development |
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330 |
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206 |
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783 |
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571 |
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Amortization of intangibles |
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7 |
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1 |
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20 |
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3 |
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Acquired in-process technology |
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1 |
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3 |
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Restructuring charges |
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2 |
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9 |
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12 |
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9 |
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Total operating expenses |
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596 |
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421 |
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1,390 |
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1,072 |
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Operating income |
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215 |
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347 |
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111 |
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301 |
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Interest and other income, net |
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25 |
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20 |
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69 |
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49 |
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Income before provision for income
taxes and minority interest |
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240 |
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367 |
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180 |
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350 |
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Provision for income taxes |
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84 |
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106 |
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83 |
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93 |
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Income before minority interest |
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156 |
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261 |
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97 |
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257 |
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Minority interest |
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4 |
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(2 |
) |
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4 |
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(5 |
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Net income |
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$ |
160 |
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$ |
259 |
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$ |
101 |
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$ |
252 |
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Net income per share: |
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Basic |
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$ |
0.52 |
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$ |
0.86 |
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$ |
0.33 |
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$ |
0.83 |
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Diluted |
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$ |
0.50 |
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$ |
0.83 |
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$ |
0.32 |
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$ |
0.80 |
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Number of shares used in computation: |
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Basic |
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309 |
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301 |
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307 |
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304 |
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Diluted |
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319 |
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311 |
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316 |
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315 |
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See accompanying Notes to Condensed Consolidated Financial Statements.
4
ELECTRONIC ARTS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
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Nine Months Ended |
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(Unaudited) |
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December 31, |
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(In millions) |
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2006 |
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2005 |
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OPERATING ACTIVITIES |
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Net income |
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$ |
101 |
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$ |
252 |
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Adjustments to reconcile net income to net cash provided by operating activities: |
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Depreciation and amortization |
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110 |
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68 |
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Stock-based compensation |
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105 |
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1 |
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Minority interest |
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(4 |
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5 |
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Realized net losses on investments and sale of property and equipment |
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1 |
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Tax benefit from exercise of stock options |
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117 |
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Acquired in-process technology |
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3 |
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Change in assets and liabilities: |
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Receivables, net |
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(338 |
) |
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(243 |
) |
Inventories |
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(7 |
) |
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(11 |
) |
Other assets |
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63 |
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(35 |
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Accounts payable |
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1 |
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50 |
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Accrued and other liabilities |
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125 |
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32 |
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Deferred net revenue |
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23 |
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23 |
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Net cash provided by operating activities |
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183 |
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259 |
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INVESTING ACTIVITIES |
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Capital expenditures |
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(118 |
) |
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(87 |
) |
Proceeds from sale of marketable equity securities |
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4 |
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Purchase of investment in affiliates |
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(1 |
) |
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(2 |
) |
Proceeds from sale of investment in affiliate |
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2 |
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Proceeds from maturities and sales of short-term investments |
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911 |
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948 |
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Purchase of short-term investments |
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(1,088 |
) |
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(347 |
) |
Acquisition of subsidiaries, net of cash acquired |
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(94 |
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(3 |
) |
Other investing activities |
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2 |
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(2 |
) |
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Net cash provided by (used in) investing activities |
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(388 |
) |
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513 |
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FINANCING ACTIVITIES |
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Proceeds from sales of common stock through employee stock plans and other plans |
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133 |
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151 |
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Excess tax benefit from stock-based compensation |
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27 |
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Repayment of note assumed in connection with acquisition |
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(14 |
) |
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Repurchase and retirement of common stock |
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(709 |
) |
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Net cash provided by (used in) financing activities |
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146 |
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(558 |
) |
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Effect of foreign exchange on cash and cash equivalents |
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16 |
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(22 |
) |
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Increase (decrease) in cash and cash equivalents |
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(43 |
) |
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|
192 |
|
Beginning cash and cash equivalents |
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|
1,242 |
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|
1,270 |
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Ending cash and cash equivalents |
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1,199 |
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|
1,462 |
|
Short-term investments |
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|
1,212 |
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|
|
1,094 |
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Ending cash, cash equivalents and short-term investments |
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$ |
2,411 |
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$ |
2,556 |
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Supplemental cash flow information: |
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Cash paid during the period for income taxes |
|
$ |
46 |
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|
$ |
23 |
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|
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|
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|
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Non-cash investing activities: |
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|
|
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|
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Change in unrealized gains (losses) on investments, net |
|
$ |
80 |
|
|
$ |
37 |
|
|
|
|
|
|
|
|
See accompanying Notes to Condensed Consolidated Financial Statements.
5
ELECTRONIC ARTS INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(1) DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION
We develop, market, publish and distribute interactive software games that are playable by
consumers on home video game consoles (such as the Sony PlayStation® 3, Microsoft Xbox
360 and Nintendo Wii), personal computers, mobile platforms (including
cellular handsets and handheld game players such as the PlayStation® Portable
(PSP) and the Nintendo DS) and online (over the Internet and other
proprietary online networks). Some of our games are based on content that we license from others
(e.g., Madden NFL Football, The Godfather and FIFA Soccer), and some of our games are based on our
own wholly-owned intellectual property (e.g., The Sims, Need for Speed and
BLACK). Our goal is to publish titles with mass-market appeal, which often means
translating and localizing them for sale in non-English speaking countries. In addition, we also
attempt to create software game franchises that allow us to publish new titles on a recurring
basis that are based on the same property. Examples of this franchise approach are the annual
iterations of our sports-based products (e.g., Madden NFL Football, NCAA® Football and
FIFA Soccer), wholly-owned properties that can be successfully sequeled (e.g., The Sims, Need for
Speed and Battlefield) and titles based on long-lived literary and/or movie properties (e.g., Lord
of the Rings and Harry Potter).
The Condensed Consolidated Financial Statements are unaudited and reflect all adjustments
(consisting only of normal recurring accruals unless otherwise indicated) that, in the opinion of
management, are necessary for a fair presentation of the results for the interim periods presented.
The preparation of these Condensed Consolidated Financial Statements requires management to make
estimates and assumptions that affect the amounts reported in these Condensed Consolidated
Financial Statements and accompanying notes. Actual results could differ materially from those
estimates. The results of operations for the current interim periods are not necessarily indicative
of results to be expected for the current year or any other period.
These Condensed Consolidated Financial Statements should be read in conjunction with the
Consolidated Financial Statements and Notes thereto included in our Annual Report on Form 10-K for
the fiscal year ended March 31, 2006, as filed with the United States Securities and Exchange
Commission (SEC) on June 12, 2006.
(2) FISCAL YEAR AND FISCAL QUARTER
Our fiscal year is reported on a 52 or 53-week period that ends on the Saturday nearest March 31.
As a result, fiscal 2006 contained 53 weeks with the first quarter containing 14 weeks. Our results
of operations for the fiscal years ending March 31, 2007 and 2006 contain the following number of
weeks:
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|
|
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Fiscal Years Ended |
|
Number of Weeks |
|
Fiscal Period End Date |
March 31, 2007
|
|
52 weeks
|
|
March 31, 2007 |
March 31, 2006
|
|
53 weeks
|
|
April 1, 2006 |
Our results of operations for the three and nine months ended December 31, 2006 and 2005 contained
the following number of weeks:
|
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|
|
|
Fiscal Period |
|
Number of Weeks |
|
Fiscal Period End Date |
Three months ended December 31, 2006
|
|
13 weeks
|
|
December 30, 2006 |
Nine months ended December 31, 2006
|
|
39 weeks
|
|
December 30, 2006 |
|
|
|
|
|
Three months ended December 31, 2005
|
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13 weeks
|
|
December 31, 2005 |
Nine months ended December 31, 2005
|
|
40 weeks
|
|
December 31, 2005 |
For simplicity of disclosure purposes, all fiscal periods are referred to as ending on a calendar
month end.
6
(3) STOCK-BASED COMPENSATION
Adoption of SFAS No. 123(R)
In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial
Accounting Standard (SFAS) No. 123 (revised 2004) (SFAS No. 123(R)), Share-Based Payment.
SFAS No. 123(R) requires that the cost resulting from all share-based payment transactions be
recognized in the financial statements using a fair-value-based method. In March 2005, the SEC
released Staff Accounting Bulletin (SAB) No. 107, Share-Based Payment, which provides the views
of the staff regarding the interaction between SFAS No. 123(R) and certain SEC rules and
regulations for public companies. SFAS No. 123(R) replaces SFAS No. 123, Accounting for
Stock-Based Compensation, as amended, supersedes Accounting Principles Board (APB) No. 25,
Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows.
We adopted SFAS No. 123(R) as of April 1, 2006 and have applied the provisions of SAB No. 107 to
our adoption of SFAS No. 123(R). SFAS No. 123(R) requires companies to estimate the fair value of
share-based payment awards on the date of grant using an option-pricing model. We elected to use
the modified prospective transition method of adoption which requires that compensation expense be
recognized in the financial statements for all awards granted after the date of adoption as well as
for existing awards for which the requisite service has not been rendered as of the date of
adoption. Accordingly, prior periods are not restated for the effect of SFAS No. 123(R).
Prior to April 1, 2006, we accounted for stock-based awards to employees using the intrinsic value
method in accordance with APB No. 25 and adopted the disclosure-only provisions of SFAS No. 123, as
amended. Also, as required by SFAS No. 148, Accounting for Stock-Based Compensation Transition
and Disclosure, we provided pro forma net income (loss) and net income (loss) per share
disclosures for stock-based awards as if the fair-value-based method defined in SFAS No. 123 had
been applied.
Valuation and Expense Recognition. Upon adoption of SFAS No. 123(R), we began to recognize
compensation costs for stock-based payment transactions to employees based on their grant-date fair
value over the service period for which such awards are expected to vest. The fair value of
restricted stock units is determined based the quoted price of our common stock on the date of
grant. The fair value of stock options and stock purchase rights granted pursuant to our employee
stock purchase plan is determined using the Black-Scholes valuation model, which was the same model
we previously used for the pro forma information required under SFAS No. 123. The determination of
fair value is affected by our stock price as well as assumptions regarding subjective and complex
variables such as expected employee exercise behavior and our expected stock price volatility over
the expected term of the award. Generally, our assumptions are based on historical information and
judgment is required to determine if historical trends may be indicators of future outcomes. The
Black-Scholes valuation model requires us to estimate the following key assumptions:
|
|
|
Risk-free interest rate. The risk-free interest rate is based on U.S. Treasury yields in
effect at the time of grant for the expected term of the option. |
|
|
|
|
Expected volatility. We use our historical stock price volatility and consider the
implied volatility computed based on the price of short-term options publicly traded on our
common stock for our expected volatility assumption. |
|
|
|
|
Expected term. The expected term represents the weighted-average period the stock
options are expected to remain outstanding. The expected term is determined based on
historical exercise behavior, post-vesting termination patterns, options outstanding and
future expected exercise behavior. |
|
|
|
|
Expected dividends. |
7
The assumptions used in the Black-Scholes valuation model to value our option grants and employee
stock purchase plan were as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Stock Option Grants |
|
|
Employee Stock Purchase Plan |
|
|
|
Three Months Ended |
|
|
Nine Months Ended |
|
|
Three Months Ended |
|
|
Nine Months Ended |
|
|
|
December 31, 2006 |
|
|
December 31, 2006 |
|
|
December 31, 2006 |
|
|
December 31, 2006 |
|
Risk-free interest rate |
|
|
4.5 - 4.6% |
|
|
|
4.5 - 5.1% |
|
|
|
4.7 - 5.1% |
|
|
|
3.7 - 5.1% |
|
Expected volatility |
|
|
32 - 43% |
|
|
|
32 - 46% |
|
|
|
33 - 35% |
|
|
|
30 - 36% |
|
Weighted-average volatility |
|
|
35% |
|
|
|
35% |
|
|
|
35% |
|
|
|
33% |
|
Expected term |
|
4.2 years |
|
|
4.2 years |
|
|
6-12 months |
|
|
6-12 months |
|
Expected dividends |
|
None |
|
|
None |
|
|
None |
|
|
None |
|
Prior to our adoption of SFAS No. 123(R), we valued our stock options based on the
multiple-award valuation method and recognized the expense using the accelerated approach over the
requisite service period. In conjunction with our adoption of SFAS No. 123(R), we changed our
method of recognizing our stock-based compensation expense for post-adoption grants to the
straight-line approach over the requisite service period; however, we continue to value our stock
options based on the multiple-award valuation method.
As required by SFAS No. 123(R), employee stock-based compensation expense recognized in the three
and nine months ended December 31, 2006 was calculated based on awards ultimately expected to vest
and has been reduced for estimated forfeitures. In subsequent periods, if actual forfeitures differ
from those estimates, an adjustment to stock-based compensation expense will be recognized at that
time.
The following table summarizes stock-based compensation expense resulting from stock options,
restricted stock, restricted stock units and our employee stock purchase plan included in our
Condensed Consolidated Statements of Operations (in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
|
Nine Months Ended |
|
|
|
December 31, |
|
|
December 31, |
|
|
|
2006 |
|
|
2005 |
|
|
2006 |
|
|
2005 |
|
Cost of goods sold |
|
$ |
|
|
|
$ |
|
|
|
$ |
1 |
|
|
$ |
|
|
Marketing and sales |
|
|
5 |
|
|
|
|
|
|
|
14 |
|
|
|
|
|
General and administrative |
|
|
10 |
|
|
|
|
|
|
|
30 |
|
|
|
|
|
Research and development |
|
|
20 |
|
|
|
|
|
|
|
60 |
|
|
|
1 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Stock-based compensation expense |
|
|
35 |
|
|
|
|
|
|
|
105 |
|
|
|
1 |
|
Benefit from income taxes |
|
|
(7 |
) |
|
|
|
|
|
|
(22 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Stock-based compensation expense, net of tax |
|
$ |
28 |
|
|
$ |
|
|
|
$ |
83 |
|
|
$ |
1 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
As of December 31, 2006, the total unrecognized compensation cost related to stock options was
$173 million and is expected to be recognized over the weighted-average service period of 1.5
years. As of December 31, 2006, the total unrecognized compensation cost related to restricted
stock and restricted stock units was $81 million and is expected to be recognized over the
weighted-average service period of 2.5 years.
8
The adoption of SFAS No. 123(R), using the fair value method, had the following effect on our
pre-tax income, net income, and basic and diluted net income per share as compared to what would
have been reported under APB No. 25 using the intrinsic value method, which was the method used
prior to our adoption (in millions, except per share data):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
|
Nine Months Ended |
|
|
|
December 31, 2006 |
|
|
December 31, 2006 |
|
|
|
|
|
|
|
Intrinsic |
|
|
|
|
|
|
|
|
|
|
Intrinsic |
|
|
|
|
|
|
Fair Value |
|
|
Value |
|
|
Impact of |
|
|
Fair Value |
|
|
Value |
|
|
Impact of |
|
|
|
Method |
|
|
Method |
|
|
Change |
|
|
Method |
|
|
Method |
|
|
Change |
|
Income before provision for income taxes
and minority interest |
|
$ |
240 |
|
|
$ |
264 |
|
|
$ |
(24 |
) |
|
$ |
180 |
|
|
$ |
264 |
|
|
$ |
(84 |
) |
Net income |
|
$ |
160 |
|
|
$ |
169 |
|
|
$ |
(9 |
) |
|
$ |
101 |
|
|
$ |
158 |
|
|
$ |
(57 |
) |
Net income per share: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic |
|
$ |
0.52 |
|
|
$ |
0.55 |
|
|
$ |
(0.03 |
) |
|
$ |
0.33 |
|
|
$ |
0.51 |
|
|
$ |
(0.18 |
) |
Diluted |
|
$ |
0.50 |
|
|
$ |
0.53 |
|
|
$ |
(0.03 |
) |
|
$ |
0.32 |
|
|
$ |
0.50 |
|
|
$ |
(0.18 |
) |
APIC Pool. In November 2005, the FASB issued FASB Staff Position (FSP) No. Financial
Accounting Standard (FAS) 123(R)-3, Transition Election Related to Accounting for the Tax
Effects of Share-Based Payment Awards. The FASB allows for a practical exception in calculating
the additional paid-in capital pool (APIC pool) of excess tax benefits upon adoption that is
available to absorb tax deficiencies recognized subsequent to the adoption of SFAS No. 123(R). For
employee stock-based compensation awards that are outstanding upon adoption of SFAS No. 123(R), the
alternative transition method provides a simplified method to establish the beginning balance of
the APIC pool related to the tax effects of employee stock-based compensation. It also provides a
simplified method to determine the subsequent impact on the APIC pool and Condensed Consolidated
Statements of Cash Flows for the tax effects of employee stock-based compensation awards. We
elected to adopt the alternative transition method provided in FSP No. FAS 123(R)-3 for calculating
the tax effects of stock-based compensation pursuant to SFAS No. 123(R).
Cash Flow Impact. Prior to our adoption of SFAS No. 123(R), cash retained as a result of tax
deductions relating to stock-based compensation was presented in operating cash flows along with
other tax cash flows. SFAS No. 123(R) requires a classification change in the statement of cash
flows. As a result, tax benefits relating to excess stock-based compensation deductions, which had
been included in operating cash flow activities, are now presented as financing cash flow
activities (total cash flows remain unchanged).
Summary of Plans and Plan Activity
Stock Option Plans
Our 2000 Equity Incentive Plan (the Equity Plan) allows us to grant options to purchase our
common stock, restricted stock, restricted stock units and stock appreciation rights to our
employees, officers and directors. Pursuant to the Equity Plan, incentive stock options may be
granted to employees and officers and non-qualified options may be granted to employees, officers
and directors, at not less than 100 percent of the fair market value on the date of grant.
We also have options outstanding that were granted under (1) the Criterion Software Limited
Approved Share Option Scheme (the Criterion Plan), which we assumed in connection with our
acquisition of Criterion, and (2) the JAMDAT Mobile Inc. Amended and Restated 2000 Stock Incentive
Plan and the JAMDAT Mobile Inc. 2004 Equity Incentive Plan (collectively, the JAMDAT Plans),
which we assumed in connection with our acquisition of JAMDAT.
Options granted under the Equity Plan generally expire ten years from the date of grant and are
generally exercisable as to 24 percent of the shares after 12 months, and then ratably over 38
months. All options granted under the Criterion Plan were exercisable as of March 31, 2005 and
expire in January 2012. Certain assumed options granted under the JAMDAT Plans have acceleration
rights upon the occurrence of various triggering events. Otherwise, the terms of the JAMDAT Plans
are similar to our Equity Plan.
9
The following table summarizes our stock option activity for the nine months ended December 31,
2006:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted- |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Average |
|
|
|
|
|
|
|
|
|
|
Weighted- |
|
|
Remaining |
|
|
Aggregate |
|
|
|
Options |
|
|
Average |
|
|
Contractual |
|
|
Intrinsic Value |
|
|
|
(in thousands) |
|
|
Exercise Price |
|
|
Term (in years) |
|
|
(in millions) |
|
Outstanding as of March 31, 2006 |
|
|
40,882 |
|
|
$ |
40.02 |
|
|
|
|
|
|
|
|
|
Activity for the nine months ended December 31, 2006: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Granted |
|
|
4,167 |
|
|
|
51.16 |
|
|
|
|
|
|
|
|
|
Exercised |
|
|
(4,023 |
) |
|
|
29.37 |
|
|
|
|
|
|
|
|
|
Forfeited, cancelled or expired |
|
|
(2,212 |
) |
|
|
52.90 |
|
|
|
|
|
|
|
|
|
Exchange Program (cancelled) |
|
|
(1,776 |
) |
|
|
64.92 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Outstanding as of December 31, 2006 |
|
|
37,038 |
|
|
$ |
40.47 |
|
|
|
6.6 |
|
|
$ |
447 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Additional stock option-related information as of December 31, 2006:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted- |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Average |
|
|
|
|
|
|
|
|
|
|
Weighted- |
|
|
Remaining |
|
|
Aggregate |
|
|
|
Options |
|
|
Average |
|
|
Contractual |
|
|
Intrinsic Value |
|
|
|
(in thousands) |
|
|
Exercise Price |
|
|
Term (in years) |
|
|
(in millions) |
|
Outstanding |
|
|
37,038 |
|
|
$ |
40.47 |
|
|
|
6.6 |
|
|
$ |
447 |
|
Vested and expected to vest |
|
|
35,115 |
|
|
$ |
39.72 |
|
|
|
6.5 |
|
|
$ |
445 |
|
Exercisable |
|
|
22,311 |
|
|
$ |
31.91 |
|
|
|
5.2 |
|
|
$ |
432 |
|
A total of 15 million shares were available for grant under our Equity Plan as of December 31,
2006, of which no more than 13 million shares were eligible for grant in the form of restricted
stock or restricted stock units.
The aggregate intrinsic value represents the total pre-tax intrinsic value based on our closing
stock price as of December 31, 2006 which would have been received by the option holders had all
option holders exercised their options as of that date. We issue new common stock from our
authorized shares upon the exercise of stock options.
The weighted-average grant-date fair value of stock options granted during the three and nine
months ended December 31, 2006 was $19.14 and $17.82, respectively. The weighted-average grant-date
fair value of stock options granted during the three and nine months ended December 31, 2005 was
$15.65 and $16.23, respectively. The total intrinsic value of options exercised during the three
and nine months ended December 31, 2006 was $38 million and $96 million, respectively. The total
intrinsic value of options exercised during the three and nine months ended December 31, 2005 was
$96 million and $154 million, respectively. The total fair value (determined at the grant date) of
shares vested during the three and nine months ended December 31, 2006 was $18 million and $72
million, respectively. The total fair value (determined at the grant date) of shares vested during
the three and nine months ended December 31, 2005 was $32 million and $99 million, respectively.
10
The following table summarizes outstanding and exercisable options as of December 31, 2006:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Options Outstanding |
|
Options Exercisable |
|
|
|
|
|
|
|
|
|
|
Weighted- |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Average |
|
|
Weighted- |
|
|
|
|
|
|
|
|
|
|
Weighted- |
|
|
|
|
|
|
|
|
|
|
Number |
|
|
Remaining |
|
|
Average |
|
|
|
|
|
|
Number |
|
|
Average |
|
|
|
|
Range of |
|
|
of Shares |
|
|
Contractual |
|
|
Exercise |
|
|
Potential |
|
|
of Shares |
|
|
Exercise |
|
|
Potential |
|
Exercise Prices |
|
|
(in thousands) |
|
|
Term (in years) |
|
|
Price |
|
|
Dilution |
|
|
(in thousands) |
|
|
Price |
|
|
Dilution |
|
$ |
|
|
0.53 - $14.99 |
|
|
|
3,608 |
|
|
|
1.71 |
|
|
$ |
11.33 |
|
|
|
1.2 |
% |
|
|
3,600 |
|
|
$ |
11.35 |
|
|
|
1.2 |
% |
|
|
|
15.00 - 24.99 |
|
|
|
4,422 |
|
|
|
4.17 |
|
|
|
23.13 |
|
|
|
1.4 |
% |
|
|
4,419 |
|
|
|
23.13 |
|
|
|
1.4 |
% |
|
|
|
25.00 - 34.99 |
|
|
|
7,844 |
|
|
|
5.44 |
|
|
|
30.12 |
|
|
|
2.5 |
% |
|
|
7,617 |
|
|
|
30.09 |
|
|
|
2.4 |
% |
|
|
|
35.00 - 44.99 |
|
|
|
2,132 |
|
|
|
7.17 |
|
|
|
42.41 |
|
|
|
0.7 |
% |
|
|
1,321 |
|
|
|
42.28 |
|
|
|
0.4 |
% |
|
|
|
45.00 - 54.99 |
|
|
|
12,812 |
|
|
|
8.50 |
|
|
|
50.92 |
|
|
|
4.1 |
% |
|
|
3,593 |
|
|
|
49.21 |
|
|
|
1.2 |
% |
|
|
|
55.00 - 65.93 |
|
|
|
6,220 |
|
|
|
8.47 |
|
|
|
60.54 |
|
|
|
2.0 |
% |
|
|
1,761 |
|
|
|
60.73 |
|
|
|
0.6 |
% |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$ |
|
|
0.53 - $65.93 |
|
|
|
37,038 |
|
|
|
6.59 |
|
|
$ |
40.47 |
|
|
|
11.9 |
% |
|
|
22,311 |
|
|
$ |
31.91 |
|
|
|
7.2 |
% |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Potential dilution is computed by dividing the options in the related range of exercise prices by
the shares of common stock issued and outstanding as of December 31, 2006 (310 million shares).
Restricted Stock Units and Restricted Stock
We grant restricted stock units and restricted stock (collectively referred to as restricted stock
rights) under our Equity Plan to employees worldwide. Restricted stock units entitle holders to
receive shares of common stock at the end of a specified period of time. Upon vesting, the
equivalent number of common shares are typically issued net of tax withholdings. Restricted stock
is issued and outstanding upon grant; however, restricted stock award holders are restricted from
selling the shares until they vest. Upon vesting, we will typically withhold shares to satisfy tax
withholding requirements. Restricted stock rights are subject to forfeiture and transfer
restrictions. Vesting for restricted stock rights are based on continued employment of the holder.
If the vesting conditions are not met, unvested restricted stock rights will be forfeited.
Generally, our restricted stock right grants vest according to one of the following vesting
schedules:
|
|
|
100 percent after one year; |
|
|
|
|
Three-year vesting with 25 percent cliff vesting at the end of each of the first and
second years, and 50 percent cliff vesting at the end of the third year; or |
|
|
|
|
Four-year vesting with 25 percent cliff vesting at the end of each year. |
The following table summarizes our restricted stock right activity for the nine months ended
December 31, 2006:
|
|
|
|
|
|
|
|
|
|
|
Restricted Stock |
|
|
Weighted- |
|
|
|
Rights |
|
|
Average Grant |
|
|
|
(in thousands) |
|
|
Date Fair Value |
|
Balance as of March 31, 2006 |
|
|
655 |
|
|
$ |
52.21 |
|
Activity for the nine months ended December 31, 2006: |
|
|
|
|
|
|
|
|
Granted |
|
|
1,113 |
|
|
|
52.89 |
|
Exchange Program (granted) |
|
|
444 |
|
|
|
54.22 |
|
Vested |
|
|
(43 |
) |
|
|
54.03 |
|
Forfeited |
|
|
(82 |
) |
|
|
52.43 |
|
|
|
|
|
|
|
|
Balance as of December 31, 2006 |
|
|
2,087 |
|
|
$ |
52.95 |
|
|
|
|
|
|
|
|
The weighted-average grant date fair value of restricted stock rights is based on the quoted market
value of our common stock on the date of grant. The weighted-average fair value of restricted stock
rights granted during the three and nine months ended December 31, 2006 was $55.57 and $52.89,
respectively. The weighted-average fair value of restricted stock rights granted during the three
and nine months ended December 31, 2005 was $56.51 and $54.35, respectively. The total fair value
of
11
restricted stock rights vested during the three and nine months ended December 31, 2006 was less
than $1 million and $2 million, respectively. There were no restricted stock rights vested during
the three and nine months ended December 31, 2005.
At our Annual Meeting of Stockholders, held on July 27, 2006, our stockholders approved amendments
to the Equity Plan to (1) increase by 11 million shares the limit on the total number of shares
underlying awards of restricted stock and restricted stock units that may be granted under the
Equity Plan from 4 million to 15 million shares, and (2) to limit the number of shares subject to
options surrendered and cancelled in the Exchange Program that will again become available for
issuance under the Equity Plan to 7 million plus the number of shares necessary for the issuance of
the restricted stock rights to be granted in connection with the Exchange Program.
Exchange Program
At our Annual Meeting of Stockholders, held on July 27, 2006, our stockholders approved a voluntary
program (the Exchange Program) to permit our eligible employees to exchange certain outstanding
stock options that were significantly underwater (that is, the exercise price is greater than the
trading price of our common stock) for a lesser number of shares of restricted stock rights to be
granted under the Equity Plan. The Exchange Program commenced on August 16, 2006 and ended on
September 15, 2006.
