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| ERTS > SEC Filings for ERTS > Form 10-Q on 6-Nov-2008 | All Recent SEC Filings |
6-Nov-2008
Quarterly Report
product and the online service. Accordingly, starting in fiscal 2008, we began
to recognize all of the revenue from the sale of our online-enabled software
products for the PC, PlayStation 2, PLAYSTATION 3, Wii and PSP on a deferred
basis over an estimated online service period, which we estimate to be six
months beginning in the month after shipment. On a quarterly basis, the deferral
amount will vary significantly depending upon the number of titles we release,
the timing of their release, sales volume, returns and price protection provided
for these online-enabled software products. In addition, we expense the cost of
goods sold related to these transactions during the period in which the product
is delivered (rather than on a deferred basis), which inherently creates
volatility in our reported gross profit percentages.
As of September 30, 2008 and March 31, 2008, we had an accumulated balance of
$424 million and $387 million, respectively, of deferred net revenue related to
online-enabled packaged goods and digital content, substantially all of which
was driven by sales made during the six months ended September 30, 2008 and
March 31, 2008, respectively.
Three Months Ended September 30, 2008
Total net revenue for the three months ended September 30, 2008 was
$894 million, up $254 million as compared to the three months ended
September 30, 2007. The impact of deferrals related to sales of online-enabled
packaged goods and digital content for the three months ended September 30, 2008
decreased our reported net revenue by $232 million as compared to a decrease of
$296 million for the three months ended September 30, 2007. Net revenue was
driven by Rock Band™, Madden NFL 09, and NCAA Football 09.
Net loss for the three months ended September 30, 2008 was $310 million as
compared to a net loss of $195 million for the three months ended September 30,
2007. Diluted loss per share for the three months ended September 30, 2008 was
$0.97 as compared to diluted loss per share of $0.62 for the three months ended
September 30, 2007. Net loss increased during the three months ended September
30, 2008 as compared to the three months ended September 30, 2007 primarily as a
result of (1) a $162 million increase in cost of goods sold, (2) a $92 million
increase in personnel-related costs primarily as a result of increases in
salaries, incentive-based compensation and stock-based compensation, (3) a
$37 million increase in external development costs due to a greater number of
projects in development as compared to the prior year, (4) a $34 million
impairment charge related to our losses on strategic investments, (5) a decrease
in interest and other income of $25 million primarily resulting from lower
yields on our cash, cash equivalent and short-term investments, and (6) a charge
of $21 million related to our decision not to pursue an acquisition of Take-Two.
These were partially offset by (1) an increase of $254 million in net revenue
due to increased sales of our games and (2) a $34 million higher income tax
benefit.
During the six months ended September 30, 2008, we used $415 million of cash in
operating activities as compared to $296 million for the six months ended
September 30, 2007. The increase in cash used in operating activities for the
six months ended September 30, 2008 as compared to the six months ended
September 30, 2007 was primarily due to an increase in personnel-related
expenses and advertising and marketing costs.
Management's Overview of Historical and Prospective Business Trends
Economic Environment. As a result of the recent national and global economic
downturn, overall consumer spending has declined. Retailers globally, and
particularly in North America, appear to be taking a more conservative stance in
ordering game inventory, particularly for older catalog titles (i.e., sales of
games that were released in a previous quarter). Historically, our industry has
been resilient to economic recessions with sales being significantly influenced
by technology drivers such as the introduction and widespread consumer adoption
of new video game consoles. While the installed base of the Xbox 360, the
PLAYSTATION 3 and the Wii is expected to continue to grow significantly, we are
cautious about our sales in the near term, and in particular, for the upcoming
holiday season.
Transition to a New Generation of Consoles. Video game hardware systems have
historically had a life cycle of four to six years, which causes the video game
software market to be cyclical as well. The current cycle began with Microsoft's
launch of the Xbox 360 in 2005, and continued in 2006 when Sony and Nintendo
launched their next-generation systems, the PLAYSTATION 3 and the Wii,
respectively. During the three months ended September 30, 2008, the installed
base of each of these systems continued to expand and, as a result, sales of our
products for these systems have also increased significantly. At the same time,
however, demand for video games for prior-generation systems, particularly the
original Xbox and the Nintendo GameCube, has declined significantly. In fiscal
2009, we expect to significantly reduce the number of titles we develop and
market for the prior-generation PlayStation 2, release only one title for the
original Xbox and do not expect to release any titles for the Nintendo GameCube.
