e10vq
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
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þ |
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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 September 30, 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
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94-2838567 |
(State or other jurisdiction of
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(I.R.S. Employer |
incorporation or organization)
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Identification No.) |
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209 Redwood Shores Parkway |
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Redwood City, California
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94065 |
(Address of principal executive offices)
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(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
November 3, 2006, there were 308,495,018 shares of the Registrants Common Stock, par value
$0.01 per share, outstanding.
ELECTRONIC ARTS INC.
FORM 10-Q
FOR THE PERIOD ENDED SEPTEMBER 30, 2006
Table of Contents
2
PART I FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements (Unaudited)
ELECTRONIC ARTS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
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(Unaudited) |
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September 30, |
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March 31, |
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(In millions, except par value data) |
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2006 |
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2006 (a) |
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ASSETS |
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Current assets: |
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Cash and cash equivalents |
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$ |
1,212 |
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$ |
1,242 |
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Short-term investments |
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960 |
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1,030 |
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Marketable equity securities |
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204 |
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160 |
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Receivables, net of allowances of $172 and $232, respectively |
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267 |
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199 |
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Inventories |
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67 |
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61 |
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Deferred income taxes, net |
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89 |
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86 |
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Other current assets |
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210 |
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234 |
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Total current assets |
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3,009 |
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3,012 |
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Property and equipment, net |
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448 |
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392 |
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Investments in affiliates |
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11 |
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11 |
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Goodwill |
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709 |
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647 |
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Other intangibles, net |
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231 |
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232 |
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Other assets |
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103 |
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92 |
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TOTAL ASSETS |
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$ |
4,511 |
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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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$ |
199 |
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$ |
163 |
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Accrued and other current liabilities |
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634 |
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706 |
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Total current liabilities |
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833 |
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869 |
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Deferred income taxes, net |
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13 |
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29 |
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Other liabilities |
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61 |
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68 |
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Total liabilities |
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907 |
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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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13 |
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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, $0.01 par value. 1,000 shares authorized; 308 and
305 shares issued and outstanding, respectively |
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3 |
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3 |
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Paid-in capital |
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1,249 |
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1,081 |
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Retained earnings |
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2,182 |
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2,241 |
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Accumulated other comprehensive income |
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157 |
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83 |
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Total stockholders equity |
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3,591 |
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3,408 |
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TOTAL LIABILITIES, MINORITY INTEREST AND STOCKHOLDERS EQUITY |
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$ |
4,511 |
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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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Six Months Ended |
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(Unaudited) |
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September 30, |
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September 30, |
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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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$ |
784 |
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$ |
675 |
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$ |
1,196 |
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$ |
1,040 |
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Cost of goods sold |
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339 |
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284 |
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506 |
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434 |
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Gross profit |
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445 |
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391 |
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690 |
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606 |
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Operating expenses: |
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Marketing and sales |
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108 |
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107 |
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185 |
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182 |
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General and administrative |
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72 |
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52 |
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131 |
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103 |
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Research and development |
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238 |
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182 |
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454 |
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365 |
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Amortization of intangibles |
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7 |
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1 |
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13 |
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2 |
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Acquired in-process technology |
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2 |
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2 |
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Restructuring charges |
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4 |
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10 |
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Total operating expenses |
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431 |
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342 |
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795 |
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652 |
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Operating income (loss) |
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14 |
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49 |
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(105 |
) |
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(46 |
) |
Interest and other income, net |
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24 |
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13 |
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45 |
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30 |
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Income (loss) before provision for (benefit from) income
taxes and minority interest |
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38 |
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62 |
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(60 |
) |
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(16 |
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Provision for (benefit from) income taxes |
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16 |
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9 |
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(1 |
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(13 |
) |
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Income (loss) before minority interest |
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22 |
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53 |
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(59 |
) |
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(3 |
) |
Minority interest |
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(2 |
) |
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(4 |
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Net income (loss) |
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$ |
22 |
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$ |
51 |
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$ |
(59 |
) |
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$ |
(7 |
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Net income (loss) per share: |
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Basic |
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$ |
0.07 |
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$ |
0.17 |
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$ |
(0.19 |
) |
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$ |
(0.02 |
) |
Diluted |
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$ |
0.07 |
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$ |
0.16 |
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$ |
(0.19 |
) |
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$ |
(0.02 |
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Number of shares used in computation: |
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Basic |
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307 |
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302 |
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306 |
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305 |
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Diluted |
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315 |
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314 |
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306 |
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305 |
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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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Six Months Ended |
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(Unaudited) |
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September 30, |
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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 loss |
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$ |
(59 |
) |
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$ |
(7 |
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Adjustments to reconcile net loss to net cash used in operating activities: |
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Depreciation and amortization |
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72 |
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46 |
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Stock-based compensation |
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70 |
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Minority interest |
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4 |
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Realized net losses on investments and sale of property and equipment |
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1 |
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2 |
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Tax benefit from exercise of stock options |
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92 |
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Acquired in-process technology |
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2 |
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Change in assets and liabilities: |
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Receivables, net |
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(63 |
) |
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(20 |
) |
Inventories |
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(5 |
) |
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(9 |
) |
Other assets |
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14 |
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(16 |
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Accounts payable |
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35 |
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34 |
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Accrued and other liabilities |
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(111 |
) |
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(145 |
) |
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Net cash used in operating activities |
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(44 |
) |
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(19 |
) |
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INVESTING ACTIVITIES |
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Capital expenditures |
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(86 |
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(56 |
) |
Proceeds from sale of marketable equity securities |
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4 |
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Proceeds from maturities and sales of short-term investments |
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680 |
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321 |
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Purchase of short-term investments |
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(604 |
) |
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(281 |
) |
Acquisition of subsidiaries, net of cash acquired |
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(67 |
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(3 |
) |
Other investing activities |
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2 |
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(1 |
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Net cash used in investing activities |
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(75 |
) |
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(16 |
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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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85 |
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60 |
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Excess tax benefit from stock-based compensation |
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12 |
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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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83 |
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(649 |
) |
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Effect of foreign exchange on cash and cash equivalents |
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6 |
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(11 |
) |
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Decrease in cash and cash equivalents |
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(30 |
) |
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(695 |
) |
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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1,212 |
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|
575 |
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Short-term investments |
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|
960 |
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1,655 |
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Ending cash, cash equivalents and short-term investments |
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$ |
2,172 |
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$ |
2,230 |
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Supplemental cash flow information: |
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Cash paid during the period for income taxes |
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$ |
34 |
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$ |
10 |
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Non-cash investing activities: |
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|
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Change in unrealized gains (losses) on investments, net |
|
$ |
50 |
|
|
$ |
54 |
|
|
|
|
|
|
|
|
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® 2, Microsoft Xbox
360TM and Xbox®, and Nintendo GameCubeTM), personal computers,
mobile platforms (including cellular handsets and handheld game players such as the
PlayStation® Portable (PSPTM) and the Nintendo DSTM) 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 SimsTM,
Need for SpeedTM and BLACKTM). 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) 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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Fiscal Years Ended |
|
Number of Weeks |
|
Fiscal Period End Date |
March 31, 2007
|
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52 weeks
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|
March 31, 2007 |
March 31, 2006
|
|
53 weeks
|
|
April 1, 2006 |
Our results of operations for the three and six months ended September 30, 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 September 30, 2006
|
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13 weeks
|
|
September 30, 2006 |
Six months ended September 30, 2006
|
|
26 weeks
|
|
September 30, 2006 |
|
Three months ended September 30, 2005
|
|
13 weeks
|
|
October 1, 2005 |
Six months ended September 30, 2005
|
|
27 weeks
|
|
October 1, 2005 |
For simplicity of presentation, all fiscal periods are treated as ending on a calendar month end.
6
(3) STOCK-BASED COMPENSATION
Adoption of SFAS No. 123R
In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial
Accounting Standard (SFAS) No. 123 (revised 2004) (SFAS No. 123R), Share-Based Payment. SFAS
No. 123R 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. 123R and certain SEC rules and regulations for public
companies. SFAS No. 123R replaces SFAS No. 123, Accounting for Stock-Based Compensation, as
amended, supersedes Accounting Principles Board No. 25 (APB No. 25), Accounting for Stock Issued
to Employees, and amends SFAS No. 95, Statement of Cash Flows.
We adopted SFAS No. 123R as of April 1, 2006 and have applied the provisions of SAB No. 107 to our
adoption of SFAS No. 123R. SFAS No. 123R 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. 123R.
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 common 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. 123R, 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 on the number of shares granted and 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 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 |
|
Six Months Ended |
|
Three Months Ended |
|
Six Months Ended |
|
|
September 30, 2006 |
|
September 30, 2006 |
|
September 30, 2006 |
|
September 30, 2006 |
Risk-free interest rate |
|
|
4.6 |
% |
|
|
4.7 |
% |
|
|
4.6 |
% |
|
|
4.6 |
% |
Expected volatility |
|
|
35 |
% |
|
|
35 |
% |
|
|
32 |
% |
|
|
31 |
% |
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. 123R, 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. 123R, 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. 123R, employee stock-based compensation expense recognized in the three and
six months ended September 30, 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 |
|
|
Six Months Ended |
|
|
|
September 30, |
|
|
September 30, |
|
|
|
2006 |
|
|
2005 |
|
|
2006 |
|
|
2005 |
|
Cost of goods sold |
|
$ |
1 |
|
|
$ |
|
|
|
$ |
1 |
|
|
$ |
|
|
Marketing and sales |
|
|
4 |
|
|
|
|
|
|
|
9 |
|
|
|
|
|
General and administrative |
|
|
9 |
|
|
|
|
|
|
|
20 |
|
|
|
|
|
Research and development |
|
|
19 |
|
|
|
1 |
|
|
|
40 |
|
|
|
1 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Stock-based compensation expense |
|
|
33 |
|
|
|
1 |
|
|
|
70 |
|
|
|
1 |
|
Benefit for income taxes |
|
|
(7 |
) |
|
|
(1 |
) |
|
|
(15 |
) |
|
|
(1 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
Stock-based compensation expense, net of tax |
|
$ |
26 |
|
|
$ |
|
|
|
$ |
55 |
|
|
$ |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
As of September 30, 2006, the total unrecognized compensation cost related to stock options
was $191 million, and restricted stock and restricted stock units was $74 million and is expected
to be recognized over the weighted-average service period of 1.65 years and 2.39 years,
respectively.
8
The adoption of SFAS No. 123R, using the fair value method, had the following effect on our pre-tax
income (loss), net income (loss), and basic and diluted net income (loss) 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 |
|
|
Six Months Ended |
|
|
|
September 30, 2006 |
|
|
September 30, 2006 |
|
|
|
|
|
|
|
Intrinsic |
|
|
|
|
|
|
|
|
|
|
Intrinsic |
|
|
|
|
|
|
Fair Value |
|
|
Value |
|
|
Impact of |
|
|
Fair Value |
|
|
Value |
|
|
Impact of |
|
|
|
Method |
|
|
Method |
|
|
Change |
|
|
Method |
|
|
Method |
|
|
Change |
|
Income (loss) before provision for (benefit from)
income taxes and minority interest |
|
$ |
38 |
|
|
$ |
65 |
|
|
$ |
(27 |
) |
|
$ |
(60 |
) |
|
$ |
1 |
|
|
$ |
(61 |
) |
Net income (loss) |
|
$ |
22 |
|
|
$ |
44 |
|
|
$ |
(22 |
) |
|
$ |
(59 |
) |
|
$ |
(12 |
) |
|
$ |
(47 |
) |
Net income (loss) per share: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic |
|
$ |
0.07 |
|
|
$ |
0.14 |
|
|
$ |
(0.07 |
) |
|
$ |
(0.19 |
) |
|
$ |
(0.04 |
) |
|
$ |
(0.15 |
) |
Diluted |
|
$ |
0.07 |
|
|
$ |
0.14 |
|
|
$ |
(0.07 |
) |
|
$ |
(0.19 |
) |
|
$ |
(0.04 |
) |
|
$ |
(0.15 |
) |
APIC Pool. In November 2005, the FASB issued FASB Staff Position (FSP) Financial Accounting
Standard (FAS) No. 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. 123R. For
employee stock-based compensation awards that are outstanding upon adoption of SFAS No. 123R, 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 FAS No. 123(R)-3 for calculating
the tax effects of stock-based compensation pursuant to SFAS No. 123R.
Cash Flow Impact. Prior to our adoption of SFAS No. 123R, 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. 123R 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 six months ended September 30, 2006:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted- |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Average |
|
|
|
|
|
|
|
|
|
|
Weighted- |
|
|
Remaining |
|
|
Aggregate |
|
|
|
Options |
|
|
Average |
|
|
Contractual |
|
|
Intrinsic Value |
|
|
|
(in thousands) |
|
|
Exercise Price |
|
|
Term (in years) |
|
|
(in millions) |
|
Outstanding at March 31, 2006 |
|
|
40,882 |
|
|
$ |
40.02 |
|
|
|
|
|
|
|
|
|
Activity for the six months ended
September 30, 2006: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Granted |
|
|
3,718 |
|
|
|
50.64 |
|
|
|
|
|
|
|
|
|
Exercised |
|
|
(2,532 |
) |
|
|
27.57 |
|
|
|
|
|
|
|
|
|
Forfeited, cancelled or expired |
|
|
(1,628 |
) |
|
|
52.24 |
|
|
|
|
|
|
|
|
|
Exchange Program (cancelled) |
|
|
(1,776 |
) |
|
|
64.92 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Outstanding at September 30, 2006 |
|
|
38,664 |
|
|
$ |
40.20 |
|
|
|
6.8 |
|
|
$ |
636 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Additional stock option-related information:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted- |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Average |
|
|
|
|
|
|
|
|
|
|
Weighted- |
|
|
Remaining |
|
|
Aggregate |
|
|
|
Options |
|
|
Average |
|
|
Contractual |
|
|
Intrinsic Value |
|
|
|
(in thousands) |
|
|
Exercise Price |
|
|
Term (in years) |
|
|
(in millions) |
|
Outstanding at September 30, 2006 |
|
|
38,664 |
|
|
$ |
40.20 |
|
|
|
6.8 |
|
|
$ |
636 |
|
Vested and expected to vest at September 30, 2006 |
|
|
36,451 |
|
|
$ |
39.37 |
|
|
|
6.7 |
|
|
$ |
628 |
|
Exercisable at September 30, 2006 |
|
|
22,692 |
|
|
$ |
31.17 |
|
|
|
5.3 |
|
|
$ |
568 |
|
A total of approximately 15 million shares were available for grant under our Equity Plan as of
September 30, 2006, of which no more than approximately 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 September 30, 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 six months
ended September 30, 2006 was $17.63 and $17.66, respectively. The weighted-average grant-date fair
value of stock options granted during the three and six months ended September 30, 2005 was $17.29
and $16.55, respectively. The total intrinsic value of options exercised during the three and six
months ended September 30, 2006 was $31 million and $58 million, respectively. The total intrinsic
value of options exercised during the three and six months ended September 30, 2005 was $32 million
and $58 million, respectively. The total fair value (determined at the grant date) of shares vested
during the three and six months ended September 30, 2006 was $22 million and $54 million,
respectively. The total fair value (determined at the grant date) of shares vested during the three
and six months ended September 30, 2005 was $31 million and $67 million, respectively.
