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| ERTS > SEC Filings for ERTS > Form 10-K on 4-Jun-2004 | All Recent SEC Filings |
4-Jun-2004
Annual Report
OVERVIEW
The following overview is a top-level discussion of our operating results aswell as the trends and drivers of our business. Management believes that anunderstanding of these trends and drivers is important in order to understandour results for fiscal 2004, as well as our future prospects. This summary isnot intended to be exhaustive, nor is it intended to be a substitute for thedetailed discussion and analysis provided elsewhere in this Form 10-K, includingin "Business", the remainder of "Management's Discussion and Analysis ofFinancial Condition and Results of Operations", "Risk Factors" or theconsolidated financial statements and related notes.
About Electronic Arts
We develop, market, publish and distribute interactive software games that areplayable by consumers on home videogame machines (such as the SonyPlayStation 2ฎ, Microsoft Xboxฎ and Nintendo GameCubeTM consoles), personalcomputers, hand-held game machines (such as the Game Boyฎ Advance) and online,over the Internet and other proprietary online networks. Many of our games arebased on content that we license from others (e.g., Madden NFL Football, HarryPotterTM and FIFA Soccer), and many of our games are based on our ownwholly-owned intellectual property (e.g., The SimsTM, Medal of HonorTM). Ourgoal is to develop titles which appeal to the mass markets and, as a result, wedevelop, market, publish and distribute our games in over 100 countries, oftentranslating and localizing them for sale in non-English speaking countries. Ourgoal is to create software game "franchises" that allow us to publish new titleson a recurring basis that are based on the same property. Examples of this arethe annual iterations of our sports-based franchises (e.g., NCAA Football andFIFA Soccer), titles based on long-lived movie properties (e.g., James BondTMand Harry Potter) and wholly-owned properties that can be successfully sequeled(e.g., The Sims and Medal of Honor).
Overview of Fiscal 2004 Financial Results
Net revenue for fiscal 2004 was $2,957.1 million, up 19.1 percent as comparedwith $2,482.2 million for fiscal 2003. We had 27 platinum titles (over onemillion units sold) in fiscal 2004 as compared to 22 platinum titles in 2003. Infiscal 2004, six franchises sold more than five million units: The Sims, Needfor SpeedTM, Medal of Honor, FIFA Soccer, The Lord of the RingsTM and Madden NFLFootball.
Net income for fiscal 2004 was $577.3 million, an 82.1 percent increase overfiscal 2003. Diluted earnings per share increased 73.1 percent to $1.87 ascompared with $1.08 for fiscal 2003. The growth in earnings was primarily drivenby higher sales volume and increased gross margin.
Operating cash flow was $669.3 million as compared with $714.5 million forfiscal 2003. The decline was primarily a result of the timing of sales duringthe fourth quarter.
Management's Overview of Historical and Prospective Business Trends
Sales of "Hit" Titles. During fiscal 2004, sales of a number of "hit" titlescontributed to our revenue growth, several of which were top sellers across anumber of international markets. Our top-five-selling titles across allplatforms worldwide in fiscal 2004 were Need for Speed TM Underground, MaddenNFL 2004, The Lord of the RingsTM; The Return of the KingTM, Medal of HonorTMRising Sun and FIFA Soccer 2004. Hit titles are important to our financialperformance because they benefit from overall economies of scale. We havedeveloped, and it is our objective to continue to develop, many of our hittitles to become franchise titles that can be regularly iterated.
Increased Console Installed Base. As consumers purchase the current generationof consoles, either as first time buyers or by upgrading from a previousgeneration, the console installed base increases. As the installed base for aparticular console increases, we are generally able to increase our unit volume;however, as consumers anticipate the next generation of consoles, unit volumesoften decrease. In the U.S. and Europe,
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we believe the installed base for the current generation of consoles PlayStation2, Xbox and Nintendo GameCube increased over 30 percent, 60 percentand 80 percent, respectively, during fiscal 2004. Accordingly, we believe thesignificant increase in the installed base for these consoles was a contributingfactor to our net revenue growth in fiscal 2004. In March 2004, Microsoftreduced the retail price of its Xbox consoles in the U.S. and in May 2004 Sonydid the same with its PlayStation2 consoles. As price reductions drive sales ofconsoles and the related installed base of these current generation consolesincreases during fiscal 2005, we expect unit sales of current generation titlesto remain strong.
Software Prices. As current generation console prices decrease, we expect morevalue-oriented consumers to become part of the interactive entertainmentsoftware market. We experienced this trend several years ago when prices werereduced on previous generation consoles (e.g., Sony PlayStation and Nintendo64). We believe that hit titles will continue to be launched at premium pricepoints and will maintain those premium price points longer than less populargames, however, as a result of a more value-oriented consumer base, and agreater number of software titles being published, we expect average softwareprices to gradually come down, which we expect to negatively impact our grossmargin.
International Sales Growth. Our fiscal 2004 net revenue from international salesaccounted for approximately 45 percent of our worldwide net revenue, up from42 percent in fiscal 2003. Our fiscal 2004 increase in international net revenuewas driven primarily by increased sales in Europe. In fiscal 2005, we anticipatethat international net revenue will continue to increase as a percentage of ourworldwide net revenue, although not at the same rate as in fiscal 2004, as westrengthen our presence in new territories and as the console installed baseexpands more rapidly outside of North America.
Foreign Exchange Impact. Given that a significant portion of our business isconducted internationally in foreign currency, fluctuations in currency pricescan have a material impact on our results of operations. For example, theaverage exchange rate for one Euro, as compared to the U.S. dollar, increasedfrom $0.99 in fiscal 2003 to $1.17 in fiscal 2004. We estimate that we had atotal foreign exchange benefit on net revenue of approximately $156 millionduring fiscal 2004 as compared to fiscal 2003. Although we intend to continue toutilize foreign exchange forward and option contracts to either mitigate orhedge against some foreign currency exposures, we cannot predict the effectforeign currency fluctuations will have on us in fiscal 2005.
Increasing Cost of Titles. Hit titles have become increasingly more expensive toproduce and market as the platforms on which they are played continue to advancetechnologically and consumers demand continual improvements in the overallgameplay experience. We expect this trend to continue as we require largerproduction teams to create our titles, the technology needed to develop titlesbecomes more complex, we continue to develop and expand the online gamingcapabilities included in our products and we develop new methods to distributeour content via the Internet. Any increase in the cost of licensing third-partyintellectual property used in our products would also make these products moreexpensive to publish.
Expansion of Studio Resources and Technology. During fiscal 2004, as part of oureffort to more efficiently utilize our resources and technology, we expanded ourstudio facilities in Los Angeles and Vancouver, allowing us to consolidateseveral smaller studios and resources. In fiscal 2005, we expect to devotesignificant resources primarily to the expansion of our studios in North Americaand Europe. As we move through the life cycle of current generation consoles, wewill devote increased resources to developing current generation titles, andincrease spending associated with tools and technologies for the next generationof consoles. We expect to develop more titles internally as a result of ourstudio expansions. We expect these activities to increase our research anddevelopment expenses and decrease our third-party development costs, both as apercentage of net revenue. In addition, we expect the decrease in third-partydevelopment costs to positively impact our gross margin.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Our financial statements have been prepared in accordance with accountingprinciples generally accepted in the United States. The preparation of theseconsolidated financial statements requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities,contingent assets and
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liabilities, and revenue and expenses during the reporting periods. The policiesdiscussed below are considered by management to be critical because they are notonly important to the portrayal of our financial condition and results ofoperations but also because application and interpretation of these policiesrequires both judgment and estimates of matters that are inherently uncertainand unknown. As a result, actual results may differ materially from ourestimates.
Sales Returns and Allowances and Bad Debt Reserves
We principally derive revenue from sales of packaged interactive software gamesdesigned for play on videogame platforms (such as the PlayStation 2, Xbox andNintendo GameCube), PCs and hand-held game machines (such as the Nintendo GameBoy Advance). Product revenue is recognized net of sales allowances. We alsohave stock-balancing programs for our PC products, which allow for the exchangeof PC products by resellers under certain circumstances. We may decide toprovide price protection for both our personal computer and videogame systemproducts. In making this determination, we evaluate inventory remaining in thechannel, the rate of inventory sell-through in the channel, and our remaininginventory on hand. It is our general practice to exchange products or givecredits, rather than give cash refunds.
We estimate potential future product returns, price protection andstock-balancing programs related to current-period product revenue. We analyzehistorical returns, current sell-through of distributor and retailer inventoryof our products, current trends in the videogame market and the overall economy,changes in customer demand and acceptance of our products and other relatedfactors when evaluating the adequacy of the sales returns and price protectionallowances. In addition, management monitors and manages the volume of our salesto retailers and distributors and their inventories, as substantial overstockingin the distribution channel can result in high returns or substantial priceprotection requirements in subsequent periods. In the past, actual returns havenot generally exceeded our reserves. However, actual returns and priceprotections may materially exceed our estimates as unsold products in thedistribution channels are exposed to rapid changes in consumer preferences,market conditions or technological obsolescence due to new platforms, productupdates or competing products. For example, the risk of product returns for ourproducts may increase as the PlayStation 2, Xbox and Nintendo GameCube consolespass the midpoint of their lifecycle and an increasing number and aggregateamount of competitive products heighten pricing and competitive pressures. Whilemanagement believes it can make reliable estimates regarding these matters,these estimates are inherently subjective. Accordingly, if our estimateschanged, our returns reserves would change, which would impact the net revenuewe report. For example, if actual returns were significantly greater than thereserves we have established, our actual results would decrease our reported netrevenue. Conversely, if actual returns were significantly less than ourreserves, this would increase our reported net revenue.
Similarly, significant judgment is required to estimate our allowance fordoubtful accounts in any accounting period. We determine our allowance fordoubtful accounts by evaluating customer creditworthiness in the context ofcurrent economic trends. Depending upon the overall economic climate and thefinancial condition of our customers, the amount and timing of our bad debtexpense and cash collection could change significantly.
We cannot predict customer bankruptcies or an inability of any of our customersto meet their financial obligations to us. Therefore, our estimates could differmaterially from actual results.
Royalties & Licenses
Our royalty expenses consist of payments to (1) co-publishing and/ordistribution affiliates, (2) content licensors, and (3) independent softwaredevelopers. Co-publishing and distribution royalties are payments made to thirdparties for delivery of product. License royalties consist of payments made tocelebrities, professional sports organizations, movie studios and otherorganizations for our use of their trademark, copyright, personal publicityrights, content and/or other intellectual property. Royalty payments toindependent software developers are payments for the development of intellectualproperty related to our games.
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Royalty-based payments made to content licensors and distribution affiliatesthat are paid in advance are generally capitalized as prepaid royalties andexpensed to cost of goods sold at the greater of the contractual or effectiveroyalty rate based on net product sales. With regard to payments made toindependent software developers and co-publishing affiliates, we are generallysubject to development risk prior to the general release of the product.Accordingly, payments that are due prior to completion of the product aregenerally expensed as research and development 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 at the higher of the contractual oreffective royalty rate based on net product sales.
Each quarter, we also evaluate the future realization of any prepaid royaltiesas well as minimum commitments not yet paid to determine amounts we deemunlikely to be realized through product sales. Any impairments determined beforethe launch of a product are charged to research and development expense.Impairments determined post-launch are charged to cost of goods sold. In eithercase, we rely on estimated revenue to evaluate the future realization of prepaidroyalties. If actual revenue, or revised sales estimates, fall below the initialsales estimate, then the actual charge taken may be greater in any given quarterthan anticipated. As of March 31, 2004 we had $22.7 million of prepaid royaltyassets and approximately $130.3 million in future obligations to ourco-publishing and/or distribution affiliates and content licensors that could beimpaired if our sales estimates changed.