The Exchange Program was open to all of our employees who were employed by us on August 16, 2006
and were still an employee on the date on which the tendered options were cancelled and restricted
stock rights were granted except (1) our named executive officers identified in our 2006 Annual
Proxy Statement, (2) members of our Board of Directors, and (3) employees who resided in China,
Belgium and Denmark due to restrictions arising under the local laws of those countries.
Option grants that had an exercise price per share equal to or greater than the threshold price
were considered eligible options. The threshold price was $61.66, which represented 125 percent
of the five-business day average closing price of our common stock prior to August 16, 2006, as
reported on the NASDAQ Global Select Market, which was $49.324. Due to local tax law restrictions,
U.K. approved options granted under the U.K Sub-Plan of the 2000 Plan approved by the U.K. HM
Revenue & Customs on May 2, 2001 (U.K. Approved Options) were not eligible for exchange. However,
options held by eligible employees other than U.K. Approved Options and that otherwise met the
requirements for eligibility were eligible for exchange. Excluded from the offer were any option
grants for fewer than five shares.
Eligible options exchanged under the program were cancelled in exchange for restricted stock rights
following the expiration of the offer. For restricted stock rights issued in exchange for unvested
options, compensation expense is recorded based on the grant-date fair value of the options
tendered over their remaining original vesting period of those options. Restricted stock rights
issued in connection with the Exchange Program vest over a period of up to three years.
The Exchange Program resulted in options to purchase approximately 1,776,000 shares of our common
stock being exchanged for approximately 444,000 shares of restricted stock rights. In connection
with the Exchange Program, a net total of 1,332,000 shares of common stock were returned to the
Equity Plan for future issuance.
Employee Stock Purchase Plan
Since September 1991, we have offered our employees the ability to participate in an employee stock
purchase plan. Pursuant to our current plan, the 2000 Employee Stock Purchase Plan (ESPP),
eligible employees may authorize payroll deductions of up to 10 percent of their compensation to
purchase shares at 85 percent of the lower of the fair market value of the common stock on the date
of commencement of the offering or on the last day of the six-month purchase period.
At our Annual Meeting of Stockholders, held on July 27, 2006, our stockholders approved an
amendment to the ESPP to increase the number of shares authorized under the ESPP by 1.5 million. As
of December 31, 2006, we had 3 million shares of common stock reserved for future issuance under
the ESPP.
12
Information related to stock issuances under the ESPP are as follows:
|
|
|
|
|
|
|
|
|
|
|
Nine Months Ended December 31, |
|
|
|
2006 |
|
|
2005 |
|
Number of shares issued (in thousands) |
|
|
370 |
|
|
|
316 |
|
Exercise prices for purchase rights |
|
$ |
43.10 |
|
|
$ |
42.31 to 47.95 |
|
Estimated weighted-average fair value of purchase rights |
|
$ |
17.30 |
|
|
$ |
16.13 |
|
We issue new common stock out of the ESPPs pool of authorized shares. The fair value above was
estimated on the date of grant using the Black-Scholes option-pricing model assumptions described
in this note under the headings Adoption of SFAS No. 123(R) and Pre-SFAS No. 123(R) Pro Forma
Accounting Disclosures.
Pre-SFAS No. 123(R) Pro Forma Accounting Disclosures
Prior to the adoption of SFAS No. 123(R), we accounted for stock-based awards to employees using
the intrinsic value method in accordance with APB No. 25 and adopted the disclosure-only provisions
of SFAS No. 123, as amended.
Had compensation cost for our stock-based compensation plans been measured based on the estimated
fair value at the grant dates in accordance with the provisions of SFAS No. 123, as amended, we
estimate that our reported net income and net income per share would have been the pro forma
amounts indicated below. The fair value of each option grant is estimated on the date of grant
using the Black-Scholes option-pricing model. The following weighted-average assumptions were used
for grants made under our stock-based compensation plan during the three and nine months ended
December 31, 2005:
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
|
Nine Months Ended |
|
|
|
December 31, 2005 |
|
|
December 31, 2005 |
|
Risk-free interest rate |
|
|
4.3 |
% |
|
|
4.0 |
% |
Expected volatility |
|
|
32 |
% |
|
|
34 |
% |
Expected term of stock options (in years) |
|
|
3.2 |
|
|
|
3.3 |
|
Expected term of employee stock purchase plan (in months) |
|
|
6 |
|
|
|
6 |
|
Expected dividends |
|
None |
|
|
None |
|
Our calculations were based on a multiple-award valuation method and forfeitures were recognized
when they occurred.
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
|
Nine Months Ended |
|
(In millions, except per share data) |
|
December 31, 2005 |
|
|
December 31, 2005 |
|
Net income: |
|
|
|
|
|
|
|
|
As reported |
|
$ |
259 |
|
|
$ |
252 |
|
Deduct: Total stock-based employee compensation
expense determined under fair-value-based method
for all awards, net of related tax effects |
|
|
(20 |
) |
|
|
(71 |
) |
Add: Stock-based employee compensation expense included
in reported net income, net of related tax effects |
|
|
|
|
|
|
1 |
|
|
|
|
|
|
|
|
Pro forma |
|
$ |
239 |
|
|
$ |
182 |
|
|
|
|
|
|
|
|
Net income per share: |
|
|
|
|
|
|
|
|
As reported basic |
|
$ |
0.86 |
|
|
$ |
0.83 |
|
Pro forma basic |
|
$ |
0.79 |
|
|
$ |
0.60 |
|
As reported diluted |
|
$ |
0.83 |
|
|
$ |
0.80 |
|
Pro forma diluted |
|
$ |
0.77 |
|
|
$ |
0.58 |
|
13
(4) BUSINESS COMBINATIONS
Digital Illusions C.E. and Mythic Entertainment, Inc.
The following table summarizes the preliminary allocation of assets acquired and liabilities
assumed in connection with the acquisitions of Mythic Entertainment, Inc. (Mythic) and the
remaining minority interest of Digital Illusions C.E. (DICE) for the nine months ended December
31, 2006 (in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
DICE |
|
|
Mythic |
|
|
Total |
|
|
|
|
Current assets |
|
$ |
|
|
|
$ |
15 |
|
|
$ |
15 |
|
Property and equipment, net |
|
|
|
|
|
|
1 |
|
|
|
1 |
|
Other long-term assets |
|
|
|
|
|
|
1 |
|
|
|
1 |
|
Acquired in-process technology |
|
|
1 |
|
|
|
2 |
|
|
|
3 |
|
Goodwill |
|
|
21 |
|
|
|
62 |
|
|
|
83 |
|
Finite-lived intangibles |
|
|
4 |
|
|
|
22 |
|
|
|
26 |
|
Liabilities |
|
|
(2 |
) |
|
|
(27 |
) |
|
|
(29 |
) |
Minority interest |
|
|
8 |
|
|
|
|
|
|
|
8 |
|
|
|
|
Total consideration |
|
$ |
32 |
|
|
$ |
76 |
|
|
$ |
108 |
|
|
|
|
Digital Illusions C.E.
Based in Sweden, DICE develops games for PCs and video game consoles. In 2003 we acquired (1)
approximately 1,911,403 shares of Class B common stock representing a 19 percent equity interest in
DICE, and (2) a warrant to acquire an additional 2,327,602 shares of to-be-issued Class A common
stock at an exercise price of SEK 43.23. Prior to our tender offer in the fourth quarter of fiscal
2005, we accounted for our Class B common stock investment in DICE under the equity method of
accounting, as prescribed by APB No. 18, The Equity Method of Accounting for Investments in Common
Stock. Separately, the warrant was recognized at a cost of $5 million as of March 31, 2006 and was
included in investments in affiliates in our Condensed Consolidated Balance Sheets.
On January 27, 2005, we completed a tender offer by acquiring 3,235,053 shares of Class A common
stock at a price of SEK 61 per share, representing 32 percent of the outstanding Class A common
stock of DICE. During the tender offer period and through the end of fiscal 2005, we acquired,
through open market purchases at an average price of SEK 60.33, an additional 1,190,658 shares of
Class A common stock, representing approximately 12 percent of the outstanding Class A common stock
of DICE. During the first three months and last two weeks of fiscal 2006, we acquired, through open
market purchases at an average price of SEK 63.07, an additional 1,071,152 shares of Class A common
stock, representing approximately 10 percent of the outstanding Class A common stock of DICE.
Accordingly, on a cumulative basis as of March 31, 2006, we owned approximately 73 percent of DICE
on an undiluted basis (excluding the warrant discussed above). As a result, we have included the
assets, liabilities and results of operations of DICE in our Condensed Consolidated Financial
Statements since January 27, 2005. The percent of DICE stock that we did not own was reflected as
minority interest on our Condensed Consolidated Financial Statements from January 27, 2005 until
the acquisition date of the remaining minority interest in October 2006. DICEs products were
primarily sold through co-publishing agreements with us and our transactions with DICE were
recorded on an arms length basis.
In October 2006, the remaining minority interest in DICE was acquired for a total of $27 million in
cash, including transaction costs. In connection with the acquisition of the remaining minority
interest of DICE, the warrant was reclassified to goodwill for this wholly owned subsidiary. We
expect further adjustments to our purchase price allocation, including the allocation of goodwill,
as a result of the acquisition of the remaining minority interest of DICE.
14
Except for acquired in-process technology, which is discussed below, the acquired finite-lived
intangible assets are being amortized on a straight-line basis over estimated lives ranging from
one to four years. The intangible assets that make up that amount as of December 31, 2006 include:
|
|
|
|
|
|
|
|
|
|
|
Gross Carrying |
|
|
Weighted-Average |
|
|
|
Amount |
|
|
Useful Life |
|
|
|
(in millions) |
|
|
(in years) |
|
Developed and Core Technology |
|
$ |
4 |
|
|
|
2 |
|
Trade Name |
|
|
2 |
|
|
|
4 |
|
|
|
|
|
|
|
|
Total Finite-Lived Intangibles |
|
$ |
6 |
|
|
|
3 |
|
|
|
|
|
|
|
|
During the nine months ended December 31, 2006, we recorded $21 million of goodwill, none of which
is tax deductible.
The acquired in-process technology was expensed in our Condensed Consolidated Statements of
Operations upon consummation of the acquisition, and in each period we increased our ownership
percentage. Acquired in-process technology includes the value of products in the development stage
that are not considered to have reached technological feasibility or have alternative future use.
We expect to finalize the preliminary purchase price allocation during the three months ended March
31, 2007.
Mythic Entertainment, Inc.
On July 24, 2006, we acquired all outstanding shares of Mythic for an aggregate purchase price of
$76 million in cash, including transaction costs. Based in Fairfax, Virginia, Mythic is a developer
and publisher of massively multiplayer online role-playing games. The results of operations of
Mythic and the estimated fair market values of the acquired assets and assumed liabilities have
been included in our Condensed Consolidated Financial Statements since the date of acquisition.
Except for acquired in-process technology, which is discussed below, the acquired finite-lived
intangible assets are being amortized on a straight-line basis over estimated lives ranging from
three to five years. The intangible assets that make up that amount as of the date of the
acquisition include:
|
|
|
|
|
|
|
|
|
|
|
Gross Carrying |
|
|
Weighted-Average |
|
|
|
Amount |
|
|
Useful Life |
|
|
|
(in millions) |
|
|
(in years) |
|
Developed and Core Technology |
|
$ |
15 |
|
|
|
4 |
|
Trade Name |
|
|
6 |
|
|
|
5 |
|
Subscribers and Other Intangibles |
|
|
1 |
|
|
|
5 |
|
|
|
|
|
|
|
|
Total Finite-Lived Intangibles |
|
$ |
22 |
|
|
|
4 |
|
|
|
|
|
|
|
|
We recorded $62 million of goodwill, none of which is tax deductible and we expensed $2 million of
acquired in-process technology in our Condensed Consolidated Statements of Operations upon
consummation of the acquisition.
We expect to finalize the preliminary purchase price allocation during the three months ended March
31, 2007.
15
(5) GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill information is as follows (in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Effects of |
|
|
|
|
|
|
As of |
|
|
|
|
|
|
Purchase |
|
|
Foreign |
|
|
As of |
|
|
|
March 31, |
|
|
Goodwill |
|
|
Accounting |
|
|
Currency |
|
|
December 31, |
|
|
|
2006 |
|
|
Acquired |
|
|
Adjustments (1) |
|
|
Translation |
|
|
2006 |
|
|
|
|
Goodwill |
|
$ |
647 |
|
|
$ |
83 |
|
|
$ |
(4 |
) |
|
$ |
4 |
|
|
$ |
730 |
|
|
|
|
|
|
|
(1) |
|
During the three months ended June 30, 2006, we finalized the purchase price
allocation including the allocation of goodwill related to our acquisition of JAMDAT
Mobile Inc. (JAMDAT). As a result, we reduced goodwill and the liability balance
assumed from JAMDAT by $4 million. |
Finite-lived intangibles consisted of the following (in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
As of December 31, 2006 |
|
|
Gross |
|
|
|
|
|
|
|
|
|
|
Other |
|
|
|
Carrying |
|
|
Accumulated |
|
|
|
|
|
|
Intangibles, |
|
|
|
Amount |
|
|
Amortization |
|
|
Other |
|
|
Net |
|
|
|
|
Developed and Core Technology |
|
$ |
180 |
|
|
$ |
(54 |
) |
|
$ |
|
|
|
$ |
126 |
|
Carrier Contracts and Related |
|
|
85 |
|
|
|
(15 |
) |
|
|
|
|
|
|
70 |
|
Trade Name |
|
|
44 |
|
|
|
(23 |
) |
|
|
|
|
|
|
21 |
|
Subscribers and Other Intangibles |
|
|
16 |
|
|
|
(11 |
) |
|
|
(1 |
) |
|
|
4 |
|
|
|
|
Total |
|
$ |
325 |
|
|
$ |
(103 |
) |
|
$ |
(1 |
) |
|
$ |
221 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
As of March 31, 2006 |
|
|
Gross |
|
|
|
|
|
|
|
|
|
|
Other |
|
|
|
Carrying |
|
|
Accumulated |
|
|
|
|
|
|
Intangibles, |
|
|
|
Amount |
|
|
Amortization |
|
|
Other |
|
|
Net |
|
|
|
|
Developed and Core Technology |
|
$ |
160 |
|
|
$ |
(31 |
) |
|
$ |
|
|
|
$ |
129 |
|
Carrier Contracts and Related |
|
|
85 |
|
|
|
(2 |
) |
|
|
|
|
|
|
83 |
|
Trade Name |
|
|
36 |
|
|
|
(21 |
) |
|
|
|
|
|
|
15 |
|
Subscribers and Other Intangibles |
|
|
15 |
|
|
|
(9 |
) |
|
|
(1 |
) |
|
|
5 |
|
|
|
|
Total |
|
$ |
296 |
|
|
$ |
(63 |
) |
|
$ |
(1 |
) |
|
$ |
232 |
|
|
|
|
Amortization of intangibles for the three and nine months ended December 31, 2006 was $14 million
(of which $7 million was recognized as cost of goods sold) and $40 million (of which $20 million
was recognized as cost of goods sold), respectively. Amortization of intangibles for the three and
nine months ended December 31, 2005 was $3 million (of which $2 million was recognized as cost of
goods sold) and $8 million (of which $5 million was recognized as cost of goods sold),
respectively. Finite-lived intangible assets are amortized using the straight-line method over the
lesser of their estimated useful lives or the agreement terms, typically from two to twelve years.
As of December 31, 2006 and March 31, 2006, the weighted-average remaining useful life for
finite-lived intangible assets was approximately 6.4 years and 7.2 years, respectively.
16
As of December 31, 2006, future amortization of finite-lived intangibles that will be recorded in
cost of goods sold and operating expenses is estimated as follows (in millions):
|
|
|
|
|
Fiscal Year
Ending March 31, |
|
|
|
|
2007 (remaining three months) |
|
$ |
14 |
|
2008 |
|
|
51 |
|
2009 |
|
|
40 |
|
2010 |
|
|
33 |
|
2011 |
|
|
29 |
|
Thereafter |
|
|
54 |
|
|
|
|
|
Total |
|
$ |
221 |
|
|
|
|
|
(6) RESTRUCTURING AND ASSET IMPAIRMENT CHARGES
Restructuring and asset impairment information as of December 31, 2006 was as follows (in
millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Fiscal 2004, |
|
|
|
|
|
|
Fiscal 2006 International |
|
|
Fiscal 2006 |
|
|
2003 and 2002 |
|
|
|
|
|
|
Publishing Reorganization |
|
|
Restructuring |
|
|
Restructurings |
|
|
|
|
|
|
Workforce |
|
|
Facilities-related |
|
|
Other |
|
|
Workforce |
|
|
Facilities-related |
|
|
Total |
|
Balances as of March 31, 2005 |
|
$ |
|
|
|
$ |
|
|
|
$ |
|
|
|
$ |
|
|
|
$ |
10 |
|
|
$ |
10 |
|
Charges to operations |
|
|
3 |
|
|
|
8 |
|
|
|
3 |
|
|
|
10 |
|
|
|
|
|
|
|
24 |
|
Charges utilized in cash |
|
|
(2 |
) |
|
|
|
|
|
|
(1 |
) |
|
|
(7 |
) |
|
|
(5 |
) |
|
|
(15 |
) |
Adjustments to operations |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
2 |
|
|
|
2 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Balances as of March 31, 2006 |
|
$ |
1 |
|
|
$ |
8 |
|
|
$ |
2 |
|
|
$ |
3 |
|
|
$ |
7 |
|
|
$ |
21 |
|
Charges to operations |
|
|
8 |
|
|
|
1 |
|
|
|
3 |
|
|
|
|
|
|
|
|
|
|
|
12 |
|
Charges utilized in cash |
|
|
(9 |
) |
|
|
|
|
|
|
(5 |
) |
|
|
(2 |
) |
|
|
(3 |
) |
|
|
(19 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Balances as of December 31, 2006 |
|
$ |
|
|
|
$ |
9 |
|
|
$ |
|
|
|
$ |
1 |
|
|
$ |
4 |
|
|
$ |
14 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
All restructuring charges recorded subsequent to December 31, 2002, were recorded in
accordance with SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities.
We generally expense restructuring costs as they are incurred and accrue costs associated with
certain facility closures at the time we exit the facility. Adjustments to our restructuring
reserves are made in future periods, if necessary, based upon then-current events and
circumstances.
Fiscal 2006 International Publishing Reorganization
In November 2005, we announced plans to establish an international publishing headquarters in
Geneva, Switzerland. Through the quarter ended September 30, 2006, we relocated certain employees
to our new facility in Geneva, closed certain facilities in the U.K., and made other related
changes in our international publishing business.
Since the inception of the restructuring plan, through December 31, 2006, we have incurred
restructuring charges of approximately $26 million, of which $11 million was for employee-related
expenses, $9 million for the closure of certain U.K. facilities, and $6 million in other costs in
connection with our international publishing reorganization. The restructuring accrual of $9
million as of December 31, 2006 is expected to be utilized by March 2017. This accrual is included
in other accrued expenses presented in Note 8 of the Notes to Condensed Consolidated Financial
Statements.
In fiscal 2007, we expect to incur between $15 million and $20 million of restructuring costs in
connection with our international publishing reorganization. Overall, including charges incurred
through December 31, 2006, we expect to incur between $40 million and $45 million of restructuring
costs, substantially all of which will result in cash expenditures by 2017. These restructuring
costs will consist primarily of employee-related relocation assistance (approximately $25 million),
facility exit costs (approximately $11 million), as well as other reorganization costs
(approximately $6 million).
17
Fiscal 2006 Restructuring
During the fourth quarter of fiscal 2006, we aligned our resources with our product plan for fiscal
2007 and strategic opportunities with next-generation consoles, online and mobile platforms. As
part of this alignment, we recorded a total pre-tax restructuring charge of $10 million consisting
entirely of one-time benefits related to headcount reductions, which are included in restructuring
charges in our Condensed Consolidated Statements of Operations. As of December 31, 2006, an
aggregate of $9 million in cash has been paid out under the restructuring plan. The remaining
restructuring accrual of $1 million is expected to be utilized during our fiscal year ending March
31, 2007. This accrual is included in other accrued expenses presented in Note 8 of the Notes to
Condensed Consolidated Financial Statements.
Fiscal 2004, 2003 and 2002 Restructurings
In fiscal 2004, 2003 and 2002, we engaged in various restructurings based on management decisions.
As of December 31, 2006, an aggregate of $30 million in cash had been paid out under these
restructuring plans. The remaining projected net cash outlay of $4 million is expected to be
utilized during our fiscal year ending March 31, 2007. The facilities-related accrued obligation
shown above is net of $4 million of estimated future sub-lease income. The restructuring accrual is
included in other accrued expenses presented in Note 8 of the Notes to Condensed Consolidated
Financial Statements.
(7) ROYALTIES AND LICENSES
Our royalty expenses consist of payments to (1) content licensors, (2) independent software
developers, and (3) co-publishing and/or distribution affiliates. License royalties consist of
payments made to celebrities, professional sports organizations, movie studios and other
organizations for our use of their trademarks, copyrights, personal publicity rights, content
and/or other intellectual property. Royalty payments to independent software developers are
payments for the development of intellectual property related to our games. Co-publishing and
distribution royalties are payments made to third parties for delivery of product.
Royalty-based obligations with content licensors and distribution affiliates are either paid in
advance and capitalized as prepaid royalties or are accrued as incurred and subsequently paid.
These royalty-based obligations are generally expensed to cost of goods sold generally at the
greater of the contractual rate or an effective royalty rate based on expected net product sales.
Prepayments made to thinly capitalized independent software developers and co-publishing affiliates
are generally in connection with the development of a particular product and, therefore, we are
generally subject to development risk prior to the release of the product. Accordingly, payments
that are due prior to completion of a product are generally amortized to research and development
over the development period as the services are incurred. Payments due after completion of the
product (primarily royalty-based in nature) are generally expensed as cost of goods sold.
Our contracts with some licensors include minimum guaranteed royalty payments which are initially
recorded as an asset and as a liability at the contractual amount when no performance remains with
the licensor. When performance remains with the licensor, we record guarantee payments as an asset
when actually paid and as a liability when incurred, rather than recording the asset and liability
upon execution of the contract. Minimum royalty payment obligations are classified as current
liabilities to the extent such royalty payments are contractually due within the next twelve
months. As of December 31, 2006 and March 31, 2006, approximately $5 million and $9 million,
respectively, of minimum guaranteed royalty obligations had been recognized.
Each quarter, we also evaluate the future realization of our royalty-based assets as well as any
unrecognized minimum commitments not yet paid to determine amounts we deem unlikely to be realized
through product sales. Any impairments determined before the launch of a product are charged to
research and development expense. Impairments determined post-launch are charged to cost of goods
sold. In either case, we rely on estimated revenue to evaluate the future realization of prepaid
royalties and commitments. If actual sales or revised revenue estimates fall below the initial
revenue estimate, then the actual charge taken may be greater in any given quarter than
anticipated. We had no impairments during the three and nine months ended December 31, 2006 and
2005.
18
The current and long-term portions of prepaid royalties and minimum guaranteed royalty-related
assets, included in other current assets and other assets, consisted of (in millions):
|
|
|
|
|
|
|
|
|
|
|
As of |
|
|
As of |
|
|
|
December 31, |
|
|
March 31, |
|
|
|
2006 |
|
|
2006 |
|
Other current assets |
|
$ |
27 |
|
|
$ |
76 |
|
Other assets |
|
|
53 |
|
|
|
55 |
|
|
|
|
|
|
|
|
Royalty-related assets |
|
$ |
80 |
|
|
$ |
131 |
|
|
|
|
|
|
|
|
At any given time, depending on the timing of our payments to our co-publishing and/or distribution
affiliates, content licensors and/or independent software developers, we recognize unpaid royalty
amounts due to these parties as either accounts payable or accrued liabilities. The current and
long-term portions of accrued royalties, included in accrued and other current liabilities as well
as other liabilities, consisted of (in millions):
|
|
|
|
|
|
|
|
|
|
|
As of |
|
|
As of |
|
|
|
December 31, |
|
|
March 31, |
|
|
|
2006 |
|
|
2006 |
|
Accrued and other current liabilities |
|
$ |
118 |
|
|
$ |
82 |
|
Other liabilities |
|
|
2 |
|
|
|
7 |
|
|
|
|
|
|
|
|
Royalty-related liabilities |
|
$ |
120 |
|
|
$ |
89 |
|
|
|
|
|
|
|
|
In addition, as of December 31, 2006, we were committed to pay approximately $1,550 million to
content licensors and co-publishing and/or distribution affiliates, but performance remained with
the counterparty (i.e., delivery of the product or content or other factors) and such commitments
were therefore not recorded in our Condensed Consolidated Financial Statements. See Note 9 of the
Notes to Condensed Consolidated Financial Statements.
(8) BALANCE SHEET DETAILS
Inventories
Inventories as of December 31, 2006 and March 31, 2006 consisted of (in millions):
|
|
|
|
|
|
|
|
|
|
|
As of |
|
|
As of |
|
|
|
December 31, |
|
|
March 31, |
|
|
|
2006 |
|
|
2006 |
|
Raw materials and work in process |
|
$ |
1 |
|
|
$ |
1 |
|
Finished goods (including manufacturing royalties) |
|
|
71 |
|
|
|
60 |
|
|
|
|
|
|
|
|
Inventories |
|
$ |
72 |
|
|
$ |
61 |
|
|
|
|
|
|
|
|
19
Property and Equipment, Net
Property and equipment, net, as of December 31, 2006 and March 31, 2006 consisted of (in millions):
|
|
|
|
|
|
|
|
|
|
|
As of |
|
|
As of |
|
|
|
December 31, |
|
|
March 31, |
|
|
|
2006 |
|
|
2006 |
|
Computer equipment and software |
|
$ |
494 |
|
|
$ |
418 |
|
Buildings |
|
|
194 |
|
|
|
127 |
|
Leasehold improvements |
|
|
90 |
|
|
|
78 |
|
Office equipment, furniture and fixtures |
|
|
65 |
|
|
|
57 |
|
Land |
|
|
64 |
|
|
|
57 |
|
Warehouse equipment and other |
|
|
10 |
|
|
|
11 |
|
Construction in progress |
|
|
19 |
|
|
|
59 |
|
|
|
|
|
|
|
|
|
|
|
936 |
|
|
|
807 |
|
Less accumulated depreciation |
|
|
(485 |
) |
|
|
(415 |
) |
|
|
|
|
|
|
|
Property and equipment, net |
|
$ |
451 |
|
|
$ |
392 |
|
|
|
|
|
|
|
|
Depreciation expense associated with property and equipment amounted to $24 million and $70 million
for the three and nine months ended December 31, 2006, respectively. Depreciation expense
associated with property and equipment amounted to $20 million and $60 million for the three and
nine months ended December 31, 2005, respectively.
Accrued and Other Current Liabilities
Accrued and other current liabilities as of December 31, 2006 and March 31, 2006 consisted of (in
millions):
|
|
|
|
|
|
|
|
|
|
|
As of |
|
|
As of |
|
|
|
December 31, |
|
|
March 31, |
|
|
|
2006 |
|
|
2006 |
|
Accrued income taxes |
|
$ |
285 |
|
|
$ |
234 |
|
Accrued compensation and benefits |
|
|
231 |
|
|
|
122 |
|
Other accrued expenses |
|
|
167 |
|
|
|
202 |
|
Accrued royalties |
|
|
118 |
|
|
|
82 |
|
Accrued value added taxes |
|
|
50 |
|
|
|
14 |
|
|
|
|
|
|
|
|
Accrued and other current liabilities |
|
$ |
851 |
|
|
$ |
654 |
|
|
|
|
|
|
|
|
Income Taxes
Effective Income Tax Rate for three and nine months ended December 31, 2006
With respect to our projected annual effective income tax rate at the end of each quarter prior to
the end of a fiscal year, we are required to make a projection of several items, including our
projected mix of full-year income in each jurisdiction in which we operate and the related income
tax expense in each jurisdiction. While this projection is always inherently uncertain, until the
third quarter of fiscal 2007, our interim projected tax rate for fiscal 2007 was unusually volatile
and subject to significantly greater variation.