10
The following table summarizes outstanding and exercisable options as of September 30, 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 |
|
|
3,751 |
|
|
|
1.95 |
|
|
$ |
11.26 |
|
|
|
1.2 |
% |
|
|
3,739 |
|
|
$ |
11.29 |
|
|
|
1.2 |
% |
15.00 - 24.99 |
|
|
4,531 |
|
|
|
4.41 |
|
|
|
23.11 |
|
|
|
1.5 |
% |
|
|
4,521 |
|
|
|
23.11 |
|
|
|
1.5 |
% |
25.00 - 34.99 |
|
|
8,665 |
|
|
|
5.69 |
|
|
|
30.13 |
|
|
|
2.8 |
% |
|
|
8,207 |
|
|
|
30.09 |
|
|
|
2.7 |
% |
35.00 - 44.99 |
|
|
2,324 |
|
|
|
7.38 |
|
|
|
42.26 |
|
|
|
0.8 |
% |
|
|
1,362 |
|
|
|
42.06 |
|
|
|
0.4 |
% |
45.00 - 54.99 |
|
|
13,179 |
|
|
|
8.71 |
|
|
|
50.88 |
|
|
|
4.3 |
% |
|
|
3,349 |
|
|
|
49.02 |
|
|
|
1.1 |
% |
55.00 - 65.93 |
|
|
6,214 |
|
|
|
8.66 |
|
|
|
60.72 |
|
|
|
2.0 |
% |
|
|
1,514 |
|
|
|
60.90 |
|
|
|
0.5 |
% |
|
|
|
|
|
$ 0.53 - $65.93 |
|
|
38,664 |
|
|
|
6.78 |
|
|
$ |
40.20 |
|
|
|
12.6 |
% |
|
|
22,692 |
|
|
$ |
31.17 |
|
|
|
7.4 |
% |
|
|
|
|
|
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 September 30, 2006 (308 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 vest, 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 six months ended
September 30, 2006:
|
|
|
|
|
|
|
|
|
|
|
Restricted Stock |
|
|
Weighted- |
|
|
|
Rights |
|
|
Average Grant |
|
|
|
(in thousands) |
|
|
Date Fair Value |
|
Balance as of March 31, 2006 |
|
|
655 |
|
|
$ |
52.21 |
|
Activity for the six months ended September 30, 2006: |
|
|
|
|
|
|
|
|
Granted |
|
|
783 |
|
|
|
51.76 |
|
Exchange Program (granted) |
|
|
444 |
|
|
|
54.22 |
|
Vested |
|
|
(36 |
) |
|
|
53.42 |
|
Forfeited |
|
|
(45 |
) |
|
|
52.30 |
|
|
|
|
|
|
|
|
Balance as of September 30, 2006 |
|
|
1,801 |
|
|
$ |
52.48 |
|
|
|
|
|
|
|
|
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 months ended September 30, 2006 was $52.67. The weighted-average
fair value of restricted stock rights granted during the three and six months ended September 30,
2005 was $59.47 and $53.49, respectively. The total fair value of restricted stock rights vested
during the three and six months ended September 30, 2006 was $1 million and $2 million,
respectively. There were no restricted stock rights vested during the three and six months ended
September 30, 2005.
11
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
stock price) 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 reside 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 following the expiration of the offer
and restricted stock rights were granted. For restricted stock rights issued in exchange for
unvested options, compensation expense will be 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
a result, a total of 6.8 million shares have been authorized to be reserved for issuance under the
ESPP.
Information related to stock issuances under this plan is as follows:
|
|
|
|
|
|
|
|
|
|
|
Six Months Ended September 30, |
|
|
|
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 |
|
12
We issued 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. 123R and Pre-SFAS No. 123R Pro Forma
Accounting Disclosures. As of September 30, 2006, we had approximately 3 million shares of common
stock reserved for future issuance under the ESPP.
Pre-SFAS No. 123R Pro Forma Accounting Disclosures
Prior to the adoption of SFAS No. 123R, 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 (loss) and net income (loss) 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 six months ended
September 30, 2005:
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
Six Months Ended |
|
|
September 30, 2005 |
|
September 30, 2005 |
Risk-free interest rate |
|
|
3.9 |
% |
|
|
3.8 |
% |
Expected volatility |
|
|
34 |
% |
|
|
34 |
% |
Expected term of stock options (in years) |
|
|
3.5 |
|
|
|
3.4 |
|
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 |
|
|
Six Months Ended |
|
(In millions, except per share data) |
|
September 30, 2005 |
|
|
September 30, 2005 |
|
Net income (loss): |
|
|
|
|
|
|
|
|
As reported |
|
$ |
51 |
|
|
$ |
(7 |
) |
Deduct: Total stock-based employee compensation
expense determined under fair-value-based method
for all awards, net of related tax effects |
|
|
(26 |
) |
|
|
(51 |
) |
|
|
|
|
|
|
|
Pro forma |
|
$ |
25 |
|
|
$ |
(58 |
) |
|
|
|
|
|
|
|
Net income (loss) per share: |
|
|
|
|
|
|
|
|
As reported basic |
|
$ |
0.17 |
|
|
$ |
(0.02 |
) |
Pro forma basic |
|
$ |
0.08 |
|
|
$ |
(0.19 |
) |
As reported diluted |
|
$ |
0.16 |
|
|
$ |
(0.02 |
) |
Pro forma diluted |
|
$ |
0.08 |
|
|
$ |
(0.19 |
) |
(4) BUSINESS COMBINATIONS
Mythic Entertainment
On July 24, 2006, we acquired all outstanding shares of Mythic Entertainment, Inc. (Mythic) for
an aggregate purchase price of $76 million, 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.
13
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.
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. Accordingly,
we expensed $2 million of acquired in-process technology in our Condensed Consolidated Statements
of Operations upon consummation of the acquisition.
The following table summarizes the preliminary allocation of assets acquired and liabilities
assumed in connection with our acquisition of Mythic (in millions):
|
|
|
|
|
Current assets |
|
$ |
15 |
|
Property and equipment, net |
|
|
1 |
|
Other long-term assets |
|
|
1 |
|
Acquired in-process technology |
|
|
2 |
|
Goodwill |
|
|
62 |
|
Finite-lived intangibles |
|
|
22 |
|
Liabilities |
|
|
(27 |
) |
|
|
|
|
Total consideration |
|
$ |
76 |
|
|
|
|
|
We expect to finalize the preliminary purchase price allocation during the three months ended December 31, 2006.
Digital Illusions C.E.
As of September 30, 2006, we owned 74 percent of Digital Illusions C.E.s (DICE) Class A common
stock. In October 2006, we acquired all of the remaining minority interest in DICE for a total of
$24 million. Since January 27, 2005, we have included the assets, liabilities and results of
operations of DICE in our Condensed Consolidated Financial Statements. We expect further
adjustments to our purchase price allocation, including the allocation of goodwill, as a result of
our purchase of the remaining minority interest of DICE.
(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 |
|
|
September 30, |
|
|
|
2006 |
|
|
Acquired |
|
|
Adjustments (1) |
|
|
Translation |
|
|
2006 |
|
|
|
|
Goodwill |
|
$ |
647 |
|
|
$ |
62 |
|
|
$ |
(4 |
) |
|
$ |
4 |
|
|
$ |
709 |
|
|
|
|
|
|
|
(1) |
|
During the three months ended June 30, 2006, we finalized the purchase price allocation including the allocation of goodwill related to our JAMDAT Mobile Inc. (JAMDAT) acquisition. As a result, we reduced goodwill and the liability balance assumed from JAMDAT by $4 million. |
14
Finite-lived intangibles consisted of the following (in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
As of September 30, 2006 |
|
|
|
Gross |
|
|
|
|
|
|
|
|
|
|
Other |
|
|
|
Carrying |
|
|
Accumulated |
|
|
|
|
|
|
Intangibles, |
|
|
|
Amount |
|
|
Amortization |
|
|
Other |
|
|
Net |
|
|
|
|
Developed and Core Technology |
|
$ |
175 |
|
|
$ |
(45 |
) |
|
$ |
2 |
|
|
$ |
132 |
|
Carrier Contracts and Related |
|
|
85 |
|
|
|
(11 |
) |
|
|
|
|
|
|
74 |
|
Trade Name |
|
|
42 |
|
|
|
(22 |
) |
|
|
|
|
|
|
20 |
|
Subscribers and Other Intangibles |
|
|
16 |
|
|
|
(11 |
) |
|
|
|
|
|
|
5 |
|
|
|
|
Total |
|
$ |
318 |
|
|
$ |
(89 |
) |
|
$ |
2 |
|
|
$ |
231 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
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 six months ended September 30, 2006 was $14 million
(of which $7 million was recognized as cost of goods sold) and $26 million (of which $13 million
was recognized as cost of goods sold), respectively. Amortization of intangibles for the three and
six months ended September 30, 2005 was $3 million (of which $2 million was recognized as cost of
goods sold) and $6 million (of which $4 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 September 30, 2006 and March 31, 2006, the weighted-average remaining useful life for
finite-lived intangible assets was approximately 6.7 years and 7.2 years, respectively.
As of September 30, 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 six months) |
|
$ |
28 |
|
2008 |
|
|
49 |
|
2009 |
|
|
38 |
|
2010 |
|
|
33 |
|
2011 |
|
|
29 |
|
Thereafter |
|
|
54 |
|
|
|
|
|
Total |
|
$ |
231 |
|
|
|
|
|
15
(6) RESTRUCTURING AND ASSET IMPAIRMENT CHARGES
Restructuring and asset impairment information as of September 30, 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 |
|
|
6 |
|
|
|
1 |
|
|
|
3 |
|
|
|
|
|
|
|
|
|
|
|
10 |
|
Charges utilized in cash |
|
|
(7 |
) |
|
|
|
|
|
|
(4 |
) |
|
|
(2 |
) |
|
|
(2 |
) |
|
|
(15 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Balances as of September 30, 2006 |
|
$ |
|
|
|
$ |
9 |
|
|
$ |
1 |
|
|
$ |
1 |
|
|
$ |
5 |
|
|
$ |
16 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
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 our quarter ending 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 September 30, 2006, we have incurred
restructuring charges of approximately $24 million, of which $9 million was for the closure of
certain U.K. facilities, $9 million for employee-related expenses, and $6 million in other costs in
connection with our international publishing reorganization. The restructuring accrual of $10
million as of September 30, 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 September 30, 2006, we expect to incur between $40 million and $50 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 $10 million), as well as other reorganization costs
(approximately $10 million).
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 September 30, 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 fiscal 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 September 30, 2006, an aggregate of $29 million in cash had been paid out under these
restructuring plans. The remaining projected net cash outlay of $5 million is expected to be
utilized during our fiscal year ending March 31, 2007. The facilities-related accrued
16
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 significant performance
remains with the licensor. When significant 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 September 30, 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 six months ended September 30, 2006 and
2005.
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 |
|
|
|
September 30, |
|
|
March 31, |
|
|
|
2006 |
|
|
2006 |
|
Other current assets |
|
$ |
59 |
|
|
$ |
76 |
|
Other assets |
|
|
54 |
|
|
|
55 |
|
|
|
|
|
|
|
|
Royalty-related assets |
|
$ |
113 |
|
|
$ |
131 |
|
|
|
|
|
|
|
|
17
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 |
|
|
|
September 30, |
|
|
March 31, |
|
|
|
2006 |
|
|
2006 |
|
Accrued and other current liabilities |
|
$ |
99 |
|
|
$ |
82 |
|
Other liabilities |
|
|
2 |
|
|
|
7 |
|
|
|
|
|
|
|
|
Royalty-related liabilities |
|
$ |
101 |
|
|
$ |
89 |
|
|
|
|
|
|
|
|
In addition, as of September 30, 2006, we were committed to pay approximately $1,542 million to
co-publishing and/or distribution affiliates and content licensors, but significant 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 September 30, 2006 and March 31, 2006 consisted of (in millions):
|
|
|
|
|
|
|
|
|
|
|
As of |
|
|
As of |
|
|
|
September 30, |
|
|
March 31, |
|
|
|
2006 |
|
|
2006 |
|
Raw materials and work in process |
|
$ |
7 |
|
|
$ |
1 |
|
Finished goods (including manufacturing royalties) |
|
|
60 |
|
|
|
60 |
|
|
|
|
|
|
|
|
Inventories |
|
$ |
67 |
|
|
$ |
61 |
|
|
|
|
|
|
|
|
Property and Equipment, Net
Property and equipment, net, as of September 30, 2006 and March 31, 2006 consisted of (in
millions):
|
|
|
|
|
|
|
|
|
|
|
As of |
|
|
As of |
|
|
|
September 30, |
|
|
March 31, |
|
|
|
2006 |
|
|
2006 |
|
Computer equipment and software |
|
$ |
483 |
|
|
$ |
418 |
|
Buildings |
|
|
196 |
|
|
|
127 |
|
Leasehold improvements |
|
|
87 |
|
|
|
78 |
|
Office equipment, furniture and fixtures |
|
|
63 |
|
|
|
57 |
|
Land |
|
|
62 |
|
|
|
57 |
|
Warehouse equipment and other |
|
|
10 |
|
|
|
11 |
|
Construction in progress |
|
|
8 |
|
|
|
59 |
|
|
|
|
|
|
|
|
|
|
|
909 |
|
|
|
807 |
|
Less accumulated depreciation |
|
|
(461 |
) |
|
|
(415 |
) |
|
|
|
|
|
|
|
Property and equipment, net |
|
$ |
448 |
|
|
$ |
392 |
|
|
|
|
|
|
|
|
Depreciation expense associated with property and equipment amounted to $23 million and $46 million
for the three and six months ended September 30, 2006, respectively. Depreciation expense
associated with property and equipment amounted to $20 million and $40 million for the three and
six months ended September 30, 2005, respectively.