Valuation of Long-Lived Assets
We evaluate both purchased intangible assets and other long-lived assets inorder to determine if events or changes in circumstances indicate a potentialimpairment in value exists. This evaluation requires us to estimate, among otherthings, the remaining useful lives of the assets and future cash flows of thebusiness. These evaluations and estimates require the use of judgment. Ouractual results could differ materially from our current estimates.
Under current accounting standards, we make judgments about the remaining usefullives of purchased intangible assets and other long-lived assets whenever eventsor changes in circumstances indicate a potential impairment in the remainingvalue of the assets recorded on our consolidated balance sheet. In order todetermine if a potential impairment has occurred, management makes variousassumptions about the future value of the asset by evaluating future businessprospects and estimated cash flows. Our future net cash flows are primarilydependent on the sale of products for play on proprietary videogame consoles,hand-held game machines and PCs ("platforms"). The success of our products isaffected by our ability to accurately predict which platforms and which productswe develop will be successful. Also, our revenue and earnings are dependent onour ability to meet our product release schedules. Due to product salesshortfalls, we may not realize the future net cash flows necessary to recoverour long-lived assets, which may result in an impairment charge being recordedin the future. We recorded $0.5 million of impairment charges on long-livedassets during fiscal 2004, $66.3 million during fiscal 2003 and $12.8 million infiscal 2002.
Income Taxes
In the ordinary course of our business, there are many transactions andcalculations where the ultimate tax determination is uncertain. As part of theprocess of preparing our consolidated financial statements, we are required toestimate our income taxes in each of the jurisdictions in which we operate priorto the completion and filing of tax returns for such periods. This processrequires estimating both our geographic mix of income and our current taxexposures in each jurisdiction where we operate. These estimates involve complexissues, require extended periods of time to resolve, and require us to makejudgments, such as anticipating the positions that we will take on tax returnsprior to our actually preparing the returns. We are also required to make thedeterminations of the need to record deferred tax liabilities and therecoverability of deferred tax assets. A valuation allowance is established tothe extent recovery of deferred tax assets is not likely based on our estimationof future taxable income in each jurisdiction.
In addition, changes in our business, including the geographic mix of income, aswell as changes in valuation allowances, the applicable accounting rules, theapplicable tax laws and regulations and interpretations
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thereof, developments in tax audit matters, and estimated level of annualpre-tax income can affect the overall effective income tax rate. For example, inthe fourth quarter of fiscal 2004, we resolved certain tax-related matters withthe Internal Revenue Service, which lowered our income tax expense by$19.7 million and resulted in a 2.5 percent rate reduction.
RESULTS OF OPERATIONS
Our fiscal year is reported on a 52/53-week period that ends on the finalSaturday of March in each year. The results of operations for the fiscal yearsended March 31, 2004, 2003 and 2002 each contain 52 weeks and ended on March 27,2004, March 29, 2003 and March 30, 2002, respectively. For simplicity ofpresentation, all fiscal periods are treated as ending on a calendar month end.
On October 20, 2003, our Board of Directors authorized a two-for-one stock splitof our Class A common stock which was distributed on November 17, 2003 in theform of a stock dividend for shareholders of record at the close of business onNovember 3, 2003. All issued and outstanding share and per-share amounts relatedto the Class A common stock have been restated to reflect the stock split forall periods presented.
Comparison of Fiscal 2004 to Fiscal 2003
Net Revenue
We principally derive net revenue from sales of packaged interactive softwaregames designed for play on videogame consoles (such as the PlayStation 2, Xboxand Nintendo GameCube), PCs and hand-held game machines (such as the NintendoGame Boy Advance). Additionally, in Europe and Asia we generate a significantportion of net revenue by marketing and selling third-party interactive softwaregames through our established distribution network. We also derive net revenuefrom selling subscriptions to online games, programming third-party web sites,allowing other companies to manufacture and sell our products in conjunctionwith other products, and selling advertisements on our online web pages.
From a geographical perspective, our net revenue for the fiscal years endedMarch 31, 2004 and 2003 was as follows (in thousands):
Year Ended March 31, ----------------------------- Increase/ % 2004 2003 (Decrease) Change ------------- ------------- ------------ ---------- North America $ 1,609,539 $ 1,435,718 $ 173,821 12.1 % --------- --------- ------- ----- Europe 1,180,274 878,904 301,370 34.3 % Asia Pacific 96,708 87,569 9,139 10.4 % Japan 70,620 80,053 (9,433 ) (11.8 %) --------- --------- ------- ----- International 1,347,602 1,046,526 301,076 28.8 % --------- --------- ------- ----- Consolidated Net Revenue $ 2,957,141 $ 2,482,244 $ 474,897 19.1 % --------- --------- ------- -----
North America
For fiscal 2004, net revenue in North America increased by 12.1 percent ascompared to fiscal 2003. From a franchise perspective, the net revenue increasewas primarily driven by higher sales of products released during the year endedMarch 31, 2004 in the following eight franchises: Need for SpeedTM, NBA STREET,NFL STREET, Madden NFL, Def JamTM, SSX, Tiger Woods/ PGA TOURฎ andMVP BaseballTM. Increased sales in these franchises resulted in increased netrevenue of $353.2 million for the year ended March 31, 2004 as compared to theyear ended March 31, 2003. Increases in net revenue from these franchises werepartially offset by (1) a decrease in our Harry Potter franchise, as the fiscal2004 title, Harry PotterTM: QuidditchTM World Cup, had no associated movierelease, while our fiscal 2003 product, Harry Potter and the Chamber ofSecretsTM, was released in conjunction with the blockbuster movie of the sametitle, (2) the termination of our Square EA joint venture agreement, and (3) adecrease in net revenue in our
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Bond franchise as a result of the timing of the release of James Bond 007 TM:Everything or NothingTM (on all platforms except the Game Boy Advance) in thefourth quarter of fiscal 2004, as compared to the strong sales of JamesBond 007: NIGHTFIRE TM, which was released in the third quarter of fiscal 2003.Together, lower sales in these franchises reduced net revenue by $176.8 millionfor the year ended March 31, 2004 as compared to the year ended March 31, 2003.
Europe
For fiscal 2004, net revenue in Europe increased by 34.3 percent as compared tofiscal 2003. We estimate foreign exchange rates (primarily the Euro and theBritish pound sterling) strengthened reported European net revenue byapproximately $136 million or 15 percent for the year ended March 31, 2004. Froma franchise perspective, the net revenue increase was primarily driven by highersales of products released during the year ended March 31, 2004 in the followingeleven franchises: Need for Speed, The Sims, FIFA Soccer, Lord of the RingsTM,Medal of Honor, Final Fantasy, SSX, Football Manager, Freedom Fighters, TigerWoods/ PGA TOUR and Rugby. Increased sales in these franchises resulted in anincrease in net revenue of $372.6 million for the year ended March 31, 2004 ascompared to the year ended March 31, 2003. The increase was partially offset by(1) a decrease in our Harry Potter franchise, as the fiscal 2004 title, HarryPotter: Quidditch World Cup, had no associated movie release, while our fiscal2003 product, Harry Potter and the Chamber of Secrets, was released inconjunction with the blockbuster movie of the same title, and (2) an expecteddecrease in sales of our World Cup franchise due to strong sales in the yearended March 31, 2003 in conjunction with the World Cup event and no similarevent in the year ended March 31, 2004. Together, the two items noted above,reduced net revenue by $92.3 million for the year ended March 31, 2004 ascompared to the year ended March 31, 2003.
Asia Pacific
For fiscal 2004, net revenue from sales in the Asia Pacific region, excludingJapan, increased by 10.4 percent as compared to fiscal 2003. The growth in netrevenue was driven by the Need for Speed, The Sims and other franchises,partially offset by declines in the Harry Potter and World Cup franchises. Weestimate foreign exchange rates strengthened reported Asia Pacific net revenueby approximately $15 million or 17 percent, for the year ended March 31, 2004.Excluding the effect of foreign exchange rates, we estimate that Asia Pacificnet revenue decreased by approximately $6 million or 7 percent, for the yearended March 31, 2004.
Japan
For fiscal 2004, net revenue from sales in Japan decreased by 11.8 percent ascompared to fiscal 2003 primarily due to declines in sales in the World Cup,Harry Potter and Final Fantasy franchises. In addition, we estimate thatfavorable changes in foreign exchange rates offset the decline in reported netrevenue in Japan by approximately $6 million or 7 percent, for the year endedMarch 31, 2004.
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Our worldwide net revenue by product line for fiscal years 2004 and 2003 was asfollows (in thousands):
Year Ended March 31, ---------------------------------------------------------------- Increase/ % 2004 2003 (Decrease) Change ------------------------------ ------------------------------ --------------- -----------
PlayStation 2 $ 1,314,758 44.4 % $ 910,693 36.7 % $ 404,065 44.4 % PC 469,692 15.9 % 499,634 20.2 % (29,942 ) (6.0 %)Xbox 384,320 13.0 % 219,378 8.8 % 164,942 75.2 % Nintendo GameCube 199,893 6.8 % 176,656 7.1 % 23,237 13.2 % Game Boy Advance 77,305 2.6 % 79,093 3.2 % (1,788 ) (2.3 %)Subscription Services 49,514 1.7 % 44,648 1.8 % 4,866 10.9 % PlayStation 29,619 1.0 % 99,951 4.0 % (70,332 ) (70.4 %) --------- ----- --------- ----- ------- ----- EA Studio Net Product Revenue 2,525,101 85.4 % 2,030,053 81.8 % 495,048 24.4 %
Co-publishing and Distribution 398,221 13.5 % 375,759 15.1 % 22,462 6.0 % Advertising, Programming, Licensing, and Other 33,819 1.1 % 76,432 3.1 % (42,613 ) (55.8 %) --------- ----- --------- ----- ------- ----- Total Net Revenue $ 2,957,141 100.0 % $ 2,482,244 100.0 % $ 474,897 19.1 % --------- ----- --------- ----- ------- -----
PlayStation 2
Net revenue from PlayStation 2 products increased from $910.7 million in fiscal2003 to $1,314.8 million in fiscal 2004. As a percentage of total net revenue,sales of PlayStation 2 products increased by 7.7 percent in fiscal 2004. Theincrease in net revenue was primarily due to growth in the installed base andgreater demand for our products.
PC
Net revenue from PC-based products decreased from $499.6 million in fiscal 2003to $469.7 million in fiscal 2004. As a percentage of total net revenue, sales ofPC products decreased by 4.3 percent in fiscal 2004. PC net revenue declined,largely due to declines of sales in the Harry Potter, World Cup and Bondfranchises as discussed above, which were partially offset by an increase insales of the Lord of the Rings franchise.
Xbox
Net revenue from Xbox products increased from $219.4 million in fiscal 2003 to$384.3 million in fiscal 2004. As a percentage of total net revenue, sales ofXbox products increased by 4.2 percent in fiscal 2004. The increase in netrevenue was primarily due to growth in the installed base and greater demand forour products.
Nintendo GameCube
Net revenue from Nintendo GameCube products increased from $176.7 million infiscal 2003 to $199.9 million in fiscal 2004. The increase in net revenue wasprimarily due to growth in the installed base of the Nintendo GameCube.
Subscription Services
In fiscal 2004, net revenue from subscription services products increased by$4.9 million to $49.5 million as compared to fiscal 2003. The increase in netrevenue was primarily due to the number of users for Club Pogo (launched in July2003) and Pogo Downloadables (launched in May 2003), partially offset by adecrease in
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subscription net revenue from The SimsTM Online, Ultima OnlineTM, and Earth &Beyond TM subscription services.
PlayStation
In fiscal 2004, net revenue from PlayStation products decreased by $70.3 millionto $29.6 million as compared to fiscal 2003. We anticipated the decline in netrevenue from PlayStation products as we continued to transition away from thatplatform. Although our PlayStation products are playable on the PlayStation 2console, we expect sales of current PlayStation products to continue to declinein the future.