The tax rate reported for the nine months ended December 31, 2006 is based on our estimated
projected annual effective tax rate for fiscal 2007. Our effective income tax rates for the three
and nine months ended December 31, 2006 were 34.9 percent and 45.9 percent, respectively. These
rates include various adjustments recorded in the three months ended December 31, 2006 for the
reinstatement of the federal research credit, additional income tax benefit resulting from certain
intercompany transactions, offset by additional tax expense due to the development of certain tax
audit related matters. Without the impact of these adjustments, our effective income tax rates for
the three and nine months ended December 31, 2006 would have been 37.3 percent and 49.0 percent,
respectively.
20
Effective Income Tax Rate for three and nine months ended December 31, 2005
During the three months ended December 31, 2005, we adjusted our projected annual effective income
tax rate from our previous projection of 28.0 percent to 29.0 percent (in each case, excluding
discrete adjustments). As a result, we recognized $4 million (or $0.01 per basic and diluted net
income per share) more income tax expense for both the three and nine months ended December 31,
2005 than we would have recognized had this projected annual effective income tax rate remained at
28.0 percent.
During the nine months ended December 31, 2005, our effective income tax rate was 26.5 percent.
This rate included various adjustments recorded in the three months ended September 30, 2005 for
the resolution of certain tax-related matters with foreign tax authorities, offset by additional
income tax provisions resulting from certain intercompany transactions during the three months
ended September 30, 2005. The net impact of these adjustments was that we recognized $9 million (or
$0.03 per basic and diluted net income per share) less income tax expense for the nine months ended
December 31, 2005 than we would have recognized had our projected annual effective income tax rate
remained at 29.0 percent.
(9) COMMITMENTS AND CONTINGENCIES
Lease Commitments and Residual Value Guarantees
We lease certain of our current facilities and equipment under non-cancelable operating lease
agreements. We are required to pay property taxes, insurance and normal maintenance costs for
certain of these facilities and will be required to pay any increases over the base year of these
expenses on the remainder of our facilities.
In February 1995, we entered into a build-to-suit lease (Phase One Lease) with a third-party
lessor for our headquarters facilities in Redwood City, California (Phase One Facilities). The
Phase One Facilities comprise a total of approximately 350,000 square feet and provide space for
sales, marketing, administration and research and development functions. In July 2001, the lessor
refinanced the Phase One Lease with Keybank National Association through July 2006. The Phase One
Lease expires in January 2039, subject to early termination in the event the underlying financing
between the lessor and its lenders is not extended. Subject to certain terms and conditions, upon
termination of the lease, we may purchase the Phase One Facilities or arrange for the sale of the
Phase One Facilities to a third party.
Pursuant to the terms of the Phase One Lease, we have an option to purchase the Phase One
Facilities at any time for a purchase price of $132 million. In the event of a sale to a third
party, if the sale price is less than $132 million, we will be obligated to reimburse the
difference between the actual sale price and $132 million, up to maximum of $117 million, subject
to certain provisions of the Phase One Lease, as amended.
On May 26, 2006, the lessor extended its loan financing underlying the Phase One Lease with its
lenders through July 2007. We may request, on behalf of the lessor and subject to lender approval,
up to two one-year extensions of the loan financing between the lessor and the lender. In the event
the lessors loan financing with the lenders is not extended, we may loan to the lessor
approximately 90 percent of the financing, and require the lessor to extend the remainder through
July 2009; otherwise the lease will terminate. We account for the Phase One Lease arrangement as an
operating lease in accordance with SFAS No. 13, Accounting for Leases, as amended.
In December 2000, we entered into a second build-to-suit lease (Phase Two Lease) with Keybank
National Association for a five and one-half year term beginning in December 2000 to expand our
Redwood City, California headquarters facilities and develop adjacent property (Phase Two
Facilities). Construction of the Phase Two Facilities was completed in June 2002. The Phase Two
Facilities comprise a total of approximately 310,000 square feet and provide space for sales,
marketing, administration and research and development functions. Subject to certain terms and
conditions, upon termination of the lease, we may purchase the Phase Two Facilities or arrange for
the sale of the Phase Two Facilities to a third party.
Pursuant to the terms of the Phase Two Lease, we have an option to purchase the Phase Two
Facilities at any time for a purchase price of $115 million. In the event of a sale to a third
party, if the sale price is less than $115 million, we will be obligated to reimburse the
difference between the actual sale price and $115 million, up to a maximum of $105 million, subject
to certain provisions of the Phase Two Lease, as amended.
21
On May 26, 2006, the lessor extended the Phase Two Lease through July 2009 subject to early
termination in the event the underlying loan financing between the lessor and its lenders is not
extended. Concurrently with the extension of the lease, the lessor extended the loan financing
underlying the Phase Two Lease with its lenders through July 2007. We may request, on behalf of the
lessor and subject to lender approval, up to two one-year extensions of the loan financing between
the lessor and the lender. In the event the lessors loan financing with the lenders is not
extended, we may loan to the lessor approximately 90 percent of the financing, and require the
lessor to extend the remainder through July 2009, otherwise the lease will terminate. We account
for the Phase Two Lease arrangement as an operating lease in accordance with SFAS No. 13, as
amended.
We believe that, as of December 31, 2006, the estimated fair values of both properties under these
operating leases exceeded their respective guaranteed residual values.
The two lease agreements with Keybank National Association described above require us to maintain
certain financial covenants as shown below, all of which we were in compliance with as of December
31, 2006.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Actual as of |
|
Financial Covenants |
|
Requirement |
|
|
December 31, 2006 |
|
Consolidated Net Worth (in millions) |
|
equal to or greater than |
|
$ |
2,430 |
|
|
|
$3,878 |
|
Fixed Charge Coverage Ratio |
|
equal to or greater than |
|
|
3.00 |
|
|
|
5.28 |
|
Total Consolidated Debt to Capital |
|
equal to or less than |
|
|
60% |
|
|
|
6.0% |
|
Quick Ratio
Q1 & Q2 |
|
equal to or greater than |
|
|
1.00 |
|
|
|
N/A |
|
Q3 & Q4 |
|
equal to or greater than |
|
|
1.75 |
|
|
|
9.19 |
|
Development, Celebrity, League and Content Licenses: Payments and Commitments
The products we produce in our studios are designed and created by our employee designers, artists,
software programmers and by non-employee software developers (independent artists or third-party
developers). We typically advance development funds to the independent artists and third-party
developers during development of our games, usually in installment payments made upon the
completion of specified development milestones. Contractually, these payments are generally
considered advances against subsequent royalties on the sales of the products. These terms are set
forth in written agreements entered into with the independent artists and third-party developers.
In addition, we have certain celebrity, league and content license contracts that contain minimum
guarantee payments and marketing commitments that may not be dependent on any deliverables.
Celebrities and organizations with whom we have contracts include: FIFA, FIFPRO Foundation, UEFA
and FAPL (Football Association Premier League Limited) (professional soccer); NASCAR (stock car
racing); National Basketball Association (professional basketball); PGA TOUR and Tiger Woods
(professional golf); National Hockey League and NHL Players Association (professional hockey);
Warner Bros. (Harry Potter, Batman and Superman); New Line Productions and Saul Zaentz Company (The
Lord of the Rings); Red Bear Inc. (John Madden), National Football League Properties and PLAYERS
Inc. (professional football); Collegiate Licensing Company (collegiate football, basketball and
baseball); Simcoh (Def Jam); Viacom Consumer Products (The Godfather); ESPN (content in EA
SPORTSTM games); and Twentieth Century Fox Licensing and Merchandising (The Simpsons).
These developer and content license commitments represent the sum of (1) the cash payments due
under non-royalty-bearing licenses and services agreements and (2) the minimum guaranteed payments
and advances against royalties due under royalty-bearing licenses and services agreements, the
majority of which are conditional upon performance by the counterparty.
22
The following table summarizes our minimum contractual obligations and commercial commitments as of
December 31, 2006 (in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Commercial |
|
|
|
|
|
|
Contractual Obligations |
|
|
Commitments |
|
|
|
|
|
|
|
|
|
|
Developer/ |
|
|
|
|
|
|
Letter of Credit, |
|
|
|
|
Fiscal Year |
|
|
|
|
|
Licensor |
|
|
|
|
|
|
Bank and |
|
|
|
|
Ending March 31, |
|
Leases (1) |
|
|
Commitments (2) |
|
|
Marketing |
|
|
Other Guarantees |
|
|
Total |
|
2007 (remaining three months) |
|
$ |
19 |
|
|
$ |
33 |
|
|
$ |
7 |
|
|
$ |
6 |
|
|
$ |
65 |
|
2008 |
|
|
54 |
|
|
|
172 |
|
|
|
41 |
|
|
|
1 |
|
|
|
268 |
|
2009 |
|
|
53 |
|
|
|
191 |
|
|
|
31 |
|
|
|
|
|
|
|
275 |
|
2010 |
|
|
35 |
|
|
|
166 |
|
|
|
31 |
|
|
|
|
|
|
|
232 |
|
2011 |
|
|
25 |
|
|
|
269 |
|
|
|
31 |
|
|
|
|
|
|
|
325 |
|
Thereafter |
|
|
66 |
|
|
|
724 |
|
|
|
185 |
|
|
|
|
|
|
|
975 |
|
|
|
|
|
|
|
|
|
|
Total |
|
$ |
252 |
|
|
$ |
1,555 |
|
|
$ |
326 |
|
|
$ |
7 |
|
|
$ |
2,140 |
|
|
|
|
|
|
|
|
|
|
|
|
|
(1) |
|
Lease commitments include contractual rental commitments of $20 million
under real estate leases for unutilized office space resulting from our restructuring
activities. These amounts, net of estimated future sub-lease income, were expensed in the
periods of the related restructuring and are included in our accrued and other current
liabilities reported on our Condensed Consolidated Balance Sheets as of December 31, 2006. See
Note 6 of the Notes to Condensed Consolidated Financial Statements. |
|
(2) |
|
Developer/licensor commitments include $5 million of commitments to
developers or licensors that have been recorded in current and long-term liabilities and a
corresponding amount in current and long-term assets in our Condensed Consolidated Balance
Sheets as of December 31, 2006 because payment is not contingent upon performance by the
developer or licensor. |
Legal Proceedings
On September 14, 2006, we received an informal inquiry from the Securities and Exchange Commission
requesting certain documents and information relating to our stock option grant practices from
January 1, 1997 to the present. We have cooperated to date with all matters related to this
request.
We are also subject to claims and litigation arising in the ordinary course of business. We believe
that any liability from any reasonably foreseeable disposition of such claims and litigation,
individually or in the aggregate, would not have a material adverse effect on our consolidated
financial position or results of operations.
Director Indemnity Agreements
We entered into indemnification agreements with the members of our Board of Directors at the time
they joined the Board to indemnify them to the extent permitted by law against any and all
liabilities, costs, expenses, amounts paid in settlement and damages incurred by the directors as a
result of any lawsuit, or any judicial, administrative or investigative proceeding in which the
directors are sued or charged as a result of their service as members of our Board of Directors.
(10) COMPREHENSIVE INCOME
SFAS No. 130, Reporting Comprehensive Income, requires classifying items of other comprehensive
income (loss) by their nature in a financial statement and displaying the accumulated balance of
other comprehensive income separately from retained earnings and additional paid-in capital in the
equity section of a balance sheet. Accumulated other comprehensive income primarily includes
foreign currency translation adjustments, and the net-of-tax amounts for unrealized gains (losses)
on investments and unrealized gains (losses) on derivatives designated as cash flow hedges.
23
The components of comprehensive income for the three and nine months ended December 31, 2006 and
2005 are summarized as follows (in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
|
Nine Months Ended |
|
|
|
December 31, |
|
|
December 31, |
|
|
|
2006 |
|
|
2005 |
|
|
2006 |
|
|
2005 |
|
Net income |
|
$ |
160 |
|
|
$ |
259 |
|
|
$ |
101 |
|
|
$ |
252 |
|
Other comprehensive income (loss): |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Change in unrealized gains (losses) on investments, net of
tax expense (benefit) of $0, $0, $0 and $5 respectively |
|
|
30 |
|
|
|
(16 |
) |
|
|
80 |
|
|
|
38 |
|
Reclassification adjustment for losses realized on
investments in net income, net of tax benefit of
$0 for each period |
|
|
|
|
|
|
|
|
|
|
1 |
|
|
|
|
|
Change in unrealized gains (losses) on derivative instruments,
net of tax expense (benefit) of $0, $0, $0 and $1, respectively |
|
|
(1 |
) |
|
|
|
|
|
|
(4 |
) |
|
|
4 |
|
Reclassification adjustment for (gains) losses realized on derivative
instrument in net income, net of tax (expense) benefit of
$0, $(2), $0 and $(2), respectively |
|
|
2 |
|
|
|
(4 |
) |
|
|
2 |
|
|
|
(4 |
) |
Foreign currency translation adjustments |
|
|
|
|
|
|
1 |
|
|
|
26 |
|
|
|
(7 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
Total other comprehensive income (loss) |
|
|
31 |
|
|
|
(19 |
) |
|
|
105 |
|
|
|
31 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total comprehensive income |
|
$ |
191 |
|
|
$ |
240 |
|
|
$ |
206 |
|
|
$ |
283 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
The foreign currency translation adjustments are not adjusted for income taxes as they relate to
indefinite investments in non-U.S. subsidiaries.
24
(11) NET INCOME PER SHARE
The following table summarizes the computations of basic earnings per share (Basic EPS) and
diluted earnings per share (Diluted EPS). Basic EPS is computed as net income divided by the
weighted-average number of common shares outstanding for the period. Diluted EPS reflects the
potential dilution that could occur from common shares issuable through stock-based compensation
plans including stock options, restricted stock, restricted stock units, warrants and other
convertible securities using the treasury stock method.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
|
Nine Months Ended |
|
|
|
December 31, |
|
|
December 31, |
|
(In millions, except per share amounts) |
|
2006 |
|
|
2005 |
|
|
2006 |
|
|
2005 |
|
Net income |
|
$ |
160 |
|
|
$ |
259 |
|
|
$ |
101 |
|
|
$ |
252 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Shares used to compute net income per share: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted-average common stock outstanding basic |
|
|
309 |
|
|
|
301 |
|
|
|
307 |
|
|
|
304 |
|
Dilutive potential common shares |
|
|
10 |
|
|
|
10 |
|
|
|
9 |
|
|
|
11 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted-average common stock outstanding diluted |
|
|
319 |
|
|
|
311 |
|
|
|
316 |
|
|
|
315 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income per share: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic |
|
$ |
0.52 |
|
|
$ |
0.86 |
|
|
$ |
0.33 |
|
|
$ |
0.83 |
|
Diluted |
|
$ |
0.50 |
|
|
$ |
0.83 |
|
|
$ |
0.32 |
|
|
$ |
0.80 |
|
Options to purchase 15 million and 16 million shares of common stock were excluded from the above
computation of diluted shares for the three and nine months ended December 31, 2006, respectively,
as their inclusion would have been antidilutive. For the three and nine months ended December 31,
2006, the weighted-average exercise price of these shares was $55.44 and $56.13 per share,
respectively.
Options to purchase 8 million and 7 million shares of common stock were excluded from the above
computation of diluted shares for both the three and nine months ended December 31, 2005,
respectively, as their inclusion would have been antidilutive. For the three and nine months ended
December 31, 2005, the weighted-average exercise price of these shares was $62.88 and $63.68 per
share, respectively.
(12) RELATED PARTY TRANSACTION
On June 24, 2002, we hired Warren C. Jenson as our Executive Vice President, Chief Financial and
Administrative Officer and agreed to loan him $4 million to be forgiven over four years based on
his continuing employment. The loan did not bear interest. On June 24, 2004, pursuant to the terms
of the loan agreement, we forgave $2 million of the loan and provided Mr. Jenson approximately $1.6
million to offset the tax implications of the forgiveness. On June 24, 2006, pursuant to the terms
of the loan agreement, we forgave the remaining outstanding loan balance of $2 million. No
additional funds were provided to offset the tax implications of the forgiveness of the $2 million
balance.
(13) SEGMENT INFORMATION
Our reporting segments are based upon: our internal organizational structure; the manner in which
our operations are managed; the criteria used by our Chief Executive Officer, our chief operating
decision maker, to evaluate segment performance; the availability of separate financial
information; and overall materiality considerations.
We manage our business primarily based on geographical performance. Accordingly, our combined
global publishing organizations represent our reportable segment, our Publishing segment, due to
their similar economic characteristics, products and distribution methods. Publishing refers to the
manufacturing, marketing, advertising and distribution of products developed or co-developed by us,
or distribution of certain third-party publishers products through our co-publishing and
distribution program.
25
The following table summarizes the financial performance of our Publishing segment and a
reconciliation of our Publishing segments profit to our consolidated operating income (in
millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
|
Nine Months Ended |
|
|
|
December 31, |
|
|
December 31, |
|
|
|
2006 |
|
|
2005 |
|
|
2006 |
|
|
2005 |
|
Publishing segment: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net revenue |
|
$ |
1,246 |
|
|
$ |
1,266 |
|
|
$ |
2,372 |
|
|
$ |
2,300 |
|
Depreciation and amortization |
|
|
(6 |
) |
|
|
(4 |
) |
|
|
(17 |
) |
|
|
(15 |
) |
Other expenses |
|
|
(615 |
) |
|
|
(680 |
) |
|
|
(1,314 |
) |
|
|
(1,336 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
Publishing segment profit |
|
|
625 |
|
|
|
582 |
|
|
|
1,041 |
|
|
|
949 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Reconciliation to consolidated operating income: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Other: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net revenue |
|
|
35 |
|
|
|
4 |
|
|
|
106 |
|
|
|
10 |
|
Depreciation and amortization |
|
|
(32 |
) |
|
|
(18 |
) |
|
|
(93 |
) |
|
|
(53 |
) |
Other expenses |
|
|
(413 |
) |
|
|
(221 |
) |
|
|
(943 |
) |
|
|
(605 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
Consolidated operating income |
|
$ |
215 |
|
|
$ |
347 |
|
|
$ |
111 |
|
|
$ |
301 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Publishing segment profit differs from consolidated operating income primarily due to the exclusion
of substantially all of our research and development expense as well as certain corporate
functional costs that are not allocated to the publishing organizations.
26
Information about our total net revenue by product line for the three and nine months ended
December 31, 2006 and 2005 is presented below (in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
|
Nine Months Ended |
|
|
|
December 31, |
|
|
December 31, |
|
|
|
2006 |
|
|
2005 |
|
|
2006 |
|
|
2005 |
|
Consoles |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
PlayStation 2 |
|
$ |
400 |
|
|
$ |
495 |
|
|
$ |
769 |
|
|
$ |
916 |
|
Xbox 360 |
|
|
172 |
|
|
|
76 |
|
|
|
399 |
|
|
|
76 |
|
Xbox |
|
|
62 |
|
|
|
152 |
|
|
|
150 |
|
|
|
332 |
|
Nintendo GameCube |
|
|
32 |
|
|
|
69 |
|
|
|
56 |
|
|
|
118 |
|
PlayStation 3 |
|
|
41 |
|
|
|
|
|
|
|
41 |
|
|
|
|
|
Wii |
|
|
29 |
|
|
|
|
|
|
|
29 |
|
|
|
|
|
Other Consoles |
|
|
|
|
|
|
1 |
|
|
|
|
|
|
|
1 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total Consoles |
|
|
736 |
|
|
|
793 |
|
|
|
1,444 |
|
|
|
1,443 |
|
PC |
|
|
218 |
|
|
|
148 |
|
|
|
370 |
|
|
|
313 |
|
Mobility |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
PSP |
|
|
118 |
|
|
|
120 |
|
|
|
219 |
|
|
|
197 |
|
Nintendo DS |
|
|
55 |
|
|
|
36 |
|
|
|
77 |
|
|
|
56 |
|
Game Boy Advance |
|
|
21 |
|
|
|
35 |
|
|
|
35 |
|
|
|
48 |
|
Cellular Handsets |
|
|
35 |
|
|
|
1 |
|
|
|
104 |
|
|
|
4 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total Mobility |
|
|
229 |
|
|
|
192 |
|
|
|
435 |
|
|
|
305 |
|
Co-publishing and Distribution |
|
|
49 |
|
|
|
99 |
|
|
|
130 |
|
|
|
161 |
|
Internet Services, Licensing and Other |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Subscription Services |
|
|
24 |
|
|
|
16 |
|
|
|
55 |
|
|
|
45 |
|
Licensing, Advertising and Other |
|
|
25 |
|
|
|
22 |
|
|
|
44 |
|
|
|
43 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total Internet Services, Licensing and Other |
|
|
49 |
|
|
|
38 |
|
|
|
99 |
|
|
|
88 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total Net Revenue |
|
$ |
1,281 |
|
|
$ |
1,270 |
|
|
$ |
2,478 |
|
|
$ |
2,310 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Information about our operations in North America, Europe and Asia as of and for the three and nine
months ended December 31, 2006 and 2005 is presented below (in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
North |
|
|
|
|
|
|
|
|
|
|
|
|
America |
|
|
Europe |
|
|
Asia |
|
|
Total |
|
Three months ended December 31, 2006 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net revenue from unaffiliated customers |
|
$ |
637 |
|
|
$ |
583 |
|
|
$ |
61 |
|
|
$ |
1,281 |
|
Long-lived assets |
|
|
1,137 |
|
|
|
254 |
|
|
|
11 |
|
|
|
1,402 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three months ended December 31, 2005 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net revenue from unaffiliated customers |
|
$ |
618 |
|
|
$ |
577 |
|
|
$ |
75 |
|
|
$ |
1,270 |
|
Long-lived assets |
|
|
347 |
|
|
|
201 |
|
|
|
9 |
|
|
|
557 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Nine months ended December 31, 2006 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net revenue from unaffiliated customers |
|
$ |
1,359 |
|
|
$ |
997 |
|
|
$ |
122 |
|
|
$ |
2,478 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Nine months ended December 31, 2005 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net revenue from unaffiliated customers |
|
$ |
1,245 |
|
|
$ |
912 |
|
|
$ |
153 |
|
|
$ |
2,310 |
|
Our direct sales to Wal-Mart Stores, Inc. represented approximately 13 percent of total net revenue
for both the three and nine months ended December 31, 2006, respectively, and approximately 12
percent and 13 percent of total net revenue for the three and nine months ended December 31, 2005,
respectively. Our direct sales to GameStop Corp. represented approximately 10 percent and 12
percent of total net revenue for the three and nine months ended December 31, 2006, respectively,
and approximately 11 percent of total net revenue for the three months ended December 31, 2005.
27
(14) IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS
In February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial
Instruments An Amendment of FASB Statements No. 133 and 140. SFAS No. 155 (1) permits fair value
measurement for any hybrid financial instrument that contains an embedded derivative that otherwise
would require bifurcation, (2) clarifies that interest-only strips and principal-only strips are
not subject to the requirements of SFAS No. 133, Accounting for Derivative Instruments and Hedging
Activities, (3) establishes a requirement to evaluate interests in securitized financial assets to
identify interests that are freestanding derivatives or that are hybrid financial instruments that
contain an embedded derivative requiring bifurcation, (4) clarifies that concentrations of credit
risk in the form of subordination are not embedded derivatives, and (5) amends SFAS No. 140,
Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities A
Replacement of FASB Statement No. 125 to eliminate the prohibition on a qualifying special-purpose
entity from holding a derivative financial instrument that pertains to a beneficial interest other
than another derivative financial instrument. SFAS No. 155 is effective for all financial
instruments acquired or issued for fiscal years beginning after September 15, 2006. We do not
expect the adoption of SFAS No. 155 to have a material impact on our Condensed Consolidated
Financial Statements.
In June 2006, the FASB ratified the consensus reached on Emerging Issues Task Force (EITF) Issue
No. 06-3, How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be
Presented in the Income Statement (That Is, Gross Versus Net Presentation). The scope of EITF
Issue No. 06-3 includes any transaction-based tax assessed by a governmental authority that is
imposed concurrent with or subsequent to a revenue-producing transaction between a seller and a
customer. The scope does not include taxes that are based on gross receipts or total revenues
imposed during the inventory procurement process. Gross versus net income statement classification
of that tax is an accounting policy decision and a voluntary change would be considered a change in
accounting policy requiring the application of SFAS No. 154, Accounting Changes and Error
Corrections. The following disclosures will be required for taxes within the scope of this issue
that are significant in amount: (1) the accounting policy elected for these taxes and (2) the
amounts of the taxes reflected gross (as revenue) in the income statement on an interim and annual
basis for all periods presented. The EITF Issue No. 06-3 ratified consensus is effective for
interim and annual periods beginning after December 15, 2006. We do not expect the adoption of EITF
Issue No. 06-3 to have a material impact on our Condensed Consolidated Financial Statements.
In July 2006, the FASB issued FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in
Income Taxes An Interpretation of FASB Statement No. 109. FIN No. 48 clarifies the accounting
for uncertainty in income taxes recognized in financial statements in accordance with SFAS No. 109,
Accounting for Income Taxes. FIN No. 48 prescribes a recognition threshold and measurement
attribute for the financial statement recognition and measurement of a tax position taken or
expected to be taken in a tax return and provides guidance on derecognition, classification,
interest and penalties, accounting in interim periods, disclosure, and transition. Under FIN No.
48, the evaluation of a tax position is a two-step process. The first step is a recognition process
where we are required to determine whether it is more likely than not that a tax position will be
sustained upon examination, including resolution of any related appeals or litigation processes,
based on the technical merits of the position. In evaluating whether a tax position has met the
more-likely-than-not recognition threshold, it is presumed that the position will be examined by
the appropriate taxing authority that has full knowledge of all relevant information. The second
step is a measurement process whereby a tax position that meets the more-likely-than-not
recognition threshold is calculated to determine the amount of benefit to recognize in the
financial statements. FIN No. 48 also requires new tabular reconciliation of the total amounts of
unrecognized tax benefits at the beginning and end of the reporting period. The provisions of FIN
No. 48 are effective for fiscal years beginning after December 15, 2006. As such, we are required
to adopt it in our first quarter of fiscal year 2008. Any changes to our income taxes due to the
adoption of FIN No. 48 are treated as the cumulative effect of a change in accounting principle. We
are evaluating what impact the adoption of FIN No. 48 will have on our Condensed Consolidated
Financial Statements; however, FIN No. 48 could have a material impact on our Condensed
Consolidated Financial Statements.
In September 2006, the SEC issued SAB No. 108, Financial Statements Considering the Effects of
Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements. SAB
No. 108 provides guidance on how prior year misstatements should be taken into consideration when
quantifying misstatements in current year financial statements for purposes of determining whether
the current years financial statements are materially misstated. The impact of correcting all
misstatements, including both the carryover and reversing effects of prior year misstatements, must
be quantified on the current year financial statements. When a current year misstatement has been
quantified, SAB No. 99, Financial Statements Materiality should be applied to determine whether
the misstatement is material and should result in an adjustment to the financial statements. SAB
No. 108 also discusses the implications of misstatements uncovered upon the
application of SAB No. 108 in situations when a registrant has historically been using either the
iron curtain approach or the rollover approach as described in the SAB. Registrants electing not to
restate prior periods should reflect the effects of initially applying the guidance
28
in Topic 1N in
their annual financial statements covering the first fiscal year ending after November 15, 2006. We
are evaluating what impact the adoption of SAB No. 108 will have on our Condensed Consolidated
Financial Statements.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. SFAS No. 157 defines
fair value, establishes a framework for measuring fair value in generally accepted accounting
principles and expands disclosures about fair value measurements. Fair value refers to the price
that would be received to sell an asset or paid to transfer a liability in an orderly transaction
between market participants in the market in which the reporting entity transacts. SFAS No. 157
establishes a fair value hierarchy that prioritizes the information used to develop those
assumptions. Fair value measurements would be separately disclosed by level within the fair value
hierarchy. The provisions of SFAS No. 157 are effective for financial statements issued for fiscal
years beginning after November 15, 2007, and interim periods within those fiscal years. We do not
expect the adoption of SFAS No. 157 to have a material impact on our Condensed Consolidated
Financial Statements.
In October 2006, the FASB issued FSP No. FAS 123(R)-6, Technical Corrections of FASB Statement No.