18
Accrued and Other Current Liabilities
Accrued and other current liabilities as of September 30, 2006 and March 31, 2006 consisted of (in
millions):
|
|
|
|
|
|
|
|
|
|
|
As of |
|
|
As of |
|
|
|
September 30, |
|
|
March 31, |
|
|
|
2006 |
|
|
2006 |
|
Accrued income taxes |
|
$ |
213 |
|
|
$ |
234 |
|
Other accrued expenses |
|
|
150 |
|
|
|
202 |
|
Accrued royalties |
|
|
99 |
|
|
|
82 |
|
Accrued compensation and benefits |
|
|
83 |
|
|
|
122 |
|
Deferred revenue |
|
|
54 |
|
|
|
52 |
|
Accrued value added taxes |
|
|
35 |
|
|
|
14 |
|
|
|
|
|
|
|
|
Accrued and other current liabilities |
|
$ |
634 |
|
|
$ |
706 |
|
|
|
|
|
|
|
|
Income Taxes
Effective Income Tax Rate for three and six months ended September 30, 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 inherently uncertain, for fiscal 2007,
our projected tax rate is unusually volatile and subject to significantly greater variation. As
such, as of the end of the second quarter of fiscal 2007 because relatively small changes in our
forecasted profitability for fiscal 2007 can significantly affect our projected annual effective
tax rate, we believe our tax rate for the six months ended September 30, 2006 is currently the most
reliable estimate of our annual effective tax rate for fiscal 2007. Accordingly, the effective
income tax rates reflected in our financial statements for the three and six months ended September
30, 2006 reflect only our estimated tax expense for the three months and estimated tax benefit for
the six months ended September 30, 2006. The overall effective income tax rate for the fiscal year
will likely be different from the tax rates in effect for the three and six months ended September 30, 2006 and could be considerably higher or
potentially lower, as it will be particularly dependent on our profitability for the year.
Effective Income Tax Rate for three and six months ended September 30, 2005
During the three months ended September 30, 2005, our effective income tax rate was 15 percent
which reflected 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 which resulted 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 share) less income tax expense during the three and six months ended
September 30, 2005 than we would have recognized had our projected effective income tax rate
remained at our original projected annual effective income tax rate of 29 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
19
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 September 30, 2006, the estimated fair values of both properties under these
operating leases exceeded their respective guaranteed residual values.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Actual as of |
|
Financial Covenants |
|
Requirement |
|
|
September 30, 2006 |
|
|
Consolidated Net Worth (in millions) |
|
equal to or greater than |
|
$ |
2,310 |
|
|
$ |
3,591 |
|
Fixed Charge Coverage Ratio |
|
equal to or greater than |
|
|
3.00 |
|
|
|
7.06 |
|
Total Consolidated Debt to Capital |
|
equal to or less than |
|
|
60% |
|
|
|
6.4% |
|
Quick Ratio |
|
Q1 & Q2 |
|
equal to or greater than |
|
|
1.00 |
|
|
|
6.29 |
|
|
|
Q3 & Q4 |
|
equal to or greater than |
|
|
1.75 |
|
|
|
N/A |
|
Letters of Credit
In July 2002, we provided an irrevocable standby letter of credit to Nintendo of Europe, which we
have amended on a number of occasions. The standby letter of credit, as amended, guarantees
performance of our obligations to pay Nintendo of Europe for trade payables. As of September 30,
2006, the standby letter of credit, as amended, guaranteed our trade payable obligations to
Nintendo of Europe for up to 20 million. As of September 30, 2006, 1 million was payable to
Nintendo of Europe under the standby letter of credit, as amended.
20
In August 2003, we provided an irrevocable standby letter of credit to 300 California Associates
II, LLC in replacement of our security deposit for office space. The standby letter of credit
guarantees performance of our obligations to pay our lease commitment up to approximately $1
million. The standby letter of credit expires in December 2006. As of September 30, 2006, we did
not have a payable balance on this standby letter of credit.
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. These minimum guarantee
payments and any related marketing commitments are included in the table below.
The following table summarizes our minimum contractual obligations and commercial commitments as of
September 30, 2006 (in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Commercial |
|
|
|
|
|
|
Contractual Obligations |
|
|
Commitments |
|
|
|
|
|
|
|
|
|
|
Developer/ |
|
|
|
|
|
|
Letter of Credit, |
|
|
|
|
Fiscal Year |
|
|
|
|
|
Licensor |
|
|
|
|
|
|
Bank and |
|
|
|
|
Ending March 31, |
|
Leases |
|
|
Commitments (1) |
|
|
Marketing |
|
|
Other Guarantees |
|
|
Total |
|
|
|
|
|
|
|
|
2007 (remaining six months) |
|
$ |
31 |
|
|
$ |
44 |
|
|
$ |
27 |
|
|
$ |
7 |
|
|
$ |
109 |
|
2008 |
|
|
48 |
|
|
|
162 |
|
|
|
30 |
|
|
|
1 |
|
|
|
241 |
|
2009 |
|
|
48 |
|
|
|
170 |
|
|
|
31 |
|
|
|
|
|
|
|
249 |
|
2010 |
|
|
35 |
|
|
|
165 |
|
|
|
31 |
|
|
|
|
|
|
|
231 |
|
2011 |
|
|
26 |
|
|
|
283 |
|
|
|
31 |
|
|
|
|
|
|
|
340 |
|
Thereafter |
|
|
63 |
|
|
|
723 |
|
|
|
186 |
|
|
|
|
|
|
|
972 |
|
|
|
|
|
|
|
|
Total |
|
$ |
251 |
|
|
$ |
1,547 |
|
|
$ |
336 |
|
|
$ |
8 |
|
|
$ |
2,142 |
|
|
|
|
|
|
|
|
|
|
|
(1) |
|
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 September 30, 2006 because payment is not contingent upon performance by the developer or licensor. |
The lease commitments disclosed above include contractual rental commitments of $21 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 September 30, 2006. See Note 6 of the Notes to
Condensed Consolidated Financial Statements.
21
Acquisition of Digital Illusions C.E.
As of September 30, 2006, we owned 74 percent of Digital Illusions C.E.s (DICE) Class A common
stock. In October 2006, we acquired all of the remaining minority interest in DICE for a total of
$24 million. Since January 27, 2005, we have included the assets, liabilities and results of
operations of DICE in our Condensed Consolidated Financial Statements. We expect further
adjustments to our purchase price allocation, including the allocation of goodwill, as a result of
our purchase of the remaining minority interest of DICE.
Legal Proceedings
On February 14, 2005, an employment-related class action lawsuit, Hasty v. Electronic Arts Inc.,
was filed against the company in Superior Court in San Mateo, California. The complaint alleges
that we improperly classified Engineers in California as exempt employees and seeks injunctive
relief, unspecified monetary damages, interest and attorneys fees. On May 16, 2006, the court
granted its preliminary approval of a settlement pursuant to which we agreed to make a lump sum
payment of approximately $15 million, to a third-party administrator to cover (a) all claims
allegedly suffered by the class members, (b) plaintiffs attorneys fees, not to exceed 25% of the
total settlement amount, (c) plaintiffs costs and expenses, (d) any incentive payments to the
named plaintiffs that may be authorized by the court, and (e) all costs of administration of the
settlement. On September 22, 2006, the court granted final approval of the settlement.
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 intend to cooperate with all matters related to this request.
In addition, we are subject to other claims and litigation arising in the ordinary course of
business. We believe that any liability from any reasonably foreseeable disposition of such other
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 have 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.
22
The components of comprehensive income for the three and six months ended September 30, 2006 and
2005 are summarized as follows (in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
|
Six Months Ended |
|
|
|
September 30, |
|
|
September 30, |
|
|
|
2006 |
|
|
2005 |
|
|
2006 |
|
|
2005 |
|
Net income (loss) |
|
$ |
22 |
|
|
$ |
51 |
|
|
$ |
(59 |
) |
|
$ |
(7 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
Other comprehensive income: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Change in unrealized gains on investments, net of tax expense of $0 for each period |
|
|
44 |
|
|
|
7 |
|
|
|
50 |
|
|
|
54 |
|
Reclassification adjustment for losses realized on investments in net income (loss), net of tax benefit of $0 for each period |
|
|
1 |
|
|
|
|
|
|
|
1 |
|
|
|
|
|
Change in unrealized gains (losses) on derivative instruments, net of tax expense (benefit) of $0, $0 and $0, $1, respectively |
|
|
(3 |
) |
|
|
|
|
|
|
(3 |
) |
|
|
4 |
|
Foreign currency translation adjustments |
|
|
8 |
|
|
|
3 |
|
|
|
26 |
|
|
|
(8 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
Total other comprehensive income |
|
$ |
50 |
|
|
$ |
10 |
|
|
$ |
74 |
|
|
$ |
50 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total comprehensive income |
|
$ |
72 |
|
|
$ |
61 |
|
|
$ |
15 |
|
|
$ |
43 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
The foreign currency translation adjustments are not adjusted for income taxes as they relate to
indefinite investments in non-U.S. subsidiaries.
(11) NET INCOME (LOSS) 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 |
|
|
Six Months Ended |
|
|
|
September 30, |
|
|
September 30, |
|
(In millions, except per share amounts) |
|
2006 |
|
|
2005 |
|
|
2006 |
|
|
2005 |
|
Net income (loss) |
|
$ |
22 |
|
|
$ |
51 |
|
|
$ |
(59 |
) |
|
$ |
(7 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
Shares used to compute net income (loss) per share: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted-average common stock outstanding basic |
|
|
307 |
|
|
|
302 |
|
|
|
306 |
|
|
|
305 |
|
Dilutive potential common shares |
|
|
8 |
|
|
|
12 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted-average common stock outstanding diluted |
|
|
315 |
|
|
|
314 |
|
|
|
306 |
|
|
|
305 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income (loss) per share: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic |
|
$ |
0.07 |
|
|
$ |
0.17 |
|
|
$ |
(0.19 |
) |
|
$ |
(0.02 |
) |
Diluted |
|
$ |
0.07 |
|
|
$ |
0.16 |
|
|
$ |
(0.19 |
) |
|
$ |
(0.02 |
) |
As a result of our net loss for the six months ended September 30, 2006, we have excluded certain
stock awards from the diluted earnings per share calculation as their inclusion would have been
antidilutive. Had we reported net income for this period, an additional 8 million shares of
potential common stock equivalents would have been included in the number of shares used to
calculate diluted earnings per share for the six months ended September 30, 2006.
23
As a result of our net loss for the six months ended September 30, 2005, we have excluded certain
stock awards from the diluted earnings per share calculation as their inclusion would have been
antidilutive. Had we reported net income for this period, an additional 11 million shares of potential common stock equivalents would have been included in the
number of shares used to calculate diluted earnings per share for the six months ended September
30, 2005.
Options to purchase 17 million and 19 million shares of common stock were excluded from the above
computation of diluted shares for the three and six months ended September 30, 2006, respectively,
as their inclusion would have been antidilutive. For the three and six months ended September 30,
2006, the weighted-average exercise price of these shares was $54.98 and $54.87 per share,
respectively.
Options to purchase 6 million shares of common stock were excluded from the above computation of
diluted shares for both the three and six months ended September 30, 2005, respectively, as their
inclusion would have been antidilutive. For the three and six months ended September 30, 2005, the
weighted-average exercise price of these shares was $64.44 and $64.16 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.
The following table summarizes the financial performance of our Publishing segment and a
reconciliation of our Publishing segments profit to our consolidated operating income (loss) (in
millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
|
Six Months Ended |
|
|
|
September 30, |
|
|
September 30, |
|
|
|
2006 |
|
|
2005 |
|
|
2006 |
|
|
2005 |
|
Publishing segment: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net revenue |
|
$ |
748 |
|
|
$ |
690 |
|
|
$ |
1,126 |
|
|
$ |
1,034 |
|
Depreciation and amortization |
|
|
(6 |
) |
|
|
(4 |
) |
|
|
(11 |
) |
|
|
(11 |
) |
Other expenses |
|
|
(453 |
) |
|
|
(418 |
) |
|
|
(699 |
) |
|
|
(656 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
Publishing segment profit |
|
|
289 |
|
|
|
268 |
|
|
|
416 |
|
|
|
367 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Reconciliation to consolidated operating income (loss): |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Other: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net revenue |
|
|
36 |
|
|
|
(15 |
) |
|
|
70 |
|
|
|
6 |
|
Depreciation and amortization |
|
|
(31 |
) |
|
|
(19 |
) |
|
|
(61 |
) |
|
|
(35 |
) |
Other expenses |
|
|
(280 |
) |
|
|
(185 |
) |
|
|
(530 |
) |
|
|
(384 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
Consolidated operating income (loss) |
|
$ |
14 |
|
|
$ |
49 |
|
|
$ |
(105 |
) |
|
$ |
(46 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
24
Publishing segment profit differs from consolidated operating income (loss) 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.