Co-Publishing and Distribution
In fiscal 2004, net revenue from co-publishing and distribution productsincreased by $22.5 million to $398.2 million as compared to fiscal 2003. Theincrease was due to a $74.5 million increase in Europe primarily from increasedsales in the Final Fantasy, Freedom Fighters and Battlefield franchises,partially offset by a decline in the Kingdom Hearts franchise in North America.Although co-publishing and distribution net revenue increased, it declined as apercentage of net revenue.
Advertising, Programming, Licensing and Other
In fiscal 2004, net revenue from advertising, programming, licensing and otherproducts decreased by $42.6 million to $33.8 million as compared to fiscal 2003.The decrease was a result of expected declines in our advertising andprogramming net revenue following our renegotiation of the terms of ourrelationship with AOL during the three months ended June 30, 2003 and anexpected decline in our Game Boy Color net revenue as we transitioned away fromthat platform.
Operations by Segment
In March 2003, we consolidated the operations of the EA.com business segmentinto our core business. We now consider online capability and gameplay to beintegral to our existing and future products. Accordingly, beginning April 1,2003, we no longer manage our online products and services as a separatebusiness segment, and we have consolidated the reporting related to our onlineproducts and services into reporting for the overall development and publicationof our core products for all reporting periods ending after that date. Webelieve that this will better reflect the way in which our Chief ExecutiveOfficer (our chief operating decision maker) reviews and manages our businessand reflects the importance of our online products and services relative to therest of our business. Concurrently, we have also eliminated separate reportingfor our Class B common stock for all reporting periods ending after April 1,2003. Fiscal 2003 and 2002 have been restated to conform with our fiscal 2004presentation. See Note 18 of the Notes to Consolidated Financial Statements,included in Item 8 hereof.
Our view and reporting of business segments may change due to changes inunderlying business facts and circumstances and the evolution of our reportingto our Chief Executive Officer.
Cost of Goods Sold
Cost of goods sold for our disk-based and cartridge-based products consists of(1) product costs, (2) certain royalty expenses for celebrities, professionalsports and other organizations and independent software developers, (3)manufacturing royalties, net of volume discounts, (4) expenses for defectiveproducts, (5) write-off of post-launch prepaid royalty costs, and (6) operationsexpenses. Cost of goods sold for our online product subscription businessconsists primarily of data center and bandwidth costs associated with hostingour websites, credit card fees and royalties for use of third party properties.Cost of goods sold for our website advertising business primarily consists of adserving costs.
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Costs of goods sold for fiscal years 2004 and 2003 (in thousands):
March 31, % of Net March 31, % of Net 2004 Revenue 2003 Revenue % Change -------------- ----------- ------------- ----------- ---------- $1,102,950 37.3 % $ 1,072,802 43.2 % 2.8 %
In fiscal 2004, cost of goods sold as a percentage of net revenue decreased by5.9 percentage points to 37.3 percent from 43.2 percent for fiscal 2003primarily due to a 3.3 percent decrease in product costs and a 2.8 percentdecrease in royalty rates.
The 3.3 percent decrease in product costs was primarily a result of:
Lower co-publishing and distribution product costs, as a percentage of
net revenue, due to a higher mix of co-publishing titles relative to distribution titles in fiscal 2004. Co-publishing titles generally have higher gross margins than distribution titles. Lower co-publishing and distribution costs, as a percentage of net revenue, increased total gross margin by 1.6 percent in fiscal 2004. Lower average manufacturing costs increased total gross margin by 1.0 percent in fiscal 2004. Lower period costs primarily due to improved inventory management in North America. Lower period costs increased total gross margin by 0.5 percent in fiscal 2004.
The 2.8 percent decrease in royalty rates was primarily the result of:
Decreased third-party development royalties primarily due to a higher mix
of titles developed internally rather than externally in fiscal 2004. Significant titles that were developed internally in fiscal 2004 for which a comparable title had been developed externally in fiscal 2003 included James Bond 007: Everything or Nothing and The Lord of the Rings; The Return of the King. We estimate that lower development royalties increased gross margin by 1.9 percent, which was spread across multiple platforms. Lower license royalties, as a percentage of net revenue, as Need for Speed Underground, our highest grossing title of fiscal 2004, had a significantly lower license royalty rate than Harry Potter and the Chamber of Secrets, our highest grossing title of fiscal 2003. Lower license royalties, as a percentage of net revenue, increased total gross margin by 1.1 percent in fiscal 2004.
We expect cost of goods sold as a percentage of net revenue to increase infiscal 2005 as a result of (1) a gradual decrease in the average selling pricedue to the current-generation lifecycle, (2) overall product mix, and (3) higherlicense royalties as a percentage of net revenue.
Marketing and Sales
Marketing and sales expenses consist of personnel-related costs and advertising,marketing and promotional expenses, net of advertising expense reimbursementsfrom third parties. In fiscal 2003, marketing and sales expense also includedthe amortization of the carriage fees payable for the distribution of our onlinegames on AOL, which we are no longer required to pay. See Note 7 of the Notes toConsolidated Financial Statements, included in Item 8 hereof.
Marketing and sales expenses for fiscal years 2004 and 2003 (in thousands):
March 31, % of Net March 31, % of Net 2004 Revenue 2003 Revenue $ Change % Change ------------ ----------- ----------- ----------- ---------- ----------- $370,468 12.5 % $ 332,453 13.4 % $ 38,015 11.4 %
Marketing and sales expenses increased by 11.4 percent in fiscal 2004 ascompared to fiscal 2003 primarily due to:
An increase in our advertising, contract services and promotional expenses of $38.0 million as we incrementally increased our advertising
campaigns to support the release of new titles.
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A 13.6 percent increase in average headcount to further support the growth of our marketing and sales functions worldwide, which resulted in
an increase to personnel-related costs of approximately $16.5 million.
The increase in marketing and sales expenses was partially offset by thediscontinuance of carriage fee payments to AOL, which resulted in a decrease of$17.9 million.
As a percentage of net revenue, marketing and sales expenses declined from13.4 percent in fiscal 2003 to 12.5 percent in fiscal 2004. Marketing and salesexpenses included vendor reimbursements for advertising expenses of$44.8 million in fiscal 2004 and $28.2 million in fiscal 2003.
General and Administrative
General and administrative expenses consist of personnel and related expenses ofexecutive and administrative staff, fees for professional services such as legaland accounting, and allowances for bad debts.
General and administrative expenses for fiscal years 2004 and 2003 (inthousands):
March 31, % of Net March 31, % of Net 2004 Revenue 2003 Revenue $ Change % Change ------------ ---------- ----------- ---------- ---------- ----------- $184,825 6.3 % $ 130,859 5.3 % $ 53,966 41.2 %
General and administrative expenses increased by 41.2 percent, or 1.0 percent ofnet revenue, in fiscal 2004 compared to fiscal 2003 primarily due to:
An increase in depreciation expense of approximately $17.8 million primarily due to accelerated depreciation on equipment and software that
are being replaced and to write-off assets that have been taken out of service. An increase of approximately 9 percent, or $14.8 million, in personnel-related costs to support the continued growth of our business. An increase in contributions of $8.5 million as we invest in our strategic university relationships. An increase of approximately $11.5 million in professional services. An increase of approximately $9.6 million in information technology and facilities expenses.
The increase in general and administrative expenses was partially offset by adecrease in bad debt expense of $9.1 million, primarily as a result ofcollecting on accounts that we had previously deemed uncollectible.
Research and Development
Research and development expenses consist of expenses incurred by our productionstudios for personnel-related costs, consulting, equipment depreciation and anyimpairment of prepaid royalties for pre-launch products. Research anddevelopment expenses for our online business include expenses incurred by ourstudios consisting of direct development costs and related overhead costs inconnection with the development and production of our online games. Research anddevelopment expenses also include expenses associated with development ofwebsite content, network infrastructure direct expenses, software licenses andmaintenance, and network and management overhead.
Research and development expenses for fiscal years 2004 and 2003 (in thousands):
March 31, % of Net March 31, % of Net 2004 Revenue 2003 Revenue $ Change % Change ------------ ----------- ----------- ----------- ----------- ----------- $510,858 17.3 % $ 400,990 16.1 % $ 109,868 27.4 %
Research and development expenses increased by 27.4 percent, or 1.2 percentagepoints of net revenue, in fiscal 2004 compared to fiscal 2003 primarily due to:
Increases in personnel-related costs of $100.8 million of which
approximately $64.3 million resulted from a 22.2 percent increase in average regular full-time employee headcount.
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An overall increase in external development expenses of $23.4 million
related to development of new products.
The increase in research and development expenses was partially offset by adecrease in depreciation and other operating expenses due to asset impairmentsrecognized in the third and fourth quarters of fiscal 2003.
We expected increased research and development expenses in fiscal 2004 as wecontinued to support the global growth of our research and developmentcapabilities. In recent quarters, we have developed a greater number of titlesinternally. We expect increased research and development spending to continue infiscal 2005 due to the development of next-generation tools and technologies andto a lesser extent, increased spending on current-generation console productsincluding the PlayStation 2, Xbox and Nintendo GameCube, as well as extendingour investment in the development of games for the PC.
Amortization of Intangibles
Amortization of intangibles for fiscal years 2004 and 2003 (in thousands):
March 31, % of Net March 31, % of Net 2004 Revenue 2003 Revenue $ Change % Change ----------- ---------- ------------ ---------- ---------- ---------- $2,735 0.1 % $ 7,482 0.3 % $ (4,747 ) (63.4 %)
Amortization of intangibles results primarily from our acquisitions of Westwood,Kesmai, DreamWorks Interactive, ABC Software, Pogo and other acquisitions. Thedecline in amortization was a result of the impairment charges taken in fiscal2003.
Restructuring and Asset Impairment Charges
Restructuring and asset impairment charges for fiscal years 2004 and 2003 (inthousands):
March 31, % of Net March 31, % of Net 2004 Revenue 2003 Revenue % Change ------------ ---------- ----------- ---------- ----------- Restructuring Charges $ 9,708 0.3 % $ 15,102 0.6 % (35.7 %) Asset Impairment Charges $ 0.0 % $ 66,329 2.7 % (100.0 %)
Fiscal 2004 Studio Restructuring
During the fourth quarter of fiscal 2004, we closed the majority of our leasedstudio facility in Walnut Creek, California and our entire owned studio facilityin Austin, Texas. The studio closures were the result of a strategic decision toconsolidate local development efforts in Redwood City, California. We recordedtotal pre-tax charges of $9.2 million, consisting of $7.0 million forconsolidation of facilities, $1.7 million for workforce reductions and$0.5 million for the write-off of non-current assets, primarily leaseholdimprovements. The facilities charge included contractual rental commitmentsunder the real estate lease for unutilized office space at our Walnut Creeklocation, offset by estimated future sub-lease income. The exit plans resultedin a workforce reduction of approximately 117 personnel in development andadministrative departments, the majority of whom are expected to be terminatedin the first quarter of fiscal 2005. In addition, we also expect immaterialcharges to be incurred during the first quarter of fiscal 2005, primarilyrelated to the Texas facility relocation.
Fiscal 2003 Studio Restructuring
During the third quarter of fiscal 2003, we closed our office located inSan Francisco, California and our studio located in Seattle, Washington. Theoffice and studio closures were the result of a strategic decision toconsolidate local development efforts in Redwood City, California and Vancouver,British Columbia, Canada. We recorded total pre-tax charges of $9.4 million,consisting of $7.3 million for consolidation of facilities, $1.5 million for thewrite-off of non-current assets, primarily leasehold improvements, and$0.6 million for workforce reductions. The facilities charge was net of areduction in deferred rent of $0.5 million. The exit plans resulted in aworkforce reduction of approximately 33 personnel in development andadministrative
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departments. The estimated costs for consolidation of facilities includedcontractual rental commitments under the real estate lease for unutilized officespace, offset by estimated future sub-lease income.