123(R), which amends various provisions of SFAS No. 123(R). FSP No. FAS 123(R)-6 (1) exempts
nonpublic entities from disclosing the aggregate intrinsic value of outstanding fully vested share
options (or share units) and share options expected to vest, (2) revises the computation of the
minimum compensation cost that must be recognized to comply with paragraph 42 of SFAS No. 123(R),
(3) amends paragraph A170 of Illustration 13(e) to indicate that at the date that the illustrative
awards were no longer probable of vesting, any previously recognized compensation cost should have
been reversed, and (4) amends the definition of short-term inducement to exclude an offer to
settle an award. The provisions of FSP No. FAS 123(R)-6 are required to be applied in the first
reporting period beginning after October 20, 2006. Retrospective application is required if an
entity had been applying Statement 123(R) inconsistent with the guidance in FSP No. FAS 123(R)-6.
We do not expect the adoption of FSP No. FAS 123(R)-6 to have a material impact on our Condensed
Consolidated Financial Statements.
29
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders
Electronic Arts Inc.:
We have reviewed the accompanying condensed consolidated balance sheet of Electronic Arts Inc. and
subsidiaries (the Company) as of December 30, 2006, the related condensed consolidated statements
of operations for the three-month and nine-month periods ended December 30, 2006 and December 31,
2005, and the related condensed consolidated statements of cash flows for the nine-month periods
ended December 30, 2006 and December 31, 2005. These condensed consolidated financial statements
are the responsibility of the Companys management.
We conducted our review in accordance with the standards of the Public Company Accounting Oversight
Board (United States). A review of interim financial information consists principally of applying
analytical procedures and making inquiries of persons responsible for financial and accounting
matters. It is substantially less in scope than an audit conducted in accordance with the
standards of the Public Company Accounting Oversight Board (United States), the objective of which
is the expression of an opinion regarding the financial statements taken as a whole. Accordingly,
we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should be made to the
condensed consolidated financial statements referred to above for them to be in conformity U.S.
generally accepted accounting principles.
We have previously audited, in accordance with standards of the Public Company Accounting Oversight
Board (United States), the consolidated balance sheet of Electronic Arts Inc. and subsidiaries as
of April 1, 2006, and the related consolidated statements of operations, stockholders equity and
comprehensive income, and cash flows for the year then ended (not presented herein); and in our
report dated June 9, 2006, we expressed an unqualified opinion on those consolidated financial
statements. In our opinion, the information set forth in the accompanying condensed consolidated
balance sheet as of April 1, 2006, is fairly stated, in all material respects, in relation to the
consolidated balance sheet from which it has been derived.
KPMG LLP
Mountain View, California
February 6, 2007
30
Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the
Private Securities Litigation Reform Act of 1995. All statements, other than statements of
historical fact, including statements regarding industry prospects and future results of operations
or financial position, made in this Quarterly Report on Form 10-Q are forward looking. We use words
such as anticipate, believe, expect, intend, estimate, (and the negative of any of these
terms), future and similar expressions to help identify forward-looking statements. These
forward-looking statements are subject to business and economic risk and reflect managements
current expectations, and involve subjects that are inherently uncertain and difficult to predict.
Our actual results could differ materially. We will not necessarily update information if any
forward-looking statement later turns out to be inaccurate. Risks and uncertainties that may affect
our future results include, but are not limited to, those discussed in this report under the
heading Risk Factors in Part II, Item 1A, as well as in our Annual Report on Form 10-K for the
fiscal year ended March 31, 2006 as filed with the Securities and Exchange Commission (SEC) on
June 12, 2006 and in other documents we have filed with the SEC.
OVERVIEW
The following overview is a top-level discussion of our operating results as well as some of the
trends and drivers that affect our business. Management believes that an understanding of these
trends and drivers is important in order to understand our results for the three and nine months
ended December 31, 2006, as well as our future prospects. This summary is not intended to be
exhaustive, nor is it intended to be a substitute for the detailed discussion and analysis provided
elsewhere in this Form 10-Q, including in the remainder of Managements Discussion and Analysis of
Financial Condition and Results of Operations, Risk Factors and the Condensed Consolidated
Financial Statements and related notes. Additional information can be found in the Business
section of our Annual Report on Form 10-K for the fiscal year ended March 31, 2006 as filed with
the SEC on June 12, 2006 and in other documents we have filed with the SEC.
About Electronic Arts
We develop, market, publish and distribute interactive software games that are playable by
consumers on home video game consoles (such as the Sony PlayStation® 3, Microsoft Xbox
360 and Nintendo Wii), personal computers, mobile platforms (including
cellular handsets and handheld game players such as the PlayStation® Portable
(PSP) and the Nintendo DS) and online (over the Internet and other
proprietary online networks). Some of our games are based on content that we license from others
(e.g., Madden NFL Football, The Godfather and FIFA Soccer), and some of our games are based on our
own wholly-owned intellectual property (e.g., The Sims, Need for Speed and
BLACK). Our goal is to publish titles with mass-market appeal, which often means
translating and localizing them for sale in non-English speaking countries. In addition, we also
attempt to create software game franchises that allow us to publish new titles on a recurring
basis that are based on the same property. Examples of this franchise approach are the annual
iterations of our sports-based products (e.g., Madden NFL Football, NCAA® Football and
FIFA Soccer), wholly-owned properties that can be successfully sequeled (e.g., The Sims, Need for
Speed and Battlefield) and titles based on long-lived literary and/or movie properties (e.g., Lord
of the Rings and Harry Potter).
Overview of Financial Results
Total net revenue for the three months ended December 31, 2006 was $1,281 million, up 1 percent as
compared to the three months ended December 31, 2005. Net revenue for the three months ended
December 31, 2006 was driven by sales of Need for Speed Carbon, FIFA 07, The Sims 2 Pets, Madden
NFL 07, and Tiger Woods PGA TOUR® 07. Need for Speed Carbon sold over eight million
copies in the quarter.
Net income for the three months ended December 31, 2006 was $160 million as compared to $259
million for the three months ended December 31, 2005. Diluted net income per share for the three
months ended December 31, 2006 was $0.50 as compared to $0.83 for the three months ended December
31, 2005.
During the nine months ended December 31, 2006, we generated $183 million of cash from operating
activities as compared to $259 million of cash generated for the nine months ended December 31,
2005. The decrease in cash provided by operating activities for the nine months ended December 31,
2006 as compared to the nine months ended December 31, 2005 resulted
primarily from an increase of $95 million in the change in net accounts receivable due to the
timing of the collection of our receivables.
31
Stock-Based Compensation. Beginning in fiscal 2007, we adopted Statement of Financial Accounting
Standard (SFAS) No. 123 (revised 2004) (SFAS No. 123(R)), Share-Based Payment, which requires
us to recognize the cost resulting from all share-based payment transactions in our financial
statements using a fair-value-based method. See Note 3 of the Notes to Condensed Consolidated
Financial Statements. The following table summarizes our stock-based compensation expense resulting
from stock options, restricted stock, restricted stock units and our employee stock purchase plan
included in our Condensed Consolidated Statements of Operations for the three and nine months ended
December 31, 2006 and 2005 (in millions):
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Three Months Ended |
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Nine Months Ended |
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December 31, |
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December 31, |
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2006 |
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2005 |
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|
2006 |
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|
2005 |
|
Cost of goods sold |
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$ |
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|
|
$ |
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|
|
$ |
1 |
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|
$ |
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|
Marketing and sales |
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5 |
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|
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|
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14 |
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General and administrative |
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10 |
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30 |
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Research and development |
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20 |
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|
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|
|
60 |
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|
1 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Stock-based compensation expense |
|
|
35 |
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|
|
|
|
|
|
105 |
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|
|
1 |
|
Benefit from income taxes |
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(7 |
) |
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(22 |
) |
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|
|
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|
|
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Stock-based compensation expense, net of tax |
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$ |
28 |
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|
$ |
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|
|
$ |
83 |
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|
$ |
1 |
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|
As of December 31, 2006, the total unrecognized compensation cost related to stock options was $173
million and is expected to be recognized over the weighted-average service period of 1.5 years. As
of December 31, 2006, the total unrecognized compensation cost related to restricted stock and
restricted stock units (collectively referred to as restricted stock rights) was $81 million and
is expected to be recognized over the weighted-average service period of 2.5 years.
On September 15, 2006, we completed a stock option exchange program pursuant to which eligible
employees were able to exchange certain outstanding stock options that were significantly
underwater (that is, the exercise price of the stock option was greater than the trading price of
our common stock at that time) for a lesser number of shares of restricted stock rights, which were
granted under our 2000 Equity Incentive Plan. In the exchange program, eligible employees exchanged
stock options to purchase approximately 1,776,000 shares of our common stock for 444,000 shares of
restricted stock rights.
Managements Overview of Historical and Prospective Business Trends
Transition to Next-Generation Consoles. Our industry is cyclical and in the midst of a transition
stage heading into the next cycle. Video game platforms have historically had a life cycle of four
to six years, which causes the video game software market to be cyclical as well. The
current generation of platforms Sonys PlayStation 2, Microsofts Xbox and the Nintendo GameCube
were initially introduced in 2000 and 2001. In November 2005, Microsoft launched the Xbox 360.
More recently, Sony introduced the PlayStation 3 in November 2006 in North America and Japan and is
expected to launch it in Europe and elsewhere in March 2007. Nintendo introduced the Wii in
November 2006 in North America and in December 2006 in Japan and Europe. We refer to Microsofts
Xbox 360, Sonys PlayStation 3 and Nintendos Wii as next-generation platforms. The release of
each of these next-generation platforms has moved the interactive entertainment industry further
along the transition into the next cycle. We expect that, as the current generation of platforms
reaches the end of its cycle and the installed base of next-generation platforms continues to grow,
sales of video games for current-generation platforms will continue to decline as consumers replace
their current-generation platforms with next-generation platforms, or defer game software purchases
until they are able to purchase a next-generation platform. This decline in current-generation
product sales may not be offset by increased sales of products for the new platforms. This pattern
is referred to in our industry as a transition to next-generation consoles. During this
transition, we intend to continue to develop new titles for certain current-generation video game
consoles while we also continue to make significant investments in the development of products for
next-generation consoles. We expect the average selling prices and unit sales of our titles for
current-generation consoles to continue to decline as more value-oriented consumers purchase
current-generation consoles, a greater number of competitive titles are published at reduced price
points, and consumers potentially defer purchases in anticipation of next-generation consoles.
Although there can be no assurance, and our actual results could differ materially, in the
short-term we expect gross
margin pressure as a result of (1) a decrease in average selling prices of titles for
current-generation platforms, (2) higher license royalty rates, and (3) amortization of our
newly-acquired intangible assets.
32
We have incurred and expect to continue to incur increased costs during this transition as we have
continued to develop and market new titles for certain current-generation video game platforms
while also making significant investments in products for the next-generation platforms. Moreover,
we expect development costs for next-generation video games to be greater on a per-title basis than
development costs for current-generation video games. As we move through the life cycle of
current-generation consoles, we will continue to devote significant resources to the development of
current-generation titles while at the same time continuing to invest heavily in tools,
technologies and titles for the next generation of platforms and technology. We expect our
operating results to continue to be volatile and difficult to predict.
Investment in Online. Today, we generate net revenue from a variety of online products and
services, including casual games and downloadable content marketed under our Pogo brand, persistent
state world games such as Ultima Online and Dark Age of Camelot®, PC-based downloadable
content and online-enabled packaged goods. As the nature of online game offerings expands and
evolves, we anticipate long-term opportunities for growth in this area. For example, we expect that
consumers will take advantage of the online connectivity of next-generation consoles at a much
higher rate than they have on current-generation consoles, allowing more consumers to enhance their
gameplay experience through multiplayer activity, community-building and downloading content. We
plan to increase the amount of content available for download on the PC and consoles, and to
increase the number of PC-based games that can be downloaded electronically. In addition, we plan
to expand our casual game offerings internationally and to invest in growing genres such as
mid-session games. To further enhance our online offerings, we acquired Mythic Entertainment
(Mythic), a developer and publisher of massively multiplayer online role-playing games in July
2006. Although we intend to make significant investments in online products, infrastructure and
services and believe that online gameplay will become an increasingly important part of our
business in the long term, we do not expect revenue from persistent state world games or online
gameplay and distribution to be significant in fiscal 2007.
Significantly Increased Deferred Revenue for Online-Enabled Games. The ubiquity of high-speed
Internet access and integration of network connectivity into next-generation game consoles is
expected to expand demand for games with online-enabled features. To address this demand, we
include online features in many of our PC, PlayStation 3, PlayStation 2, Xbox 360, Xbox, and PSP
products, which enable consumers to participate in online communities and play against one another
via the Internet. In order to support the online functionality of our games for the PC, PlayStation
2, PlayStation 3 and the PSP, we provide our consumers with access to servers which we maintain.
Starting in fiscal 2008, we will no longer be able to objectively determine the fair value of such
services which will prevent us from recognizing revenue related to the software already sold and
hosting services separately. Therefore, we will be required to recognize revenue from the sale of
our online-enabled packaged goods for the PC, PlayStation 2, PlayStation 3 and the PSP over the
estimated online service period. We anticipate that, in fiscal 2008, we will likely defer more than
$400 million in net revenue from the sale of these online-enabled packaged goods games into fiscal
2009 (currently expected to be recognized over six months).
Expansion of Mobile Platforms. Advances in mobile technology have resulted in a variety of new and
evolving platforms for on-the-go interactive entertainment that appeal to a broader demographic of
consumers. Our efforts to capitalize on the growth in mobile interactive entertainment are focused
in two broad areas packaged goods games for handheld game systems and downloadable games for
cellular handsets.
We have developed and published games for a variety of handheld platforms, including the Nintendo
Game Boy and Game Boy Advance, for several years. The introductions of the Sony PSP and the
Nintendo DS, with their enhanced graphics, deeper gameplay, and online functionality, provide a
richer mobile gaming experience for consumers.
We expect sales of games for cellular handsets to become an increasingly important part of our
business worldwide. To accelerate our position in this growing segment, in February 2006, we
acquired JAMDAT Mobile Inc. (JAMDAT), a global publisher of wireless games and other wireless
entertainment applications. As a result of this acquisition, we expect our net revenue from games
for cellular handsets to increase significantly in fiscal 2007. Likewise, the acquisition, along
with the additional investment required to grow this portion of our business globally, will result
in increased development and operating expenses.
As mobile technology continues to evolve and the installed base of both handheld game systems and
game-enabled cellular phones likely expands, we anticipate that sales of our titles for mobile
platforms for both handhelds and cellular handsets will become an increasingly important part
of our business.
International Expansion. We expect international sales to remain a fundamental part of our
business. As part of our international expansion strategy, we may seek to partner with established
local companies through acquisitions, joint ventures or other similar
33
arrangements. We are planning
to expand our development and business activities internationally. We believe that in order to
succeed internationally, it is important to locally develop content that is specifically directed
toward local cultures and consumers. As such, we expect to continue to devote resources to hiring
local development talent and expanding our infrastructure outside of North America, most notably,
through the expansion and creation of local studio facilities in Asia. In addition, we are in the
process of establishing online game marketing, publishing and distribution functions in China and
Singapore.
Sales of Hit Titles. Sales of hit titles, several of which were top
sellers in a number of countries, contributed significantly to our net revenue. Our top-selling
titles across all platforms worldwide during the three months ended
December 31, 2006 were Need
for Speed Carbon, FIFA 07, The Sims 2 Pets, Madden NFL 07, and Tiger
Woods PGA TOUR 07. Hit titles
are important to our financial performance because they benefit from overall economies of scale.
We have developed, and it is our objective to continue to develop, many of our hit titles to
become franchise titles that can be regularly iterated.
Increasing Licensing Costs. We generate a significant portion of our net revenue and operating
income from games based on licensed content such as Madden NFL Football, FIFA Soccer and Harry
Potter. We have recently entered into new licenses and renewed older licenses, some of which may
contain higher royalty rates or guarantees than similar license agreements we have entered into in
the past. We believe these licenses, and the product franchises they support, will continue to be
important to our future operations, but the higher costs of these licenses will negatively impact
our gross margins.
Foreign Currency Exchange Impact. Net revenue from international sales accounted for approximately
45 percent of our total net revenue during the first nine months of fiscal 2007 and approximately
46 percent of our total net revenue during the first nine months of fiscal 2006. Our international
net revenue was primarily driven by sales in Europe and, to a much lesser extent, in Asia.
Year-over-year, foreign exchange rates had a favorable impact on our net revenue of $33 million, or
1 percent, for the nine months ended December 31, 2006.
Acquisitions, Investments and Strategic Transactions. We have engaged in, evaluated, and expect to
continue to engage in and evaluate, a wide array of potential strategic transactions, including (1)
acquisitions of companies, businesses, intellectual properties, and other assets, and (2)
investments in new interactive entertainment businesses, such as online and mobile games. In
October 2006, the remaining outstanding shares of Digital Illusions C.E. (DICE) were purchased,
thereby completing the acquisition of the remaining minority interest of DICE. In July 2006, we
acquired Mythic as part of our efforts to accelerate our growth in the massively multiplayer online
role-playing market. In fiscal 2006, we acquired JAMDAT as part of our efforts to accelerate our
growth in mobile gaming.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Our Condensed Consolidated Financial Statements have been prepared in accordance with accounting
principles generally accepted in the United States. The preparation of these Condensed Consolidated
Financial Statements requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities, contingent assets and liabilities, and revenue and expenses
during the reporting periods. The policies discussed below are considered by management to be
critical because they are not only important to the portrayal of our financial condition and
results of operations but also because application and interpretation of these policies requires
both judgment and estimates of matters that are inherently uncertain and unknown. As a result,
actual results may differ materially from our estimates.
Revenue Recognition, Sales Returns, Allowances and Bad Debt Reserves
We principally derive revenue from sales of packaged interactive software games designed for play
on video game consoles (such as the PlayStation 3, Xbox 360 and Wii), PCs and mobile platforms
including handheld game players (such as the Sony PSP, Nintendo DS and Nintendo Game Boy Advance)
and cellular handsets. We evaluate the recognition of revenue based on the criteria set forth in
Statement of Position (SOP) 97-2, Software Revenue Recognition, as amended by SOP 98-9,
Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions and
Staff Accounting Bulletin (SAB) No. 101, Revenue Recognition in Financial Statements, as
revised by SAB No. 104, Revenue Recognition. We evaluate revenue recognition using the following
basic criteria and recognize revenue when all four of the following criteria are met:
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Evidence of an arrangement: Evidence of an agreement with the customer that reflects the
terms and conditions to deliver products must be present in order to recognize revenue. |
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Delivery: Delivery is considered to occur when the products are shipped and risk of loss
and reward have been transferred to the customer. For online games and services, revenue is
recognized as the service is provided. |
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Fixed or determinable fee: If a portion of the arrangement fee is not fixed or
determinable, we recognize revenue as the amount becomes fixed or determinable. |
34
|
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Collection is deemed probable: At the time of the transaction, we conduct a credit review
of each customer involved in a significant transaction to determine the creditworthiness of
the customer. Collection is deemed probable if we expect the customer to be able to pay
amounts under the arrangement as those amounts become due. If we determine that collection
is not probable, we recognize revenue when collection becomes probable (generally upon cash
collection). |
Determining whether and when some of these criteria have been satisfied often involves assumptions
and judgments that can have a significant impact on the timing and amount of revenue we report. For
example, for multiple element arrangements, we must make assumptions and judgments in order to: (1)
determine whether and when each element has been delivered; (2) determine whether undelivered
products or services are essential to the functionality of the delivered products and services; (3)
determine whether vendor-specific objective evidence of fair value (VSOE) exists for each
undelivered element; and (4) allocate the total price among the various elements we must deliver.
Changes to any of these assumptions or judgments, or changes to the elements in a software
arrangement, could cause a material increase or decrease in the amount of revenue that we report in
a particular period. For example, some of our packaged goods products are sold with online
services. Because we are able to determine VSOE for the online services to be delivered, we are
able to allocate the total price received from the combined product and online service sale between
these two elements and recognize the related revenue separately. However, starting in fiscal 2008,
VSOE will not exist for the online services to be delivered and all revenue from these transactions
will be recognized over the estimated online service period. Accordingly, this relatively small
change (from having VSOE for online hosting services to no longer having VSOE) will have a
significant effect on our reported results.
Product revenue, including sales to resellers and distributors (channel partners), is recognized
when the above criteria are met. We reduce product revenue for estimated future returns, price
protection, and other offerings, which may occur with our customers and channel partners. In
certain countries, we have stock-balancing programs for our PC and video game system products,
which allow for the exchange of these products by resellers under certain circumstances. It is our
general practice to exchange products or give credits rather than to give cash refunds.
In certain countries, from time to time, we decide to provide price protection for both our PC and
video game system products. When evaluating the adequacy of sales returns and price protection
allowances, we analyze historical returns, current sell-through of distributor and retailer
inventory of our products, current trends in the video game market and the overall economy, changes
in customer demand and acceptance of our products, and other related factors. In addition, we
monitor the volume of sales to our channel partners and their inventories, as substantial
overstocking in the distribution channel could result in high returns or higher price protection
costs in subsequent periods.
In the future, actual returns and price protections may materially exceed our estimates as unsold
products in the distribution channels are exposed to rapid changes in consumer preferences, market
conditions or technological obsolescence due to new platforms, product updates or competing
products. For example, the risk of product returns and/or price protection for our products may
continue to increase as the PlayStation 2 console moves through its lifecycle and an increasing
number and the aggregated amount of competitive products heighten pricing and competitive
pressures. While we believe we can make reliable estimates regarding these matters, these estimates
are inherently subjective. Accordingly, if our estimates changed, our returns and price protection
reserves would change, which would impact the total net revenue we report. For example, if actual
returns and/or price protection were significantly greater than the reserves we have established,
our actual results would decrease our reported total net revenue. Conversely, if actual returns
and/or price protection were significantly less than our reserves, this would increase our reported
total net revenue.
Determining whether a transaction constitutes an online service transaction or a download of a
product can be difficult; however, the accounting for these transactions is significantly
different. Revenue from product downloads is recognized when the download occurs assuming all other
recognition criteria are met. Revenue from online services is recognized as EAs
services are rendered. In addition, some of our online services do not have a defined service
period. In those situations, we recognize revenue over the estimated service period. Determining
the estimated service period is inherently subjective and is subject to regular revision based on
historical online usage.
Significant judgment is required to estimate our allowance for doubtful accounts in any accounting
period. We determine our allowance for doubtful accounts by evaluating customer creditworthiness in
the context of current economic trends and historical experience. Depending upon the overall
economic climate and the financial condition of our customers, the amount and timing of our bad
debt expense and cash collection could change significantly.
35
Royalties and Licenses
Our royalty expenses consist of payments to (1) content licensors, (2) independent software
developers, and (3) co-publishing and/or distribution affiliates. License royalties consist of
payments made to celebrities, professional sports organizations, movie studios and other
organizations for our use of their trademarks, copyrights, personal publicity rights, content
and/or other intellectual property. Royalty payments to independent software developers are
payments for the development of intellectual property related to our games. Co-publishing and
distribution royalties are payments made to third parties for delivery of product.
Royalty-based obligations with content licensors and distribution affiliates are either paid in
advance and capitalized as prepaid royalties or are accrued as incurred and subsequently paid.
These royalty-based obligations are generally expensed to cost of goods sold generally at the
greater of the contractual rate or an effective royalty rate based on expected net product sales.
Significant judgment is required to estimate the effective royalty rate for a particular contract.
Because the computation of effective royalty rates requires us to project future revenue, it is
inherently subjective as our future revenue projections must anticipate, for example, (1) the total
number of titles subject to the contract, (2) the timing of the release of these titles, (3) the
number of software units we expect to sell which can be impacted by a number of variables,
including product quality and competition, and (4) future pricing. Determining the effective
royalty rate for hit-based titles is particularly difficult due to the inherent risk of such
titles. Accordingly, if our future revenue projections change, our effective royalty rates would
change, which could impact the royalty expense we recognize. Prepayments made to thinly capitalized
independent software developers and co-publishing affiliates are generally in connection with the
development of a particular product and, therefore, we are generally subject to development risk
prior to the release of the product. Accordingly, payments that are due prior to completion of a
product are generally amortized to research and development over the development period as the
services are incurred. Payments due after completion of the product (primarily royalty-based in
nature) are generally expensed as cost of goods sold.
Our contracts with some licensors include minimum guaranteed royalty payments which are initially
recorded as an asset and as a liability at the contractual amount when no performance remains with
the licensor. When performance remains with the licensor, we record guarantee payments as an asset
when actually paid and as a liability when incurred, rather than recording the asset and liability
upon execution of the contract. Minimum royalty payment obligations are classified as current
liabilities to the extent such royalty payments are contractually due within the next twelve
months. As of December 31, 2006 and March 31, 2006, approximately $5 million and $9 million,
respectively, of minimum guaranteed royalty obligations had been recognized.
Each quarter, we also evaluate the future realization of our royalty-based assets as well as any
unrecognized minimum commitments not yet paid to determine amounts we deem unlikely to be realized
through product sales. Any impairments determined before the launch of a product are charged to
research and development expense. Impairments determined post-launch are charged to cost of goods
sold. In either case, we rely on estimated revenue to evaluate the future realization of prepaid
royalties and commitments. If actual sales or revised revenue estimates fall below the initial
revenue estimate, then the actual charge taken may be greater in any given quarter than
anticipated. We had no impairments during the three and nine months ended December 31, 2006 and
2005.
Valuation of Long-Lived Assets, including goodwill and other intangible assets
We evaluate both purchased intangible assets and other long-lived assets in order to determine if
events or changes in circumstances indicate a potential impairment in value exists. This evaluation
requires us to estimate, among other things, the
remaining useful lives of the assets and future cash flows of the business. These evaluations and
estimates require the use of judgment. Our actual results could differ materially from our current
estimates.
Under current accounting standards, we make judgments about the recoverability of purchased
intangible assets and other long-lived assets whenever events or changes in circumstances indicate
a potential impairment in the remaining value of the assets recorded on our Condensed Consolidated
Balance Sheets. In order to determine if a potential impairment has occurred, management makes
various assumptions about the future value of the asset by evaluating future business prospects and
estimated cash flows. Our future net cash flows are primarily dependent on the sale of products for
play on proprietary video game consoles, handheld game players, PCs, and cellular handsets
(platforms). The sales of our products are affected by our ability to accurately predict which
platforms and which products we develop will be successful. Also, our revenue and earnings are
dependent on our ability to meet our product release schedules. Due to product sales shortfalls, we
may not realize the future net cash flows necessary to recover our long-lived assets, which may
result in an impairment charge being recorded in the future. There were no impairment charges
recorded in the three and nine months ended December 31, 2006 and December 31, 2005.
36
SFAS No. 142, Goodwill and Other Intangible Assets requires at least an annual assessment for
impairment of goodwill by applying a fair-value-based test. A two-step approach is required to test
goodwill for impairment for each reporting unit. The first step tests for impairment by applying
fair value-based tests at the reporting unit level. The second step (if necessary) measures the
amount of impairment by applying fair value-based tests to individual assets and liabilities within
each reporting unit. Application of the goodwill impairment test requires judgment, including
identification of reporting units, assignment of assets and liabilities to reporting units,
assignment of goodwill to reporting units, and determination of the fair value of each reporting
unit. The fair value of each reporting unit is estimated using a discounted cash flow methodology
which requires significant judgment to estimate the future cash flows, determine the appropriate
discount rates, growth rates and other assumptions. The determination of fair value for each
reporting unit could be materially affected by changes in these estimates and assumptions which
could trigger impairment. In fiscal 2006, we completed the first step of the annual goodwill
impairment testing as of January 1, 2006 and found no indicators of impairment of our recorded
goodwill. We did not recognize an impairment loss on goodwill in fiscal 2006 or 2005. Future
impairment tests may result in a charge to earnings and there is a potential for a write-down of
goodwill in connection with the annual impairment test.