Information about our total net revenue by product line for the three and six months ended
September 30, 2006 and 2005 is presented below (in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
|
Six Months Ended |
|
|
|
September 30, |
|
|
September 30, |
|
|
|
2006 |
|
|
2005 |
|
|
2006 |
|
|
2005 |
|
Consoles
PlayStation 2 |
|
$ |
269 |
|
|
$ |
304 |
|
|
$ |
369 |
|
|
$ |
421 |
|
Xbox 360 |
|
|
166 |
|
|
|
|
|
|
|
226 |
|
|
|
|
|
Xbox |
|
|
65 |
|
|
|
136 |
|
|
|
88 |
|
|
|
180 |
|
Nintendo GameCube |
|
|
14 |
|
|
|
27 |
|
|
|
24 |
|
|
|
49 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total Consoles |
|
|
514 |
|
|
|
467 |
|
|
|
707 |
|
|
|
650 |
|
PC |
|
|
86 |
|
|
|
91 |
|
|
|
152 |
|
|
|
165 |
|
Mobility
PSP |
|
|
64 |
|
|
|
45 |
|
|
|
101 |
|
|
|
77 |
|
Nintendo DS |
|
|
14 |
|
|
|
8 |
|
|
|
23 |
|
|
|
20 |
|
Game Boy Advance |
|
|
8 |
|
|
|
7 |
|
|
|
14 |
|
|
|
13 |
|
Cellular Handsets |
|
|
35 |
|
|
|
2 |
|
|
|
68 |
|
|
|
3 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total Mobility |
|
|
121 |
|
|
|
62 |
|
|
|
206 |
|
|
|
113 |
|
Co-publishing and Distribution |
|
|
39 |
|
|
|
32 |
|
|
|
81 |
|
|
|
62 |
|
Internet Services, Licensing and Other
Subscription Services |
|
|
15 |
|
|
|
14 |
|
|
|
31 |
|
|
|
29 |
|
Licensing, Advertising and Other |
|
|
9 |
|
|
|
9 |
|
|
|
19 |
|
|
|
21 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total Internet Services, Licensing and Other |
|
|
24 |
|
|
|
23 |
|
|
|
50 |
|
|
|
50 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total Net Revenue |
|
$ |
784 |
|
|
$ |
675 |
|
|
$ |
1,196 |
|
|
$ |
1,040 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Information about our operations in North America, Europe and Asia as of and for the three and six
months ended September 30, 2006 and 2005 is presented below (in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
North |
|
|
|
|
|
|
|
|
|
|
|
|
America |
|
|
Europe |
|
|
Asia |
|
|
Total |
|
Three months ended September 30, 2006 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net revenue from unaffiliated customers |
|
$ |
512 |
|
|
$ |
245 |
|
|
$ |
27 |
|
|
$ |
784 |
|
Long-lived assets |
|
|
1,157 |
|
|
|
218 |
|
|
|
13 |
|
|
|
1,388 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three months ended September 30, 2005 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net revenue from unaffiliated customers |
|
$ |
443 |
|
|
$ |
191 |
|
|
$ |
41 |
|
|
$ |
675 |
|
Long-lived assets |
|
|
334 |
|
|
|
205 |
|
|
|
10 |
|
|
|
549 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Six months ended September 30, 2006 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net revenue from unaffiliated customers |
|
$ |
721 |
|
|
$ |
414 |
|
|
$ |
61 |
|
|
$ |
1,196 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Six months ended September 30, 2005 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net revenue from unaffiliated customers |
|
$ |
627 |
|
|
$ |
335 |
|
|
$ |
78 |
|
|
$ |
1,040 |
|
Our direct sales to GameStop Corp. represented approximately 16 percent and 14 percent of total net
revenue for the three and six months ended September 30, 2006, respectively. Our direct sales to Wal-Mart Stores, Inc. represented approximately 14
25
percent and 13 percent of total net revenue for
the three and six months ended September 30, 2006, respectively, and approximately 14 percent of
total net revenue for both the three and six months ended September 30, 2005.
(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 -
26
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 FSP FAS No. 123(R)-5. FSP FAS No. 123(R)-5 addresses whether a
modification of an instrument in connection with an equity restructuring should be considered a
modification for purposes of applying FSP FAS No. 123(R)-1, Classification and Measurement of
Freestanding Financial Instruments Originally Issued in Exchange for Employee Services under FASB
Statement No. 123(R). If (1) there is no increase in fair value of the award or the anti-dilution
provision is not added to the terms of the award in contemplation of an equity restructuring, and
(2) all holders of the same class of equity instruments are treated in the same manner, no change
in recognition or measurement will result for instruments that were originally issued as employee
compensation and then modified in connection with an equity restructuring that occurs when the
holders are no longer employees. The provisions in FSP FAS No. 123(R)-5 are effective for the first
reporting period beginning after October 10, 2006. We do not expect the adoption of FSP FAS No.
123(R)-5 to have a material impact on our Condensed Consolidated Financial Statements.
27
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 September 30, 2006, the related condensed consolidated statements
of operations for the three-month and six-month periods ended September 30, 2006 and October 1,
2005, and the related condensed consolidated statements of cash flows for the six-month periods
ended September 30, 2006 and October 1, 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 with
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
November 6, 2006
28
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 six months
ended September 30, 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 or the Condensed Consolidated
Financial Statements and related notes. Additional information can be found within 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® 2, Microsoft Xbox
360TM and Xbox®, and Nintendo GameCubeTM), personal computers,
mobile platforms (including cellular handsets and handheld game players such as the
PlayStation® Portable (PSPTM) and the Nintendo DSTM) 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 SimsTM,
Need for SpeedTM and BLACKTM). 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 September 30, 2006 was $784 million, up 16 percent as
compared to the three months ended September 30, 2005. Net revenue for the three months ended
September 30, 2006 was driven by sales of Madden NFL 07, NCAA® Football 07, FIFA 07, NBA
Live 07 and NHL® 07. Madden NFL 07 sold over five million copies in the quarter. NCAA
Football 07 sold over two million copies in the quarter.
Net income for the three months ended September 30, 2006 was $22 million as compared to $51 million
for the three months ended September 30, 2005. Diluted net income per share for the three months
ended September 30, 2006 was $0.07 as compared to $0.16 for the three months ended September 30,
2005.
We used $44 million in cash from operations during the six months ended September 30, 2006 as
compared to $19 million during the six months ended September 30, 2005. The increase in cash used
in operating activities for the six months ended September 30, 2006 as compared to the six months
ended September 30, 2005 resulted primarily from (1) an increase of $24 million paid for income
taxes, (2) $16 million paid in connection with the settlement of certain employee-related
litigation
29
matters, and (3) $15 million in acquisition-related restricted cash. These payments were partially
offset by a decrease in prepaid royalties as compared to the prior year.
Stock-Based Compensation. Beginning in fiscal 2007, we adopted Statement of Financial Accounting
Standard (SFAS) No. 123 (revised 2004) (SFAS No. 123R), 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 units, restricted stock awards and our employee stock purchase
plan included in our Condensed Consolidated Statements of Operations for the three and six months
ended September 30, 2006 and 2005 (in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
|
Six Months Ended |
|
|
|
September 30, |
|
|
September 30, |
|
|
|
2006 |
|
|
2005 |
|
|
2006 |
|
|
2005 |
|
Cost of goods sold |
|
$ |
1 |
|
|
$ |
|
|
|
$ |
1 |
|
|
$ |
|
|
Marketing and sales |
|
|
4 |
|
|
|
|
|
|
|
9 |
|
|
|
|
|
General and administrative |
|
|
9 |
|
|
|
|
|
|
|
20 |
|
|
|
|
|
Research and development |
|
|
19 |
|
|
|
1 |
|
|
|
40 |
|
|
|
1 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Stock-based compensation expense |
|
|
33 |
|
|
|
1 |
|
|
|
70 |
|
|
|
1 |
|
Benefit for income taxes |
|
|
(7 |
) |
|
|
(1 |
) |
|
|
(15 |
) |
|
|
(1 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
Stock-based compensation expense, net of tax |
|
$ |
26 |
|
|
$ |
|
|
|
$ |
55 |
|
|
$ |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
As of September 30, 2006, the total unrecognized compensation cost related to stock options was
$191 million, and restricted stock and restricted stock units (collectively referred to as
restricted stock rights) was $74 million and is expected to be recognized over the
weighted-average service period of 1.65 years and 2.39 years, respectively.
On September 15, 2006, we completed a stock option exchange program pursuant to which permitted
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. Microsoft launched the Xbox 360 in November 2005. We expect Sony
to introduce the PlayStation® 3 beginning in November 2006 in North America and Japan
and continuing through spring 2007 in Europe and elsewhere. We expect Nintendo to introduce the
Wii in November in North America and in December in Japan and Europe. We expect that, as the
current generation of consoles continue to progress and eventually reach the end of their
commercial life cycle and next-generation consoles are introduced into the market, sales of video
games for current-generation consoles will continue to decline as consumers replace their
current-generation consoles with next-generation consoles, or defer game software purchases until
they are able to purchase a next-generation console. 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 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 the number of units 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, 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.
We have incurred, and expect to continue to incur, higher costs during this transition to
next-generation consoles. 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,
30
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.
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 richer 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.
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 OnlineTM, 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 on July 24, 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.
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 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 September 30, 2006 were Madden NFL 07, NCAA
Football 07, FIFA 07, NBA Live 07 and NHL 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, Harry Potter
and ESPN. We have recently entered into new licenses and renewed older licenses, some of which
contain higher royalty rates than similar license agreements we have entered
31
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
40 percent of our total net revenue during the first six months of both fiscal 2007 and 2006. Our
international net revenue was primarily driven by sales in Europe and, to a lesser extent, in Asia.
Year-over-year, foreign exchange rates had an insignificant impact on our net revenue for the six
months ended September 30, 2006; however, our future results of operations, including our reported
net revenue and net income, and financial condition could be significantly affected by foreign
currency fluctuations.
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. During
October 2006, we completed our acquisition of Digital Illusions C.E. (DICE) by purchasing the
remaining outstanding DICE shares. 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 2, Xbox 360, Xbox and Nintendo GameCube), 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:
|
|
|
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. |
|
|
|
|
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. |
|
|
|
|
Fixed or determinable fee: If a portion of the arrangement fee is not fixed or
determinable, we recognize that amount as revenue when the amount becomes fixed or
determinable. |
|
|
|
|
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)
32
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 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 the elements and
recognize the related revenue separately. If we were unable to determine VSOE for the online
services to be delivered, all revenue from the transaction would be recognized over the online
service period.
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, Xbox and Nintendo GameCube consoles move through their
lifecycles and an increasing number and aggregate 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 the 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.
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.
33
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, 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 significant performance
remains with the licensor. When significant 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 September 30, 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 six months ended September 30, 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 six months ended September 30, 2006 and September 30, 2005.
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
34
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. 123R and applied the
provisions of SAB No. 107, Share-Based
Payment, on our
adoption of SFAS No. 123R. SFAS No. 123R 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. 123R 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 $33 million and $70 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 six months ended September 30, 2006, respectively.
We recognized $1 million of stock-based compensation related to employee restricted stock units and
non-employee stock options during the three and six months ended September 30, 2005.
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. 123R, employee stock-based compensation expense recognized in the three and
six months ended September 30, 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.
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
structure, changes in the geographic location of business functions, changes in the geographic mix
and amount of income, as well as changes in our agreements with
35
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. As
such, as of the end of the second quarter of fiscal 2007 because relatively small changes in our
forecasted profitability for fiscal 2007 can significantly affect our projected annual effective
tax rate, we believe our tax rate for the six months ended September 30, 2006 is currently the most
reliable estimate of our annual effective tax rate for fiscal 2007. Accordingly, the effective
income tax rates reflected in our financial statements for the three and six months ended September
30, 2006 reflect only our estimated tax expense for the three months and estimated tax benefit for
the six months ended September 30, 2006. The overall effective income tax rate for the fiscal year
will likely be different from the tax rates in effect for the three
and six months ended September 30, 2006 and could be
considerably higher or potentially lower, as it will be particularly
dependent on our profitability for the year.
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 six months ended September 30, 2006 and 2005 contained
the following number of weeks:
|
|
|
|
|
Fiscal Period |
|
Number of Weeks |
|
Fiscal Period End Date |
Three months ended September 30, 2006 |
|
13 weeks |
|
September 30, 2006 |
Six months ended September 30, 2006 |
|
26 weeks |
|
September 30, 2006 |
|
|
|
|
|
|
Three months ended September 30, 2005 |
|
13 weeks |
|
October 1, 2005 |
Six months ended September 30, 2005 |
|
27 weeks |
|
October 1, 2005 |
For simplicity of presentation, all fiscal periods are treated as ending on a calendar month end.
Beginning in fiscal 2007, we adopted SFAS No. 123R and applied the provisions of SAB No. 107 to our adoption of SFAS No. 123R. 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. 123R. Prior to our adoption
of SFAS No. 123R, 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. 123R, 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.
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. 123R. Stock-based compensation expense for the
three and six months ended September 30, 2006 was $33 million and $70 million, respectively.
36
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 2, Xbox 360, Xbox and Nintendo GameCube), PCs
and mobile platforms which include 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.