Additionally, during the fourth quarter of fiscal 2003, we approved a plan toconsolidate the Los Angeles, California, Irvine, California and Las Vegas,Nevada, studios into one major game studio in Los Angeles. These measures weretaken in order to maximize efficiencies and streamline the creative developmentprocess and operations of our studios. In connection with these consolidationactivities, we recorded a total pre-tax restructuring charge of $5.1 million,including $1.6 million for the shutdown of facilities related to non-cancelablelease payments for permanently vacated properties and associated costs,$2.0 million for the write-off of abandoned equipment and leasehold improvementsat facilities that were permanently vacated and $1.5 million for employeeseverance expenses related to involuntary terminations.
Fiscal 2003 Online Restructuring
In March 2003, we consolidated the operations of EA.com into our core business,and eliminated separate reporting for its Class B common stock for all futurereporting periods after fiscal 2003. We consider online functionality to be anintegral component of our existing and future products.
During fiscal 2003, we recorded restructuring charges, including assetimpairment, of $67.0 million, consisting of $1.8 million for workforcereductions, $2.3 million for consolidation of facilities and otheradministrative charges, and $62.9 million for the write-off of non-currentassets. The estimated costs for workforce reduction included severance chargesfor terminated employees, costs for certain outplacement service contracts andcosts associated with the tender offer to retire employee Class B options. Theworkforce reduction resulted in the termination of approximately 50 positions.The consolidation of facilities resulted in the closure of EA.com's Chicago andVirginia facilities and an adjustment for the closure of EA.com's San Diegostudio in fiscal 2002. The estimated costs for consolidation of facilities andother administrative charges included contractual rental commitments under realestate leases for unutilized office space reduced by estimated future sub-leaseincome and costs to close the facilities.
As part of the restructuring efforts, we performed impairment tests underSFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets",to evaluate the recoverability of our long-lived assets and remainingfinite-lived identifiable intangible assets utilized in the EA.com business.This test was performed in the fourth quarter of fiscal 2003 in conjunction withthe overall valuation of the EA.com legal entity and its Class B common stock.In February 2003, our only outside holder of Class B common stock, AOL,exercised its right to exchange its Class B shares for shares of Class A commonstock. In late December 2002, EA.com launched The Sims Online, an online gamebased on our "The Sims" line of PC games, which have sold over 20 million unitsworldwide. The Sims Online was expected to be EA.com's flagship onlinesubscription offering. As of March 31, 2003, the number of units sold and thenumber of subscribers for this product along with other EA.com revenue weresignificantly below our expectations. We considered these developments to be atriggering event under SFAS No. 144, which caused us to cancel most of our plansto develop similar online products that would have utilized long-lived assetsassociated with the EA.com business. Impairment charges on long-lived assetsamounted to $62.9 million and included $24.9 million relating to impairedcustomized internal-use software systems for the EA.com infrastructure,$25.6 million for other long-lived assets and $12.4 million of finite-livedintangibles impairment charges relating to EA.com's acquisitions of KesmaiCorporation and Pogo Corporation (now referred to as "Kesmai" and "Pogo",respectively) studios. As of March 31, 2003, there were no finite-livedintangible balances remaining related to Kesmai and Pogo studios.
In conjunction with our annual policy to reassess the remaining useful lives ofgoodwill and certain indefinite-lived intangibles and test the recoverability ofthese long-lived assets in accordance with SFAS No. 142, our fair value basedtests did not indicate an impairment of our recorded goodwill and certainindefinite-lived intangibles at the EA.com reporting unit level as of January 1,2003. The remaining portion of Kesmai goodwill assets as of March 31, 2003 was$13.8 million. The remaining portion of Pogo goodwill assets as of March 31,2003 was $15.9 million. There are no assurances that future impairment testswill not result in a charge to earnings and a corresponding write down ofgoodwill and certain indefinite-lived intangibles.
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The following table reflects our unaudited pro forma consolidated basic earningsper share for the fiscal years ended 2003 and 2002 as if the consolidation ofthe operations of our EA.com business segment into our core business hadoccurred at the beginning of each of the periods presented (in thousands, exceptper share data):
Year Ended March 31, -------------------------- 2003 2002 ------------ ----------- Net income: As reported $ 317,097 $ 101,509 Pro forma $ 317,097 $ 101,509 Earnings per share: As reported $ 1.17 $ 0.45 Pro forma $ 1.12 $ 0.37 Number of shares used in computation: As reported 281,978 273,665 Add: conversion of AOL and News Corp Class B 1,028 1,368 Pro forma 283,006 275,033
All restructuring charges recorded prior to December 31, 2002 were recorded inaccordance with Emerging Issues Task Force ("EITF") No. 94-3, "LiabilityRecognition for Certain Employee Termination Benefits and Other Costs to Exit anActivity (Including Certain Costs Incurred in a Restructuring)", EITF No. 95-3,"Recognition of Liabilities in Connection with a Purchase Business Combination",and Staff Accounting Bulletin ("SAB") No. 100, "Restructuring and ImpairmentCharges". All restructuring charges recorded subsequent to December 31, 2002were recorded in accordance with SFAS No. 146, "Accounting for Costs Associatedwith Exit or Disposal Activities". Adjustments to the restructuring reserveswill be made in future periods, if necessary, based upon the then-current eventsand circumstances.
For further discussion on our restructurings and asset impairment charges,please see Note 6 in our Consolidated Financial Statements, included in item 8hereof.
Interest and Other Income, Net
Interest and other income, net, for fiscal years 2004 and 2003 (in thousands):
March 31, % of Net March 31, % of Net 2004 Revenue 2003 Revenue $ Change % Change ----------- ---------- ------------ ---------- ---------- ---------- $20,963 0.7 % $ 5,222 0.2 % $ 15,741 301.4 %
Interest and other income, net, in fiscal 2004 increased from fiscal 2003primarily due to:
Interest income increased $7.9 million in fiscal 2004 as a result of
higher average cash balances in the current year. During the year ended March 31, 2003, we recorded $10.6 million for an other-than-temporary impairment of investments in affiliates, offset by income of $5.5 million recorded from our equity investment in Square EA, LLC.
Income Taxes
Income taxes for fiscal years 2004 and 2003 (in thousands):
March 31, Effective March 31, Effective 2004 Tax Rate 2003 Tax Rate % Change ------------ ----------- ----------- ----------- ----------- $219,268 27.5 % $ 143,049 31.0 % 53.3 %
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Our effective income tax rate reflects tax benefits derived from significantoperations outside the U.S., which are generally taxed at rates lower than theU.S. statutory rate of 35 percent. The effective income tax rate was27.5 percent for fiscal 2004 and 31.0 percent for fiscal 2003. The reducedeffective income tax rate in fiscal 2004 primarily reflects the resolution ofcertain tax-related matters with the Internal Revenue Service in the fourthquarter of fiscal 2004, which lowered our income tax expense by $19.7 millionand resulted in a 2.5 percent rate reduction and a change in the geographic mixof taxable income subject to lower tax rates.
We intend to indefinitely reinvest our international earnings outside the U.S.and, accordingly, have not provided U.S. taxes that would be incurred if suchearnings were repatriated back to the U.S. Undistributed earnings of our foreignsubsidiaries amounted to approximately $738.3 million at March 31, 2004.
We are currently projecting an effective income tax rate of approximately29 percent for fiscal 2005. An effective income tax rate projection, which isinherently uncertain, is based on current tax law and current projections of themix of income in various taxing jurisdictions and assumes no material changes inour business or the applicable tax or accounting rules.
Our actual effective income tax rates for fiscal 2005 and future periods candiffer from the projected effective income tax rates due to a variety offactors, including changes in our business that were not taken into account inconnection with our projection, a variation between the projected and actual mixof income between international and domestic operations, changes orinterpretations to applicable tax laws and regulations, changes in theapplicable accounting rules or our ability to realize deferred tax assets, ordevelopments in tax audit matters with various tax authorities. For example, inthe fourth quarter of fiscal 2004, we resolved certain tax-related matters withthe Internal Revenue Service, which lowered our income tax expense by$19.7 million and resulted in a 2.5 percent rate reduction.
Finally, our projected effective income tax rate for fiscal 2005 does not takeinto account a new election that is available under the U.S. income tax rulesregarding the allocation between U.S. and foreign jurisdictions tax deductionsattributable to employee stock option compensation. If we take advantage of thiselection, it could detrimentally affect our effective income tax rate. We havenot yet determined the impact that the election would have on our reportedresults.
Net Income
Net income for fiscal years 2004 and 2003 (in thousands):
March 31, % of Net March 31, % of Net 2004 Revenue 2003 Revenue $ Change % Change ------------ ----------- ----------- ----------- ----------- ----------- $577,292 19.5 % $ 317,097 12.8 % $ 260,195 82.1 %
Reported net income increased in fiscal 2004 compared to fiscal 2003 primarilydue to the reasons discussed above. Although the dollar amount of our expensesincreased in fiscal 2004 as compared to fiscal 2003, net income as a percentageof net revenue increased to 19.5 percent as compared to 12.8 percent in fiscal2003 because expenses, including our cost of goods sold, grew at a slower ratethan did our net revenue.
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Comparison of Fiscal 2003 to Fiscal 2002
Net Revenue
From a geographical perspective, our net revenue for the fiscal years endedMarch 31, 2003 and 2002 was as follows (in thousands):
Year Ended March 31, ----------------------------- Increase/ % 2003 2002 (Decrease) Change ------------- ------------- ------------ -------- North America $ 1,435,718 $ 1,093,244 $ 342,474 31.3 % --------- --------- ------- ---- Europe 878,904 519,458 359,446 69.2 % Asia Pacific 87,569 53,376 34,193 64.1 % Japan 80,053 58,597 21,456 36.6 % --------- --------- ------- ---- International 1,046,526 631,431 415,095 65.7 % --------- --------- ------- ---- Consolidated Net Revenue $ 2,482,244 $ 1,724,675 $ 757,569 43.9 % --------- --------- ------- ----
North America
For fiscal 2003, net revenue in North America increased by 31.3 percent ascompared to fiscal 2002. From a franchise perspective, the net revenue increasewas primarily driven by sales of products released during the year endedMarch 31, 2003 in the following nine franchises: Medal of Honor, Lord of theRings, Kingdom Hearts, The Sims, Need for Speed, Harry Potter, NCAA Football,Bond and Tiger Woods/ PGA TOUR. Increased sales in these franchises resulted inincreased net revenue of $451.1 million for the year ended March 31, 2003 ascompared to the year ended March 31, 2002. The increase was offset by decreasesin net revenue in our Final Fantasy, SSX and NBA Street franchises as none ofthese franchises had products released during fiscal 2003. Together, decreasedsales in these franchises reduced net revenue by $108.1 million for the yearended March 31, 2003 as compared to the year ended March 31, 2002.
Europe
For fiscal 2003, net revenue in Europe increased by 69.2 percent as compared tofiscal 2002. From a franchise perspective, the net revenue increase wasprimarily driven by sales of products released during the year ended March 31,2003 in the following eleven franchises: Lord of the Rings, Medal of Honor, TheSims, FIFA Soccer, Bond, World Cup, Harry Potter, Need for Speed, Battlefield,SimCityTM and Tiger Woods/ PGA TOUR. Increased sales in these franchisesresulted in increased net revenue of $345.6 million for the year ended March 31,2003 as compared to the year ended March 31, 2002.
Asia Pacific
For fiscal 2003, net revenue from sales in the Asia Pacific region, excludingJapan, increased by 64.1 percent compared to the year ended March 31, 2002. Ournet revenue from sales of products on the PlayStation 2 and Xbox platformsincreased by $15.7 and $6.3 million, respectively, for the year ended March 31,2003 primarily due to the higher installed base on both platforms and the factthat 20 Xbox titles were available in the Asia Pacific region in 2003 ascompared to three in 2002. Sales of co-publishing and distribution titlesincreased $11.1 million primarily due to sales of Final Fantasy X andBattlefield 1942 in fiscal 2003.