Stock-Based Compensation
On April 1, 2006, we adopted SFAS No. 123(R) and applied the provisions of SAB No. 107,
Share-Based Payment, on our adoption of SFAS No. 123(R). SFAS No. 123(R) requires that the cost
resulting from all share-based payment transactions be recognized in the financial statements using
a fair-value-based method. We elected to use the modified prospective transition method of
adoption. SFAS No. 123(R) requires us to measure compensation cost for all outstanding unvested
stock-based awards made to our employees and directors based on estimated fair values and recognize
compensation over the service period for awards expected to vest. We recognized $35 million and
$105 million of stock-based compensation related to employee stock options, restricted stock units,
restricted stock awards and our employee stock purchase plan (ESPP) for the three and nine months
ended December 31, 2006, respectively. We recognized less than $1 million and $1 million of
stock-based compensation related to employee restricted stock units and non-employee stock options
during the three and nine months ended December 31, 2005, respectively.
For options and ESPP, we use the Black-Scholes option valuation model to determine the grant date
fair value. The Black-Scholes option valuation model requires us to make certain assumptions about
the future. The determination of fair value is affected by our stock price as well as assumptions
regarding subjective and complex variables such as expected employee exercise behaviors and our
expected stock price volatility over the term of the award. Generally, our assumptions are based on
historical information and judgment is required to determine if historical trends may be indicators
of future outcomes. We estimated the following key assumptions for the Black-Scholes valuation
calculation:
|
|
|
Risk-free interest rate. The risk-free interest rate is based on U.S. Treasury yields in
effect at the time of grant for the expected term of the option. |
|
|
|
|
Expected volatility. We use our historical stock price volatility and consider the
implied volatility computed based on the price of short-term options publicly traded on our
common stock for our expected volatility assumption. |
|
|
|
|
Expected term. The expected term represents the weighted-average period the stock
options are expected to remain outstanding. The expected term is determined based on
historical exercise behavior, post-vesting termination patterns, options outstanding and
future expected exercise behavior. |
|
|
|
|
Expected dividends. |
As required by SFAS No. 123(R), employee stock-based compensation expense recognized in the three
and nine months ended December 31, 2006 was calculated based on awards ultimately expected to vest
and has been reduced for estimated forfeitures. Forfeitures are revised, if necessary, in
subsequent periods if actual forfeitures differ from those estimates and an adjustment will be
recognized at that time.
Changes to our underlying stock price, our assumptions used in the Black-Scholes option valuation
calculation and our forfeiture rate as well as future grants of equity could significantly impact
compensation expense to be recognized in fiscal 2007 and future periods.
37
Income Taxes
In the ordinary course of our business, there are many transactions and calculations where the tax
law and ultimate tax determination is uncertain. As part of the process of preparing our Condensed
Consolidated Financial Statements, we are required to estimate our income taxes in each of the
jurisdictions in which we operate prior to the completion and filing of tax returns for such
periods. This process requires estimating both our geographic mix of income and our current tax
exposures in each jurisdiction where we operate. These estimates involve complex issues, require
extended periods of time to resolve, and require us to make judgments, such as anticipating the
positions that we will take on tax returns prior to our actually preparing the returns and the
outcomes of disputes with tax authorities. We are also required to make determinations of the need
to record deferred tax liabilities and the recoverability of deferred tax assets. A valuation
allowance is established to the extent recovery of deferred tax assets is not likely based on our
estimation of future taxable income in each jurisdiction.
In addition, changes in our business, including acquisitions, changes in our international
corporate structure, changes in the geographic location of business functions or assets, changes in
the geographic mix and amount of income, as well as changes in our agreements with tax authorities,
valuation allowances, applicable accounting rules, applicable tax laws and regulations, rulings and
interpretations thereof, developments in tax audit and other matters, and variations in the
estimated and actual level of annual pre-tax income can affect the overall effective income tax
rate and result in a variance between the projected effective tax rate for any quarter and the
final effective tax rate for the fiscal year.
With respect to our projected annual effective income tax rate at the end of each quarter prior to
the end of a fiscal year, we are required to make a projection of several items, including our
projected mix of full-year income in each jurisdiction in which we operate and the related income
tax expense in each jurisdiction. While this projection is inherently uncertain, for fiscal 2007,
our projected tax rate is unusually volatile and subject to significantly greater variation.
RESULTS OF OPERATIONS
Our fiscal year is reported on a 52 or 53-week period that ends on the Saturday nearest March 31.
As a result, fiscal 2006 contained 53 weeks with the first quarter containing 14 weeks. Our results
of operations for the fiscal years ending March 31, 2007 and 2006 contain the following number of
weeks:
|
|
|
|
|
Fiscal Years Ended |
|
Number of Weeks |
|
Fiscal Period End Date |
March 31, 2007
|
|
52 weeks
|
|
March 31, 2007 |
March 31, 2006
|
|
53 weeks
|
|
April 1, 2006 |
|
Our results of operations for the three and nine months ended December 31, 2006 and 2005 contained
the following number of weeks:
|
|
Fiscal Period |
|
Number of Weeks |
|
Fiscal Period End Date |
Three months ended December 31, 2006
|
|
13 weeks
|
|
December 30, 2006 |
Nine months ended December 31, 2006
|
|
39 weeks
|
|
December 30, 2006 |
|
|
|
|
|
Three months ended December 31, 2005
|
|
13 weeks
|
|
December 31, 2005 |
Nine months ended December 31, 2005
|
|
40 weeks
|
|
December 31, 2005 |
For simplicity of disclosure purposes, all fiscal periods are referred to as ending on a calendar
month end.
Beginning in fiscal 2007, we adopted SFAS No. 123(R) and applied the provisions of SAB No. 107 to
our adoption of SFAS No. 123(R). We elected to use the modified prospective transition method of
adoption which requires that compensation expense be recognized in the financial statements for all
awards granted after the date of adoption as well as for existing awards for which the requisite
service has not been rendered as of the date of adoption. Accordingly, prior periods are not
restated for the effect of SFAS No. 123(R). Prior to our adoption of SFAS No. 123(R), we valued our
stock options based on the multiple-award valuation method and recognized the expense using the
accelerated approach over the requisite service period. In conjunction with our adoption of SFAS
No. 123(R), we changed our method of recognizing our stock-based compensation expense to the
straight-line approach over the requisite service period; however, we continue to value our stock
options based on the multiple-award valuation method.
38
Prior to fiscal 2007, we accounted for stock-based awards to employees using the intrinsic value
method in accordance with Accounting Principles Board No. 25, Accounting for Stock Issued to
Employees and adopted the disclosure-only provisions of SFAS No. 123, Accounting for Stock-Based
Compensation, as amended. Also, as required by SFAS No. 148, Accounting for Stock-Based
Compensation Transition and Disclosure, we provided pro forma net income and net income per
common share disclosures for stock-based awards as if the fair-value-based method defined in SFAS
No. 123 had been applied. As a result, prior periods are not restated for the effect of SFAS No.
123(R). Stock-based compensation expense for the three and nine months ended December 31, 2006 was
$35 million and $105 million, respectively. Stock-based compensation expense for the three and nine
months ended December 31, 2005 was less than $1 million and $1 million, respectively.
Net Revenue
We principally derive net revenue from sales of packaged interactive software games designed for
play on video game consoles (such as the PlayStation 3, PlayStation 2, Xbox 360 and Wii), PCs and
handheld game players (such as the Sony PSP, Nintendo DS and Nintendo Game Boy Advance) and
cellular handsets. We also derive net revenue from selling services in connection with some of our
online games, programming third-party web sites with our game content, allowing other companies to
manufacture and sell our products in conjunction with other products, and selling advertisements on
our online web pages and in our games.
From a geographical perspective, our total net revenue for the three and nine months ended December
31, 2006 and 2005 was as follows (in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended December 31, |
|
Increase / |
|
% |
|
|
2006 |
|
|
2005 |
|
|
(Decrease) |
|
Change |
|
|
|
|
|
|
|
|
|
North America |
|
$ |
637 |
|
|
|
50 |
% |
|
$ |
618 |
|
|
|
49 |
% |
|
$ |
19 |
|
|
|
3 |
% |
|
|
|
|
|
|
|
|
|
|
Europe |
|
|
583 |
|
|
|
45 |
% |
|
|
577 |
|
|
|
45 |
% |
|
|
6 |
|
|
|
1 |
% |
Asia |
|
|
61 |
|
|
|
5 |
% |
|
|
75 |
|
|
|
6 |
% |
|
|
(14 |
) |
|
|
(19 |
%) |
|
|
|
|
|
|
|
|
|
International |
|
|
644 |
|
|
|
50 |
% |
|
|
652 |
|
|
|
51 |
% |
|
|
(8 |
) |
|
|
(1 |
%) |
|
|
|
|
|
|
|
|
|
Total Net Revenue |
|
$ |
1,281 |
|
|
|
100 |
% |
|
$ |
1,270 |
|
|
|
100 |
% |
|
$ |
11 |
|
|
|
1 |
% |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Nine Months Ended December 31, |
|
Increase / |
|
% |
|
|
2006 |
|
|
2005 |
|
|
(Decrease) |
|
Change |
|
|
|
|
|
|
|
|
|
North America |
|
$ |
1,359 |
|
|
|
55 |
% |
|
$ |
1,245 |
|
|
|
54 |
% |
|
$ |
114 |
|
|
|
9 |
% |
|
|
|
|
|
|
|
|
|
|
Europe |
|
|
997 |
|
|
|
40 |
% |
|
|
912 |
|
|
|
39 |
% |
|
|
85 |
|
|
|
9 |
% |
Asia |
|
|
122 |
|
|
|
5 |
% |
|
|
153 |
|
|
|
7 |
% |
|
|
(31 |
) |
|
|
(20 |
%) |
|
|
|
|
|
|
|
|
|
International |
|
|
1,119 |
|
|
|
45 |
% |
|
|
1,065 |
|
|
|
46 |
% |
|
|
54 |
|
|
|
5 |
% |
|
|
|
|
|
|
|
|
|
Total Net Revenue |
|
$ |
2,478 |
|
|
|
100 |
% |
|
$ |
2,310 |
|
|
|
100 |
% |
|
$ |
168 |
|
|
|
7 |
% |
|
|
|
|
|
|
|
|
|
North America
For the three months ended December 31, 2006, net revenue in North America was $637 million, driven
primarily by (1) sales of Need for Speed Carbon, which was released during the three months ended
December 31, 2006, (2) sales of Madden NFL 07, which was released during the second quarter of
fiscal 2007, and (3) growth in our cellular handset games business resulting from our acquisition
of JAMDAT on February 15, 2006. Overall, net revenue increased $19 million, or 3 percent, as
compared to the three months ended December 31, 2005.
The increase in net revenue for the three months ended December 31, 2006, as compared to the three
months ended December 31, 2005 was primarily driven by (1) a $51 million increase in
catalog(a) net revenue, (2) a $26 million increase in cellular handset net revenue, and
(3) an $8 million increase in subscription services net revenue. These increases were partially
offset by (1) a $48 million decrease in frontline(b) net revenue primarily due to lower
sales in our Harry Potter franchise as we did not have a title release during the three months
ended December 31, 2006 and (2) a $19 million decrease in net revenue from co-publishing and
distribution products.
39
For the nine months ended December 31, 2006, net revenue in North America was $1,359 million,
driven primarily by (1) sales of Madden NFL 07, Need for Speed Carbon and NCAA® Football
07 and (2) growth in our cellular handset games business resulting from our acquisition of JAMDAT.
Overall, net revenue increased $114 million, or 9 percent, as compared to the nine months ended
December 31, 2005.
The increase in net revenue for the nine months ended December 31, 2006, as compared to the nine
months ended December 31, 2005 was primarily driven by (1) a $79 million increase in cellular
handset net revenue and (2) a $67 million increase in catalog net revenue. These increases were
partially offset by a $36 million decrease in frontline net revenue.
|
(a) |
|
We refer to catalog net revenue as net revenue derived from an EA Studio SKU (a
version of a title designed for play on a particular platform) for consoles, PC, PSP,
Nintendo DS, and Game Boy Advance subsequent to the fiscal period in which the SKU was
released. |
|
|
(b) |
|
We refer to frontline net revenue as net revenue derived from an EA Studio SKU
for consoles, PC, PSP, Nintendo DS, and Game Boy Advance during the fiscal period the SKU
was released. |
Europe
For the three months ended December 31, 2006, net revenue in Europe was $583 million, driven
primarily by sales of Need for Speed Carbon, FIFA 07, and The Sims 2 Pets. Overall, net revenue
increased $6 million, or 1 percent, as compared to the three months ended December 31, 2005. We
estimate that foreign exchange rates (primarily the Euro and the British pound sterling) increased
reported European net revenue by approximately $35 million, or 6 percent, for the three months
ended December 31, 2006 as compared to the three months ended December 31, 2005. Excluding the
effect of foreign exchange rates, we estimate that European net revenue decreased by approximately
$29 million, or 5 percent, for the three months ended December 31, 2006.
The overall increase in net revenue of $6 million for the three months ended December 31, 2006, as
compared to the three months ended December 31, 2005 was driven primarily by (1) a $12 million
increase in frontline net revenue, (2) a $10 million increase in catalog net revenue,
and (3) an $8 million increase in cellular handset net revenue. These increases were partially
offset by a $26 million decrease in co-publishing and distribution net revenue.
For the nine months ended December 31, 2006, net revenue in Europe was $997 million, driven
primarily by sales of FIFA 07, Need for Speed Carbon, and The Sims 2 Pets. Overall, net revenue
increased $85 million, or 9 percent, as compared to the nine months ended December 31, 2005. We
estimate that foreign exchange rates (primarily the Euro and the British pound sterling) increased
reported European net revenue by approximately $38 million, or 4 percent, for the nine months ended
December 31, 2006 as compared to the nine months ended December 31, 2005. Excluding the effect of
foreign exchange rates, we estimate that European net revenue increased by approximately $47
million, or 5 percent, for the nine months ended December 31, 2006.
The increase in net revenue for the nine months ended December 31, 2006, as compared to the nine
months ended December 31, 2005 was driven primarily by (1) a $67 million increase in catalog
net revenue and (2) a $19 million increase in cellular handset net revenue.
Asia
For the three months ended December 31, 2006, net revenue in Asia decreased by $14 million, or 19
percent, as compared to the three months ended December 31, 2005. The decrease in net revenue for
the three months ended December 31, 2006 was driven primarily by (1) lower sales of co-publishing
and distribution titles of $6 million and (2) a $6 million decrease in frontline net revenue.
For the nine months ended December 31, 2006, net revenue in Asia decreased by $31 million, or 20
percent, as compared to the nine months ended December 31, 2005. The decrease in net revenue for
the nine months ended December 31, 2006 was driven primarily by (1) a $21 million decrease in
frontline net revenue and (2) a $16 million decrease in co-publishing and distribution net revenue.
These decreases were partially offset by an $8 million increase in catalog net revenue. We estimate
that changes in foreign exchange rates decreased reported net revenue in Asia by approximately $5
million, or 3 percent, for the nine months ended December 31, 2006. Excluding the effect of foreign
exchange rates, we estimate that Asia net revenue decreased by approximately $26 million, or 17
percent, for the nine months ended December 31, 2006 as compared to the nine months ended December
31, 2005.
40
Our total net revenue by product line for the three and nine months ended December 31, 2006 and
2005 was as follows (in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended December 31, |
|
Increase/ |
|
% |
|
|
2006 |
|
2005 |
|
(Decrease) |
|
Change |
Consoles |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
PlayStation 2 |
|
$ |
400 |
|
|
|
31 |
% |
|
$ |
495 |
|
|
|
39 |
% |
|
$ |
(95 |
) |
|
|
(19 |
%) |
Xbox 360 |
|
|
172 |
|
|
|
13 |
% |
|
|
76 |
|
|
|
6 |
% |
|
|
96 |
|
|
|
126 |
% |
Xbox |
|
|
62 |
|
|
|
5 |
% |
|
|
152 |
|
|
|
12 |
% |
|
|
(90 |
) |
|
|
(59 |
%) |
PlayStation 3 |
|
|
41 |
|
|
|
3 |
% |
|
|
|
|
|
|
|
|
|
|
41 |
|
|
|
N/M |
|
Nintendo GameCube |
|
|
32 |
|
|
|
3 |
% |
|
|
69 |
|
|
|
5 |
% |
|
|
(37 |
) |
|
|
(54 |
%) |
Wii |
|
|
29 |
|
|
|
2 |
% |
|
|
|
|
|
|
|
|
|
|
29 |
|
|
|
N/M |
|
Other Consoles |
|
|
|
|
|
|
|
|
|
|
1 |
|
|
|
|
|
|
|
(1 |
) |
|
|
(100 |
%) |
|
|
|
|
|
|
|
|
|
Total Consoles |
|
|
736 |
|
|
|
57 |
% |
|
|
793 |
|
|
|
62 |
% |
|
|
(57 |
) |
|
|
(7 |
%) |
PC |
|
|
218 |
|
|
|
17 |
% |
|
|
148 |
|
|
|
12 |
% |
|
|
70 |
|
|
|
47 |
% |
Mobility |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
PSP |
|
|
118 |
|
|
|
9 |
% |
|
|
120 |
|
|
|
9 |
% |
|
|
(2 |
) |
|
|
(2 |
%) |
Nintendo DS |
|
|
55 |
|
|
|
4 |
% |
|
|
36 |
|
|
|
3 |
% |
|
|
19 |
|
|
|
53 |
% |
Game Boy Advance |
|
|
21 |
|
|
|
2 |
% |
|
|
35 |
|
|
|
3 |
% |
|
|
(14 |
) |
|
|
(40 |
%) |
Cellular Handsets |
|
|
35 |
|
|
|
3 |
% |
|
|
1 |
|
|
|
|
|
|
|
34 |
|
|
|
N/M |
|
|
|
|
|
|
|
|
|
|
Total Mobility |
|
|
229 |
|
|
|
18 |
% |
|
|
192 |
|
|
|
15 |
% |
|
|
37 |
|
|
|
19 |
% |
Co-publishing and Distribution |
|
|
49 |
|
|
|
4 |
% |
|
|
99 |
|
|
|
8 |
% |
|
|
(50 |
) |
|
|
(51 |
%) |
Internet Services, Licensing and Other |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Subscription Services |
|
|
24 |
|
|
|
2 |
% |
|
|
16 |
|
|
|
1 |
% |
|
|
8 |
|
|
|
50 |
% |
Licensing, Advertising and Other |
|
|
25 |
|
|
|
2 |
% |
|
|
22 |
|
|
|
2 |
% |
|
|
3 |
|
|
|
14 |
% |
|
|
|
|
|
|
|
|
|
Total Internet Services, Licensing and Other |
|
|
49 |
|
|
|
4 |
% |
|
|
38 |
|
|
|
3 |
% |
|
|
11 |
|
|
|
29 |
% |
|
|
|
|
|
|
|
|
|
Total Net Revenue |
|
$ |
1,281 |
|
|
|
100 |
% |
|
$ |
1,270 |
|
|
|
100 |
% |
|
$ |
11 |
|
|
|
1 |
% |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Nine Months Ended December 31, |
|
Increase/ |
|
% |
|
|
2006 |
|
2005 |
|
(Decrease) |
|
Change |
Consoles |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
PlayStation 2 |
|
$ |
769 |
|
|
|
31 |
% |
|
$ |
916 |
|
|
|
40 |
% |
|
$ |
(147 |
) |
|
|
(16 |
%) |
Xbox 360 |
|
|
399 |
|
|
|
16 |
% |
|
|
76 |
|
|
|
3 |
% |
|
|
323 |
|
|
|
425 |
% |
Xbox |
|
|
150 |
|
|
|
6 |
% |
|
|
332 |
|
|
|
14 |
% |
|
|
(182 |
) |
|
|
(55 |
%) |
Nintendo GameCube |
|
|
56 |
|
|
|
2 |
% |
|
|
118 |
|
|
|
5 |
% |
|
|
(62 |
) |
|
|
(53 |
%) |
PlayStation 3 |
|
|
41 |
|
|
|
2 |
% |
|
|
|
|
|
|
|
|
|
|
41 |
|
|
|
N/M |
|
Wii |
|
|
29 |
|
|
|
1 |
% |
|
|
|
|
|
|
|
|
|
|
29 |
|
|
|
N/M |
|
Other Consoles |
|
|
|
|
|
|
|
|
|
|
1 |
|
|
|
|
|
|
|
(1 |
) |
|
|
(100 |
%) |
|
|
|
|
|
|
|
|
|
Total Consoles |
|
|
1,444 |
|
|
|
58 |
% |
|
|
1,443 |
|
|
|
62 |
% |
|
|
1 |
|
|
|
|
|
PC |
|
|
370 |
|
|
|
15 |
% |
|
|
313 |
|
|
|
14 |
% |
|
|
57 |
|
|
|
18 |
% |
Mobility |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
PSP |
|
|
219 |
|
|
|
9 |
% |
|
|
197 |
|
|
|
9 |
% |
|
|
22 |
|
|
|
11 |
% |
Nintendo DS |
|
|
77 |
|
|
|
3 |
% |
|
|
56 |
|
|
|
2 |
% |
|
|
21 |
|
|
|
38 |
% |
Game Boy Advance |
|
|
35 |
|
|
|
2 |
% |
|
|
48 |
|
|
|
2 |
% |
|
|
(13 |
) |
|
|
(27 |
%) |
Cellular Handsets |
|
|
104 |
|
|
|
4 |
% |
|
|
4 |
|
|
|
|
|
|
|
100 |
|
|
|
N/M |
|
|
|
|
|
|
|
|
|
|
Total Mobility |
|
|
435 |
|
|
|
18 |
% |
|
|
305 |
|
|
|
13 |
% |
|
|
130 |
|
|
|
43 |
% |
Co-publishing and Distribution |
|
|
130 |
|
|
|
5 |
% |
|
|
161 |
|
|
|
7 |
% |
|
|
(31 |
) |
|
|
(19 |
%) |
Internet Services, Licensing and Other |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Subscription Services |
|
|
55 |
|
|
|
2 |
% |
|
|
45 |
|
|
|
2 |
% |
|
|
10 |
|
|
|
22 |
% |
Licensing, Advertising and Other |
|
|
44 |
|
|
|
2 |
% |
|
|
43 |
|
|
|
2 |
% |
|
|
1 |
|
|
|
2 |
% |
|
|
|
|
|
|
|
|
|
Total Internet Services, Licensing and Other |
|
|
99 |
|
|
|
4 |
% |
|
|
88 |
|
|
|
4 |
% |
|
|
11 |
|
|
|
13 |
% |
|
|
|
|
|
|
|
|
|
Total Net Revenue |
|
$ |
2,478 |
|
|
|
100 |
% |
|
$ |
2,310 |
|
|
|
100 |
% |
|
$ |
168 |
|
|
|
7 |
% |
|
|
|
|
|
|
|
|
|
41
PlayStation 2
For the three months ended December 31, 2006, net revenue from sales of titles for the PlayStation
2 was $400 million, driven primarily by sales of Need for Speed Carbon, FIFA 07, The Sims 2 Pets,
and Madden NFL 07. Overall, PlayStation 2 net revenue decreased $95 million, or 19 percent,
compared to the three months ended December 31, 2005. Although we are unable to specifically
quantify the impact, we believe the decrease was primarily due to the transition to next-generation
consoles.
For the nine months ended December 31, 2006, net revenue from sales of titles for the PlayStation 2
was $769 million, driven primarily by sales of Madden NFL 07, Need for Speed Carbon, and FIFA 07.
Overall, PlayStation 2 net revenue decreased $147 million, or 16 percent, compared to the nine
months ended December 31, 2005. Although we are unable to specifically quantify the impact, we
believe the decrease was primarily due to the transition to next-generation consoles.
We expect PlayStation 2 related net revenue to continue to decline as consumers increasingly
migrate to new platforms.
Xbox 360
The Xbox 360 was launched in North America, Europe and Japan during the three months ended December
31, 2005 and in the rest of Asia during the three months ended March 31, 2006. Net revenue from
sales of titles for the Xbox 360 was $172 million for the three months ended December 31, 2006,
driven by sales of Need for Speed Carbon, FIFA 07, and Tiger Woods PGA TOUR 07.
For the nine months ended December 31, 2006, net revenue from sales of titles for the Xbox 360 was
$399 million driven by sales of Madden NFL 07, Need for Speed Carbon, FIFA 07, and NCAA Football
07.
We expect net revenue from sales of titles for the Xbox 360 to increase as the installed base grows
and we release more titles.
Xbox
For the three months ended December 31, 2006, net revenue from sales of titles for the Xbox was $62
million, driven primarily by sales of Need for Speed Carbon, FIFA 07, and Madden NFL 07. Overall,
Xbox net revenue decreased $90 million, or 59 percent, as compared to the three months ended
December 31, 2005. Although we are unable to specifically quantify the impact, we believe the
decrease was primarily due to the transition to next-generation consoles.
For the nine months ended December 31, 2006, net revenue from sales of titles for the Xbox was $150
million, driven primarily by sales of Madden NFL 07, Need for Speed Carbon, NCAA Football 07, and
FIFA 07. Overall, Xbox net revenue decreased $182 million, or 55 percent, as compared to the nine
months ended December 31, 2005. Although we are unable to specifically quantify the impact, we
believe the decrease was primarily due to the transition to next-generation consoles.
We expect Xbox related net revenue to continue to decline as consumers increasingly migrate to new
platforms.
Nintendo GameCube
For the three months ended December 31, 2006, net revenue from sales of titles for the Nintendo
GameCube was $32 million, driven primarily by sales of Need for Speed Carbon, The Sims 2 Pets, FIFA
07, and Madden NFL 07. Overall, Nintendo GameCube net revenue decreased $37 million, or 54 percent,
as compared to the three months ended December 31, 2005. Although we are unable to specifically
quantify the impact, we believe the decrease was primarily due to the transition to next-generation
consoles.
For the nine months ended December 31, 2006, net revenue from sales of titles for the Nintendo
GameCube was $56 million, driven primarily by sales of Madden NFL 07, Need for Speed Carbon, FIFA
07, and The Sims 2 Pets. Overall, Nintendo GameCube net revenue decreased $62 million, or 53
percent, as compared to the nine months ended December 31, 2005. Although we are unable to quantify
the impact, we believe the decrease was primarily due to the transition to next-generation
consoles.
We expect Nintendo GameCube related net revenue to continue to decline as consumers increasingly
migrate to new platforms.
42
PlayStation 3
The PlayStation 3 launched in North America and Japan during the three months ended December 31,
2006. Net revenue from sales of titles for the PlayStation 3 was $41 million for the three and nine
months ended December 31, 2006, driven by sales of Madden NFL 07 and Need for Speed Carbon.
We expect net revenue from sales of titles for the PlayStation 3 to increase as the installed base
grows and we release more titles.
Wii
The Wii launched in North America, Europe and Japan during the three months ended December 31,
2006. Net revenue from sales of titles for the Wii was $29 million for the three and nine months
ended December 31, 2006, driven by sales of Need for Speed Carbon and Madden NFL 07.
We expect net revenue from sales of titles for the Wii to increase as the installed base grows and
we release more titles.
PC
For the three months ended December 31, 2006, net revenue from sales of titles for the PC was $218
million driven primarily by sales of titles from The Sims and Battlefield franchises. Overall, PC
net revenue increased $70 million, or 47 percent, as compared to the three months ended December
31, 2005. The increase was driven primarily by a $72 million increase in frontline net revenue.
For the nine months ended December 31, 2006, net revenue from sales of titles for the PC was $370
million driven primarily by sales of titles from The Sims and Battlefield franchises. Overall, PC
net revenue increased $57 million, or 18 percent, as compared to the nine months ended December 31,
2005. The increase was due to a $48 million increase in catalog net revenue and a $9 million
increase in frontline net revenue.
Mobile Platforms
Net revenue from mobile products, which consist of packaged goods games for handheld systems and
downloadable games for cellular handsets, increased from $192 million in the three months ended
December 31, 2005 to $229 million in the three months ended December 31, 2006. The increase was
primarily due to $34 million year-over-year growth in our cellular handset games business resulting
from our acquisition of JAMDAT and $19 million increased net revenue from sales of titles for the
Nintendo DS. These increases were partially offset by a $14 million decrease in net revenue from
titles for the Game Boy Advance.