From a geographical perspective, our total net revenue for the three and six months ended September
30, 2006 and 2005 was as follows (in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended September 30, |
|
Increase / |
|
% |
|
|
2006 |
|
2005 |
|
(Decrease) |
|
Change |
North America |
|
$ |
512 |
|
|
|
65 |
% |
|
$ |
443 |
|
|
|
66 |
% |
|
$ |
69 |
|
|
|
16 |
% |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Europe |
|
|
245 |
|
|
|
31 |
% |
|
|
191 |
|
|
|
28 |
% |
|
|
54 |
|
|
|
28 |
% |
Asia |
|
|
27 |
|
|
|
4 |
% |
|
|
41 |
|
|
|
6 |
% |
|
|
(14 |
) |
|
|
(34 |
%) |
|
|
|
|
|
|
|
|
|
International |
|
|
272 |
|
|
|
35 |
% |
|
|
232 |
|
|
|
34 |
% |
|
|
40 |
|
|
|
17 |
% |
|
|
|
|
|
|
|
|
|
Total Net Revenue |
|
$ |
784 |
|
|
|
100 |
% |
|
$ |
675 |
|
|
|
100 |
% |
|
$ |
109 |
|
|
|
16 |
% |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Six Months Ended September 30, |
|
Increase / |
|
% |
|
|
2006 |
|
2005 |
|
(Decrease) |
|
Change |
North America |
|
$ |
721 |
|
|
|
60 |
% |
|
$ |
627 |
|
|
|
60 |
% |
|
$ |
94 |
|
|
|
15 |
% |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Europe |
|
|
414 |
|
|
|
35 |
% |
|
|
335 |
|
|
|
32 |
% |
|
|
79 |
|
|
|
24 |
% |
Asia |
|
|
61 |
|
|
|
5 |
% |
|
|
78 |
|
|
|
8 |
% |
|
|
(17 |
) |
|
|
(22 |
%) |
|
|
|
|
|
|
|
|
|
International |
|
|
475 |
|
|
|
40 |
% |
|
|
413 |
|
|
|
40 |
% |
|
|
62 |
|
|
|
15 |
% |
|
|
|
|
|
|
|
|
|
Total Net Revenue |
|
$ |
1,196 |
|
|
|
100 |
% |
|
$ |
1,040 |
|
|
|
100 |
% |
|
$ |
156 |
|
|
|
15 |
% |
|
|
|
|
|
|
|
|
|
North America
For the three months ended September 30, 2006, net revenue in North America was $512 million,
driven primarily by sales of (1) Madden NFL 07, NCAA Football 07, and NBA Live 07 which
were released during the three months ended September 30, 2006, and (2) our cellular handset games
business resulting from our acquisition of JAMDAT on February 15, 2006. Overall, net revenue
increased $69 million, or 16 percent, as compared to the three months ended September 30, 2005.
The increase in net revenue for the three months ended September 30, 2006, as compared to the three
months ended September 30, 2005 was primarily driven by (1) a $27 million increase in cellular
handset net revenue, (2) a $21 million increase in catalog(a) net revenue, and (3) a $16
million increase in frontline(b) net revenue due to sales of titles for the Xbox 360
which had not yet been released during the three months ended September 30, 2005.
For the six months ended September 30, 2006, net revenue in North America was $721 million, driven
primarily by sales of (1) Madden NFL 07, NCAA Football 07, and NBA Live 07 which were released
during the three months ended September 30, 2006 and (2) our cellular handset games business
resulting from our acquisition of JAMDAT. Overall, net revenue increased $94 million, or 15
percent, as compared to the six months ended September 30, 2005.
The increase in net revenue for the six months ended September 30, 2006, as compared to the six
months ended September 30, 2005 was primarily driven by (1) a $55 million increase in cellular
handset net revenue and (2) a $45 million increase in catalog net revenue. These increases were
partially offset by a $16 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 quarter in which the SKU was released. |
37
|
|
|
|
(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 quarter the SKU was
released. |
Europe
For the three months ended September 30, 2006, net revenue in Europe was $245 million, driven
primarily by sales of FIFA 07, The Godfather The Game, and Tiger Woods PGA TOUR® 07.
Overall, net revenue increased $54 million, or 28 percent, as compared to the three months ended
September 30, 2005. We estimate that foreign exchange rates (primarily the Euro and the British
pound sterling) increased reported European net revenue by approximately $10 million, or 5 percent,
for the three months ended September 30, 2006 as compared to the three months ended September 30,
2005. Excluding the effect of foreign exchange rates, we estimate that European net revenue
increased by approximately $44 million, or 23 percent, for the three months ended September 30,
2006.
The increase in net revenue for the three months ended September 30, 2006, as compared to the three
months ended September 30, 2005 was primarily driven by (1) a $25 million increase in catalog
net revenue, (2) a $17 million increase in frontline net revenue due to sales of titles for
the Xbox 360, which had not yet been released during the three months ended September 30, 2005, and
(3) a $10 million increase in co-publishing and distribution net revenue primarily due to Dead
Rising and the recognition of three months of revenue for sales of titles from the Half-Life
franchise in our second quarter of fiscal 2007 as compared to the recognition of one month of
revenue in our second quarter of fiscal 2006.
For the six months ended September 30, 2006, net revenue in Europe was $414 million, driven
primarily by sales of FIFA 07, 2006 FIFA World Cup, The Godfather The Game, and Need for Speed
Most Wanted. Overall, net revenue increased $79 million, or 24 percent, as compared to the six
months ended September 30, 2005. We estimate that foreign exchange rates (primarily the Euro and
the British pound sterling) increased reported European net revenue by approximately $3 million, or
1 percent, for the six months ended September 30, 2006 as compared to the six months ended
September 30, 2005. Excluding the effect of foreign exchange rates, we estimate that European net
revenue increased by approximately $76 million, or 23 percent, for the six months ended September
30, 2006.
The increase in net revenue for the six months ended September 30, 2006, as compared to the six
months ended September 30, 2005 was primarily driven by (1) a $35 million increase in catalog
net revenue, (2) a $23 million increase in co-publishing and distribution net revenue
primarily due to sales of titles from the Half-Life franchise, and (3) a $13 million increase in
frontline net revenue due to sales of titles on Xbox 360.
Asia
For the three months ended September 30, 2006, net revenue in Asia decreased by $14 million, or 34
percent, as compared to the three months ended September 30, 2005. The decrease in net revenue for
the three months ended September 30, 2006 was primarily driven by (1) an $11 million decrease in
catalog net revenue and (2) lower sales of co-publishing and distribution titles of $3 million. The
overall decrease in net revenue was mitigated by $3 million from sales of titles for the Xbox 360,
which had not yet been released during the three months ended September 30, 2005.
For the six months ended September 30, 2006, net revenue in Asia decreased by $17 million, or 22
percent, as compared to the six months ended September 30, 2005. The decrease in net revenue for
the six months ended September 30, 2006 was primarily driven by (1) a $9 million decrease in
catalog net revenue and (2) lower sales of co-publishing and distribution titles of $9 million. The
overall decrease in net revenue was mitigated by $7 million from sales of titles for the Xbox 360.
We estimate that changes in foreign exchange rates decreased reported net revenue in Asia by
approximately $3 million, or 4 percent, for the six months ended September 30, 2006. Excluding the
effect of foreign exchange rates, we estimate that Asia net revenue decreased by approximately $14
million, or 18 percent for the six months ended September 30, 2006 as compared to the six months
ended September 30, 2005.
38
Our total net revenue by product line for the three and six months ended September 30, 2006 and
2005 was as follows (in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended September 30, |
|
Increase/ |
|
% |
|
|
2006 |
|
2005 |
|
(Decrease) |
|
Change |
Consoles |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
PlayStation 2 |
|
$ |
269 |
|
|
|
35 |
% |
|
$ |
304 |
|
|
|
45 |
% |
|
$ |
(35 |
) |
|
|
(12 |
%) |
Xbox 360 |
|
|
166 |
|
|
|
21 |
% |
|
|
|
|
|
|
|
|
|
|
166 |
|
|
|
N/M |
|
Xbox |
|
|
65 |
|
|
|
8 |
% |
|
|
136 |
|
|
|
20 |
% |
|
|
(71 |
) |
|
|
(52 |
%) |
Nintendo GameCube |
|
|
14 |
|
|
|
2 |
% |
|
|
27 |
|
|
|
4 |
% |
|
|
(13 |
) |
|
|
(48 |
%) |
|
|
|
|
|
|
|
|
|
Total Consoles |
|
|
514 |
|
|
|
66 |
% |
|
|
467 |
|
|
|
69 |
% |
|
|
47 |
|
|
|
10 |
% |
PC |
|
|
86 |
|
|
|
11 |
% |
|
|
91 |
|
|
|
14 |
% |
|
|
(5 |
) |
|
|
(5 |
%) |
Mobility |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
PSP |
|
|
64 |
|
|
|
8 |
% |
|
|
45 |
|
|
|
7 |
% |
|
|
19 |
|
|
|
42 |
% |
Nintendo DS |
|
|
14 |
|
|
|
2 |
% |
|
|
8 |
|
|
|
1 |
% |
|
|
6 |
|
|
|
75 |
% |
Game Boy Advance |
|
|
8 |
|
|
|
1 |
% |
|
|
7 |
|
|
|
1 |
% |
|
|
1 |
|
|
|
14 |
% |
Cellular Handsets |
|
|
35 |
|
|
|
4 |
% |
|
|
2 |
|
|
|
|
|
|
|
33 |
|
|
|
N/M |
|
|
|
|
|
|
|
|
|
|
Total Mobility |
|
|
121 |
|
|
|
15 |
% |
|
|
62 |
|
|
|
9 |
% |
|
|
59 |
|
|
|
95 |
% |
Co-publishing and Distribution |
|
|
39 |
|
|
|
5 |
% |
|
|
32 |
|
|
|
5 |
% |
|
|
7 |
|
|
|
22 |
% |
Internet Services, Licensing and Other |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Subscription Services |
|
|
15 |
|
|
|
2 |
% |
|
|
14 |
|
|
|
2 |
% |
|
|
1 |
|
|
|
7 |
% |
Licensing, Advertising and Other |
|
|
9 |
|
|
|
1 |
% |
|
|
9 |
|
|
|
1 |
% |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total Internet
Services, Licensing
and Other |
|
|
24 |
|
|
|
3 |
% |
|
|
23 |
|
|
|
3 |
% |
|
|
1 |
|
|
|
4 |
% |
|
|
|
|
|
|
|
|
|
Total Net Revenue |
|
$ |
784 |
|
|
|
100 |
% |
|
$ |
675 |
|
|
|
100 |
% |
|
$ |
109 |
|
|
|
16 |
% |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Six Months Ended September 30, |
|
Increase/ |
|
% |
|
|
2006 |
|
2005 |
|
(Decrease) |
|
Change |
Consoles |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
PlayStation 2 |
|
$ |
369 |
|
|
|
31 |
% |
|
$ |
421 |
|
|
|
40 |
% |
|
$ |
(52 |
) |
|
|
(12 |
%) |
Xbox 360 |
|
|
226 |
|
|
|
19 |
% |
|
|
|
|
|
|
|
|
|
|
226 |
|
|
|
N/M |
|
Xbox |
|
|
88 |
|
|
|
7 |
% |
|
|
180 |
|
|
|
17 |
% |
|
|
(92 |
) |
|
|
(51 |
%) |
Nintendo GameCube |
|
|
24 |
|
|
|
2 |
% |
|
|
49 |
|
|
|
5 |
% |
|
|
(25 |
) |
|
|
(51 |
%) |
|
|
|
|
|
|
|
|
|
Total Consoles |
|
|
707 |
|
|
|
59 |
% |
|
|
650 |
|
|
|
62 |
% |
|
|
57 |
|
|
|
9 |
% |
PC |
|
|
152 |
|
|
|
13 |
% |
|
|
165 |
|
|
|
16 |
% |
|
|
(13 |
) |
|
|
(8 |
%) |
Mobility |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
PSP |
|
|
101 |
|
|
|
8 |
% |
|
|
77 |
|
|
|
8 |
% |
|
|
24 |
|
|
|
31 |
% |
Nintendo DS |
|
|
23 |
|
|
|
2 |
% |
|
|
20 |
|
|
|
2 |
% |
|
|
3 |
|
|
|
15 |
% |
Game Boy Advance |
|
|
14 |
|
|
|
1 |
% |
|
|
13 |
|
|
|
1 |
% |
|
|
1 |
|
|
|
8 |
% |
Cellular Handsets |
|
|
68 |
|
|
|
6 |
% |
|
|
3 |
|
|
|
|
|
|
|
65 |
|
|
|
N/M |
|
|
|
|
|
|
|
|
|
|
Total Mobility |
|
|
206 |
|
|
|
17 |
% |
|
|
113 |
|
|
|
11 |
% |
|
|
93 |
|
|
|
82 |
% |
Co-publishing and Distribution |
|
|
81 |
|
|
|
7 |
% |
|
|
62 |
|
|
|
6 |
% |
|
|
19 |
|
|
|
31 |
% |
Internet Services, Licensing and Other |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Subscription Services |
|
|
31 |
|
|
|
3 |
% |
|
|
29 |
|
|
|
3 |
% |
|
|
2 |
|
|
|
7 |
% |
Licensing, Advertising and Other |
|
|
19 |
|
|
|
1 |
% |
|
|
21 |
|
|
|
2 |
% |
|
|
(2 |
) |
|
|
(10 |
%) |
|
|
|
|
|
|
|
|
|
Total Internet
Services, Licensing
and Other |
|
|
50 |
|
|
|
4 |
% |
|
|
50 |
|
|
|
5 |
% |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total Net Revenue |
|
$ |
1,196 |
|
|
|
100 |
% |
|
$ |
1,040 |
|
|
|
100 |
% |
|
$ |
156 |
|
|
|
15 |
% |
|
|
|
|
|
|
|
|
|
39
PlayStation 2
For the three months ended September 30, 2006, net revenue from sales of titles for the PlayStation
2 was $269 million, driven primarily by sales of Madden NFL 07, FIFA 07, NCAA Football 07, NBA Live
07, and NHL 07. Overall, PlayStation 2 net revenue decreased $35 million, or 12 percent, compared
to the three months ended September 30, 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 six months ended September 30, 2006, net revenue from sales of titles for the PlayStation 2
was $369 million, driven primarily by sales of Madden NFL 07, FIFA 07, NCAA Football 07, 2006 FIFA
World Cup, and NBA Live 07. Overall, PlayStation 2 net revenue decreased $52 million, or 12
percent, compared to the six months ended September 30, 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 $166 million for the three months ended September 30, 2006,
driven by sales of Madden NFL 07, NCAA Football 07, The Lord of the Rings, The Battle for
Middle-earth II, and The Godfather The Game.