Japan
For fiscal 2003, net revenue from sales in Japan increased by 36.6 percentcompared to fiscal 2002. The increase was due primarily to the higherPlayStation 2 installed base and strong sales of PlayStation 2 titles, mostnotably Medal of Honor FrontlineTM, 2002 FIFA World Cup and Project FIFA WorldCup which generated an additional $15.7 million in net revenue in fiscal 2003.We also had an increase in revenues from co-publishing and distribution productsof $11.0 million due in large part to sales of Final Fantasy 11. These increaseswere offset by a decrease in PlayStation revenue of $5.7 million.
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Our worldwide net revenue by product line for fiscal 2003 and 2002 was asfollows (in thousands):
Year Ended March 31, ---------------------------------------------------------------- Increase/ % 2003 2002 (Decrease) Change ------------------------------ ------------------------------ --------------- -----------
PlayStation 2 $ 910,693 36.7 % $ 482,882 28.0 % $ 427,811 88.6 % PC 499,634 20.2 % 456,292 26.5 % 43,342 9.5 % Xbox 219,378 8.8 % 78,363 4.5 % 141,015 180.0 % Nintendo GameCube 176,656 7.1 % 51,740 3.0 % 124,916 241.4 % Game Boy Advance 79,093 3.2 % 43,653 2.5 % 35,440 81.2 % Subscription Services 44,648 1.8 % 34,236 2.0 % 10,412 30.4 % PlayStation 99,951 4.0 % 189,535 11.0 % (89,584 ) (47.3 %) --------- ----- --------- ----- ------- ----- EA Studio Net Product Revenue 2,030,053 81.8 % 1,336,701 77.5 % 693,352 51.9 %
Co-publishing and Distribution 375,759 15.1 % 269,010 15.6 % 106,749 39.7 % Advertising, Programming, Licensing, and Other 76,432 3.1 % 118,964 6.9 % (42,532 ) (35.8 %) --------- ----- --------- ----- ------- ----- Total Net Revenue $ 2,482,244 100.0 % $ 1,724,675 100.0 % $ 757,569 43.9 % --------- ----- --------- ----- ------- -----
PlayStation 2
Net revenue from sales of PlayStation 2 products increased from $482.9 millionin fiscal 2002 to $910.7 million in fiscal 2003. As a percentage of total netrevenue, sales of PlayStation 2 products increased by 8.7 percent in fiscal2003. The increase in net revenue was primarily due to growth in the installedbase and greater demand for our products. For example, in the U.S., theinstalled base for the PlayStation 2 increased approximately 115 percent, ascompared to fiscal 2002, due in part to Sony's hardware price cut in NorthAmerica in May 2002.
PC
Net revenue from sales of titles for the PC increased in fiscal 2003 by9.5 percent to $499.6 million as compared to $456.3 million in fiscal 2002. Theincrease was primarily due to strong sales of The Sims franchise titles, and therelease of SimCity 4 TM, for a combined increase of $71.0 million, partiallyoffset by lower net revenue from fiscal 2002 releases Black and White TM andDune Emperor totaling $32.2 million. Although PC net revenue increased in fiscal2003, PC net revenue declined as a percentage of net revenue as consumersmigrated to console gameplay.
Xbox
Net revenue from sales of Xbox products increased from $78.4 million to$219.4 million, or 4.3 percent of net revenue, in fiscal 2003 as compared tofiscal 2002. The increase in net revenue was primarily due to growth in theinstalled base and greater demand for our products . The installed baseincreased in fiscal 2003 due to the launch of Xbox in the United States inNovember 2001 and in Europe in March 2002. In fiscal 2002, there was only ashort period (five months in the United States and one month in Europe) duringwhich the consoles were available as compared to twelve months in fiscal 2003.As a result, we were able to release Xbox products during all of fiscal 2003.
Nintendo GameCube
Net revenue from Nintendo GameCube products increased from $51.7 million to$176.7 million, or 4.1 percent of net revenue, in fiscal 2003 as compared tofiscal 2002. The increase in net revenue for fiscal 2003 was primarily due togrowth in the installed base of the Nintendo GameCube, which was available inevery
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major market in which we operated during fiscal 2003. The Nintendo GameCube waslaunched in Japan in September 2001 and North America in November 2001, but notin Europe until May 2002.
Game Boy Advance
Net revenue from sales of Game Boy Advance titles increased in fiscal 2003 by81.2 percent to $79.1 million as compared to $43.7 million in fiscal 2002,primarily due to increased net revenue in the Lord of the Rings and Harry Potterfranchises and the increased number of Game Boy Advance titles available infiscal 2003. In fiscal 2003, we released seven titles on the Game Boy Advanceplatform compared to three in fiscal 2002.
PlayStation
In fiscal 2003, net revenue from PlayStation products decreased by $89.6 millionto $100.0 million as compared to fiscal 2002. The decrease in net revenue wasattributable to the market transition to newer generation console systems andour transition away from that platform.
Co-Publishing and Distribution
Net revenue from co-publishing products and distribution products increased39.7 percent to $375.8 million in fiscal 2003 compared to $269.0 million infiscal 2002 primarily due to strong sales of hit titles including KingdomHearts, 1503 A.D. The New World and higher Battlefield 1942 franchise netrevenue.
Advertising, Programming, Licensing and Other
In fiscal 2003, net revenue from advertising, programming, licensing and otherproducts decreased by $42.5 million to $76.4 million as compared to fiscal 2002.The decrease was primarily a result of an expected decline in our Game Boy Colorand Nintendo 64 net revenue as we transitioned away from those platforms. Inaddition, revenue derived from advertising on our online games sites decreased16 percent in fiscal 2003 compared to the prior fiscal year primarily due to$3.8 million in lower advertising revenue generated from AOL and co-branded AOLonline properties, and a $1.8 million decrease in online advertising purchasedby online game companies that link their games sites to ours.
Cost of Goods Sold
Costs of goods sold for fiscal years 2003 and 2002 (in thousands):
March 31, % of Net March 31, % of Net 2003 Revenue 2002 Revenue % Change -------------- ----------- ----------- ----------- ----------- $1,072,802 43.2 % $ 814,783 47.2 % 31.7 %
In fiscal 2003, cost of goods sold as a percentage of net revenue decreased by4.0 percent to 43.2 percent in fiscal 2003 from 47.2 percent in fiscal 2002primarily due to:
Higher PC margins resulting from (1) higher sales of wholly-owned intellectual properties such as SimCity 4 and Command & Conquer Generals,
(2) lower developer royalties in general, and (3) higher average sales prices of our products. Higher PC margins increased our total gross margin by 1.7 percent. Higher margins on co-publishing and distribution products primarily due to a higher volume of co-publishing products, which have a higher gross margin than distribution products, released in fiscal 2003, such as Battlefield 1942, Ty the Tasmanian Tiger and The Simpsons Road Rage. Higher margins on co-publishing and distribution products contributed 0.9 percent to our total gross margin. Higher margins on PlayStation 2 products primarily due to volume discounts received from Sony and overall lower average manufacturing royalty rates, all of which contributed 0.8 percent to our total gross margin.
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Marketing and Sales
Marketing and sales expenses for fiscal years 2003 and 2002 (in thousands):
March 31, % of Net March 31, % of Net 2003 Revenue 2002 Revenue $ Change % Change ------------ ----------- ----------- ----------- ---------- ----------- $332,453 13.4 % $ 241,109 14.0 % $ 91,344 37.9 %
Marketing and sales expenses increased by 37.9 percent in fiscal 2003 comparedto fiscal 2002 primarily due to:
Higher advertising spending of $46.1 million to support product releases
on multiple platforms and across multiple territories including Madden NFLTM 2003, NBA Live 2003, The Lord of the Rings, The Two Towers, Harry Potter and the Chamber of Secrets, The Sims franchise titles and The Sims Online. Overall, we released 86 SKUs in fiscal 2003 versus 64 SKUs in fiscal 2002. An increase in headcount and related expenses of $20.5 million to support the growth of our marketing and sales functions worldwide.
As a percentage of net revenue, marketing and sales expenses declined from14.0 percent of net revenue in fiscal 2002 to 13.4 percent of net revenue infiscal 2003. Marketing and sales includes vendor reimbursements for advertisingexpenses of $28.2 million in fiscal 2003 and $8.9 million in fiscal 2002.
General and Administrative
General and administrative expenses for fiscal years 2003 and 2002 (inthousands):
March 31, % of Net March 31, % of Net 2003 Revenue 2002 Revenue $ Change % Change ------------ ---------- ----------- ---------- ---------- ----------- $130,859 5.3 % $ 107,059 6.2 % $ 23,800 22.2 %
General and administrative expenses increased by 22.2 percent in fiscal 2003compared to fiscal 2002 primarily due to an increase in payroll costs of$26.9 million to support the increased growth of these functions worldwide.
As a percentage of net revenue, general and administrative expenses declinedfrom 6.2 percent of net revenue in fiscal 2002 to 5.3 percent of net revenue.
Research and Development
Research and development expenses for fiscal years 2003 and 2002 (in thousands):
March 31, % of Net March 31, % of Net 2003 Revenue 2002 Revenue $ Change % Change ------------ ----------- ----------- ----------- ---------- ---------- $400,990 16.1 % $ 380,564 22.0 % $ 20,426 5.4 %
Research and development expenses increased by 5.4 percent in fiscal 2003compared to fiscal 2002 primarily due to additional headcount-related expenses,offset by lower advance write-offs and development spending on discontinuedproducts in fiscal 2003.
As a percentage of revenue, research and development expenses declined from22.0 percent of net revenue in fiscal 2002 to 16.1 percent of net revenue infiscal 2003. Research and development includes vendor reimbursements fordevelopment expenses of $15.0 million in fiscal 2003 and $17.0 million in fiscal2002.
Amortization of Intangibles
Amortization of intangibles for fiscal years 2003 and 2002 (in thousands):
March 31, % of Net March 31, % of Net 2003 Revenue 2002 Revenue $ Change % Change ----------- ---------- ----------- ---------- ----------- ---------- $7,482 0.3 % $ 25,418 1.5 % $ (17,936 ) (70.6 %)
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The decrease in amortization in fiscal 2003 of $17.9 million was primarily dueto:
Adoption of SFAS No. 142 in fiscal 2003, which required us to stop
amortizing goodwill. For fiscal 2002, amortization of goodwill totaled $13.1 million. Certain identifiable intangible assets related to Westwood and DreamWorks were amortized in fiscal 2002, resulting in a decrease of $3.5 million. Impairment of Pogo and Kesmai finite-lived intangible assets as a result of the restructuring of the EA.com segment in fiscal 2003 and 2002, resulting in lower amortization expense of $2.9 million.
In addition, we recorded intangible impairment charges relating to ourrestructuring of the EA.com business segment of $12.4 million in fiscal 2003 and$1.6 million in fiscal 2002. For further information, please see our discussionunder "Restructuring and Asset Impairment Charges" below.
Restructuring and Asset Impairment Charges
Restructuring and asset impairment charges for fiscal years 2003 and 2002 (inthousands):
March 31, % of Net March 31, % of Net 2003 Revenue 2002 Revenue % Change ----------- ---------- ----------- ---------- ---------- Restructuring Charges $ 15,102 0.6 % $ 7,485 0.4 % 101.8 % Asset Impairment Charges $ 66,329 2.7 % $ 12,818 0.8 % 417.5 %
For a discussion of our Fiscal 2003 restructurings, please refer to "Comparisonof Fiscal 2004 to Fiscal 2003" above.
Fiscal 2002 Restructuring
In October 2001, we announced a restructuring plan for EA.com. The restructuringinitiatives involved strategic decisions to discontinue certain productofferings and focus only on key online priorities that aligned with our fiscal2003 operational objectives. A concurrent workforce reduction resulted in thetermination of approximately 270 positions.