Net revenue from mobile products increased from $305 million in the nine months ended December 31,
2005 to $435 million in the nine months ended December 31, 2006. The increase was primarily due to
a $100 million year-over-year growth in our cellular handset games business resulting from our
acquisition of JAMDAT and an increase in net revenue from sales of titles for the PSP and the
Nintendo DS totaling $43 million.
Co-Publishing and Distribution
Net revenue from co-publishing and distribution products decreased from $99 million in the three
months ended December 31, 2005 to $49 million in the three months ended December 31, 2006. The
decrease was primarily due to (1) a $16 million decrease in sales of Black & White 2, (2) a $15
million decrease in sales of the Half-Life franchise, and (3) an $8 million decrease in sales of
Resident Evil® 4.
Net revenue from co-publishing and distribution products decreased from $161 million in the nine
months ended December 31, 2005 to $130 million in the nine months ended December 31, 2006. The
decrease was primarily due to (1) a $14 million decrease in sales of Black & White 2 and (2) a $7
million decrease in sales of Resident Evil 4.
Cost of Goods Sold
Cost of goods sold for our packaged-goods business consists of (1) product costs, (2) certain
royalty expenses for celebrities, professional sports and other organizations and independent
software developers, (3) manufacturing royalties, net of volume
43
discounts and other vendor
reimbursements, (4) expenses for defective products, (5) write-offs of post-launch prepaid royalty
costs, (6) amortization of certain intangible assets, and (7) operational expenses. Volume
discounts are generally recognized upon achievement of milestones and vendor reimbursements are
generally recognized as the related revenue is recognized. Cost of goods sold for our online
products consists primarily of data center and bandwidth costs associated with hosting our web
sites, credit card fees and royalties for use of third-party properties. Cost of goods sold for our
web site advertising business primarily consists of ad-serving costs.
Cost of goods sold for the three and nine months ended December 31, 2006 and 2005 were as follows
(in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Change as a % |
|
|
December 31, |
|
% of Net |
|
December 31, |
|
% of Net |
|
|
|
|
|
of Net |
|
|
2006 |
|
Revenue |
|
2005 |
|
Revenue |
|
% Change |
|
Revenue |
|
|
|
Three months ended |
|
$ |
470 |
|
|
|
36.7 |
% |
|
$ |
502 |
|
|
|
39.5 |
% |
|
|
(6.4 |
%) |
|
|
(2.8 |
%) |
|
|
|
Nine months ended |
|
$ |
977 |
|
|
|
39.4 |
% |
|
$ |
937 |
|
|
|
40.6 |
% |
|
|
4.3 |
% |
|
|
(1.2 |
%) |
|
|
|
For the three months ended December 31, 2006, cost of goods sold decreased by 2.8 percentage points
as a percentage of total net revenue as compared to the three months ended December 31, 2005. This
decrease was primarily due to:
|
|
|
Lower average product costs as a percentage of total net revenue primarily driven by (1)
fewer returns and less price protection taken, or expected to be taken, during the three
months ended December 31, 2006 as compared to the three months ended December 31, 2005 and
(2) our acquisition of JAMDAT in February 2006 which created a higher mix of cellular
handset net revenue in the three months ended December 31, 2006. We estimate average
product costs as a percentage of total net revenue decreased by approximately 3 percent in
the three months ended December 31, 2006 as compared to the three months ended December 31,
2005; and |
|
|
|
|
Lower royalty costs of approximately 1 percent as a percentage of total net revenue
primarily due to lower co-publishing and distribution royalties for titles in the three
months ended December 31, 2006 as compared to the three months ended December 31, 2005. |
As a percentage of total net revenue, the decreases above were partially offset by an approximate 1
percent increase in amortization of intangibles during the three months ended December 31, 2006 as
compared to the three months ended December 31, 2005 primarily due to our acquisition of JAMDAT.
For the nine months ended December 31, 2006, cost of goods sold decreased by 1.2 percentage points
as a percentage of total net revenue as compared to the nine months ended December 31, 2005. This
decrease was primarily due to lower average product costs as a percentage of total net revenue
primarily driven by (1) fewer returns and less price protection taken, or expected to be taken,
during the nine months ended December 31, 2006 as compared to the nine months ended December 31,
2005 and (2) our acquisition of JAMDAT in February 2006 which created a higher mix of cellular
handset net revenue in the nine months ended December 31, 2006. We estimate average product costs
as a percentage of total net revenue decreased by approximately 3 percent in the nine months ended
December 31, 2006 as compared to the nine months ended December 31, 2005.
As a percentage of total net revenue, the decrease in average product costs was partially offset by
an estimated 2 percent increase in license royalties during the nine months ended December 31, 2006
as compared to the nine months ended December 31, 2005 primarily due to new license agreements
associated with our EA SPORTS titles and from our acquisition of JAMDAT.
Cost of goods sold as a percentage of total net revenue is difficult to predict. In the short-term,
we expect gross margin pressure as a result of (1) a decrease in average selling prices of titles
for current-generation platforms, (2) higher license royalty rates, and (3) amortization of our
newly-acquired intangible assets.
Marketing and Sales
Marketing and sales expenses consist of personnel-related costs and advertising, marketing and
promotional expenses, net of qualified advertising cost reimbursements from third parties.
44
Marketing and sales expenses for the three and nine months ended December 31, 2006 and 2005 were as
follows (in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
December 31, |
|
% of Net |
|
December 31, |
|
% of Net |
|
|
|
|
|
|
2006 |
|
Revenue |
|
2005 |
|
Revenue |
|
$ Change |
|
% Change |
|
|
|
Three months ended |
|
$ |
165 |
|
|
|
13 |
% |
|
$ |
147 |
|
|
|
12 |
% |
|
$ |
18 |
|
|
|
12 |
% |
|
|
|
Nine months ended |
|
$ |
350 |
|
|
|
14 |
% |
|
$ |
329 |
|
|
|
14 |
% |
|
$ |
21 |
|
|
|
6 |
% |
|
|
|
For the three months ended December 31, 2006, marketing and sales expenses increased by $18
million, or 12 percent, as compared to the three months ended December 31, 2005 primarily due to
(1) an increase of $10 million in our annual bonus expense, (2) an increase of $5 million in
stock-based compensation expense recognized as a result of our adoption of SFAS No. 123(R), and (3)
$5 million in additional personnel-related costs resulting from an increase in headcount.
For the nine months ended December 31, 2006, marketing and sales expenses increased by $21 million,
or 6 percent, as compared to the nine months ended December 31, 2005 primarily due to (1) an
increase of $14 million in stock-based compensation expense recognized as a result of our adoption
of SFAS No. 123(R), (2) an increase of $13 million in our annual bonus expense, and (3) $6 million
in additional personnel-related costs resulting from an increase in headcount. These increases were
partially offset by a decrease of $15 million in our marketing, advertising, promotional and
related contracted services as a result of higher advertising spend in the prior year to support
our product releases, primarily for our Harry Potter and Burnout franchises.
General and Administrative
General and administrative expenses consist of personnel and related expenses of executive and
administrative staff, fees for professional services such as legal and accounting, and allowances
for doubtful accounts.
General and administrative expenses for the three and nine months ended December 31, 2006 and 2005
were as follows (in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
December 31, |
|
% of Net |
|
December 31, |
|
% of Net |
|
|
|
|
|
|
2006 |
|
Revenue |
|
2005 |
|
Revenue |
|
$ Change |
|
% Change |
|
|
|
Three months ended |
|
$ |
91 |
|
|
|
7 |
% |
|
$ |
58 |
|
|
|
5 |
% |
|
$ |
33 |
|
|
|
57 |
% |
|
|
|
Nine months ended |
|
$ |
222 |
|
|
|
9 |
% |
|
$ |
160 |
|
|
|
7 |
% |
|
$ |
62 |
|
|
|
39 |
% |
|
|
|
For the three months ended December 31, 2006, general and administrative expenses increased by $33
million, or 57 percent, as compared to the three months ended December 31, 2005 primarily due to
(1) a $12 million increase in our annual bonus expense, (2) a $10 million increase in stock-based
compensation expense recognized as a result of our adoption of SFAS No. 123(R), and (3) an increase
of $8 million in professional and contracted services in support of our technology infrastructure.
For the nine months ended December 31, 2006, general and administrative expenses increased by $62
million, or 39 percent, as compared to the nine months ended December 31, 2005 due to (1) an
increase of $30 million in stock-based compensation expense recognized as a result of our adoption
of SFAS No. 123(R), (2) a $12 million increase in our annual bonus expense, and (3) an increase of
$9 million in professional and contracted services in support of our technology infrastructure.
Research and Development
Research and development expenses consist of expenses incurred by our production studios for
personnel-related costs, contracted services, equipment depreciation and any impairment of prepaid
royalties for pre-launch products. Research and development expenses for our online business
include expenses incurred by our studios consisting of direct development and related overhead
costs in connection with the development and production of our online games. Research and
development expenses also include expenses associated with the development of web site content,
network infrastructure direct expenses, software licenses and maintenance, and network and
management overhead.
45
Research and development expenses for the three and nine months ended December 31, 2006 and 2005
were as follows (in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
December 31, |
|
% of Net |
|
December 31, |
|
% of Net |
|
|
|
|
|
|
2006 |
|
Revenue |
|
2005 |
|
Revenue |
|
$ Change |
|
% Change |
|
|
|
Three months ended |
|
$ |
330 |
|
|
|
26 |
% |
|
$ |
206 |
|
|
|
16 |
% |
|
$ |
124 |
|
|
|
60 |
% |
|
|
|
Nine months ended |
|
$ |
783 |
|
|
|
32 |
% |
|
$ |
571 |
|
|
|
25 |
% |
|
$ |
212 |
|
|
|
37 |
% |
|
|
|
For the three months ended December 31, 2006, research and development expenses increased by $124
million, or 60 percent, as compared to the three months ended December 31, 2005. The increase was
primarily due to (1) a $52 million increase in our annual bonus expense, (2) $28 million in
additional personnel-related costs, primarily due to an increase in headcount resulting from our
acquisitions of JAMDAT and Mythic, and to support development for next-generation consoles, (3) $20
million of stock-based compensation expense recognized as a result of our adoption of SFAS No.
123(R), (4) an increase of $17 million in external development expenses primarily due to a greater
number of projects in development as compared to the prior year, and (5) an increase of $10 million
in facilities-related expenses in support of our research and development functions worldwide.
For the nine months ended December 31, 2006, research and development expenses increased by $212
million, or 37 percent, as compared to the nine months ended December 31, 2005. The increase was
primarily due to (1) a $65 million increase in our annual bonus expense, (2) an increase of $59
million in stock-based compensation expense recognized as a result of our adoption of SFAS No.
123(R), (3) $50 million in additional personnel-related costs, primarily due to an increase in
headcount resulting from our acquisitions of JAMDAT and Mythic, and to support development for
next-generation consoles, (4) an increase of $32 million in external development expenses primarily
due to a greater number of projects in development as compared to the prior year as well as
expenses in our cellular handset business resulting from our acquisition of JAMDAT, and (5) an
increase of $24 million in facilities-related expenses in support of our research and development
functions worldwide.
We expect research and development expenses to increase in absolute dollars for the fourth quarter
fiscal 2007 as compared to the fourth quarter of fiscal 2006 primarily as a result of (1) our
recognition of stock-based compensation expense and (2) our investment in developing titles for
next-generation consoles, online and mobile platforms.
Amortization of Intangibles
Amortization of intangibles for the three and nine months ended December 31, 2006 and 2005 were as
follows (in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
December 31, |
|
% of Net |
|
December 31, |
|
% of Net |
|
|
|
|
|
|
2006 |
|
Revenue |
|
2005 |
|
Revenue |
|
$ Change |
|
% Change |
|
|
|
Three months ended |
|
$ |
7 |
|
|
|
1 |
% |
|
$ |
1 |
|
|
|
|
|
|
$ |
6 |
|
|
|
600 |
% |
|
|
|
Nine months ended |
|
$ |
20 |
|
|
|
1 |
% |
|
$ |
3 |
|
|
|
|
|
|
$ |
17 |
|
|
|
567 |
% |
|
|
|
For the three and nine months ended December 31, 2006, amortization of intangibles increased by $6
million and $17 million, respectively, as compared to the three and nine months ended December 31,
2005. These increases were primarily due to the amortization of intangibles related to our
acquisition of JAMDAT.
We expect amortization expenses of intangible assets to increase in fiscal 2007 as compared to
fiscal 2006 primarily due to the amortization of intangibles related to our JAMDAT and Mythic
acquisitions.
Acquired In-process Technology
The acquired in-process technology charges we incurred for the three and nine months ended December
31, 2006 of $1 million and $3 million, respectively, were the result of the acquisitions of Mythic
and the remaining minority interest in DICE. Acquired in-process technology charges incurred during
the three and nine months ended December 31, 2005 were zero and less than $1 million, respectively.
Acquired in-process technology includes the value of products in the development stage that are not
considered to have reached technological feasibility or have an alternative future use.
Accordingly, upon consummation of the acquisitions of Mythic and the remaining minority interest in
DICE, we incurred a charge for the acquired in-process technology
46
as reflected in our Condensed
Consolidated Statements of Operations. See Note 4 of the Notes to Condensed Consolidated Financial
Statements.
Restructuring Charges
Restructuring charges for three and nine months ended December 31, 2006 and 2005 were as follows
(in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
December 31, |
|
% of Net |
|
December 31, |
|
% of Net |
|
|
|
|
|
|
2006 |
|
Revenue |
|
2005 |
|
Revenue |
|
$ Change |
|
% Change |
|
|
|
Three months ended |
|
$ |
2 |
|
|
|
|
|
|
$ |
9 |
|
|
|
1 |
% |
|
$ |
(7 |
) |
|
|
(78 |
%) |
|
|
|
Nine months ended |
|
$ |
12 |
|
|
|
|
|
|
$ |
9 |
|
|
|
|
|
|
$ |
3 |
|
|
|
33 |
% |
|
|
|
In November 2005, we announced plans to establish an international publishing headquarters in
Geneva, Switzerland. Through our quarter ended September 30, 2006, we relocated certain employees
to our new facility in Geneva, closed certain facilities in the U.K., and made other related
changes in our international publishing business. During the three months ended December 31, 2006,
restructuring charges were approximately $2 million for employee-related expenses. During the nine
months ended December 31, 2006, restructuring charges were approximately $12 million, of which $8
million was for employee-related expenses. We incurred restructuring charges of $9 million during
the three and nine months ended December 31, 2005, of which $7 million for the closure of certain
U.K. facilities.
For the remainder of fiscal 2007, we expect to incur up to $3 million of restructuring costs in
connection with our international publishing reorganization. Overall, including charges incurred
through December 31, 2006, we expect to incur between $40 million and $45 million of restructuring
costs in connection with our international publishing reorganization, substantially all of which
will result in cash expenditures by 2017. These restructuring costs will consist primarily of
employee-related relocation assistance (approximately $25 million), facility exit costs
(approximately $11 million), as well as other reorganization costs (approximately $6 million).
Interest and Other Income, Net
Interest and other income, net, for the three and nine months ended December 31, 2006 and 2005 were
as follows (in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
December 31, |
|
% of Net |
|
December 31, |
|
% of Net |
|
|
|
|
|
|
2006 |
|
Revenue |
|
2005 |
|
Revenue |
|
$ Change |
|
% Change |
|
|
|
Three months ended |
|
$ |
25 |
|
|
|
2 |
% |
|
$ |
20 |
|
|
|
2 |
% |
|
$ |
5 |
|
|
|
25 |
% |
|
|
|
Nine months ended |
|
$ |
69 |
|
|
|
3 |
% |
|
$ |
49 |
|
|
|
2 |
% |
|
$ |
20 |
|
|
|
41 |
% |
|
|
|
|
For the three and nine months ended December 31, 2006, interest and other income, net, increased by
$5 million, or 25 percent, and $20 million, or 41 percent, respectively, as compared to the three
and nine months ended December 31, 2005. These increases were primarily due to an increase of $9
million and $21 million in the three and nine months ended December 31, 2006, respectively, in
interest income as a result of higher yields on our cash, cash equivalent and short-term investment
balances in fiscal 2007.
|
|
Income Taxes
|
|
Income taxes for the three and nine months ended December 31, 2006 and 2005 were as follows (in
millions):
|
|
|
|
December 31, |
|
Effective |
|
December 31, |
|
Effective |
|
|
|
|
|
|
|
|
2006 |
|
Tax Rate |
|
2005 |
|
Tax Rate |
|
% Change |
|
|
|
|
|
|
|
|
|
|
|
Three months ended |
|
$ |
84 |
|
|
|
34.9 |
% |
|
$ |
106 |
|
|
|
29.0 |
% |
|
|
(21 |
%) |
|
|
|
|
|
|
|
|
|
|
|
Nine months ended |
|
$ |
83 |
|
|
|
45.9 |
% |
|
$ |
93 |
|
|
|
26.5 |
% |
|
|
(11 |
%) |
|
|
|
|
|
|
|
|
|
|
|
47
The tax rate reported for the nine months ended December 31, 2006 is based on our estimated
projected annual effective tax rate for fiscal 2007. Our effective income tax rates for the three
and nine months ended December 31, 2006 were 34.9 percent and 45.9 percent, respectively. These
rates include various adjustments recorded in the three months ended December 31, 2006 for the
reinstatement of the federal research credit, additional income tax benefit resulting from certain
intercompany transactions, offset by additional tax expense due to the development of certain tax
audit related matters. Without the impact of these adjustments, our effective income tax rates for
the three and nine months ended December 31, 2006 would have been 37.3 percent and 49.0 percent,
respectively.
The overall effective income tax rate for the fiscal year could be different from the tax rates in
effect for the three and nine months ended December 31, 2006 and will be dependent on our
profitability for the remainder of the fiscal year. In addition, our effective income tax rates for
the remainder of fiscal 2007 and future periods will depend on a variety of factors, including
changes in our business such as acquisitions and intercompany transactions (for example, the
acquisition of and intercompany transactions relating to Mythic and DICE), changes in our
international corporate structure, changes in the geographic location of business functions or
assets, changes in the geographic mix of income, as well as changes in, or termination of, our
agreements with tax authorities, valuation allowances, applicable accounting rules, applicable tax
laws and regulations, rulings and interpretations thereof, developments in tax audit and other
matters. Also, variations in the estimated and actual level of annual pre-tax income can affect the
overall effective income tax rate for the remainder of fiscal 2007 and future fiscal periods. We
incur certain tax expenses that do not decline proportionately with declines in our consolidated
income or increase in consolidated loss. As a result, in absolute dollar terms, our tax expense
will have a greater influence on our effective tax rate at lower levels of pre-tax income than
higher levels. In addition, at lower levels of pre-tax income or loss, our effective tax rate will
be more volatile.
We historically have considered undistributed earnings of our foreign subsidiaries to be
indefinitely reinvested and, accordingly, no U.S. taxes have been provided thereon.
In July 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation (FIN)
No. 48, Accounting for Uncertainty in Income Taxes An Interpretation of FASB Statement No. 109.
FIN No. 48 clarifies the accounting for uncertainty in income taxes recognized in financial
statements in accordance with SFAS No. 109, Accounting for Income Taxes. FIN No. 48 prescribes a
recognition threshold and measurement attribute for the financial statement recognition and
measurement of a tax position taken or expected to be taken in a tax return and provides guidance
on derecognition, classification, interest and penalties, accounting in interim periods,
disclosure, and transition. Under FIN No. 48, the evaluation of a tax position is a two-step
process. The first step is a recognition process where we are required to determine whether it is
more likely than not that a tax position will be sustained upon examination, including resolution
of any related appeals or litigation processes, based on the technical merits of the position. In
evaluating whether a tax position has met the more-likely-than-not recognition threshold, it is
presumed that the position will be examined by the appropriate taxing authority that has full
knowledge of all relevant information. The second step is a measurement process whereby a tax
position that meets the more-likely-than-not recognition threshold is calculated to determine the
amount of benefit to recognize in the financial statements. FIN No. 48 also requires new tabular
reconciliation of the total amounts of unrecognized tax benefits at the beginning and end of the
reporting period. The provisions of FIN No. 48 are effective for fiscal years beginning after
December 15, 2006. As such, we are required to adopt it in our first quarter of fiscal year 2008.
Any changes to our income taxes due to the adoption of FIN No. 48 are treated as the cumulative
effect of a change in accounting principle. We are evaluating what impact the adoption of FIN No.
48 will have on our Condensed Consolidated Financial Statements; however, FIN No. 48 could have a
material impact on our Condensed Consolidated Financial Statements.
Impact of Recently Issued Accounting Standards
In February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial
Instruments An Amendment of FASB Statements No. 133 and 140. SFAS No. 155 (1) permits fair value
measurement for any hybrid financial instrument that contains an embedded derivative that otherwise
would require bifurcation, (2) clarifies that interest-only strips and principal-only strips are
not subject to the requirements of SFAS No. 133, Accounting for Derivative Instruments and Hedging
Activities, (3) establishes a requirement to evaluate interests in securitized financial assets to
identify interests that are freestanding derivatives or that are hybrid financial instruments that
contain an embedded derivative requiring bifurcation, (4) clarifies that concentrations of credit
risk in the form of subordination are not embedded derivatives, and (5) amends SFAS No. 140,
Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities A
Replacement of FASB Statement No. 125 to eliminate the prohibition on a qualifying special-purpose
entity from holding a derivative
financial instrument that pertains to a beneficial interest other than another derivative financial
instrument. SFAS No. 155 is effective for
48
all financial instruments acquired or issued for fiscal
years beginning after September 15, 2006. We do not expect the adoption of SFAS No. 155 to have a
material impact on our Condensed Consolidated Financial Statements.
In June 2006, the FASB ratified the consensus reached on Emerging Issues Task Force (EITF) Issue
No. 06-3, How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be
Presented in the Income Statement (That Is, Gross Versus Net Presentation). The scope of EITF
Issue No. 06-3 includes any transaction-based tax assessed by a governmental authority that is
imposed concurrent with or subsequent to a revenue-producing transaction between a seller and a
customer. The scope does not include taxes that are based on gross receipts or total revenues
imposed during the inventory procurement process. Gross versus net income statement classification
of that tax is an accounting policy decision and a voluntary change would be considered a change in
accounting policy requiring the application of SFAS No. 154, Accounting Changes and Error
Corrections. The following disclosures will be required for taxes within the scope of this issue
that are significant in amount: (1) the accounting policy elected for these taxes and (2) the
amounts of the taxes reflected gross (as revenue) in the income statement on an interim and annual
basis for all periods presented. The EITF Issue No. 06-3 ratified consensus is effective for
interim and annual periods beginning after December 15, 2006. We do not expect the adoption of EITF
Issue No. 06-3 to have a material impact on our Condensed Consolidated Financial Statements.
In September 2006, the SEC issued SAB No. 108, Financial Statements Considering the Effects of
Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements. SAB
No. 108 provides guidance on how prior year misstatements should be taken into consideration when
quantifying misstatements in current year financial statements for purposes of determining whether
the current years financial statements are materially misstated. The impact of correcting all
misstatements, including both the carryover and reversing effects of prior year misstatements, must
be quantified on the current year financial statements. When a current year misstatement has been
quantified, SAB No. 99, Financial Statements Materiality should be applied to determine whether
the misstatement is material and should result in an adjustment to the financial statements. SAB
No. 108 also discusses the implications of misstatements uncovered upon the application of SAB No.
108 in situations when a registrant has historically been using either the iron curtain approach or
the rollover approach as described in the SAB. Registrants electing not to restate prior periods
should reflect the effects of initially applying the guidance in Topic 1N in their annual financial
statements covering the first fiscal year ending after November 15, 2006. We are evaluating what
impact the adoption of SAB No. 108 will have on our Condensed Consolidated Financial Statements.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. SFAS No. 157 defines
fair value, establishes a framework for measuring fair value in generally accepted accounting
principles and expands disclosures about fair value measurements. Fair value refers to the price
that would be received to sell an asset or paid to transfer a liability in an orderly transaction
between market participants in the market in which the reporting entity transacts. SFAS No. 157
establishes a fair value hierarchy that prioritizes the information used to develop those
assumptions. Fair value measurements would be separately disclosed by level within the fair value
hierarchy. The provisions of SFAS No. 157 are effective for financial statements issued for fiscal
years beginning after November 15, 2007, and interim periods within those fiscal years. We do not
expect the adoption of SFAS No. 157 to have a material impact on our Condensed Consolidated
Financial Statements.
In October 2006, the FASB issued FASB Staff Position (FSP) No. Financial Accounting Standard
(FAS)123(R)-6, Technical Corrections of FASB Statement No. 123(R), which amends various
provisions of SFAS No. 123(R). FSP No. FAS 123(R)-6 (1) exempts nonpublic entities from disclosing
the aggregate intrinsic value of outstanding fully vested share options (or share units) and share
options expected to vest, (2) revises the computation of the minimum compensation cost that must be
recognized to comply with paragraph 42 of SFAS No. 123(R), (3) amends paragraph A170 of
Illustration 13(e) to indicate that at the date that the illustrative awards were no longer
probable of vesting, any previously recognized compensation cost should have been reversed, and (4)
amends the definition of short-term inducement to exclude an offer to settle an award. The
provisions of FSP No. FAS 123(R)-6 are required to be applied in the first reporting period
beginning after October 20, 2006. Retrospective application is required if an entity had been
applying Statement 123(R) inconsistent with the guidance in FSP No. FAS 123(R)-6. We do not expect
the adoption of FSP No. FAS 123(R)-6 to have a material impact on our Condensed Consolidated
Financial Statements.
49
LIQUIDITY AND CAPITAL RESOURCES
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
As of |
|
|
As of |
|
|
|
|
|
|
December 31, |
|
|
March 31, |
|
|
Increase / |
|
(In millions) |
|
2006 |
|
|
2006 |
|
|
(Decrease) |
|
Cash and cash equivalents |
|
$ |
1,199 |
|
|
$ |
1,242 |
|
|
$ |
(43 |
) |
Short-term investments |
|
|
1,212 |
|
|
|
1,030 |
|
|
|
182 |
|
Marketable equity securities |
|
|
235 |
|
|
|
160 |
|
|
|
75 |
|
|
|
|
|
|
|
|
|
|
|
Total |
|
$ |
2,646 |
|
|
$ |
2,432 |
|
|
$ |
214 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Percentage of total assets |
|
|
52 |
% |
|
|
55 |
% |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Nine Months Ended |
|
|
|
|
|
|
December 31, |
|
|
Increase / |
|
(In millions) |
|
2006 |
|
|
2005 |
|
|
(Decrease) |
|
Cash provided by operating activities |
|
$ |
183 |
|
|
$ |
259 |
|
|
$ |
(76 |
) |
Cash provided by (used in) investing activities |
|
|
(388 |
) |
|
|
513 |
|
|
|
(901 |
) |
Cash provided by (used in) financing activities |
|
|
146 |
|
|
|
(558 |
) |
|
|
704 |
|
Effect of foreign exchange on cash and cash equivalents |
|
|
16 |
|
|
|
(22 |
) |
|
|
38 |
|
|
|
|
|
|
|
|
|
|
|
Net increase (decrease) in cash and cash equivalents |
|
$ |
(43 |
) |
|
$ |
192 |
|
|
$ |
(235 |
) |
|
|
|
|
|
|
|
|
|
|
Changes in Cash Flow
During the nine months ended December 31, 2006, we generated $183 million of cash from operating
activities as compared to $259 million of cash generated for the nine months ended December 31,
2005. The decrease in cash provided by operating activities for the nine months ended December 31,
2006 as compared to the nine months ended December 31, 2005 resulted primarily from an increase of
$95 million in the change in net accounts receivable due to the timing of the collection of our
receivables. We expect total cash flow from operating activities to decline in fiscal 2007.