As a result, we expect our sales of video games for prior-generation systems
will continue to
decline. The decline in prior-generation product sales, particularly the
PlayStation 2, may be greater or faster than we anticipate, and sales of
products for the new platforms may be lower or increase more slowly than we
anticipate. Moreover, we expect development costs for the new video game systems
to continue to be greater on a per-title basis than development costs for
prior-generation video game systems. We expect research and development expenses
to increase on an absolute basis in fiscal 2009 as compared to fiscal 2008
(although not necessarily as a percentage of net revenue).
Online. Today, we generate net revenue from a variety of online products and
services, including casual games and downloadable content marketed under our
Pogo brand, massively-multiplayer online role-playing games (such as Warhammer®
Online: Age of Reckoning™, Ultima Online™, and Dark Age of Camelot®), PC-based
downloadable content and online-enabled packaged goods. We intend to make
significant investments in online products, infrastructure and services and
believe that online gameplay will become an increasingly important part of our
business in the long term.
Mobile Platforms. Advances in mobile technology have resulted in a variety of
new and evolving platforms for on-the-go interactive entertainment that appeal
to a broader demographic of consumers. Our efforts in mobile interactive
entertainment are focused in two broad areas - packaged goods games for handheld
game systems and downloadable games for wireless devices. We expect sales of
games for handhelds and wireless devices to continue to be an important part of
our business worldwide.
Acquisitions and Investments. We have engaged in, evaluated, and expect to
continue to engage in and evaluate, a wide array of potential strategic
transactions, including acquisitions of companies, businesses, intellectual
properties, and other assets. Since the beginning of fiscal 2008, we have
announced and/or completed several acquisitions and investments, including:
• In May 2008, we acquired ThreeSF, Inc. Based in San Francisco, California,
ThreeSF's Rupture service is an online social network for gamers.
• In May 2008, we acquired certain assets of Hands-On Mobile Inc. and its affiliates relating to its Korean Mobile games business based in Seoul, Korea.
• In January 2008, we acquired VG Holding Corp. ("VGH"), owner of both BioWare Corp. and Pandemic Studios, LLC, which create action, adventure, and role-playing games. BioWare Corp. and Pandemic Studios are located in Edmonton, Canada; Los Angeles, California; Austin, Texas; and Brisbane, Australia. The development of the projects for which we incurred an acquired-in-process technology charge in connection with the acquisition continued to be in-progress at September 30, 2008.
• In May 2007, we entered into a licensing agreement with and made a strategic equity investment in The9 Limited, a leading online game operator in China. The licensing agreement gives The9 exclusive publishing rights for EA SPORTS™ FIFA Online in mainland China.
• In April 2007, we expanded our commercial agreements with and made strategic equity investments in Neowiz Corporation and a related online gaming company, Neowiz Games (we refer to Neowiz Corporation and Neowiz Games collectively as "Neowiz"). Based in Korea, Neowiz is an online media and gaming company with which we are currently partnering to launch EA SPORTS NBA STREET Online in Asia.
On March 13, 2008, we commenced an unsolicited $26.00 per share cash tender
offer for all of the outstanding shares of Take-Two Interactive Software, Inc.,
a Delaware corporation ("Take-Two"), for a total purchase price of approximately
$2.1 billion. On August 18, 2008, we allowed the tender offer to expire without
purchasing any shares of Take-Two and, on September 14, 2008, we announced that
we had terminated discussions with, and would not be making a proposal to
acquire, Take-Two. During the six months ended September 30, 2008, we incurred
but had not yet recognized certain costs in our Condensed Consolidated
Statements of Operations in connection with the abandoned acquisition of
Take-Two. As a result of the terminated discussions, during the three months
ended September 30, 2008, we recognized $21 million in related costs consisting
of legal, banking and other consulting fees.