For the six months ended September 30, 2006, net revenue from sales of titles for the Xbox 360 was
$226 million driven by sales of Madden NFL 07, NCAA Football 07, 2006 FIFA World Cup, and
Battlefield 2: Modern Combat.
We expect net revenue from sales of titles for the Xbox 360 to increase in fiscal 2007 as the
installed base grows and we release more titles.
Xbox
For the three months ended September 30, 2006, net revenue from sales of titles for the Xbox was
$65 million, driven primarily by sales of Madden NFL 07 and NCAA Football 07. Overall, Xbox net
revenue decreased $71 million, or 52 percent, as compared to the three months ended September 30,
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 six months ended September 30, 2006, net revenue from sales of titles for the Xbox was $88
million, driven primarily by sales of Madden NFL 07, NCAA Football 07, and 2006 FIFA World Cup.
Overall, Xbox net revenue decreased $92 million, or 51 percent, as compared to the six months ended
September 30, 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 September 30, 2006, net revenue from sales of titles for the Nintendo
GameCube was $14 million, driven primarily by sales of Madden NFL 07 and FIFA 07. Overall, Nintendo
GameCube net revenue decreased $13 million, or 48 percent, as compared to the three months ended
September 30, 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 six months ended September 30, 2006, net revenue from sales of titles for the Nintendo
GameCube was $24 million, driven primarily by sales of Madden NFL 07, 2006 FIFA World Cup, and FIFA
07. Overall, Nintendo GameCube net revenue decreased $25 million, or 51 percent, as compared to the
six months ended September 30, 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.
40
PC
For the three months ended September 30, 2006, net revenue from sales of titles for the PC was $86
million driven primarily by sales of titles from The Sims and FIFA franchises. Overall, PC net
revenue decreased $5 million, or 5 percent, as compared to the three months ended September 30,
2005. The decrease was primarily due to an $11 million decline in sales from our Battlefield
franchise. The overall decrease in net revenue was mitigated by $6 million in higher combined sales
from our Lord of the Rings franchise and Dark Age of Camelot, a franchise we acquired in connection
with our acquisition of Mythic Entertainment on July 24, 2006.
For the six months ended September 30, 2006, net revenue from sales of titles for the PC was $152
million driven primarily by sales of titles from The Sims and Battlefield franchises. Overall, PC
net revenue decreased $13 million, or 8 percent, as compared to the six months ended September 30,
2005. The decrease was primarily due to a $41 million decline in sales from our Battlefield
franchise. The overall decrease in net revenue was mitigated by $23 million in higher combined
sales from our Lord of the Rings, World Cup, and The Sims franchises.
Mobile Platforms
Net revenue from mobile products, which consist of packaged goods games for handheld systems and
downloadable games for cellular handsets, increased from $62 million in the three months ended
September 30, 2005 to $121 million in the three months ended September 30, 2006. The increase was
primarily due to a $33 million year-over-year growth in our cellular handset games business
resulting from our acquisition of JAMDAT and increased net revenue from sales of titles for the
PSP. We released nine titles for the PSP during the three months ended September 30, 2006, as
compared to three titles during the three months ended September 30, 2005.
Net revenue from mobile products increased from $113 million in the six months ended September 30,
2005 to $206 million in the six months ended September 30, 2006. The increase was primarily due to
a $65 million year-over-year growth in our cellular handset games business resulting from our
acquisition of JAMDAT and increased net revenue from sales of titles for the PSP. We released 11
titles for the PSP during the six months ended September 30, 2006, as compared to six titles during
the six months ended September 30, 2005.
Co-Publishing and Distribution
Net revenue from co-publishing and distribution products increased from $32 million in the three
months ended September 30, 2005 to $39 million in the three months ended September 30, 2006. The
increase was primarily due to sales of Dead Rising, which was released during the three months
ended September 30, 2006.
Net revenue from co-publishing and distribution products increased from $62 million in the six
months ended September 30, 2005 to $81 million in the six months ended September 30, 2006. The
increase was primarily due to the recognition of six months of revenue for sales of titles from the
Half-Life franchise in our second quarter of fiscal 2007 as compared to the recognition of one
month of revenue in the our second quarter of fiscal 2006.
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 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.
41
Cost of goods sold for the three and six months ended September 30, 2006 and 2005 were as follows
(in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Change as a % |
|
|
September 30, |
|
% of Net |
|
September 30, |
|
% of Net |
|
|
|
|
|
of |
|
|
2006 |
|
Revenue |
|
2005 |
|
Revenue |
|
% Change |
|
Net Revenue |
|
|
|
Three months ended |
|
$ |
339 |
|
|
|
43.2 |
% |
|
$ |
284 |
|
|
|
42.1 |
% |
|
|
19.4 |
% |
|
|
1.1 |
% |
|
|
|
Six months ended |
|
$ |
506 |
|
|
|
42.3 |
% |
|
$ |
434 |
|
|
|
41.7 |
% |
|
|
16.6 |
% |
|
|
0.6 |
% |
|
|
|
During the three and six months ended September 30, 2006, license royalties increased as a
percentage of total net revenue, as compared to the three and six months ended September 30, 2005,
primarily due to the increase in royalty rates associated with our football titles and our
acquisition of JAMDAT, which incurs license royalties on the majority of its products. We estimate
that license royalties as a percentage of total net revenue increased by approximately 3 and 4
percent during the three and six months ended September 30, 2006 as compared to the three and six
months ended September 30, 2005, respectively.
As a percentage of total net revenue, the increase in license royalties was partially offset by
lower average product costs as a result of the impact of higher returns in Europe due to
lower-than-expected demand for our products during the three and six months ended September 30,
2005 and a higher mix of cellular handset net revenue resulting from our acquisition of JAMDAT in
February 2006. We estimate that average product costs as a percentage of total net revenue
decreased by approximately 2 and 3 percent during the three and six months ended September 30, 2006
as compared to the three and six months ended September 30, 2005, respectively.
Overall, we were negatively impacted by a slight decline in the average selling price of our titles
for current-generation platforms during the three and six months ended September 30, 2006 as
compared to the three and six months ended September 30, 2005.
Cost of goods sold as a percentage of total net revenue is difficult to predict. 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.
Marketing and sales expenses for the three and six months ended September 30, 2006 and 2005 were as
follows (in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
September 30, |
|
% of Net |
|
September 30, |
|
% of Net |
|
|
|
|
|
|
2006 |
|
Revenue |
|
2005 |
|
Revenue |
|
$ Change |
|
% Change |
|
|
|
Three months ended |
|
$ |
108 |
|
|
|
14 |
% |
|
$ |
107 |
|
|
|
16 |
% |
|
$ |
1 |
|
|
|
1 |
% |
|
|
|
Six months ended |
|
$ |
185 |
|
|
|
15 |
% |
|
$ |
182 |
|
|
|
18 |
% |
|
$ |
3 |
|
|
|
2 |
% |
|
|
|
For the three months ended September 30, 2006, marketing and sales expenses increased by $1
million, or 1 percent, as compared to the three months ended September 30, 2005 due to an increase
of $9 million in personnel-related costs partially attributable to $4 million of stock-based
compensation expense recognized as a result of our adoption of SFAS No. 123R. This increase was
offset by a decrease of $9 million in our marketing, advertising, promotional and related
contracted services as a result of higher advertising spend in the prior year to support our
releases.
For the six months ended September 30, 2006, marketing and sales expenses increased by $3 million,
or 2 percent, as compared to the six months ended September 30, 2005 due to an increase of $12
million in personnel-related costs primarily attributable to $9 million of stock-based compensation
expense recognized as a result of our adoption of SFAS No. 123R. This increase was substantially
offset by a decrease of $10 million in our marketing, advertising, promotional and related
contracted services as a result of higher advertising spend in the prior year to support our
releases.
42
We expect marketing and sales expenses to increase in absolute dollars in fiscal 2007 primarily due
to our adoption of SFAS No. 123R.
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 six months ended September 30, 2006 and 2005
were as follows (in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
September 30, |
|
% of Net |
|
September 30, |
|
% of Net |
|
|
|
|
|
|
2006 |
|
Revenue |
|
2005 |
|
Revenue |
|
$ Change |
|
% Change |
|
|
|
Three months ended |
|
$ |
72 |
|
|
|
9 |
% |
|
$ |
52 |
|
|
|
8 |
% |
|
$ |
20 |
|
|
|
38 |
% |
|
|
|
Six months ended |
|
$ |
131 |
|
|
|
11 |
% |
|
$ |
103 |
|
|
|
10 |
% |
|
$ |
28 |
|
|
|
27 |
% |
|
|
|
For the three months ended September 30, 2006, general and administrative expenses increased by $20
million, or 38 percent, as compared to the three months ended September 30, 2005 due to an increase
of $14 million in personnel-related costs primarily attributable to $9 million of stock-based
compensation expense recognized as a result of our adoption of SFAS No. 123R.
For the six months ended September 30, 2006, general and administrative expenses increased by $28
million, or 27 percent, as compared to the six months ended September 30, 2005 due to an increase
of $23 million in personnel-related costs primarily attributable to $20 million of stock-based
compensation expense recognized as a result of our adoption of SFAS No. 123R.
We expect general and administrative expenses to increase in absolute dollars in fiscal 2007
primarily due to our adoption of SFAS No. 123R.
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.
Research and development expenses for the three and six months ended September 30, 2006 and 2005
were as follows (in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
September 30, |
|
% of Net |
|
September 30, |
|
% of Net |
|
|
|
|
|
|
2006 |
|
Revenue |
|
2005 |
|
Revenue |
|
$ Change |
|
% Change |
|
|
|
Three months ended |
|
$ |
238 |
|
|
|
30 |
% |
|
$ |
182 |
|
|
|
27 |
% |
|
$ |
56 |
|
|
|
31 |
% |
|
|
|
Six months ended |
|
$ |
454 |
|
|
|
38 |
% |
|
$ |
365 |
|
|
|
35 |
% |
|
$ |
89 |
|
|
|
24 |
% |
|
|
|
For the three months ended September 30, 2006, research and development expenses increased by $56
million, or 31 percent, as compared to the three months ended September 30, 2005. The increase was
primarily due to (1) $19 million of stock-based compensation expense recognized as a result of our
adoption of SFAS No. 123R, (2) $17 million related to additional personnel-related costs, primarily
due to an increase in employee headcount worldwide resulting from our acquisition of JAMDAT and to
support development for next-generation consoles, (3) an increase of $11 million in external
development expenses primarily in our cellular handset business resulting from our acquisition of
JAMDAT as well as a greater number of consultants developing current-generation products, and (4)
an increase of $9 million in facilities-related expenses in support of our research and development
functions worldwide.
43
For the six months ended September 30, 2006, research and development expenses increased by $89
million, or 24 percent, as compared to the six months ended September 30, 2005. The increase was
primarily due to (1) $40 million of stock-based compensation expense recognized as a result of our
adoption of SFAS No. 123R, (2) $21 million related to additional personnel-related costs, primarily
due to an increase in employee headcount worldwide resulting from our acquisition of JAMDAT and to
support development for next-generation consoles, (3) an increase of $15 million in external
development expenses primarily in our cellular handset business resulting from our acquisition of
JAMDAT as well as a greater number of consultants developing current-generation products , and (4)
an increase of $14 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 in fiscal 2007
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 six months ended September 30, 2006 and 2005 were as
follows (in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
September 30, |
|
% of Net |
|
September 30, |
|
% of Net |
|
|
|
|
|
|
2006 |
|
Revenue |
|
2005 |
|
Revenue |
|
$ Change |
|
% Change |
|
|
|
Three months ended |
|
$ |
7 |
|
|
|
1 |
% |
|
$ |
1 |
|
|
|
|
|
|
$ |
6 |
|
|
|
600 |
% |
|
|
|
Six months ended |
|
$ |
13 |
|
|
|
1 |
% |
|
$ |
2 |
|
|
|
|
|
|
$ |
11 |
|
|
|
550 |
% |
|
|
|
For the three and six months ended September 30, 2006, amortization of intangibles increased by $6
million, or 600 percent, and $11 million, or 550 percent, respectively, as compared to the three
and six months ended September 30, 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 primarily due to
the amortization of intangibles related to our JAMDAT and Mythic acquisitions.
Acquired In-process Technology
The $2 million acquired in-process technology charge we incurred for the three and six months ended
September 30, 2006 was the result of our acquisition of Mythic. We did not incur a charge for
acquired in-process technology during the three and six months ended September 30, 2005. 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 our acquisition of Mythic, we incurred a charge for the acquired
in-process technology as reflected in our Condensed Consolidated Statements of Operations. See Note
4 of the Notes to Condensed Consolidated Financial Statements.
In connection with our acquisition of the remaining shares of DICE, we expect to incur a charge for
acquired in-process technology during the third quarter of fiscal 2007.
Restructuring Charges
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. During the three months ended September 30, 2006,
restructuring charges were approximately $4 million, of which $2 million was for employee-related
expenses. During the six months ended September 30, 2006, restructuring charges were approximately
$10 million, of which $6 million was for employee-related expenses. We did not incur restructuring
costs during the three months ended September 30, 2005, and we incurred less than $1 million of
restructuring costs during the six months ended September 30, 2005.