During fiscal 2002, we recorded restructuring charges of $20.3 million,consisting of $4.2 million for workforce reductions, $3.3 million forconsolidation of facilities and other administrative charges, and $12.8 millionfor the write-off of non-current assets and facilities. The estimated costs forworkforce reduction included severance charges for terminated employees andcosts for certain outplacement service contracts. The consolidation offacilities resulted in the closure of EA.com's San Diego studio andconsolidation of its San Francisco and Virginia facilities. The estimated costsfor consolidation of facilities included contractual rental commitments underreal estate leases for unutilized office space offset by estimated futuresub-lease income, costs to close or consolidate facilities, and costs to writeoff a portion of the assets from these facilities. Impairment charges onlong-lived assets amounted to $12.8 million and included $11.2 million relatingto abandoned technologies consisting of customized internal-use software systemsfor the EA.com infrastructure, $1.0 million of Kesmai intangibles impairmentbecause associated products and services were discontinued and $0.6 million ofgoodwill charges relating to EA.com's San Diego studio closure. The remainingportion of Kesmai assets as of March 31, 2002 was $15.9 million, consisting of$13.1 million of goodwill and $2.8 million of intangibles relating to Kesmai'sdeveloped and core technology and acquired workforce.
For further discussion on our restructurings and asset impairment charges,please see Note 6 in our Consolidated Financial Statements, included in item 8hereof.
Interest and Other Income, Net
Interest and other income, net, for fiscal years 2003 and 2002 (in thousands):
March 31, % of Net March 31, % of Net 2003 Revenue 2002 Revenue $ Change % Change ----------- ---------- ----------- ---------- ---------- ---------- $5,222 0.2 % $ 12,848 0.7 % $ (7,626 ) (59.4 %)
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Interest and other income, net, in fiscal 2003 decreased from fiscal 2002primarily due to an other-than-temporary impairment of investments in affiliatesof $10.6 million in fiscal 2003, partially offset by higher interest income infiscal 2003 of $5.1 million, as a result of higher average cash balances duringthe fiscal year.
Income Taxes
Income taxes for fiscal years 2003 and 2002 (in thousands):
March 31, Effective March 31, Effective 2003 Tax Rate 2002 Tax Rate % Change ------------ ----------- ----------- ----------- ---------- $143,049 31.0 % $ 45,969 31.0 % 211.2 %
Our effective tax rate was 31.0 percent for fiscal 2003 and fiscal 2002.
Net Income
Net income for fiscal years 2003 and 2002 (in thousands):
March 31, % of Net March 31, % of Net 2003 Revenue 2002 Revenue $ Change % Change ------------ ----------- ----------- ---------- ----------- ---------- $317,097 12.8 % $ 101,509 5.9 % $ 215,588 212.4 %
Reported net income increased in fiscal 2003 compared to fiscal 2002 primarilydue to the reasons discussed above. Although the dollar amount of expenses rosein fiscal 2003 versus fiscal 2002, net income as a percentage of net revenueincreased to 12.8 percent versus 5.9 percent as expenses grew at a slower ratethan did our net revenue.
Impact of Recently Issued Accounting Standards
In January 2003, the Financial Accounting Standards Board ("FASB") issuedInterpretation No. 46 ("FIN 46"), "Consolidation of Variable Interest Entities".This interpretation of Accounting Research Bulletin No. 51, "ConsolidatedFinancial Statements," addresses consolidation by business enterprises ofvariable interest entities ("VIEs") that either (i) do not have sufficientequity investment at risk to permit the entity to finance its activities withoutadditional subordinated financial support, or (ii) are owned by equity investorswho lack an essential characteristic of a controlling financial interest. Thisinterpretation applies immediately to VIEs created after January 31, 2003. Withregard to VIEs already in existence prior to February 1, 2003, theimplementation of FIN 46 was delayed and currently applies to the first fiscalyear or interim period beginning after December 15, 2003. FIN 46 requiresdisclosure of VIEs in financial statements issued after January 31, 2003, if itis reasonably possible that as of the transition date (i) we will be the primarybeneficiary of an existing VIE that will require consolidation, or (ii) we willhold a significant variable interest in, or have significant involvement with,an existing VIE. We adopted FIN 46 in the quarter ended December 31, 2003;however, it did not have a material impact on our consolidated financialposition or results of operations.
In January 2003, the Emerging Issues Task Force reached consensus on IssueNo. 00-21 ("EITF 00-21"), "Revenue Arrangements with Multiple Deliverables".EITF 00-21 provides guidance on how to determine whether an arrangementinvolving multiple deliverables requires that such deliverables be accounted forseparately. EITF 00-21 allows for prospective adoption for arrangements enteredinto after June 15, 2003 or adoption via a cumulative effect of a change inaccounting principle. We adopted EITF 00-21 in the quarter ended June 30, 2003;however, it did not have a material impact on our consolidated financialposition or results of operations.
In March 2004, the Emerging Issues Task Force ratified the consensus reached onparagraphs 6 through 23 of Issue No. 03-01 ("EITF 03-1"), "The Meaning ofOther-Than-Temporary Impairment and Its Application to Certain Investments".EITF 03-1 requires that certain quantitative and qualitative disclosures shouldbe required for debt and marketable equity securities classified asavailable-for-sale or held-to-maturity under SFAS No. 115, "Accounting forCertain Investments in Debt and Equity Securities" and SFAS No. 124,
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"Accounting for Certain Investments Held by Not-for-Profit Organizations" thatare impaired at the balance sheet date but for which an other-than-temporaryimpairment has not been recognized. We adopted EITF 03-1 in the year endedMarch 31, 2004; however, it did not have a material impact on the disclosures inour Consolidated Financial Statements.
In March 2004, the FASB, issued an exposure draft on the Proposed Statement ofFinancial Accounting Standards, "Share-Based Payment an amendment of FASBStatements No. 123 and 95". The proposed statement addresses the accounting forshare-based payment transactions with employees and other third-parties. Theproposed standard would eliminate the ability to account for share-basedcompensation transactions using Accounting Principles Board ("APB") OpinionNo. 25, "Accounting for Stock Issued to Employees", and generally would requirethat such transactions be accounted for using a fair-value-based method. If thefinal standard is approved as currently drafted in the exposure draft, it wouldhave a material impact on the amount of earnings we report. Management has notyet determined the impact that the proposed statement will have on our business.
LIQUIDITY AND CAPITAL RESOURCES
Year Ended --------------------------------------------------------- March 31, March 31, Increase/ 2004 2003 (Decrease) (In millions) ----------------- ----------------- ---------------Cash, cash equivalents and short-term investments $ 2,414 $ 1,588 $ 826 Marketable equity securities 1 1 ------- ------- ------ $ 2,415 $ 1,589 $ 826 ------- ------- ------ Percentage of total assets 71.0 % 67.3 %
Year Ended -------------------------------------------------------- March 31, March 31, Increase/ 2004 2003 (Decrease) (In millions) ----------------- ---------------- ---------------Cash provided by operating activities $ 669 $ 714 $ (45 ) Cash provided by (used in) investing activities 288 (463 ) 751 Cash provided by financing activities 225 132 93 Effect of foreign exchange on cash and cash equivalents 18 14 4 ------- ------ ------ Net increase in cash and cash equivalents $ 1,200 $ 397 $ 803 ------- ------ ------
Changes in Cash Flow
During the year ended March 31, 2004, we generated $669.3 million of cash fromoperating activities compared to $714.5 million for the year ended March 31,2003. This decline was primarily the result of our fourth quarter sales infiscal 2004 occurring later in the quarter as compared to fiscal 2003,particularly in Europe. We expect to continue to generate similar levels ofoperating cash flow in fiscal 2005. For the year ended March 31, 2004, ourprimary use of cash in non-operating activities consisted of $89.6 million incapital expenditures, primarily related to the expansions of our Los Angeles andVancouver studios. These non-operating expenditures were offset by net proceedsof $371.8 million in short-term investments and $227.8 million in proceeds fromthe sale of our common stock through stock plans during the year ended March 31,2004.
Receivables, Net
Our gross accounts receivable balance was $366.6 million and $246.7 million asof March 31, 2004 and March 31, 2003, respectively. The increase in our accountsreceivable balance was primarily due to our fourth quarter sales in fiscal 2004occurring later in the quarter as compared to fiscal 2003, particularly inEurope. We expect to collect a substantial portion of these amounts in the threemonths ended June 30, 2004. Reserves for sales returns, pricing allowances anddoubtful accounts decreased from $164.6 million as of March 31, 2003 to$154.7 million as of March 31, 2004. Both the sales return and price protectionreserves decreased in absolute dollars and as a percentage of trailing six andnine month net revenue as of March 31,
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2004. We believe these reserves are adequate based on historical experience andour current estimate of potential returns and allowances.
Inventories
Inventories increased to $55.1 million as of March 31, 2004 from $39.7 millionas of March 31, 2003 primarily due to overall growth in Europe. We typicallyhave a higher inventory balance, as a percentage of net revenue, on hand inEurope compared to North America, due to the need to provide multiple languageversions of each title in that region. No single title represented more than$4.0 million of inventory as of March 31, 2004.
Other Current Assets
Other current assets increased to $143.9 million as of March 31, 2004 from$83.5 million as of March 31, 2003 primarily due to increases in volume rebatesand advertising credits owed to us by our suppliers and VAT receivable, bothrelating to the growth of our business, offset by lower prepaid royalties as wecontinue to increase internal title development.
Accounts Payable
Accounts payable increased to $114.1 million as of March 31, 2004 from$106.3 million as of March 31, 2003 primarily due to the higher sales volume weexperienced in the fourth quarter of fiscal 2004 as compared to fiscal 2003.
Accrued and Other Liabilities
Our accrued and other liabilities increased to $608.2 million as of March 31,2004 from $464.5 million as of March 31, 2003, as a result of the overallincrease in our sales and related operational expenses and profit. The increasewas due to increases in income taxes payable, accrued compensation and benefits,accrued development, deferred revenue and VAT payable. We anticipate our accruedand other liabilities balance to decline following our tax and bonus paymentsduring the three months ended June 30, 2004.
Financial Condition
We believe the existing cash, cash equivalents, short-term investments,marketable equity securities and cash generated from operations will besufficient to meet our operating requirements for at least the next twelvemonths, including working capital requirements, capital expenditures andpotential future acquisitions or strategic investments. We may choose at anytime to raise additional capital to strengthen our financial position,facilitate expansion, pursue strategic investments or to take advantage ofbusiness opportunities as they arise. There can be no guarantee that suchadditional capital will be available to us on favorable terms, if at all, orthat it will not result in substantial dilution to our existing stockholders.
A portion of our cash is generated from operations domiciled in foreign taxjurisdictions (approximately $554.4 million as of March 31, 2004) that isdesignated as indefinitely reinvested in the respective tax jurisdiction. Whilewe have no plans to repatriate these funds to the United States in theshort-term, if we were required to do so to fund our operations in the UnitedStates, we would accrue and pay additional taxes in connection with theirrepatriation.
On January 8, 2004, we filed an amended registration statement on Form S-3 withthe Securities and Exchange Commission. This registration statement, includingthe base prospectus contained therein, became effective on January 15, 2004 anduses a "shelf" registration process. This shelf registration statement allowsus, at any time, to offer any combination of securities described in theprospectus in one or more offerings up to a total amount of $2.0 billion. Unlessotherwise specified in a prospectus supplement accompanying the base prospectus,we will use the net proceeds from the sale of any securities offered pursuant tothe shelf registration statement for general corporate purposes, including forworking capital, financing capital expenditures, research and development,marketing and distribution efforts and, if opportunities arise, for acquisitionsor strategic alliances. Pending such uses, we may invest the net proceeds ininterest-bearing securities. In addition, we may conduct concurrent or otherfinancings at any time.
Our ability to maintain sufficient liquidity could be affected by various risksand uncertainties including, but not limited to, those related to customerdemand and acceptance of our titles on new platforms and new
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versions of our titles on existing platforms, our ability to collect ouraccounts receivable as they become due, successfully achieving our productrelease schedules and attaining our forecasted sales objectives, the impact ofcompetition, the economic conditions in the domestic and international markets,seasonality in operating results, risks of product returns and the other risksdescribed in the "Risk Factors" section below.