International Operations and Foreign Currency Exchange Impact. International
sales are a fundamental part of our business. Net revenue from international
sales accounted for approximately 42 percent of our total net revenue during the
first six months of fiscal 2009 and approximately 49 percent of our total net
revenue during the first six months of fiscal 2008. Our international net
revenue was primarily driven by sales in Europe and, to a much lesser extent, in
Asia. We believe that in order to succeed internationally, it is important to
locally develop content that is specifically directed toward local cultures and
consumers. Year-over-year, we estimate that foreign exchange rates had a
favorable impact on our net revenue of $59 million, or 6 percent, for
the six months ended September 30, 2008. During October 2008, the U.S. dollar
grew stronger against other currencies, including the Euro and the British pound
sterling. If the U.S. dollar continues to strengthen against these currencies,
then foreign exchange rates may have an unfavorable impact on our net revenue.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Our Condensed Consolidated Financial Statements have been prepared in accordance
with accounting principles generally accepted in the United States. The
preparation of these Condensed Consolidated Financial Statements requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities, contingent assets and liabilities, and revenue and
expenses during the reporting periods. The policies discussed below are
considered by management to be critical because they are not only important to
the portrayal of our financial condition and results of operations, but also
because application and interpretation of these policies requires both judgment
and estimates of matters that are inherently uncertain and unknown. As a result,
actual results may differ materially from our estimates.
Revenue Recognition, Sales Returns, Allowances and Bad Debt Reserves
We derive revenue principally from sales of interactive software games designed
for play on video game consoles (such as the PlayStation 2, PLAYSTATION 3, Xbox
360 and Wii), PCs and mobile platforms including handheld game players (such as
the PSP and Nintendo DS), and wireless devices. We evaluate the recognition of
revenue based on the criteria set forth in Statement of Position ("SOP") 97-2,
"Software Revenue Recognition", as amended by SOP 98-9, "Modification of SOP
97-2, Software Revenue Recognition, With Respect to Certain Transactions" and
Staff Accounting Bulletin ("SAB") No. 104, "Revenue Recognition". We evaluate
and recognize revenue when all four of the following criteria are met:
• Evidence of an arrangement. Evidence of an agreement with the customer that
reflects the terms and conditions to deliver products that must be present
in order to recognize revenue.
• Delivery. Delivery is considered to occur when a product is shipped and the risk of loss and rewards of ownership have been transferred to the customer. For online game services, delivery is considered to occur as the service is provided. For digital downloads that do not have an online service component, delivery is considered to occur generally when the download occurs.
• Fixed or determinable fee. If a portion of the arrangement fee is not fixed or determinable, we recognize revenue as the amount becomes fixed or determinable.
• Collection is deemed probable. We conduct a credit review of each customer involved in a significant transaction to determine the creditworthiness of the customer. Collection is deemed probable if we expect the customer to be able to pay amounts under the arrangement as those amounts become due. If we determine that collection is not probable, we recognize revenue when collection becomes probable (generally upon cash collection).
Determining whether and when some of these criteria have been satisfied often
involves assumptions and judgments that can have a significant impact on the
timing and amount of revenue we report in each period. For example, for multiple
element arrangements, we must make assumptions and judgments in order to
(1) determine whether and when each element has been delivered, (2) determine
whether undelivered products or services are essential to the functionality of
the delivered products and services, (3) determine whether VSOE exists for each
undelivered element, and (4) allocate the total price among the various elements
we must deliver. Changes to any of these assumptions or judgments, or changes to
the elements in a software arrangement, could cause a material increase or
decrease in the amount of revenue that we report in a particular period. For
example, in connection with some of our packaged goods product sales, we offer
an online service without an additional fee. Prior to fiscal 2008, we were able
to determine VSOE for the online service to be delivered; therefore, we were
able to allocate the total price received from the combined product and online
service sale between these two elements and recognize the related revenue
separately. However, starting in fiscal 2008, VSOE no longer existed for the
online service to be delivered for certain platforms and all revenue from these
transactions is recognized over the estimated online service period. More
specifically, starting in fiscal 2008, we began to recognize the revenue from
sales of certain online-enabled packaged goods on a straight-line basis over a
six month period beginning in the month after shipment. Accordingly, this
relatively small change (from having VSOE for the online service to no longer
having VSOE) has had a significant effect on our reported results.
Determining whether a transaction constitutes an online game service transaction
or a download of a product requires judgment and can be difficult. The
accounting for these transactions is significantly different. Revenue from
product downloads is
generally recognized when the download occurs (assuming all other recognition
criteria are met). Revenue from an online game service is recognized as the
service is rendered. If the service period is not defined, we recognize the
revenue over the estimated service period. Determining the estimated service
period is inherently subjective and is subject to regular revision based on
historical online usage.