For the remainder of fiscal 2007, we expect to incur between $5 million and $15 million of
restructuring costs. Overall, including charges incurred through September 30, 2006, we expect to
incur between $40 million and $50 million of restructuring costs in connection with our
international publishing reorganization, substantially all of which will result in cash
44
expenditures by 2017. These restructuring costs will consist primarily of employee-related
relocation assistance (approximately $25 million), facility exit costs (approximately $10 million),
as well as other reorganization costs (approximately $10 million).
Interest and Other Income, Net
Interest and other income, net, for the three and six months ended September 30, 2006 and 2005 were
as follows (in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
September 30, |
|
% of Net |
|
September 30, |
|
% of Net |
|
|
|
|
|
|
2006 |
|
Revenue |
|
2005 |
|
Revenue |
|
$ Change |
|
% Change |
|
|
|
Three months ended |
|
$ |
24 |
|
|
|
3 |
% |
|
$ |
13 |
|
|
|
2 |
% |
|
$ |
11 |
|
|
|
85 |
% |
|
|
|
Six months ended |
|
$ |
45 |
|
|
|
4 |
% |
|
$ |
30 |
|
|
|
3 |
% |
|
$ |
15 |
|
|
|
50 |
% |
|
|
|
For the three and six months ended September 30, 2006, interest and other income, net, increased by
$11 million, or 85 percent, and $15 million, or 50 percent, respectively, as compared to the three
and six months ended September 30, 2005. These increases were primarily due to an increase of $10
million and $12 million in the three and six months ended September 30, 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 six months ended September 30, 2006 and 2005 were as follows (in
millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
September 30, |
|
Effective |
|
September 30, |
|
Effective |
|
|
|
|
|
|
|
|
2006 |
|
Tax Rate |
|
2005 |
|
Tax Rate |
|
% Change |
|
|
|
|
|
|
|
|
|
|
|
Three months ended |
|
$ |
16 |
|
|
|
41.8 |
% |
|
$ |
9 |
|
|
|
15.0 |
% |
|
|
78 |
% |
|
|
|
|
|
|
|
|
|
|
|
Six months ended |
|
$ |
(1 |
) |
|
|
(2.3 |
%) |
|
$ |
(13 |
) |
|
|
(80.0 |
%) |
|
|
92 |
% |
|
|
|
|
|
|
|
|
|
|
|
Our effective income tax rates were a provision of 41.8 percent and a benefit of 2.3 percent for
the three and six months ended September 30, 2006, respectively. Because relatively small changes
in our forecasted profitability for fiscal 2007 can significantly affect our projected annual
effective tax rate, we believe our tax benefit rate of 2.3 percent for the six months ended
September 30, 2006 is currently the most reliable estimate of our annual effective tax rate for
fiscal 2007. Nevertheless, our quarterly tax rates for the remainder
of fiscal 2007 are particularly dependent
on our profitability and could fluctuate significantly.
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 both Mythic and DICE), changes in our international 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, and 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
45
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 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
46
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) Financial Accounting Standard (FAS)
No. 123(R)-5. FSP FAS No. 123(R)-5 addresses whether a modification of an instrument in connection
with an equity restructuring should be considered a modification for purposes of applying FSP FAS
No. 123(R)-1, Classification and Measurement of Freestanding Financial Instruments Originally
Issued in Exchange for Employee Services under FASB Statement No. 123(R). If (1) there is no
increase in fair value of the award or the anti-dilution provision is not added to the terms of the
award in contemplation of an equity restructuring, and (2) all holders of the same class of equity
instruments are treated in the same manner, no change in recognition or measurement will result for
instruments that were originally issued as employee compensation and then modified in connection
with an equity restructuring that occurs when the holders are no longer employees. The provisions
in FSP FAS No. 123(R)-5 are effective for the first reporting period beginning after October 10,
2006. We do not expect the adoption of FSP FAS No. 123(R)-5 to have a material impact on our
Condensed Consolidated Financial Statements.
47
LIQUIDITY AND CAPITAL RESOURCES
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
As of September 30, |
|
|
Increase / |
|
(In millions) |
|
2006 |
|
|
2005 |
|
|
(Decrease) |
|
Cash and cash equivalents |
|
$ |
1,212 |
|
|
$ |
575 |
|
|
$ |
637 |
|
Short-term investments |
|
|
960 |
|
|
|
1,655 |
|
|
|
(695 |
) |
Marketable equity securities |
|
|
204 |
|
|
|
182 |
|
|
|
22 |
|
|
|
|
|
|
|
|
|
|
|
Total |
|
$ |
2,376 |
|
|
$ |
2,412 |
|
|
$ |
(36 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Percentage of total assets |
|
|
53 |
% |
|
|
64 |
% |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Six Months Ended |
|
|
|
|
|
|
September 30, |
|
|
Increase / |
|
(In millions) |
|
2006 |
|
|
2005 |
|
|
(Decrease) |
|
Cash used in operating activities |
|
$ |
(44 |
) |
|
$ |
(19 |
) |
|
$ |
(25 |
) |
Cash used in investing activities |
|
|
(75 |
) |
|
|
(16 |
) |
|
|
(59 |
) |
Cash provided by (used in) financing activities |
|
|
83 |
|
|
|
(649 |
) |
|
|
732 |
|
Effect of foreign exchange on cash and cash equivalents |
|
|
6 |
|
|
|
(11 |
) |
|
|
17 |
|
|
|
|
|
|
|
|
|
|
|
Net decrease in cash and cash equivalents |
|
$ |
(30 |
) |
|
$ |
(695 |
) |
|
$ |
665 |
|
|
|
|
|
|
|
|
|
|
|
Changes in Cash Flow
During the six months ended September 30, 2006, we used $44 million of cash from operating
activities as compared to the use of $19 million for the six months ended September 30, 2005. The
increase in cash used in operating activities for the six months ended September 30, 2006 as
compared to the six months ended September 30, 2005 resulted primarily from (1) an increase of $24
million paid for income taxes, (2) $16 million paid in connection with the settlement of certain
employee-related litigation matters, and (3) $15 million in acquisition-related restricted cash.
These payments were partially offset by a decrease in prepaid royalties as compared to the prior
year. We expect total cash flow from operating activities to decline in fiscal 2007.
For the six months ended September 30, 2006, we generated $680 million of cash proceeds from
maturities and sales of short-term investments, and $85 million in proceeds from sales of common
stock through our stock plans. Our primary use of cash in non-operating activities consisted of
$604 million used to purchase short-term investments, $86 million in capital expenditures primarily
related to investments in our worldwide development tools, technologies and equipment and the
expansion of our Vancouver studio, as well as $67 million for our Mythic acquisition. 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.
As of September 30, 2006, we owned 74 percent of Digital Illusions C.E.s (DICE) Class A common
stock. In October 2006, we acquired all of the remaining minority interest in DICE for a total of
$24 million.
Short-term investments and marketable equity securities
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
As of |
|
|
Percentage |
|
|
As of |
|
|
Percentage |
|
|
|
|
|
|
September 30, |
|
|
of |
|
|
March 31, |
|
|
of |
|
|
|
|
|
|
2006 |
|
|
Total |
|
|
2006 |
|
|
Total |
|
|
Decrease |
|
Cash and cash equivalents |
|
$ |
1,212 |
|
|
|
56 |
% |
|
$ |
1,242 |
|
|
|
55 |
% |
|
$ |
(30 |
) |
Short-term investments |
|
|
960 |
|
|
|
44 |
% |
|
|
1,030 |
|
|
|
45 |
% |
|
|
(70 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cash, cash equivalents and
short-term investments |
|
$ |
2,172 |
|
|
|
100 |
% |
|
$ |
2,272 |
|
|
|
100 |
% |
|
$ |
(100 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
The decrease in cash and cash equivalents was primarily due to $604 million used to purchase
short-term investments and $86 million in capital expenditures, partially offset by $680 million in
proceeds received from the maturities and sales of short-term investments. Due to our mix of fixed
and variable rate securities, our short-term investment portfolio is susceptible to changes
48
in short-term interest rates. As of September 30, 2006, our short-term investments had gross
unrealized losses of approximately $1 million, or less than one 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 losses.
Marketable equity securities increased to $204 million as of September 30, 2006, from $160 million
as of March 31, 2006, due to an increase in the fair value of our investment in Ubisoft
Entertainment.
Receivables, net
Our gross accounts receivable balances were $439 million and $431 million as of September 30, 2006
and March 31, 2006, respectively. The increase in our accounts receivable balance was expected due
to higher sales volume in the second quarter of fiscal 2007 as compared to the fourth quarter of
fiscal 2006. We expect our accounts receivable balance to increase during the three months ending
December 31, 2006 based on our seasonal product release schedule. Reserves for sales returns,
pricing allowances and doubtful accounts decreased in absolute dollars from $232 million as of
March 31, 2006 to $172 million as of September 30, 2006. Reserves remained flat at 9 percent as a
percentage of trailing nine month net revenue for both September 30, 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 $67 million as of September 30, 2006, from $61 million as of March 31,
2006. Other than FIFA 07, no single title represented more than $4 million of inventory as of
September 30, 2006.
Other current assets
Other current assets decreased to $210 million as of September 30, 2006, from $234 million as of
March 31, 2006, primarily due to the collection of advertising credits owed to us by our vendors.
Accounts payable
Accounts payable increased to $199 million as of September 30, 2006, from $163 million as of March
31, 2006, primarily due to (1) higher sales volumes and higher related expenditures to support the
seasonality of our business in the second quarter of fiscal 2007 as compared to the fourth quarter
of fiscal 2006, and (2) investments in next-generation tools and technologies.
Accrued and other current liabilities
Our accrued and other current liabilities decreased to $634 million as of September 30, 2006 from
$706 million as of March 31, 2006. The decrease was primarily due to (1) a decrease of $30 million
in accrued compensation and benefits, (2) $16 million in payments made in connection with the
settlement of certain employee-related litigation matters, and (3) $14 million liabilities paid in
connection with our JAMDAT acquisition. We anticipate our accrued and other current liabilities
balance will increase during the three months ending December 31, 2006 primarily due to an increase
in royalties payable.
Deferred income taxes, net
Our long-term net deferred income tax liability decreased to $13 million as of September 30, 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. 123R.
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
49
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 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 September 30, 2006, approximately $692 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 $2.0
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
Letters of Credit
In July 2002, we provided an irrevocable standby letter of credit to Nintendo of Europe, which we
have amended on a number of occasions. The standby letter of credit, as amended, guarantees
performance of our obligations to pay Nintendo of Europe for trade payables. As of September 30,
2006, the standby letter of credit, as amended, guaranteed our trade payable obligations to
Nintendo of Europe for up to 20 million. As of September 30, 2006, 1 million was payable to
Nintendo of Europe under the standby letter of credit, as amended.
In August 2003, we provided an irrevocable standby letter of credit to 300 California Associates
II, LLC in replacement of our security deposit for office space. The standby letter of credit
guarantees performance of our obligations to pay our lease commitment up to approximately $1
million. The standby letter of credit expires in December 2006. As of September 30, 2006, we did
not have a payable balance on this standby letter of credit.
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.
50
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. These minimum guarantee
payments and any related marketing commitments are included in the table below.
The following table summarizes our minimum contractual obligations and commercial commitments as of
September 30, 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 six months) |
|
$ |
31 |
|
|
$ |
44 |
|
|
$ |
27 |
|
|
$ |
7 |
|
|
$ |
109 |
|
2008 |
|
|
48 |
|
|
|
162 |
|
|
|
30 |
|
|
|
1 |
|
|
|
241 |
|
2009 |
|
|
48 |
|
|
|
170 |
|
|
|
31 |
|
|
|
|
|
|
|
249 |
|
2010 |
|
|
35 |
|
|
|
165 |
|
|
|
31 |
|
|
|
|
|
|
|
231 |
|
2011 |
|
|
26 |
|
|
|
283 |
|
|
|
31 |
|
|
|
|
|
|
|
340 |
|
Thereafter |
|
|
63 |
|
|
|
723 |
|
|
|
186 |
|
|
|
|
|
|
|
972 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total |
|
$ |
251 |
|
|
$ |
1,547 |
|
|
$ |
336 |
|
|
$ |
8 |
|
|
$ |
2,142 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(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 September 30, 2006 because payment is not contingent upon performance by the
developer or licensor. |
The lease commitments disclosed above include contractual rental commitments of $21 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 September 30, 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.
51
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 September 30, 2006, the estimated fair values of both properties under these
operating leases exceeded their respective guaranteed residual values.
52
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Actual as of |
|
Financial Covenants |
|
Requirement |
|
|
September 30, 2006 |
|
Consolidated Net Worth (in millions) |
|
equal to or greater than |
|
|
$2,310 |
|
|
|
$3,591 |
|
Fixed Charge Coverage Ratio |
|
equal to or greater than |
|
|
3.00 |
|
|
|
7.06 |
|
Total Consolidated Debt to Capital |
|
equal to or less than |
|
|
60% |
|
|
|
6.4% |
|
Quick Ratio - |
|
Q1 & Q2 |
|
equal to or greater than |
|
|
1.00 |
|
|
|
6.29 |
|
|
|
Q3 & Q4 |
|
equal to or greater than |
|
|
1.75 |
|
|
|
N/A |
|
Legal Proceedings
On February 14, 2005, an employment-related class action lawsuit, Hasty v. Electronic Arts Inc.,
was filed against the company in Superior Court in San Mateo, California. The complaint alleges
that we improperly classified Engineers in California as exempt employees and seeks injunctive
relief, unspecified monetary damages, interest and attorneys fees. On May 16, 2006, the court
granted its preliminary approval of a settlement pursuant to which we agreed to make a lump sum
payment of approximately $15 million, to a third-party administrator to cover (a) all claims
allegedly suffered by the class members, (b) plaintiffs attorneys fees, not to exceed 25% of the
total settlement amount, (c) plaintiffs costs and expenses, (d) any incentive payments to the
named plaintiffs that may be authorized by the court, and (e) all costs of administration of the
settlement. On September 22, 2006, the court granted final approval of the settlement.