Contractual Obligations and Commercial Commitments
Letters of Credit
In July 2002, we provided an irrevocable standby letter of credit to Nintendo ofEurope. The standby letter of credit guarantees performance of our obligationsto pay Nintendo of Europe for trade payables of up to 8.0 million Euros. Thestandby letter of credit expires in July 2005. As of March 31, 2004, we had0.2 million Euros payable to Nintendo of Europe covered by this standby letterof credit.
In August 2003, we provided an irrevocable standby letter of credit to 300California Associates II, LLC in replacement of our security deposit for officespace. The standby letter of credit guarantees performance of our obligations topay our lease commitment up to $1.1 million. The standby letter of creditexpires in December 2006. As of March 31, 2004, we did not have a payablebalance on this standby letter of credit.
Development, Celebrity, League and Content Licenses: Payments and Commitments
The products produced by our studios are designed and created by our employeedesigners, artists, software programmers and by non-employee software developers("independent artists" or "third-party developers"). We typically advancedevelopment funds to the independent artists and third-party developers duringdevelopment of our games, usually in installment payments made upon thecompletion of specified development milestones. These payments are consideredadvances against subsequent royalties based on the sales of the products. Theseterms are set forth in written agreements entered into with the independentartists and third-party developers. In addition, we have certain celebrity,league and content license contracts that contain minimum guarantee payments andmarketing commitments that are not dependent on any deliverables. Celebritiesand organizations with whom we have contracts include: FIFA and UEFA(professional soccer); NASCAR (stock car racing); John Madden (professionalfootball); National Basketball Association (professional basketball); PGA TOUR(professional golf); Tiger Woods (professional golf); National Hockey League andNHLPA (professional hockey); Warner Bros. (Harry Potter, Catwoman and Superman);MGM/ Danjaq (James Bond); New Line Productions (The Lord of the Rings); NationalFootball League and Players Inc. (professional football); Collegiate LicensingCompany (collegiate football and basketball); ISC (stock car racing); MajorLeague Baseball Properties; MLB Players Association (professional baseball) andIsland Def Jam (fighting). These developer and content license commitmentsrepresent the sum of (i) the cash payments due under non-royalty-bearinglicenses and services agreements, and (ii) the minimum payments and advancesagainst royalties due under royalty-bearing licenses and services agreements.These minimum guarantee payments and marketing commitments are included in thefollowing table.
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The following table summarizes our minimum contractual obligations andcommercial commitments as of March 31, 2004, and the effect we expect them tohave on our liquidity and cash flow in future periods (in thousands):
Commercial Contractual Obligations Commitments ----------------------------------------- -------------------------- Fiscal Year Developer/ Bank and Letters Ended Licensee Other of March 31, Leases(1) Commitments Marketing Guarantees Credit Total ----------- ----------- ------------- ----------- ------------- ---------- ----------- 2005 $ 20,234 $ 42,691 $ 24,744 $ 2,234 $ 305 $ 90,208 2006 23,041 36,962 7,167 234 67,404 2007 17,254 12,789 4,152 204 34,399 2008 14,132 16,003 4,152 204 34,491 2009 9,816 10,503 4,152 203 24,674 Thereafter 35,758 11,307 203 47,268 ------- ------- ------ ------- ----- ------- Total $ 120,235 $ 130,255 $ 44,367 $ 3,282 $ 305 $ 298,444 ------- ------- ------ ------- ----- -------
(1) See discussion on operating leases in the "Off-Balance Sheet Commitments"
section herein and Note 10 in the Notes to Consolidated Financial Statements, included in Item 8 hereof, for additional information.
The lease commitments disclosed above exclude commitments included in ourrestructuring activities for contractual rental commitments of $31.3 millionunder real estate leases for unutilized office space, offset by $18.4 million ofestimated future sub-lease income. These amounts were expensed in the periods ofthe related restructuring and are included in our accrued liabilities reportedon our Consolidated Balance Sheet as of March 31, 2004. Please see Note 6 in theNotes to Consolidated Financial Statements, included in Item 8 hereof, foradditional information.
Transactions with Related Parties
Transactions with Executive Officers
On June 24, 2002, we agreed to loan Warren Jenson $4,000,000, to be forgivenover four years based on his continuing employment. Two million dollars of thenote will be forgiven after two years employment (at which time we will provideMr. Jenson the funds required to offset the tax implications of theforgiveness), and the remainder forgiven after four years. No additional fundswill be provided to offset the tax implications of the forgiveness of the secondtwo million dollars. The loan does not bear interest. The entire balance of theloan was outstanding as of June 1, 2004.
In April 2002, we agreed to pay certain taxes incurred by Bruce McMillan,Executive Vice President, Group Studio General Manager, Worldwide Studios,arising from his temporary employment with us in the United Kingdom.Mr. McMillan agreed to reimburse us for those payments upon receipt of hiscorresponding tax refund from the Canadian taxing authorities. We subsequentlypaid approximately $168,704 and $32,931 in October 2002 and April 2003,respectively, to the UK Inland Revenue for taxes incurred by Mr. McMillan. InMay 2003, Mr. McMillan became an executive officer of Electronic Arts. As ofJanuary 22, 2004, Mr. McMillan had repaid us the entire amount of the taxpayments we made on his behalf.
OFF-BALANCE SHEET COMMITMENTS
Lease Commitments
We lease certain of our current facilities and certain equipment undernon-cancelable operating lease agreements. We are required to pay propertytaxes, insurance and normal maintenance costs for certain of our facilities andwill be required to pay any increases over the base year of these expenses onthe remainder of our facilities.
In February 1995, we entered into a build-to-suit lease with a third party forour headquarters facility in Redwood City, California, which was refinanced withKeybank National Association in July 2001 and expires in July 2006. We accountedfor this arrangement as an operating lease in accordance with SFAS No. 13,
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"Accounting for Leases", as amended. Existing campus facilities developed inphase one comprise a total of 350,000 square feet and provide space for sales,marketing, administration and research and development functions. We have anoption to purchase the property (land and facilities) for a maximum of$145.0 million or, at the end of the lease, to arrange for (i) an extension ofthe lease or (ii) sale of the property to a third party while we retain anobligation to the owner for approximately 90 percent of the difference betweenthe sale price and the guaranteed residual value of up to $128.9 million if thesales price is less than this amount, subject to certain provisions of thelease.
In December 2000, we entered into a second build-to-suit lease with KeybankNational Association for a five-year term beginning December 2000 to expand ourRedwood City, California headquarters facilities and develop adjacent propertyadding approximately 310,000 square feet to our campus. Construction wascompleted in June 2002. We accounted for this arrangement as an operating leasein accordance with SFAS No. 13, as amended. The facilities provide space formarketing, sales and research and development. We have an option to purchase theproperty for a maximum of $130.0 million or, at the end of the lease, to arrangefor (i) an extension of the lease, or (ii) sale of the property to a third partywhile we retain an obligation to the owner for approximately 90 percent of thedifference between the sale price and the guaranteed residual value of up to$118.8 million if the sales price is less than this amount, subject to certainprovisions of the lease.
We believe the estimated fair values of both properties under these operatingleases are in excess of their respective guaranteed residual values as ofMarch 31, 2004.
For the two lease agreements with Keybank National Association, as describedabove, the lease rates are based upon the Commercial Paper Rate and require usto maintain certain financial covenants as shown below, all of which we were incompliance with as of March 31, 2004.
Actual as of Financial Covenants Requirement March 31, 2004 ------------------------------------ ----------------- ----------------- Consolidated Net Worth $ 1,684 million $ 2,678 million Fixed Charge Coverage Ratio 3.00 31.15 Total Consolidated Debt to Capital 60 % 8.5 % Quick Ratio Q1 & Q2 1.00 N/A Q3 & Q4 1.75 10.55
In July 2003, we entered into a lease agreement with an independent third party("the Landlord") for a studio facility in Los Angeles, California, whichcommenced in October 2003 and expires in September 2013 with two five-yearoptions to extend the lease term. Additionally, we have options to purchase theproperty after five and ten years based on the fair market value of the propertyat the date of sale, a right of first offer to purchase the property upon termsoffered by the landlord, and a right to share in the profits from a sale of theproperty. We have accounted for this arrangement as an operating lease inaccordance with SFAS No. 13, as amended. Existing campus facilities comprise atotal of 243,000 square feet and provide space for research and developmentfunctions. Our rental obligation under this agreement is $50.2 million over theinitial ten-year term of the lease. We are taking possession of the propertyover a period of 18 months as the facilities become available for use. Thiscommitment is offset by sublease income of $5.8 million for the sublet to anaffiliate of the Landlord of 18,000 square feet of the Los Angeles facility,which commenced in October 2003 and expires in September 2013 with options ofearly termination by the affiliate after five years and by EA after four andfive years.
INFLATION
We believe the impact of inflation on our results of operations has not beensignificant for each of the past three fiscal years.
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RISK FACTORS
Our business is subject to many risks and uncertainties, which may affect ourfuture financial performance. The risks and uncertainties discussed below arenot the only ones we face. There may be additional risks and uncertainties notcurrently known to us or that we currently do not believe are material that mayharm our business and financial performance. If any of the events orcircumstances described below occurs, our business and financial performancecould be harmed, our actual results could differ materially from ourexpectations, and the market value of our securities could decline.
The success of our business is highly dependent on being able to predict whichnew videogame platforms will be successful, and on the market acceptance andtimely release of those platforms.
We derive most of our revenue from the sale of products for play on videogameplatforms manufactured by third parties, such as Sony's PlayStation 2.Therefore, the success of our products is driven in large part by the success ofnew videogame hardware systems and our ability to accurately predict whichplatforms will be most successful in the marketplace. We must make productdevelopment decisions and commit significant resources well in advance of theanticipated introduction of a new platform. A new platform for which we aredeveloping products may be delayed, may not succeed or may have a shorter lifecycle than anticipated. If the platforms for which we are developing productsare not released when anticipated or do not attain wide market acceptance, ourrevenue growth will suffer, we may be unable to fully recover the resources wehave committed, and our financial performance will be harmed.
Our platform licensors set the royalty rates and other fees that we must pay topublish games for their platforms, and therefore have significant influence onour costs. If one or more of the platform licensors adopt a different feestructure for future game consoles or we are unable to obtain such licenses, ourprofitability will be materially impacted.
In the next few years, we expect our platform licensors to introduce new gamemachines into the market. In order to publish products for a new game machine,we must take a license from the platform licensor which gives the platformlicensor the opportunity to set the fee structure that we must pay in order topublish games for that platform. Similarly, the platform licensors have retainedthe flexibility to change their fee structures for online gameplay and featuresfor their consoles. The control that platform licensors have over the feestructures for their future platforms and online access makes it difficult forus to predict our costs and profitability in the medium to long term. It is alsopossible that platform licensors will not renew our licenses. Because publishingproducts for videogame consoles is the largest portion of our business, anyincrease in fee structures or failure to secure a license relationship wouldhave a significant negative impact on our business model and profitability.
Our business is both seasonal and cyclical. If we fail to deliver our productsat the right times, our sales will suffer.
Our business is highly seasonal, with the highest levels of consumer demand, anda significant percentage of our revenue, occurring in the December quarter. Ifwe miss this key selling period, due to product delays or delayed introductionof a new platform for which we have developed products, our sales will sufferdisproportionately. Our industry is also cyclical. Videogame platforms havehistorically had a life cycle of four to six years. As one group of platforms isreaching the end of its cycle and new platforms are emerging, consumers oftendefer game software purchases until the new platforms are available, causingsales to decline. This decline may not be offset by increased sales of productsfor the new platform. For example, following the launch of Sony's PlayStation2platform, we experienced a significant decline in revenue from sales of productsfor Sony's older PlayStation game console, which was not immediately offset byrevenue generated from sales of products for the PlayStation2 platform.
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Our business is intensely competitive and increasingly "hit" driven. If we donot continue to deliver "hit" products, our success will be limited.