Product revenue, including sales to resellers and distributors ("channel
partners"), is recognized when the above criteria are met. We reduce product
revenue for estimated future returns, price protection, and other offerings,
which may occur with our customers and channel partners. Price protection
represents the right to receive a credit allowance in the event we lower our
wholesale price on a particular product. The amount of the price protection is
generally the difference between the old price and the new price. In certain
countries, we have stock-balancing programs for our PC and video game system
products, which allow for the exchange of these products by resellers under
certain circumstances. It is our general practice to exchange products or give
credits rather than to give cash refunds.
In certain countries, from time to time, we decide to provide price protection
for our products. When evaluating the adequacy of sales returns and price
protection allowances, we analyze historical returns, current sell-through of
distributor and retailer inventory of our products, current trends in retail and
the video game segment, changes in customer demand and acceptance of our
products, and other related factors. In addition, we monitor the volume of sales
to our channel partners and their inventories, as substantial overstocking in
the distribution channel could result in high returns or higher price protection
costs in subsequent periods.
In the future, actual returns and price protections may materially exceed our
estimates as unsold products in the distribution channels are exposed to rapid
changes in consumer preferences, market conditions or technological obsolescence
due to new platforms, product updates or competing products. For example, the
risk of product returns and/or price protection for our products may continue to
increase as the PlayStation 2 console moves through its lifecycle. While we
believe we can make reliable estimates regarding these matters, these estimates
are inherently subjective. Accordingly, if our estimates changed, our returns
and price protection reserves would change, which would impact the total net
revenue we report. For example, if actual returns and/or price protection were
significantly greater than the reserves we have established, our actual results
would decrease our reported total net revenue. Conversely, if actual returns
and/or price protection were significantly less than our reserves, this would
increase our reported total net revenue. In addition, if our estimates of
returns and price protection related to online-enabled packaged goods products
change, the amount of net deferred revenue we recognize in the future would
change.
Significant judgment is required to estimate our allowance for doubtful accounts
in any accounting period. We determine our allowance for doubtful accounts by
evaluating customer creditworthiness in the context of current economic trends
and historical experience. Depending upon the overall economic climate and the
financial condition of our customers, the amount and timing of our bad debt
expense and cash collection could change significantly.
Fair Value Estimates
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States often requires us to determine the fair
value of a particular item in order to fairly present our financial statements.
Without an independent market or another representative transaction, determining
the fair value of a particular item requires us to make several assumptions that
are inherently difficult to predict and can have a material impact on the
conclusion on the appropriate accounting.
There are various valuation techniques used to estimate fair value. These
include (1) the market approach where market transactions for identical or
comparable assets or liabilities are used to determine the fair value, (2) the
income approach, which uses valuation techniques to convert future amounts (for
example, future cash flows or future earnings) to a single present amount, and
(3) the cost approach, which is based on the amount that would be required to
replace an asset. For many of our fair value estimates, including our estimates
of the fair value of acquired intangible assets, acquired in-process technology
and equity instruments granted for services, we use the income approach. Using
the income approach requires the use of financial models, which require us to
make various estimates including, but not limited to (1) the potential future
cash flows for the asset, liability or equity instrument being measured, (2) the
timing of receipt or payment of those future cash flows, (3) the time value of
money associated with the delayed receipt or payment of such cash flows, and
(4) the inherent risk associated with the cash flows (risk premium). Making
these cash flow estimates are inherently difficult and subjective, and, if any
of the estimates used to determine the fair value using the income approach
turns out to be inaccurate, our financial results may be negatively impacted.
Furthermore, relatively small changes in many of these estimates can have a
significant impact to the estimated fair value resulting from the financial
models or the related accounting conclusion reached. For example, a relatively
small change
in the estimated fair value of an asset may change a conclusion as to whether an
asset is impaired.
While we are required to make certain fair value assessments associated with the
accounting for several types of transactions, the following areas are the most
sensitive to the assessments:
Business Combinations. We must estimate the fair value of assets acquired,
liabilities assumed and acquired in-process technology in a business
combination. Our assessment of the estimated fair value of each of these can
have a material affect on our reported results as intangible assets are
amortized over various lives and acquired in-process technology is expensed upon
consummation. Furthermore, a change in the estimated fair value of an asset or
liability often has a direct impact on the amount to recognize as goodwill, an
asset that is not amortized. Often determining the fair value of these assets
and liabilities assumed requires an assessment of expected use of the asset, the
expected cost to extinguish the liability or our expectations related to the
. . .
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