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 intend to cooperate with all matters related to this request.
In addition, we are subject to other claims and litigation arising in the ordinary course of
business. We believe that any liability from any reasonably foreseeable disposition of such other
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 have 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.
53
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
September 30, 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 September 30, 2006, we had forward foreign exchange contracts to purchase and sell
approximately $100 million in foreign currencies. Of this amount, $96 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. The fair value of our forward contracts was immaterial as of
September 30, 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 September 30, 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 $10 million and $14 million, respectively, as of September 30, 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.
54
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 September 30, 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
September 30, 2006 and March 31, 2006 (in millions):
|
|
|
|
|
|
|
|
|
|
|
As of |
|
|
As of |
|
|
|
September 30, |
|
|
March 31, |
|
|
|
2006 |
|
|
2006 |
|
Asset-backed and other debt securities |
|
$ |
373 |
|
|
$ |
65 |
|
U.S. agency securities |
|
|
244 |
|
|
|
575 |
|
Corporate bonds |
|
|
222 |
|
|
|
178 |
|
U.S. Treasury securities |
|
|
121 |
|
|
|
212 |
|
|
|
|
|
|
|
|
Total short-term investments |
|
$ |
960 |
|
|
$ |
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 September 30, 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 |
|
|
September 30, |
|
|
Basis Points |
|
|
|
(150 BPS) |
|
|
(100 BPS) |
|
|
(50 BPS) |
|
|
2006 |
|
|
50 BPS |
|
|
100 BPS |
|
|
150 BPS |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Asset-backed and other debt securities |
|
$ |
375 |
|
|
$ |
374 |
|
|
$ |
374 |
|
|
$ |
373 |
|
|
$ |
372 |
|
|
$ |
372 |
|
|
$ |
371 |
|
U.S. agency securities |
|
|
250 |
|
|
|
248 |
|
|
|
246 |
|
|
|
244 |
|
|
|
241 |
|
|
|
239 |
|
|
|
237 |
|
Corporate bonds |
|
|
228 |
|
|
|
226 |
|
|
|
224 |
|
|
|
222 |
|
|
|
221 |
|
|
|
219 |
|
|
|
217 |
|
U.S. Treasury securities |
|
|
125 |
|
|
|
124 |
|
|
|
122 |
|
|
|
121 |
|
|
|
120 |
|
|
|
119 |
|
|
|
118 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total short-term investments |
|
$ |
978 |
|
|
$ |
972 |
|
|
$ |
966 |
|
|
$ |
960 |
|
|
$ |
954 |
|
|
$ |
949 |
|
|
$ |
943 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Market Price Risk
The value of our equity investments in publicly traded companies are subject to market price
volatility. As of September 30, 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 $204 million and $160 million as of
September 30, 2006 and March 31, 2006, respectively.
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
55
equity securities as of September 30, 2006, arising from changes in market prices plus or minus 25
percent, 50 percent and 75 percent.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Valuation of Securities Given an X |
|
|
Fair Value |
|
|
Valuation of Securities Given an X |
|
|
|
Percentage Decrease in Each |
|
|
as of |
|
|
Percentage Increase in Each |
|
(In millions) |
|
Stock's Market Price |
|
|
September 30, |
|
|
Stock's Market Price |
|
|
|
(75%) |
|
|
(50%) |
|
|
(25%) |
|
|
2006 |
|
|
25% |
|
|
50% |
|
|
75% |
|
Marketable equity securities |
|
$ |
51 |
|
|
$ |
102 |
|
|
$ |
153 |
|
|
$ |
204 |
|
|
$ |
256 |
|
|
$ |
307 |
|
|
$ |
358 |
|
56
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 September 30, 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.
57
PART II OTHER INFORMATION
Item 1. Legal Proceedings
On February 14, 2005, an employment-related class action lawsuit, Hasty v. Electronic Arts Inc.,
was filed against the company in Superior Court in San Mateo, California. The complaint alleges
that we improperly classified Engineers in California as exempt employees and seeks injunctive
relief, unspecified monetary damages, interest and attorneys fees. On May 16, 2006, the court
granted its preliminary approval of a settlement pursuant to which we agreed to make a lump sum
payment of approximately $15 million, to a third-party administrator to cover (a) all claims
allegedly suffered by the class members, (b) plaintiffs attorneys fees, not to exceed 25% of the
total settlement amount, (c) plaintiffs costs and expenses, (d) any incentive payments to the
named plaintiffs that may be authorized by the court, and (e) all costs of administration of the
settlement. On September 22, 2006, the court granted final approval of the settlement.
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 intend to cooperate with all matters related to this request.
In addition, we are subject to other claims and litigation arising in the ordinary course of
business. We believe that any liability from any reasonably foreseeable disposition of such other
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 and Xbox 360. The
success of our business is driven in large part by the availability of an adequate supply of
current-generation video game platforms (such as the PlayStation 2), the timely release, adequate
supply, and, increasingly, the 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. Sonys PlayStation 2 was introduced in 2000 and
Microsofts Xbox and the Nintendo GameCube were introduced in 2001. Microsoft launched the Xbox 360
in November 2005. We expect Sony to introduce the PlayStation 3 beginning in November 2006 in North
America and Japan and continuing through spring 2007 in Europe and elsewhere. We expect Nintendo to
introduce the Wii in November in North America and in December in Japan and Europe. We refer to
58
Microsofts Xbox 360, Sonys PlayStation 3 and Nintendos Wii as next-generation platforms. As a
result, we believe that the interactive entertainment industry is in the midst of a transition
stage leading into the next cycle. We have incurred and expect to continue to incur increased costs
during the transition to next-generation platforms 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
next-generation platforms are introduced into the market, 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. 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 royalty rates 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 adopt a different fee structure for future game consoles or we are unable to
obtain such licenses, our profitability will be materially impacted.
Microsoft launched the Xbox 360 in November 2005 and we expect Sony and Nintendo to introduce the
PlayStation 3 and Wii, respectively, in November 2006. In order to publish products for a new video
game player, we must take a license from the platform licensor, which gives the platform licensor
the opportunity to set the fee structure that we must pay in order to publish games for that
platform.
Similarly, certain platform licensors have retained the flexibility to change their fee structures
for online gameplay and features for their consoles. The control that platform licensors have over
the fee structures for their future platforms and online access makes it difficult for us to
predict our costs, profitability and impact on margins. It is also possible that platform licensors
may choose not to renew our licenses. Because publishing products for video game consoles is the
largest portion of our business, any increase in fee structures or failure to secure a license
relationship would 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 revenue 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
59
release schedules would likely result in a delay of revenue and/or possibly a significant shortfall in our revenue, 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.
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
60
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 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.
61
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.
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.
62
Our international net revenue is subject to currency fluctuations.
For the six months ended September 30, 2006, international net revenue comprised 40 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 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.
In our fiscal year 2007, we began to recognize expense for stock-based compensation related to our
employee equity compensation and employee stock purchase programs. The recognition of this expense
will significantly lower our reported net income (or increase our reported net loss).
Beginning in our current fiscal year, we adopted Statement of Financial Accounting Standard
(SFAS) No. 123 (revised 2004) (SFAS No. 123R), 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
63
as stock purchases under our 2000 Employee Stock Purchase Plan. This expense is in addition to the
stock-based compensation expense we have recognized in prior periods related to restricted stock
unit grants, acquisitions and other grants. The stock-based compensation charges we incur depend on
the number of equity-based awards we grant, the number of shares of common stock we sell under our
2000 Employee Stock Purchase Plan, as well as a number of estimates and variables such as estimated
forfeiture rates, the trading price and volatility of our common stock, the expected term of our
options, and interest rates. As a result, our stock-based compensation charges can vary
significantly from period to period. Going forward, our adoption of SFAS No. 123R will continue to
significantly lower our reported net income (or increase our reported net loss), which could have
an adverse impact on the trading price of our common stock.
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, accounting policies affecting software revenue recognition
have been the subject of frequent interpretations, which could significantly affect the way we
account for revenue related to our products and services. It is likely that, as the industry
transitions to the next generation of consoles, a more significant portion of our business could be
generated through online services and, as a result, we could be required to recognize the related
revenue over an extended period of time rather than up front and all at once. For example, if we
are unable to determine the fair value of the free (to the consumer) online services we include in
our packaged goods products, we would be required to recognize the revenue from the sale of the
packaged goods ratably over the entire online service period. 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 4 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. 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 and taxes, could have a significant adverse effect on our reported results
although not necessarily on our cash flows.
It is likely that, as the industry transitions to the next generation of consoles, a more
significant portion of our business could be generated through online services and, as a result, we
would recognize the related revenue over an extended period of time rather than up front and all at
once.
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 September 30, 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 six months ended September 30, 2006. Worldwide, we had direct sales to
two customers, GameStop Corp. and Wal-Mart Stores, Inc., which represented approximately 14 percent
and 13 percent, respectively, of total net revenue in the six months ended September 30, 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
64
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:
|
|
|
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, |
|
|
|
|
Cultural challenges associated with integrating employees from an acquired company or
business into our organization, |
|
|
|
|
Retaining key employees from the businesses we acquire, |
|
|
|
|
The need to integrate an acquired companys accounting, management information, human
resource and other administrative systems to permit effective management, and |
|
|
|
|
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.
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.
65
Item 4. Submission of Matters to a Vote of Security Holders
At our Annual Meeting of Stockholders, held on July 27, 2006, our stockholders elected the
following individuals to the Board of Directors for one-year terms:
|
|
|
|
|
|
|
|
|
|
|
For |
|
Withheld |
M. Richard Asher |
|
|
269,612,228 |
|
|
|
6,916,064 |
|
Leonard S. Coleman |
|
|
272,845,046 |
|
|
|
3,683,246 |
|
Gary M. Kusin |
|
|
270,937,502 |
|
|
|
5,590,790 |
|
Gregory B. Maffei |
|
|
274,427,940 |
|
|
|
2,100,352 |
|
Timothy Mott |
|
|
194,694,181 |
|
|
|
81,834,111 |
|
Vivek Paul |
|
|
274,407,072 |
|
|
|
2,121,220 |
|
Lawrence F. Probst III |
|
|
270,660,649 |
|
|
|
5,867,643 |
|
Richard A. Simonson |
|
|
274,476,494 |
|
|
|
2,051,798 |
|
Linda J. Srere |
|
|
266,762,434 |
|
|
|
9,765,858 |
|
In addition, the following matters were voted on and approved by the stockholders:
1. |
|
A voluntary program (the Exchange Program) that would permit our eligible employees to
exchange certain outstanding stock options that are significantly underwater (that is, the
exercise price is greater than the stock price) for a lesser number of shares of restricted
stock or restricted stock units to be granted under our 2000 Equity Incentive Plan (Equity
Plan). |
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|
|
|
|
|
|
For |
|
Against |
|
Abstain |
|
Broker Non-vote |
|
198,119,467 |
|
46,784,260 |
|
1,711,274 |
|
29,913,291 |
2. |
|
An amendment to our Equity Plan to (a) 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 (b) 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. |
|
|
|
|
|
|
|
For |
|
Against |
|
Abstain |
|
Broker Non-vote |
|
185,650,796 |
|
59,119,646 |
|
1,844,559 |
|
29,913,291 |
3. |
|
An amendment to our 2000 Employee Stock Purchase Plan to increase by 1,500,000 the number of shares of common stock reserved for issuance thereunder. |
|
|
|
|
|
|
|
For |
|
Against |
|
Abstain |
|
Broker Non-vote |
|
202,945,066 |
|
42,013,407 |
|
1,656,528 |
|
29,913,291 |
4. |
|
Ratification of the appointment of KPMG LLP as our independent registered public accounting
firm for fiscal 2007. |
|
|
|
|
|
|
|
For |
|
Against |
|
Abstain |
|
Broker Non-vote |
|
269,588,778 |
|
5,324,823 |
|
1,614,691 |
|
|
66
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:
|
|
|
Exhibit |
|
|
Number |
|
Title |
|
|
|
15.1
|
|
Awareness Letter of KPMG LLP, Independent Registered Public Accounting Firm. |
|
|
|
31.1
|
|
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. |
|
|
|
31.2
|
|
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. |
|
|
|
Additional exhibits furnished with this report: |
|
|
|
32.1
|
|
Certification of Chairman and Chief Executive Officer pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002. |
|
|
|
32.2
|
|
Certification of Executive Vice President, Chief Financial and Administrative
Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
67
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.
|
|
|
|
|
|
|
ELECTRONIC ARTS INC. (Registrant) |
|
|
|
|
|
|
|
|
|
/s/ Warren C. Jenson |
|
|
DATED: |
|
WARREN C. JENSON |
|
|
November 6, 2006 |
|
Executive Vice President, Chief Financial and Administrative Officer |
|
|
68
ELECTRONIC ARTS INC.
FORM 10-Q
FOR THE PERIOD ENDED SEPTEMBER 30, 2006
EXHIBIT INDEX
|
|
|
EXHIBIT |
|
|
NUMBER |
|
EXHIBIT TITLE |
|
|
|
15.1
|
|
Awareness Letter of KPMG LLP, Independent Registered Public Accounting Firm. |
|
|
|
31.1
|
|
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. |
|
|
|
31.2
|
|
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. |
|
|
|
Additional exhibits furnished with this report: |
|
|
|
32.1
|
|
Certification of Chairman and Chief Executive Officer pursuant to Section
906 of the Sarbanes-Oxley Act of 2002. |
|
|
|
32.2
|
|
Certification of Executive Vice President, Chief Financial and
Administrative Officer pursuant to Section 906 of the Sarbanes-Oxley Act of
2002. |
69