Competition in our industry is intense, and new products are regularlyintroduced. A relatively small number of "hit" titles accounts for a significantportion of total sales. For example, during calendar year 2003, approximately19 percent of the sales of videogames in North America consisted of only20 "hit" products. If our competitors develop more successful products, or if wedo not continue to develop consistently high-quality products, our revenue andprofitability will decline.
If we are unable to maintain or acquire licenses to intellectual property, wewill publish fewer hit titles and our revenue, profitability and cash flows willdecline. Competition for these licenses may make them more expensive andincrease our costs.
Many of our products are based on or incorporate intellectual property owned byothers. For example, our EA SPORTS products include rights licensed from themajor sports leagues and players associations. Similarly, many of our hit EAGAMES franchises, such as Bond, Harry Potter and Lord of the Rings, are based onkey film and literary licenses. Competition for these licenses is intense. If weare unable to maintain these licenses and obtain additional licenses withsignificant commercial value, our revenues and profitability will declinesignificantly. Competition for these licenses may also drive up the advances,guarantees and royalties that we must pay to the licensor, which couldsignificantly increase our costs.
If patent claims continue to be asserted against us, we may be unable to sustainour current business models or profits.
Many patents have been issued that may apply to widely used game technologies.Additionally, infringement claims under many recently issued patents are nowbeing asserted against Internet implementations of existing games. Several suchclaims have been asserted against us. Such claims can harm our business. Weincur substantial expenses in evaluating and defending against such claims,regardless of the merits of the claims. In the event that there is adetermination that we have infringed a third-party patent, we could incursignificant monetary liability and be prevented from using the rights in thefuture.
Other intellectual property claims may increase our product costs or require usto cease selling affected products.
Many of our products include extremely realistic graphical images, and we expectthat 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 mayinadvertently infringe upon the intellectual property rights of others. Althoughwe believe that we make reasonable efforts to ensure that our products do notviolate the intellectual property rights of others, it is possible that thirdparties still may claim infringement. From time to time, we receivecommunications from third parties regarding such claims. Existing or futureinfringement claims against us, whether valid or not, may be time consuming andexpensive to defend. Such claims or litigations could require us to stop sellingthe affected products, redesign those products to avoid infringement, or obtaina license, all of which would be costly and harm our business.
Our business, our products and our distribution are subject to increasingregulation in key territories of content, consumer privacy and online delivery.If we do not successfully respond to these regulations, our business may suffer.
Legislation is continually being introduced that may affect both the content ofour products and their distribution. For example, privacy laws in the UnitedStates and Europe impose various restrictions on our web sites. Those rules varyby territory although the Internet recognizes no geographical boundaries. Othercountries, such as Germany, have adopted laws regulating content both inpackaged goods and those transmitted over the Internet that are stricter thancurrent United States laws. In the United States, the federal and several stategovernments are considering content restrictions on products such as ours, aswell as restrictions on distribution of such products. Any one or more of thesefactors could harm our business by limiting the products we are able to offer toour customers and by requiring additional differentiation between
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products for different territories to address varying regulations. Thisadditional product differentiation would be costly.
If we do not consistently meet our product development schedules, we willexperience fluctuations in our operating results.
Our ability to meet product development schedules is affected by a number offactors, including the creative processes involved, the coordination of largeand sometimes geographically dispersed development teams required by theincreasing complexity of our products, and the need to refine and tune ourproducts prior to their release. We have in the past experienced developmentdelays for several of our products. Failure to meet anticipated production or"go live" schedules may cause a shortfall in our revenue and profitability andcause our operating results to be materially different from expectations. Delaysthat prevent release of our products during peak selling seasons or inconjunction with specific events, such as the release of a related movie or thebeginning of a sports season or major sporting event, could adversely affect ourfinancial performance.
Technology changes rapidly in our business, and if we fail to anticipate newtechnologies, the quality, timeliness and competitiveness of our products willsuffer.
Rapid technology changes in our industry require us to anticipate, sometimesyears in advance, which technologies our products must take advantage of inorder to make them competitive in the market at the time they are released.Therefore, we usually start our product development with a range of technicaldevelopment goals that we hope to be able to achieve. We may not be able toachieve these goals, or our competition may be able to achieve them more quicklythan we can. In either case, our products may be technologically inferior tocompetitive products, or less appealing to consumers, or both. If we cannotachieve our technology goals within the original development schedule of ourproducts, then we may delay products until these technology goals can beachieved, which may delay or reduce revenue and increase our developmentexpenses. Alternatively, we may increase the resources employed in research anddevelopment in an attempt to accelerate our development of new technologies,either to preserve our product launch schedule or to keep up with ourcompetition, which would increase our development expenses.
If we do not continue to attract and retain key personnel, we will be unable toeffectively conduct our business.
The market for technical, creative, marketing and other personnel essential tothe development and marketing of our products and management of our businessesis extremely competitive. Our leading position within the interactiveentertainment industry makes us a prime target for recruiting of executives andkey creative talent. If we cannot successfully recruit and retain the employeeswe need, or replace key employees following their departure, our ability todevelop and manage our businesses will be impaired.
Our platform licensors are our chief competitors and frequently control themanufacturing of and/or access to our videogame products. If they do not approveour 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 Nintendo for the Nintendo GameCube) typically givesignificant control to the licensor over the approval and manufacturing of ourproducts, which could, in certain circumstances, leave us unable to get ourproducts approved, manufactured and shipped to customers. These hardwarelicensors are also our chief competitors. In most events, control of theapproval and manufacturing process by the platform licensors increases both ourmanufacturing lead times and costs as compared to those we can achieveindependently. While we believe that our relationships with our hardwarelicensors are currently good, the potential for these licensors to delay orrefuse to approve or manufacture our products exists. Such occurrences wouldharm our business and our financial performance.
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We compete directly with Microsoft and Sony for sales of products with onlinecapabilities. We also require compatibility code and the consent of each inorder to include online capabilities in our products for their respectiveplatforms. As online capabilities for videogame platforms become moresignificant, Microsoft and Sony could restrict our ability to provide onlinecapabilities for our console platform products. If Microsoft or Sony refused toapprove our products with online capabilities or significantly impacted thefinancial terms on which these services are offered to our customers, ourbusiness could be harmed.
Our international net revenue is subject to currency fluctuations.
For the year ended March 31, 2004, international net revenue comprised45 percent of total net revenue. For the fiscal year ended March 31, 2003,international net revenue comprised 42 percent of total consolidated netrevenue. We expect foreign sales to continue to account for a significant andgrowing portion of our revenue. Such sales are subject to unexpected regulatoryrequirements, tariffs and other barriers. Additionally, foreign sales areprimarily made in local currencies, which may fluctuate against the dollar.While we utilize foreign exchange forward contracts to mitigate foreign currencyrisk associated with foreign currency denominated assets and liabilities(primarily certain intercompany receivables and payables), and foreign currencyoption contracts to hedge some foreign currency forecasted transactions(primarily related to revenue generated by our operational subsidiaries), ourresults of operations and financial condition may, nonetheless, be adverselyaffected by foreign currency fluctuations.
Our reported financial results could be affected if significant changes incurrent accounting principles are adopted.
Recent actions and public comments from the SEC have focused on the integrity offinancial reporting generally. Similarly, Congress has considered a variety ofbills that could affect certain accounting principles. The FASB and otherregulatory accounting agencies have recently introduced several new or proposedaccounting standards, such as accounting for stock options, some of whichrepresent a significant change from current practices. For example, changes inour accounting for stock options could materially increase our reportedexpenses.
Our stock price has been volatile and may continue to fluctuate significantly.
As a result of the factors discussed in this report, general economicconditions, and other factors that may arise in the future, the market price ofour common stock historically has been, and we expect will continue to be,subject to significant fluctuations. These fluctuations may be due to factorsspecific to us, to changes in analysts' earnings estimates, to factors affectingthe computer, software, Internet, entertainment, media or electronicsbusinesses, or to national and international economic conditions.
The majority of our sales are made to a relatively small number of keycustomers. If these customers reduce their purchases of our products or becomeunable to pay for them, our business could be harmed.
In the U.S. in fiscal 2004, over 70 percent of our sales were made to six keycustomers. In Europe, our top ten customers accounted for over 35 percent of oursales in that territory in fiscal 2004. Worldwide, we had direct sales to onecustomer, Wal-Mart Stores, Inc., which represented 13 percent of total netrevenue in fiscal 2004. Though our products are available to consumers through avariety of retailers, the concentration of our sales in one, or a few, largecustomers could lead to short-term disruption in our sales if one or more ofthese customers significantly reduced their purchases or ceased to carry ourproducts, and could make us more vulnerable to collection risk if one or more ofthese large customers became unable to pay for our products. Additionally, ourreceivables from these large customers increase significantly in the Decemberquarter as they stock up for the holiday selling season. Also, having such alarge portion of our total net revenue concentrated in a few customers reducesour negotiating leverage with these customers.
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Acquisitions, investments and other strategic transactions could result inoperating difficulties, dilution to our investors and other negativeconsequences.
We have evaluated, and expect to continue to evaluate, a wide array of potentialstrategic transactions, including (1) acquisitions of companies, businesses,intellectual properties, and other assets, and (2) investments in newinteractive entertainment businesses (for example, online and mobile games). Anyof these strategic transactions could be material to our financial condition andresults of operations. Although we regularly search for opportunities to engagein strategic transactions, we may not be successful in identifying suitableopportunities. We may not be able to consummate potential acquisitions orinvestments or an acquisition or investment may not enhance our business or maydecrease rather than increase our earnings. In addition, the process ofintegrating an acquired company or business, or successfully exploiting acquiredintellectual property or other assets, could divert a significant amount of ourmanagement's time and focus and may create unforeseen operating difficulties andexpenditures. 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 employees from the businesses we acquire, The need to integrate an acquired company's 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 equitysecurities, potentially diluting our existing stockholders, the incurrence ofdebt, contingent liabilities or amortization expenses, or write-offs ofgoodwill, any of which could harm our financial condition. Our stockholders maynot have the opportunity to review, vote on or evaluate future acquisitions orinvestments.
We have begun the implementation of a common set of financial informationsystems throughout our worldwide organization, which, if not completed in asuccessful and timely manner, could impede our ability to accurately process,prepare and analyze important financial data.
As part of our effort to improve efficiencies throughout our worldwideorganization, we have begun the implementation of a common set of practices,processes and financial information systems. The successful conversion from ourcurrent financial information systems to new financial information systemsentails a number of risks due to the complexity of the conversion andimplementation process. Such risks include verifying the accuracy of thebusiness data and information prior to conversion, the actual conversion of thatdata and information to the new systems and then using that business data andinformation in the new systems after the conversion. In addition, because theimplementation is company-wide, there is a need for substantial andcomprehensive company-wide employee training. While testing of these new systemsand processes and training of employees are done in advance of implementation,there are inherent limitations in our ability to simulate a full-scale operatingenvironment in advance of implementation. Finally, there can be no assurancethat the conversion to, and the implementation of, the new financial informationsystems will not impede our ability to accurately and timely process, prepareand analyze the financial data we use in making operating decisions and whichform the basis of the financial information we include in the periodic reportswe file with the SEC.
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Our products are subject to the threat of piracy by a variety of organizationsand 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 soldthan legitimate copies. Though piracy has not had a material impact on ouroperating results to date, highly organized pirate operations have beenexpanding globally. In addition, the proliferation of technology designed tocircumvent the protection measures we use in our products, the availability ofbroadband access to the Internet, the ability to download pirated copies of ourgames from various Internet sites, and the widespread proliferation of Internetcafes using pirated copies of our products, all have contributed to ongoing andexpanding piracy. Though we take steps to make the unauthorized copying anddistribution of our products more difficult, as do the manufacturers of consoleson which our games are played, neither our efforts nor those of the consolemanufacturers may be successful in controlling the piracy of our products. Thiscould have a negative effect on our growth and profitability in the future.
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