For the nine months ended December 31, 2006, we generated $911 million of cash proceeds from
maturities and sales of short-term investments, and $133 million in proceeds from sales of common
stock through our stock plans. Our primary use of cash in non-operating activities consisted of (1)
$1,088 million used to purchase short-term investments, (2) $118 million in capital expenditures
primarily related to investments in our worldwide development tools, technologies and equipment and
expansions of our Vancouver and U.K. studios, as well as (3) $94 million for the acquisitions of
Mythic and the remaining minority interest in DICE. During the remainder of fiscal 2007, we
anticipate making continued capital investments in our studios as well as investments in
technologies to support development of products for the next-generation of consoles, online
infrastructure and mobile platforms.
Cash, cash equivalents, short-term investments and marketable equity securities
The decrease in cash and cash equivalents was primarily due to $1,088 million used to purchase
short-term investments and $118 million in capital expenditures, partially offset by $911 million
in proceeds received from the maturities and sales of short-term investments and $133 million in
proceeds from sales of common stock through our stock plans. Due to our mix of fixed and variable
rate securities, our short-term investment portfolio is susceptible to changes in short-term
interest rates. As of December 31, 2006, our short-term investments had gross unrealized gains of
$1 million, or less than 1 percent of the total in short-term investments, and gross unrealized
losses of approximately $2 million, or less than 1 percent of the total in short-term investments.
From time to time, we may liquidate some or all of our short-term investments to fund operational
needs or other activities, such as capital expenditures, business acquisitions or stock repurchase
programs. Depending on which short-term investments we liquidate to fund these activities, we could
recognize a portion, or all, of the gross unrealized gains or losses.
Marketable equity securities increased to $235 million as of December 31, 2006, from $160 million
as of March 31, 2006, due to an increase in the fair value of our investment in Ubisoft
Entertainment.
50
Receivables, net
Our gross accounts receivable balances were $779 million and $431 million as of December 31, 2006
and March 31, 2006, respectively. The increase in our accounts receivable balance was expected due
to higher sales volume in the third quarter of fiscal 2007 as compared to the fourth quarter of
fiscal 2006. We expect our accounts receivable balance to decrease during the three months ending
March 31, 2007 based on collections and our lower sales volume. Reserves for sales returns, pricing
allowances and doubtful accounts decreased slightly in absolute dollars from $232 million as of
March 31, 2006 to $228 million as of December 31, 2006. Reserves remained flat at 9 percent as a
percentage of trailing nine month net revenue for both December 31, 2006 and March 31, 2006. We
believe these reserves are adequate based on historical experience and our current estimate of
potential returns, pricing allowances and doubtful accounts.
Inventories
Inventories increased to $72 million as of December 31, 2006, from $61 million as of March 31, 2006
due to our seasonal product release schedule. Other than Need for Speed Carbon, no single title
represented more than $4 million of inventory as of December 31, 2006.
Other current assets
Other current assets decreased to $170 million as of December 31, 2006, from $234 million as of
March 31, 2006, primarily due to a decrease in prepaid royalties and the collection of advertising
credits owed to us by our vendors.
Accounts payable
Accounts payable increased to $170 million as of December 31, 2006, from $163 million as of March
31, 2006, primarily due to higher sales volumes and higher related expenditures to support the
seasonality of our business in the third quarter of fiscal 2007 as compared to the fourth quarter
of fiscal 2006.
Accrued and other current liabilities
Our accrued and other current liabilities increased to $851 million as of December 31, 2006 from
$654 million as of March 31, 2006. The increase was primarily due to (1) an increase of $109
million in accrued compensation and benefits, and (2) an increase of $51 million in accrued income
taxes.
Deferred income taxes, net
Our long-term net deferred income tax liability decreased to $6 million as of December 31, 2006
from $29 million as of March 31, 2006 primarily due to adjustments related to our amortization of
intangibles and stock-based compensation expensed in accordance with SFAS No. 123(R).
Financial Condition
We believe that existing cash, cash equivalents, short-term investments, marketable equity
securities and cash generated from operations will be sufficient to meet our operating requirements
for at least the next twelve months, including working capital requirements, capital expenditures,
and potential future acquisitions or strategic investments. We may choose at any time to raise
additional capital to strengthen our financial position, facilitate expansion, pursue strategic
acquisitions and investments or to take advantage of business opportunities as they arise. There
can be no assurance, however, that such additional capital will be available to us on favorable
terms, if at all, or that it will not result in substantial dilution to our existing stockholders.
The loan financing arrangements supporting our Redwood City headquarters leases with Keybank
National Association, described in the Off-Balance Sheet Commitments section below, are scheduled
to expire in July 2007. Upon expiration of the financing, we may request, on behalf of the lessor
and subject to lender approval, up to two one-year extensions of the loan financing between the
lessor and the lender. In the event the lessors loan financing with the lenders is not extended,
we may loan to the lessor approximately 90 percent of the financing, and require the lessor to
extend the remainder through July 2009, otherwise the leases will terminate. Upon expiration of the
leases, we may purchase the facilities for $247 million, or arrange
for a sale of the facilities to a third party. In the event of a sale to a third party, if the sale
price is less than $247 million, we will be
51
obligated to reimburse the difference between the
actual sale price and $247 million, up to maximum of $222 million, subject to certain provisions of
the leases.
As of December 31, 2006, approximately $810 million of our cash, cash equivalents, short-term
investments and marketable equity securities that was generated from operations was domiciled in
foreign tax jurisdictions. While we have no plans to repatriate these funds to the United States in
the short term, if we choose to do so, we would accrue and pay additional taxes in connection with
the repatriation.
We have a shelf registration statement on Form S-3 on file with the SEC. This shelf registration
statement, which includes a base prospectus, allows us at any time to offer any combination of
securities described in the prospectus in one or more offerings up to a total amount of $2 billion.
Unless otherwise specified in a prospectus supplement accompanying the base prospectus, we will use
the net proceeds from the sale of any securities offered pursuant to the shelf registration
statement for general corporate purposes, including for working capital, financing capital
expenditures, research and development, marketing and distribution efforts and, if opportunities
arise, for acquisitions or strategic alliances. Pending such uses, we may invest the net proceeds
in interest-bearing securities. In addition, we may conduct concurrent or other financings at any
time.
Our ability to maintain sufficient liquidity could be affected by various risks and uncertainties
including, but not limited to, those related to customer demand and acceptance of our products on
new platforms and new versions of our products on existing platforms, our ability to collect our
accounts receivable as they become due, successfully achieving our product release schedules and
attaining our forecasted sales objectives, the impact of competition, economic conditions in the
United States and abroad, the seasonal and cyclical nature of our business and operating results,
risks of product returns and the other risks described in the Risk Factors section, included in
Part II, Item 1A of this report.
Contractual Obligations and Commercial Commitments
Development, Celebrity, League and Content Licenses: Payments and Commitments
The products we produce in our studios are designed and created by our employee designers, artists,
software programmers and by non-employee software developers (independent artists or third-party
developers). We typically advance development funds to the independent artists and third-party
developers during development of our games, usually in installment payments made upon the
completion of specified development milestones. Contractually, these payments are generally
considered advances against subsequent royalties on the sales of the products. These terms are set
forth in written agreements entered into with the independent artists and third-party developers.
In addition, we have certain celebrity, league and content license contracts that contain minimum
guarantee payments and marketing commitments that may not be dependent on any deliverables.
Celebrities and organizations with whom we have contracts include: FIFA, FIFPRO Foundation, UEFA
and FAPL (Football Association Premier League Limited) (professional soccer); NASCAR (stock car
racing); National Basketball Association (professional basketball); PGA TOUR and Tiger Woods
(professional golf); National Hockey League and NHL Players Association (professional hockey);
Warner Bros. (Harry Potter, Batman and Superman); New Line Productions and Saul Zaentz Company (The
Lord of the Rings); Red Bear Inc. (John Madden), National Football League Properties and PLAYERS
Inc. (professional football); Collegiate Licensing Company (collegiate football, basketball and
baseball); Simcoh (Def Jam); Viacom Consumer Products (The Godfather); ESPN (content in EA
SPORTSTM games); and Twentieth Century Fox Licensing and Merchandising (The Simpsons).
These developer and content license commitments represent the sum of (1) the cash payments due
under non-royalty-bearing licenses and services agreements and (2) the minimum guaranteed payments
and advances against royalties due under royalty-bearing licenses and services agreements, the
majority of which are conditional upon performance by the counterparty.
52
The following table summarizes our minimum contractual obligations and commercial commitments
as of December 31, 2006, and the effect we expect them to have on our liquidity and cash flow in
future periods (in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Commercial |
|
|
|
|
|
|
Contractual Obligations |
|
Commitments |
|
|
|
|
|
|
|
|
|
|
Developer/ |
|
|
|
|
|
|
Letter of Credit, |
|
|
|
|
Fiscal Year |
|
|
|
|
|
Licensor |
|
|
|
|
|
|
Bank and |
|
|
|
|
Ending March 31, |
|
Leases (1) |
|
|
Commitments (2) |
|
|
Marketing |
|
Other Guarantees |
|
|
Total |
|
2007 (remaining three months) |
|
$ |
19 |
|
|
$ |
33 |
|
|
$ |
7 |
|
|
$ |
6 |
|
|
$ |
65 |
|
2008 |
|
|
54 |
|
|
|
172 |
|
|
|
41 |
|
|
|
1 |
|
|
|
268 |
|
2009 |
|
|
53 |
|
|
|
191 |
|
|
|
31 |
|
|
|
|
|
|
|
275 |
|
2010 |
|
|
35 |
|
|
|
166 |
|
|
|
31 |
|
|
|
|
|
|
|
232 |
|
2011 |
|
|
25 |
|
|
|
269 |
|
|
|
31 |
|
|
|
|
|
|
|
325 |
|
Thereafter |
|
|
66 |
|
|
|
724 |
|
|
|
185 |
|
|
|
|
|
|
|
975 |
|
|
|
|
|
|
|
|
|
|
Total |
|
$ |
252 |
|
|
$ |
1,555 |
|
|
$ |
326 |
|
|
$ |
7 |
|
|
$ |
2,140 |
|
|
|
|
|
|
|
|
|
|
(1) |
|
See discussion on operating leases in the Off-Balance Sheet Commitments
section below for additional information. |
(2) |
|
Developer/licensor commitments include $5 million of commitments to
developers or licensors that have been recorded in current and long-term liabilities and a
corresponding amount in current and long-term assets in our Condensed Consolidated Balance
Sheets as of December 31, 2006 because payment is not contingent upon performance by the
developer or licensor. |
Lease commitments include contractual rental commitments of $20 million under real estate leases
for unutilized office space resulting from our restructuring activities. These amounts, net of
estimated future sub-lease income, were expensed in the periods of the related restructuring and
are included in our accrued and other current liabilities reported on our Condensed Consolidated
Balance Sheets as of December 31, 2006. See Note 6 of the Notes to Condensed Consolidated Financial
Statements.
Related Party Transaction
On June 24, 2002, we hired Warren C. Jenson as our Executive Vice President, Chief Financial and
Administrative Officer and agreed to loan him $4 million to be forgiven over four years based on
his continuing employment. The loan did not bear interest. On June 24, 2004, pursuant to the terms
of the loan agreement, we forgave $2 million of the loan and provided Mr. Jenson approximately $1.6
million to offset the tax implications of the forgiveness. On June 24, 2006, pursuant to the terms
of the loan agreement, we forgave the remaining outstanding loan balance of $2 million. No
additional funds were provided to offset the tax implications of the forgiveness of the $2 million
balance.
53
OFF-BALANCE SHEET COMMITMENTS
Lease Commitments and Residual Value Guarantees
We lease certain of our current facilities and equipment under non-cancelable operating lease
agreements. We are required to pay property taxes, insurance and normal maintenance costs for
certain of these facilities and will be required to pay any increases over the base year of these
expenses on the remainder of our facilities.
In February 1995, we entered into a build-to-suit lease (Phase One Lease) with a third-party
lessor for our headquarters facilities in Redwood City, California (Phase One Facilities). The
Phase One Facilities comprise a total of approximately 350,000 square feet and provide space for
sales, marketing, administration and research and development functions. In July 2001, the lessor
refinanced the Phase One Lease with Keybank National Association through July 2006. The Phase One
Lease expires in January 2039, subject to early termination in the event the underlying financing
between the lessor and its lenders is not extended. Subject to certain terms and conditions, upon
termination of the lease, we may purchase the Phase One Facilities or arrange for the sale of the
Phase One Facilities to a third party.
Pursuant to the terms of the Phase One Lease, we have an option to purchase the Phase One
Facilities at any time for a purchase price of $132 million. In the event of a sale to a third
party, if the sale price is less than $132 million, we will be obligated to reimburse the
difference between the actual sale price and $132 million, up to maximum of $117 million, subject
to certain provisions of the Phase One Lease, as amended.
On May 26, 2006, the lessor extended its loan financing underlying the Phase One Lease with its
lenders through July 2007. We may request, on behalf of the lessor and subject to lender approval,
up to two one-year extensions of the loan financing between the lessor and the lender. In the event
the lessors loan financing with the lenders is not extended, we may loan to the lessor
approximately 90 percent of the financing, and require the lessor to extend the remainder through
July 2009; otherwise the lease will terminate. We account for the Phase One Lease arrangement as an
operating lease in accordance with SFAS No. 13, Accounting for Leases, as amended.
In December 2000, we entered into a second build-to-suit lease (Phase Two Lease) with Keybank
National Association for a five and one-half year term beginning in December 2000 to expand our
Redwood City, California headquarters facilities and develop adjacent property (Phase Two
Facilities). Construction of the Phase Two Facilities was completed in June 2002. The Phase Two
Facilities comprise a total of approximately 310,000 square feet and provide space for sales,
marketing, administration and research and development functions. Subject to certain terms and
conditions, upon termination of the lease, we may purchase the Phase Two Facilities or arrange for
the sale of the Phase Two Facilities to a third party.
Pursuant to the terms of the Phase Two Lease, we have an option to purchase the Phase Two
Facilities at any time for a purchase price of $115 million. In the event of a sale to a third
party, if the sale price is less than $115 million, we will be obligated to reimburse the
difference between the actual sale price and $115 million, up to a maximum of $105 million, subject
to certain provisions of the Phase Two Lease, as amended.
On May 26, 2006, the lessor extended the Phase Two Lease through July 2009 subject to early
termination in the event the underlying loan financing between the lessor and its lenders is not
extended. Concurrently with the extension of the lease, the lessor extended the loan financing
underlying the Phase Two Lease with its lenders through July 2007. We may request, on behalf of the
lessor and subject to lender approval, up to two one-year extensions of the loan financing between
the lessor and the lender. In the event the lessors loan financing with the lenders is not
extended, we may loan to the lessor approximately 90 percent of the financing, and require the
lessor to extend the remainder through July 2009, otherwise the lease will terminate. We account
for the Phase Two Lease arrangement as an operating lease in accordance with SFAS No. 13, as
amended.
We believe that, as of December 31, 2006, the estimated fair values of both properties under these
operating leases exceeded their respective guaranteed residual values.
The two lease agreements with Keybank National Association described above require us to maintain
certain financial covenants as shown below, all of which we were in compliance with as of December
31, 2006.
54
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Actual as of |
|
Financial Covenants |
|
Requirement |
|
|
December 31, 2006 |
|
Consolidated Net Worth (in millions) |
|
equal to or greater than |
|
|
$2,430 |
|
|
|
$3,878 |
|
Fixed Charge Coverage Ratio |
|
equal to or greater than |
|
|
3.00 |
|
|
|
5.28 |
|
Total Consolidated Debt to Capital |
|
equal to or less than |
|
|
60% |
|
|
|
6.0% |
|
Quick Ratio Q1 & Q2 |
|
equal to or greater than |
|
|
1.00 |
|
|
|
N/A |
|
Q3 & Q4 |
|
equal to or greater than |
|
|
1.75 |
|
|
|
9.19 |
|
Legal Proceedings
On September 14, 2006, we received an informal inquiry from the Securities and Exchange Commission
requesting certain documents and information relating to our stock option grant practices from
January 1, 1997 to the present. We have cooperated to date with all matters related to this
request.
We are also subject to claims and litigation arising in the ordinary course of business. We believe
that any liability from any reasonably foreseeable disposition of such claims and litigation,
individually or in the aggregate, would not have a material adverse effect on our consolidated
financial position or results of operations.
Director Indemnity Agreements
We entered into indemnification agreements with the members of our Board of Directors at the time
they joined the Board to indemnify them to the extent permitted by law against any and all
liabilities, costs, expenses, amounts paid in settlement and damages incurred by the directors as a
result of any lawsuit, or any judicial, administrative or investigative proceeding in which the
directors are sued or charged as a result of their service as members of our Board of Directors.
55
Item 3. Quantitative and Qualitative Disclosures About Market Risk
MARKET RISK
We are exposed to various market risks, including changes in foreign currency exchange rates,
interest rates, and market prices. Market risk is the potential loss arising from changes in market
rates and market prices. We employ established policies and practices to manage these risks.
Foreign exchange option and forward contracts are used to hedge anticipated or mitigate some
existing exposures subject to foreign exchange risk as discussed below. We have not historically,
nor do we currently, hedge our short-term investment portfolio. We do not consider our cash and
cash equivalents to be exposed to significant interest rate risk because our cash and cash
equivalent portfolio consists of highly liquid investments with original maturities of three months
or less. We also do not currently hedge our market price risk relating to our equity investments.
We do not enter into derivatives or other financial instruments for trading or speculative
purposes.
Foreign Currency Exchange Rate Risk
From time to time, we hedge a portion of our foreign currency risk related to forecasted
foreign-currency-denominated sales and expense transactions by purchasing option contracts that
generally have maturities of 15 months or less. These transactions are designated and qualify as
cash flow hedges. The derivative assets associated with our hedging activities are recorded at fair
value in other current assets in our Condensed Consolidated Balance Sheets. The effective portion
of gains or losses resulting from changes in fair value of these hedges is initially reported, net
of tax, as a component of accumulated other comprehensive income in stockholders equity and
subsequently reclassified into net revenue or operating expenses, as appropriate in the period when
the forecasted transaction is recorded. The ineffective portion of gains or losses resulting from
changes in fair value, if any, is reported in each period in interest and other income, net, in our
Condensed Consolidated Statements of Operations. Our hedging programs reduce, but do not entirely
eliminate, the impact of currency exchange rate movements in revenue and operating expenses. As of
December 31, 2006, we had foreign currency option contracts outstanding with a total fair value of
$1 million included in other current assets.
We utilize foreign exchange forward contracts to mitigate foreign currency risk associated with
foreign-currency-denominated assets and liabilities, primarily intercompany receivables and
payables. The forward contracts generally have a contractual term of approximately one month and
are transacted near month-end. Therefore, the fair value of the forward contracts generally is not
significant at each month-end. Our foreign exchange forward contracts are not designated as hedging
instruments under SFAS No. 133 and are accounted for as derivatives whereby the fair value of the
contracts are reported as other current assets or other current liabilities in our Condensed
Consolidated Balance Sheets, and gains and losses from changes in fair value are reported in
interest and other income, net. The gains and losses on these forward contracts generally offset
the gains and losses on the underlying foreign-currency-denominated assets and liabilities, which
are also reported in interest and other income, net, in our Condensed Consolidated Statements of
Operations.
As of December 31, 2006, we had forward foreign exchange contracts to purchase and sell
approximately $425 million in foreign currencies. Of this amount, $403 million represented
contracts to sell foreign currencies in exchange for U.S. dollars, $4 million to sell foreign
currencies in exchange for British pound sterling and $18 million to purchase foreign currency in
exchange for U.S. dollars. The fair value of our forward contracts was immaterial as of December
31, 2006.
The counterparties to these forward and option contracts are creditworthy multinational commercial
banks. The risks of counterparty nonperformance associated with these contracts are not considered
to be material.
Notwithstanding our efforts to mitigate some foreign currency exchange rate risks, there can be no
assurances that our hedging activities will adequately protect us against the risks associated with
foreign currency fluctuations. As of December 31, 2006, a hypothetical adverse foreign currency
exchange rate movement of 10 percent or 15 percent would result in potential loss in fair value of
our option contracts of $1 million in both scenarios. A hypothetical adverse foreign currency
exchange rate movement of 10 percent or 15 percent would result in potential losses on our forward
contracts of $42 million and $63 million, respectively, as of December 31, 2006. This sensitivity
analysis assumes a parallel adverse shift in foreign currency exchange rates, which do not always
move in the same direction. Actual results may differ materially.
56
Interest Rate Risk
Our exposure to market risk from changes in interest rates relates primarily to our short-term
investment portfolio. We manage our interest rate risk by maintaining an investment portfolio
generally consisting of debt instruments of high credit quality and relatively short maturities.
Additionally, the contractual terms of the securities do not permit the issuer to call, prepay or
otherwise settle the securities at prices less than the stated par value of the securities. Our
investments are held for purposes other than trading. Also, we do not use derivative financial
instruments in our short-term investment portfolio.
As of December 31, 2006 and March 31, 2006, our short-term investments were classified as
available-for-sale and, consequently, recorded at fair market value with unrealized gains or losses
resulting from changes in fair value reported as a separate component of accumulated other
comprehensive income, net of any tax effects, in stockholders equity. Our portfolio of short-term
investments consisted of the following investment categories, summarized by fair value as of
December 31, 2006 and March 31, 2006 (in millions):
|
|
|
|
|
|
|
|
|
|
|
As of |
|
|
As of |
|
|
|
December 31, |
|
|
March 31, |
|
|
|
2006 |
|
|
2006 |
|
Commercial paper |
|
$ |
518 |
|
|
$ |
25 |
|
U.S. agency securities |
|
|
260 |
|
|
|
575 |
|
Corporate bonds |
|
|
245 |
|
|
|
178 |
|
U.S. Treasury securities |
|
|
98 |
|
|
|
212 |
|
Asset-backed securities |
|
|
91 |
|
|
|
40 |
|
|
|
|
|
|
|
|
Total short-term investments |
|
$ |
1,212 |
|
|
$ |
1,030 |
|
|
|
|
|
|
|
|
Notwithstanding our efforts to manage interest rate risks, there can be no assurance that we will
be adequately protected against risks associated with interest rate fluctuations. At any time, a
sharp change in interest rates could have a significant impact on the fair value of our investment
portfolio. The following table presents the hypothetical changes in fair value in our short-term
investment portfolio as of December 31, 2006, arising from potential changes in interest rates. The
modeling technique estimates the change in fair value from immediate hypothetical parallel shifts
in the yield curve of plus or minus 50 basis points (BPS), 100 BPS, and 150 BPS.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Valuation of Securities Given |
|
|
Fair Value |
|
|
Valuation of Securities Given |
|
|
|
an Interest Rate Decrease of X |
|
|
as of |
|
|
an Interest Rate Increase of X |
|
(In millions) |
|
Basis Points |
|
|
December 31, |
|
|
Basis Points |
|
|
|
(150 BPS) |
|
|
(100 BPS) |
|
|
(50 BPS) |
|
|
2006 |
|
|
50 BPS |
|
|
100 BPS |
|
|
150 BPS |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Commercial paper |
|
$ |
521 |
|
|
$ |
520 |
|
|
$ |
519 |
|
|
$ |
518 |
|
|
$ |
518 |
|
|
$ |
517 |
|
|
$ |
516 |
|
U.S. agency securities |
|
|
267 |
|
|
|
264 |
|
|
|
262 |
|
|
|
260 |
|
|
|
257 |
|
|
|
255 |
|
|
|
253 |
|
Corporate bonds |
|
|
250 |
|
|
|
248 |
|
|
|
246 |
|
|
|
245 |
|
|
|
243 |
|
|
|
241 |
|
|
|
239 |
|
U.S. Treasury securities |
|
|
102 |
|
|
|
101 |
|
|
|
99 |
|
|
|
98 |
|
|
|
97 |
|
|
|
96 |
|
|
|
95 |
|
Asset-backed securities |
|
|
93 |
|
|
|
92 |
|
|
|
92 |
|
|
|
91 |
|
|
|
91 |
|
|
|
90 |
|
|
|
89 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total short-term investments |
|
$ |
1,233 |
|
|
$ |
1,225 |
|
|
$ |
1,218 |
|
|
$ |
1,212 |
|
|
$ |
1,206 |
|
|
$ |
1,199 |
|
|
$ |
1,192 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Market Price Risk
The value of our equity investments in publicly traded companies are subject to market price
volatility. As of December 31, 2006 and March 31, 2006, our marketable equity securities were
classified as available-for-sale and, consequently, were recorded in our Condensed Consolidated
Balance Sheets at fair market value with unrealized gains or losses reported as a separate
component of accumulated other comprehensive income, net of any tax effects, in stockholders
equity. The fair value of our marketable equity securities was $235 million and $160 million as of
December 31, 2006 and March 31, 2006, respectively.
57
At any time, a sharp change in market prices in our investments in marketable equity securities
could have a significant impact on the fair value of our investments. The following table presents
the hypothetical changes in fair value in our marketable equity securities as of December 31, 2006,
arising from changes in market prices plus or minus 25 percent, 50 percent and 75 percent.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Valuation of Securities Given an |
|
|
Fair Value |
|
|
Valuation of Securities Given an |
|
|
|
X Percentage Decrease in Each |
|
|
as of |
|
|
X Percentage Increase in Each |
|
(In millions) |
|
Stocks Market Price |
|
|
December 31, |
|
|
Stocks Market Price |
|
|
|
(75%) |
|
|
(50%) |
|
|
(25%) |
|
|
2006 |
|
|
25% |
|
|
50% |
|
|
75% |
|
Marketable equity securities |
|
$ |
59 |
|
|
$ |
117 |
|
|
$ |
176 |
|
|
$ |
235 |
|
|
$ |
294 |
|
|
$ |
352 |
|
|
$ |
411 |
|
58
Item 4. Controls and Procedures
Definition and limitations of disclosure controls
Our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the
Securities Exchange Act of 1934, as amended (the Exchange Act)) are controls and other procedures
that are designed to ensure that information required to be disclosed in our reports filed under
the Exchange Act, such as this report, is recorded, processed, summarized and reported within the
time periods specified in the SECs rules and forms. Disclosure controls and procedures are also
designed to ensure that such information is accumulated and communicated to our management,
including the Chief Executive Officer and Chief Financial and Administrative Officer, as
appropriate to allow timely decisions regarding required disclosure. Our management evaluates these
controls and procedures on an ongoing basis.
There are inherent limitations to the effectiveness of any system of disclosure controls and
procedures. These limitations include the possibility of human error, the circumvention or
overriding of the controls and procedures and reasonable resource constraints. In addition, because
we have designed our system of controls based on certain assumptions, which we believe are
reasonable, about the likelihood of future events, our system of controls may not achieve its
desired purpose under all possible future conditions. Accordingly, our disclosure controls and
procedures provide reasonable assurance, but not absolute assurance, of achieving their objectives.
Evaluation of disclosure controls and procedures
Our Chief Executive Officer and our Chief Financial and Administrative Officer, after evaluating
the effectiveness of our disclosure controls and procedures, believe that as of the end of the
period covered by this report, our disclosure controls and procedures were effective in providing
the requisite reasonable assurance that material information required to be disclosed in the
reports that we file or submit under the Exchange Act is recorded, processed, summarized and
reported within the time periods specified in the SECs rules and forms, and is accumulated and
communicated to our management, including our Chief Executive Officer and Chief Financial and
Administrative Officer, as appropriate to allow timely decisions regarding the required disclosure.
Changes in internal control over financial reporting
During the quarter ended December 31, 2006, no changes occurred in our internal control over
financial reporting that materially affected, or are reasonably likely to materially affect, our
internal control over financial reporting.
59
PART II OTHER INFORMATION
Item 1. Legal Proceedings
On September 14, 2006, we received an informal inquiry from the Securities and Exchange Commission
requesting certain documents and information relating to our stock option grant practices from
January 1, 1997 to the present. We have cooperated to date with all matters related to this
request.
We are also subject to claims and litigation arising in the ordinary course of business. We believe
that any liability from any reasonably foreseeable disposition of such claims and litigation,
individually or in the aggregate, would not have a material adverse effect on our consolidated
financial position or results of operations.
Item 1A. Risk Factors
Our business is subject to many risks and uncertainties, which may affect our future financial
performance. If any of the events or circumstances described below occurs, our business and
financial performance could be harmed, our actual results could differ materially from our
expectations and the market value of our stock could decline. The risks and uncertainties discussed
below are not the only ones we face. There may be additional risks and uncertainties not currently
known to us or that we currently do not believe are material that may harm our business and
financial performance.
Our business is highly dependent on the success, timely release and availability of new video game
platforms, on the continued availability of existing video game platforms, as well as our ability
to develop commercially successful products for these platforms.
We derive most of our revenue from the sale of products for play on video game platforms
manufactured by third parties, such as Sonys PlayStation 2 and Microsofts Xbox 360. The success
of our business is driven in large part by the availability of an adequate supply of these video
game platforms, the timely release and success of new video game hardware systems (such as the Xbox
360, Sonys PlayStation 3 and the Nintendo Wii), our ability to accurately predict which platforms
will be successful in the marketplace, and our ability to develop commercially successful products
for these platforms. We must make product development decisions and commit significant resources
well in advance of the anticipated introduction of a new platform. A new platform for which we are
developing products may be delayed, may not succeed or may have a shorter life cycle than
anticipated. Alternatively, a platform for which we have not devoted significant resources could be
more successful than we had initially anticipated, causing us to miss out on a meaningful revenue
opportunity. If the platforms for which we are developing products are not released when
anticipated, are not available in adequate quantities to meet consumer demand or are lower than our
expectations, or do not attain wide market acceptance, our revenue will suffer, we may be unable to
fully recover the investments we have made in developing our products, and our financial
performance will be harmed.
Our industry is cyclical and is in the midst of a transition period heading into the next cycle.
During the transition, we expect our costs to continue to increase, we may experience a decline in
sales as consumers anticipate and adopt next-generation products and our operating results may
suffer and become more difficult to predict.
Video game platforms have historically had a life cycle of four to six years, which causes the
video game software market to be cyclical as well. The current generation of platforms
Sonys PlayStation 2, Microsofts Xbox and the Nintendo GameCube were initially introduced in
2000 and 2001. In November 2005, Microsoft launched the Xbox 360. More recently, Sony introduced
the PlayStation 3 in November 2006 in North America and Japan and is expected to launch it in
Europe and elsewhere in March 2007. Nintendo introduced the Wii in November 2006 in North America
and in December 2006 in Japan and Europe. We refer to Microsofts Xbox 360, Sonys PlayStation 3
and Nintendos Wii as next-generation platforms. The release of each of these next-generation
platforms has moved the interactive entertainment industry further along the transition into the
next cycle. We have incurred and expect to continue to incur increased costs during this transition
as we have continued to develop and market new titles for certain current-generation video game
platforms while also making significant investments in products for the next-generation platforms.
Moreover, we expect development costs for next-generation video games to be greater on a per-title
basis than development costs for current-generation video games.
We also expect that, as the current generation of platforms reaches the end of its cycle and the
installed base of next-generation platforms continues to grow, sales of video games for
current-generation platforms will continue to decline as consumers
replace their current-generation platforms with next-generation platforms, or defer game software
purchases until they are able to
60
purchase a next-generation platform. This decline in
current-generation product sales may not be offset by increased sales of products for the new
platforms. For example, following the launch of Sonys PlayStation 2 platform, we experienced a
significant decline in revenue from sales of products for Sonys older PlayStation game console,
which was not immediately offset by revenue generated from sales of products for the PlayStation 2.
More recently, we have seen a sharp decrease in sales of titles for the Xbox following the launch
of the Xbox 360. In addition, during the transition, we expect our operating results to be more
volatile and difficult to predict, which could cause our stock price to fluctuate significantly.
We expect the average price of current-generation titles to continue to decline.
As a result of the transition to next-generation platforms, a more value-oriented consumer base, a
greater number of current-generation titles being published, and significant pricing pressure from
our competitors, we have experienced a decrease in the average price of our titles for
current-generation platforms. As the interactive entertainment industry continues to transition to
next-generation platforms, we expect few, if any, current-generation titles will be able to command
premium price points, and we expect that even these titles will be subject to price reductions at
an earlier point in their sales cycle than we have seen in prior years. We expect the average price
of current-generation titles to continue to decline, which will have a negative effect on our
margins and operating results.
Our platform licensors set the business models, royalty rates, manufacturing costs and other fees
that we must pay to publish games for their platforms, and therefore have significant influence on
our costs. If one or more of the platform licensors change their fee structure for their platforms,
our profitability will be materially impacted.
In order to publish products for any proprietary video game player or handheld (such as the
Xbox 360, PlayStation 3, Nintendo Wii, PlayStation Portable or Nintendo Dual Screen), we take a
license from the platform licensor. For each platform, the licensor (Microsoft, Sony or Nintendo)
has the right to set the fee structure that we pay in order to publish games using proprietary
technology and trademarks and provide online services for that platform; such licenses may require
the payment of royalties, manufacturing costs and fees for other components and services provided
by the platform licensor. In some cases, the platform licensor reserves the right to change these
fees and costs in the future. With current-generation platforms such as the PlayStation 2, Xbox and
Nintendo GameCube, the platform licensors generally have reduced these fees and costs over the life
cycle of these platforms, but there can be no assurance that they will follow the same pattern on
the newer platforms, or that such fees and costs will not increase. Because publishing products for
video game consoles and handheld game machines is the largest portion of our business, any increase
in fee structure, or lack of future decrease during the life cycle of the platform, could
significantly harm our ability to generate revenues and/or profits.
If we do not consistently meet our product development schedules, our operating results will be
adversely affected.
Our business is highly seasonal, with the highest levels of consumer demand and a significant
percentage of our sales occurring in the December quarter. In addition, we seek to release many of
our products in conjunction with specific events, such as the release of a related movie or the
beginning of a sports season or major sporting event. If we miss these key selling periods for any
reason, including product delays or delayed introduction of a new platform for which we have
developed products, our sales will suffer disproportionately. Likewise, if a key event to which our
product release schedule is tied were to be delayed or cancelled, our sales would also suffer
disproportionately. Our ability to meet product development schedules is affected by a number of
factors, including the creative processes involved, the coordination of large and sometimes
geographically dispersed development teams required by the increasing complexity of our products
and the platforms for which they are developed, and the need to fine-tune our products prior to
their release. We have experienced development delays for our products in the past, which caused us
to push back release dates. In the future, any failure to meet anticipated production or release
schedules would likely result in a delay of sales and/or possibly a significant shortfall in our
sales, harm our profitability, and cause our operating results to be materially different than
anticipated.
Our business is subject to risks generally associated with the entertainment industry, any of which
could significantly harm our operating results.
Our business is subject to risks that are generally associated with the entertainment industry,
many of which are beyond our control. These risks could negatively impact our operating results and
include: the popularity, price and timing of our games and the platforms on which they are played;
economic conditions that adversely affect discretionary consumer spending;
changes in consumer demographics; the availability and popularity of other forms of entertainment;
and critical reviews and public tastes and preferences, which may change rapidly and cannot
necessarily be predicted.
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Technology changes rapidly in our business and if we fail to anticipate or successfully implement
new technologies or the manner in which people play our games, the quality, timeliness and
competitiveness of our products and services will suffer.
Rapid technology changes in our industry require us to anticipate, sometimes years in advance,
which technologies we must implement and take advantage of in order to make our products and
services competitive in the market. Therefore, we usually start our product development with a
range of technical development goals that we hope to be able to achieve. We may not be able to
achieve these goals, or our competition may be able to achieve them more quickly and effectively
than we can. In either case, our products and services may be technologically inferior to our
competitors, less appealing to consumers, or both. If we cannot achieve our technology goals
within the original development schedule of our products and services, then we may delay their
release until these technology goals can be achieved, which may delay or reduce revenue and
increase our development expenses. Alternatively, we may increase the resources employed in
research and development in an attempt to accelerate our development of new technologies, either to
preserve our product or service launch schedule or to keep up with our competition, which would
increase our development expenses.
Our business is intensely competitive and hit driven. If we do not continue to deliver hit
products and services or if consumers prefer our competitors products or services over our own,
our operating results could suffer.
Competition in our industry is intense and we expect new competitors to continue to emerge in the
United States and abroad. While many new products and services are regularly introduced, only a
relatively small number of hit titles accounts for a significant portion of total revenue in our
industry. Hit products or services offered by our competitors may take a larger share of consumer
spending than we anticipate, which could cause revenue generated from our products and services to
fall below expectations. If our competitors develop more successful products or services, offer
competitive products or services at lower price points or based on payment models perceived as
offering a better value proposition (such as pay-for-play or subscription-based models), or if we
do not continue to develop consistently high-quality and well-received products and services, our
revenue, margins, and profitability will decline.
If we are unable to maintain or acquire licenses to intellectual property, we will publish fewer
hit titles and our revenue, profitability and cash flows will decline. Competition for these
licenses may make them more expensive and increase our costs.
Many of our products are based on or incorporate intellectual property owned by others. For
example, our EA SPORTS products include rights licensed from major sports leagues and players
associations. Similarly, many of our other hit franchises, such as The Godfather, Harry Potter and
Lord of the Rings, are based on key film and literary licenses. Competition for these licenses is
intense. If we are unable to maintain these licenses or obtain additional licenses with significant
commercial value, our revenues and profitability will decline significantly. Competition for these
licenses may also drive up the advances, guarantees and royalties that we must pay to the licensor,
which could significantly increase our costs.
If patent claims continue to be asserted against us, we may be unable to sustain our current
business models or profits, or we may be precluded from pursuing new business opportunities in the
future.
Many patents have been issued that may apply to widely-used game technologies, or to potential new
modes of delivering, playing or monetizing game software products. For example, infringement claims
under many issued patents are now being asserted against interactive software or online game sites.
Several such claims have been asserted against us. We incur substantial expenses in evaluating and
defending against such claims, regardless of the merits of the claims. In the event that there is a
determination that we have infringed a third-party patent, we could incur significant monetary
liability and be prevented from using the rights in the future, which could negatively impact our
operating results. We may also discover that future opportunities to provide new and innovative
modes of game play and game delivery to consumers may be precluded by existing patents that we are
unable to license on reasonable terms.
Other intellectual property claims may increase our product costs or require us to cease selling
affected products.
Many of our products include extremely realistic graphical images, and we expect that as technology
continues to advance, images will become even more realistic. Some of the images and other content
are based on real-world examples that may inadvertently infringe upon the intellectual property
rights of others. Although we believe that we make reasonable efforts to
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ensure that our products
do not violate the intellectual property rights of others, it is possible that third parties still
may claim infringement. From time to time, we receive communications from third parties regarding
such claims. Existing or future infringement claims against us, whether valid or not, may be time
consuming and expensive to defend. Such claims or litigations could require us to stop selling the
affected products, redesign those products to avoid infringement, or obtain a license, all of which
would be costly and harm our business.
From time to time we may become involved in other legal proceedings which could adversely affect
us.
We are currently, and from time to time in the future may become, subject to other legal
proceedings, claims and litigation, which could be expensive, lengthy, and disruptive to normal
business operations. In addition, the outcome of any legal proceedings, claims or litigation may be
difficult to predict and could have a material adverse effect on our business, operating results,
or financial condition. For further information regarding certain legal proceedings, claims and
litigation in which we are currently involved, see Part II Item 1. Legal Proceedings above.
Our business, our products and our distribution are subject to increasing regulation of content,
consumer privacy, distribution and online hosting and delivery in the key territories in which we
conduct business. If we do not successfully respond to these regulations, our business may suffer.
Legislation is continually being introduced that may affect both the content of our products and
their distribution. For example, data and consumer protection laws in the United States and Europe
impose various restrictions on our web sites. Those rules vary by territory although the Internet
recognizes no geographical boundaries. Other countries, such as Germany, have adopted laws
regulating content both in packaged games and those transmitted over the Internet that are stricter
than current United States laws. In the United States, the federal and several state governments
are continually considering content restrictions on products such as ours, as well as restrictions
on distribution of such products. For example, recent legislation has been adopted in several
states, and could be proposed at the federal level, that prohibits the sale of certain games (e.g.,
violent games or those with M (Mature) or AO (Adults Only) ratings) to minors. Any one or more
of these factors could harm our business by limiting the products we are able to offer to our
customers, by limiting the size of the potential market for our products, and by requiring
additional differentiation between products for different territories to address varying
regulations. This additional product differentiation could be costly.
If one or more of our titles were found to contain hidden, objectionable content, our business
could suffer.
Throughout the history of our industry, many video games have been designed to include certain
hidden content and gameplay features that are accessible through the use of in-game cheat codes or
other technological means that are intended to enhance the gameplay experience. However, in several
recent cases, hidden content or features have been found to be included in other publishers
products by an employee who was not authorized to do so or by an outside developer without the
knowledge of the publisher. From time to time, some hidden content and features have contained
profanity, graphic violence and sexually explicit or otherwise objectionable material. In a few
cases, the Entertainment Software Ratings Board (ESRB) has reacted to discoveries of hidden
content and features by reviewing the rating that was originally assigned to the product, requiring
the publisher to change the game packaging and/or fining the publisher. Retailers have on occasion
reacted to the discovery of such hidden content by removing these games from their shelves,
refusing to sell them, and demanding that their publishers accept them as product returns.
Likewise, consumers have reacted to the revelation of hidden content by refusing to purchase such
games, demanding refunds for games theyve already purchased, and refraining from buying other
games published by the company whose game contained the objectionable material.
We have implemented preventative measures designed to reduce the possibility of hidden,
objectionable content from appearing in the video games we publish. Nonetheless, these preventative
measures are subject to human error, circumvention, overriding, and reasonable resource
constraints. If a video game we published were found to contain hidden, objectionable content, the
ESRB could demand that we recall a game and change its packaging to reflect a revised rating,
retailers could refuse to sell it and demand we accept the return of any unsold copies or returns
from customers, and consumers could refuse to buy it or demand that we refund their money. This
could have a material negative impact on our operating results and
financial condition. In addition, our reputation could be harmed, which could impact sales of other
video games we sell. If any of these consequences were to occur, our business and financial
performance could be significantly harmed.
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If we ship defective products, our operating results could suffer.
Products such as ours are extremely complex software programs, and are difficult to develop,
manufacture and distribute. We have quality controls in place to detect defects in the software,
media and packaging of our products before they are released. Nonetheless, these quality controls
are subject to human error, overriding, and reasonable resource constraints. Therefore, these
quality controls and preventative measures may not be effective in detecting defects in our
products before they have been reproduced and released into the marketplace. In such an event, we
could be required to recall a product, or we may find it necessary to voluntarily recall a product,
and/or scrap defective inventory, which could significantly harm our business and operating
results.
If we do not continue to attract and retain key personnel, we will be unable to effectively conduct
our business. In addition, compensation-related changes in accounting requirements, as well as
evolving legal and operational factors, could have a significant impact on our expenses, financial
controls and operating results.
The market for technical, creative, marketing and other personnel essential to the development and
marketing of our products and management of our businesses is extremely competitive. Our leading
position within the interactive entertainment industry makes us a prime target for recruiting of
executives and key creative talent. If we cannot successfully recruit and retain the employees we
need, or replace key employees following their departure, our ability to develop and manage our
businesses will be impaired.
We annually review and evaluate with the Compensation Committee of our Board of Directors the
compensation and benefits that we offer our employees to ensure that we are able to attract and
retain our talent. Within our regular review, we have considered recent changes in the accounting
treatment of stock options, the competitive market for technical, creative, marketing and other
personnel, and the evolving nature of job functions within our studios, marketing organizations and
other areas of the business. Any changes we make to our compensation programs could result in
increased expenses and have a significant impact on our operating results.
Our platform licensors are our chief competitors and frequently control the manufacturing of and/or
access to our video game products. If they do not approve our products, we will be unable to ship
to our customers.
Our agreements with hardware licensors (such as Sony for the PlayStation 2, Microsoft for the Xbox
and Xbox 360, and Nintendo for the Nintendo GameCube) typically give significant control to the
licensor over the approval and manufacturing of our products, which could, in certain
circumstances, leave us unable to get our products approved, manufactured and shipped to customers.
These hardware licensors are also our chief competitors. In most events, control of the approval
and manufacturing process by the platform licensors increases both our manufacturing lead times and
costs as compared to those we can achieve independently. While we believe that our relationships
with our hardware licensors are currently good, the potential for these licensors to delay or
refuse to approve or manufacture our products exists. Such occurrences would harm our business and
our financial performance.
We also require compatibility code and the consent of Microsoft, Sony and Nintendo in order to
include online capabilities in our products for their respective platforms. As online capabilities
for video game platforms become more significant, Microsoft, Sony and Nintendo could restrict the
manner in which we provide online capabilities for our console platform products. If Microsoft,
Sony or Nintendo refused to approve our products with online capabilities or significantly impacted
the financial terms on which these services are offered to our customers, our business could be
harmed.
Our international net revenue is subject to currency fluctuations.
For the nine months ended December 31, 2006, international net revenue comprised 45 percent of our
total net revenue. For the fiscal year ended March 31, 2006, international net revenue comprised 46
percent of our total net revenue. We expect foreign sales to continue to account for a significant
portion of our total net revenue. Such sales may be subject to unexpected regulatory requirements,
tariffs and other barriers. Additionally, foreign sales are primarily made in local currencies,
which may fluctuate against the U.S. dollar. While we utilize foreign exchange forward contracts to
mitigate some foreign currency risk associated with foreign currency denominated assets and
liabilities (primarily certain intercompany receivables and payables) and, from time to time,
foreign currency option contracts to hedge foreign currency forecasted transactions (primarily
related to a portion of the revenue and expenses denominated in foreign currency generated by our
operational
subsidiaries), our results of
64
operations, including our reported net revenue and net income, and
financial condition would be adversely affected by unfavorable foreign currency fluctuations,
particularly the Euro, British pound sterling and Canadian dollar.
Changes in our tax rates or exposure to additional tax liabilities could adversely affect our
operating results and financial condition.
We are subject to income taxes in the United States and in various foreign jurisdictions.
Significant judgment is required in determining our worldwide provision for income taxes, and, in
the ordinary course of our business, there are many transactions and calculations where the
ultimate tax determination is uncertain.
We are also required to estimate what our taxes will be in the future. Although we believe our tax
estimates are reasonable, the estimate process and the applicable law are inherently uncertain, and
our estimates are not binding on tax authorities. Our effective tax rate could be adversely
affected by changes in our business, including the mix of earnings in countries with differing
statutory tax rates, changes in the elections we make, changes in applicable tax laws as well as
other factors. Further, our tax determinations are regularly subject to audit by tax authorities
and developments in those audits could adversely affect our income tax provision. Should our
ultimate tax liability exceed our estimates, our income tax provision and net income could be
materially affected.
We incur certain tax expenses that do not decline proportionately with declines in our consolidated
pre-tax income. As a result, in absolute dollar terms, our tax expense will have a greater
influence on our effective tax rate at lower levels of pre-tax income than higher levels. In
addition, at lower levels of pre-tax income, our effective tax rate will be more volatile.
We are also required to pay taxes other than income taxes, such as payroll, sales, use,
value-added, net worth, property and goods and services taxes, in both the United States and
various foreign jurisdictions. We are regularly under examination by tax authorities with respect
to these non-income taxes. There can be no assurance that the outcomes from these examinations,
changes in our business or changes in applicable tax rules will not have an adverse effect on our
operating results and financial condition.
Changes in our worldwide operating structure could have adverse tax consequences.
As we expand our international operations and implement changes to our operating structure or
undertake intercompany transactions in light of changing tax laws, expiring rulings, acquisitions
and our current and anticipated business and operational requirements, our tax expense could
increase. For example, in the second and fourth quarters of fiscal 2006, we incurred additional
income taxes resulting from certain intercompany transactions.
In the fourth quarter of fiscal 2006, we repatriated $375 million under the American Jobs Creation
Act of 2004. As a result, we recorded an additional one-time tax expense in fiscal 2006 of $17
million.
Our reported financial results could be adversely affected by changes in financial accounting
standards or by the application of existing or future accounting standards to our business as it
evolves.
As a result of the enactment of the Sarbanes-Oxley Act and the review of accounting policies by the
SEC and national and international accounting standards bodies, the frequency of accounting policy
changes may accelerate. For example, we adopted Statement of Financial Accounting Standard (SFAS)
No. 123 (revised 2004) (SFAS No. 123(R)), Share-Based Payment, which requires us to recognize
compensation expense for all stock-based compensation based on estimated fair values. As a result,
beginning with our first quarter of fiscal 2007, our operating results contain a charge for
stock-based compensation related to the equity-based compensation we provide to our employees, as
well as stock purchases under our 2000 Employee Stock Purchase Plan. In addition, the rules for tax
accounting have recently been changed. In July 2006, the Financial Accounting Standards Board
(FASB) issued FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes -
An Interpretation of FASB Statement No. 109, which clarifies the accounting for uncertainty in
income taxes recognized in financial statements in accordance with SFAS No. 109, Accounting for
Income Taxes (see Note 14 of the Notes to Condensed Consolidated Financial Statements). We are
evaluating what impact the adoption of FIN No. 48 will have on our Condensed Consolidated Financial
Statements. While these and future accounting standards may not necessarily impact our cash flows,
they could materially impact our reported results.
65
As we enhance, expand and diversify our business and product offerings, the application of existing
or future financial accounting standards, particularly those relating to the way we account for
revenue, could have a significant adverse effect on our reported results although not necessarily
on our cash flows. For example, in order to support the online functionality of our package goods
games for the PC, PlayStation 2, PlayStation 3 and the PSP, we provide our consumers with access to
servers which we maintain. Starting in fiscal 2008, we will no longer be able to establish the fair
value, as determined under U.S. GAAP, of such online services, which will prevent us from
recognizing the related revenue separately from the revenue associated with the packaged good sale.
Therefore, under U.S. GAAP, we will be required to recognize revenue from the combined sale of the
packaged good game and the online service over the estimated online service period. As a result, we
anticipate that we will likely defer more than $400 million in net revenue from the sale of these
online-enabled games from fiscal 2008 into fiscal 2009, thereby reducing our fiscal 2008 net
revenue, net income and earnings per share.
The majority of our sales are made to a relatively small number of key customers. If these
customers reduce their purchases of our products or become unable to pay for them, our business
could be harmed.
In the quarter ended December 31, 2006, over 70 percent of our U.S. sales were made to seven key
customers. In Europe, our top ten customers accounted for approximately 31 percent of our sales in
that territory during the nine months ended December 31, 2006. Worldwide, we had direct sales to
two customers, Wal-Mart Stores, Inc. and GameStop Corp., which represented approximately 13 percent
and 12 percent, respectively, of total net revenue in the nine months ended December 31, 2006.
Though our products are available to consumers through a variety of retailers, the concentration of
our sales in one, or a few, large customers could lead to a short-term disruption in our sales if
one or more of these customers significantly reduced their purchases or ceased to carry our
products, and could make us more vulnerable to collection risk if one or more of these large
customers became unable to pay for our products. Additionally, our receivables from these large
customers increase significantly in the December quarter as they stock up for the holiday selling
season. Also, having such a large portion of our total net revenue concentrated in a few customers
reduces our negotiating leverage with these customers.
Acquisitions, investments and other strategic transactions could result in operating difficulties,
dilution to our investors and other negative consequences.
We have engaged in, evaluated, and expect to continue to engage in and evaluate, a wide array of
potential strategic transactions, including (i) acquisitions of companies, businesses, intellectual
properties, and other assets, and (ii) investments in new interactive entertainment businesses (for
example, online and mobile games). Any of these strategic transactions could be material to our
financial condition and results of operations. Although we regularly search for opportunities to
engage in strategic transactions, we may not be successful in identifying suitable opportunities.
We may not be able to consummate potential acquisitions or investments or an acquisition or
investment may not enhance our business or may decrease rather than increase our earnings. In
addition, the process of integrating an acquired company or business, or successfully exploiting
acquired intellectual property or other assets, could divert a significant amount of our
managements time and focus and may create unforeseen operating difficulties and expenditures.
Additional risks we face include:
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The need to implement or remediate controls, procedures and policies appropriate for a
public company in an acquired company that, prior to the acquisition, lacked these controls,
procedures and policies, |
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Cultural challenges associated with integrating employees from an acquired company or
business into our organization, |
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Retaining key employees from the businesses we acquire, |
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The need to integrate an acquired companys accounting, management information, human
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To the extent that we engage in strategic transactions outside of the United States, we
face additional risks, including risks related to integration of operations across different
cultures and languages, currency risks and the particular economic, political and regulatory
risks associated with specific countries. |
Future acquisitions and investments could involve the issuance of our equity securities,
potentially diluting our existing stockholders, the incurrence of debt, contingent liabilities or
amortization expenses, write-offs of goodwill, intangibles, or
acquired in-process technology, or other increased expenses, any of which could harm our financial
condition. Our stockholders may not have the opportunity to review, vote on or evaluate future
acquisitions or investments.
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Our products are subject to the threat of piracy by a variety of organizations and individuals. If
we are not successful in combating and preventing piracy, our sales and profitability could be
harmed significantly.
In many countries around the world, more pirated copies of our products are sold than legitimate
copies. Though we believe piracy has not had a material impact on our operating results to date,
highly organized pirate operations have been expanding globally. In addition, the proliferation of
technology designed to circumvent the protection measures we use in our products, the availability
of broadband access to the Internet, the ability to download pirated copies of our games from
various Internet sites, and the widespread proliferation of Internet cafes using pirated copies of
our products, all have contributed to ongoing and expanding piracy. Though we take steps to make
the unauthorized copying and distribution of our products more difficult, as do the manufacturers
of consoles on which our games are played, neither our efforts nor those of the console
manufacturers may be successful in controlling the piracy of our products. This could have a
negative effect on our growth and profitability in the future.
Our stock price has been volatile and may continue to fluctuate significantly.
The market price of our common stock historically has been, and we expect will continue to be,
subject to significant fluctuations. These fluctuations may be due to factors specific to us
(including those discussed in the risk factors above as well as others not currently known to us or
that we currently do not believe are material), to changes in securities analysts earnings
estimates or ratings, to our results or future financial guidance falling below our expectations
and analysts and investors expectations, to factors affecting the computer, software, Internet,
entertainment, media or electronics industries, or to national or international economic
conditions.
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Item 6. Exhibits
The following exhibits (other than exhibits 32.1 and 32.2, which are furnished with this report) are
filed as part of this report:
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Exhibit |
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15.1 |
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Awareness Letter of KPMG LLP, Independent Registered Public Accounting Firm. |
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31.1 |
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Certification of Chairman and Chief Executive Officer pursuant to Rule 13a-14(a)
of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of
2002. |
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31.2 |
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Certification of Executive Vice President, Chief Financial and Administrative
Officer pursuant to Rule 13a-14(a) of the Exchange Act, as adopted pursuant to Section
302 of the Sarbanes-Oxley Act of 2002. |
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Additional exhibits furnished with this report: |
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32.1 |
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Certification of Chairman and Chief Executive Officer pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002. |
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32.2 |
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Certification of Executive Vice President, Chief Financial and Administrative
Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused
this report to be signed on its behalf by the undersigned thereunto duly authorized.
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ELECTRONIC ARTS INC.
(Registrant) |
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/s/ Warren C. Jenson |
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DATED:
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WARREN C. JENSON |
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February 6, 2007
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Executive Vice President, |
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Chief Financial and Administrative Officer |
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ELECTRONIC ARTS INC.
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2006
EXHIBIT INDEX
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EXHIBIT |
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NUMBER |
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EXHIBIT TITLE |
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15.1
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Awareness Letter of KPMG LLP, Independent Registered Public Accounting Firm. |
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31.1
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Certification of Chairman and Chief Executive Officer pursuant to Rule
13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002. |
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31.2
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Certification of Executive Vice President, Chief Financial and
Administrative Officer pursuant to Rule 13a-14(a) of the Exchange Act, as
adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
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Additional exhibits furnished with this report: |
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32.1
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Certification of Chairman and Chief Executive Officer pursuant to Section
906 of the Sarbanes-Oxley Act of 2002. |
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32.2
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Certification of Executive Vice President, Chief Financial and
Administrative Officer pursuant to Section 906 of the Sarbanes-Oxley Act of
2002. |
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