Activision Blizzard, Inc.
ACTIVISION INC /NY (Form: 10-Q, Received: 11/14/2003 06:40:31)      

 

SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

FORM 10-Q

 

(Mark one)

 

ý

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the Quarterly Period Ended September 30, 2003

 

O R

 

o

 

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                      to

 

 

 

Commission File Number 0-12699

 

 

ACTIVISION, INC.

(Exact name of registrant as specified in its charter)

 

Delaware

 

95-4803544

(State or other jurisdiction of
incorporation or organization)

 

(I.R.S. Employer Identification No.)

 

 

 

3100 Ocean Park Boulevard, Santa Monica, CA

 

90405

(Address of principal executive offices)

 

(Zip Code)

 

 

 

(310) 255-2000

(Registrant’s telephone number, including area code)

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  ý   No  o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).  Yes  ý   No  o

 

The number of shares of the registrant’s Common Stock outstanding as of November 4, 2003 was 88,676,227.

 

 



 

ACTIVISION, INC. AND SUBSIDIARIES

 

INDEX

 

PART I.

FINANCIAL INFORMATION

 

 

 

 

Item 1.

Financial Statements

 

 

 

 

 

Consolidated Balance Sheets as of September 30, 2003 (Unaudited) and March 31, 2003

 

 

 

 

 

 

Consolidated Statements of Operations for the three and six months ended September 30, 2003 and 2002 (Unaudited)

 

 

 

 

 

 

Consolidated Statements of Cash Flows for the six months ended September 30, 2003 and 2002 (Unaudited)

 

 

 

 

 

 

Consolidated Statement of Changes in Shareholders’ Equity for the six months ended September 30, 2003 (Unaudited)

 

 

 

 

 

 

Notes to Consolidated Financial Statements for the three and six months ended September 30, 2003 (Unaudited)

 

 

 

 

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

 

 

 

Item 3.

Quantitative and Qualitative Disclosures about Market Risk

 

 

 

 

Item 4.

Controls and Procedures

 

 

 

 

 

 

 

PART II.

OTHER INFORMATION

 

 

 

 

Item 1.

Legal Proceedings

 

 

 

 

Item 4.

Submission of Matters to a Vote of Security Holders

 

 

 

 

Item 6.

Exhibits and Reports on Form 8-K

 

 

 

 

SIGNATURES

 

 

 

CERTIFICATIONS

 

 

2



 

Part I.  Financial Information .  

 

Item 1.  Financial Statements.

   

ACTIVISION, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)

 

 

 

September 30,
2003

 

March 31,
2003

 

 

 

(Unaudited)

 

 

 

Assets

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

313,446

 

$

285,554

 

Short-term investments

 

97,990

 

121,400

 

Accounts receivable, net of allowances of  $50,074 and $57,356 at September 30, 2003 and March 31, 2003, respectively

 

29,502

 

15,822

 

Inventories

 

21,163

 

19,577

 

Software development

 

63,109

 

26,791

 

Intellectual property licenses

 

17,239

 

8,906

 

Deferred income taxes

 

32,375

 

38,290

 

Other current assets

 

23,099

 

10,565

 

 

 

 

 

 

 

Total current assets

 

597,923

 

526,905

 

 

 

 

 

 

 

Software development

 

23,665

 

35,281

 

Intellectual property licenses

 

24,987

 

36,943

 

Property and equipment, net

 

26,562

 

22,265

 

Deferred income taxes

 

20,300

 

10,322

 

Other assets

 

1,893

 

5,081

 

Goodwill

 

67,726

 

68,019

 

 

 

 

 

 

 

Total assets

 

$

763,056

 

$

704,816

 

 

 

 

 

 

 

Liabilities and Shareholders’ Equity

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Current portion of long-term debt

 

$

 

$

147

 

Accounts payable

 

49,015

 

45,602

 

Accrued expenses

 

49,947

 

58,656

 

 

 

 

 

 

 

Total current liabilities

 

98,962

 

104,405

 

 

 

 

 

 

 

Long-term debt, less current portion

 

 

2,671

 

 

 

 

 

 

 

Total liabilities

 

98,962

 

107,076

 

 

 

 

 

 

 

Commitments and contingencies (Note 13)

 

 

 

 

 

 

 

 

 

 

 

Shareholders’ equity:

 

 

 

 

 

Preferred stock, $.000001 par value, 3,750,000 shares authorized, no shares issued at September 30, 2003 and March 31, 2003

 

 

 

Series A Junior Preferred stock, $.000001 par value, 1,250,000 shares authorized, no shares issued at September 30, 2003 and March 31, 2003

 

 

 

Common stock, $.000001 par value, 125,000,000 shares authorized, 108,072,503 and 107,372,727 shares issued and 88,475,620 and 90,084,245 shares outstanding at September 30, 2003 and March 31, 2003, respectively

 

 

 

Additional paid-in capital

 

681,233

 

592,295

 

Retained earnings

 

124,634

 

130,564

 

Less:  Treasury stock, at cost, 19,596,883 and 17,288,482 shares at September 30, 2003 and March 31, 2003, respectively

 

(142,946

)

(121,685

)

Accumulated other comprehensive income (loss)

 

1,173

 

(3,434

)

 

 

 

 

 

 

Total shareholders’ equity

 

664,094

 

597,740

 

 

 

 

 

 

 

Total liabilities and shareholders’ equity

 

$

763,056

 

$

704,816

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

3



   

ACTIVISION, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(In thousands, except per share data)

 

 

 

For the three months ended
September 30,

 

For the six months ended
September 30,

 

 

 

2003

 

2002

 

2003

 

2002

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

$

117,523

 

$

169,172

 

$

276,248

 

$

360,430

 

 

 

 

 

 

 

 

 

 

 

Costs and expenses:

 

 

 

 

 

 

 

 

 

Cost of sales – product costs

 

72,391

 

80,779

 

149,001

 

164,123

 

Cost of sales – software royalties and amortization

 

11,397

 

18,055

 

26,895

 

33,893

 

Cost of sales – intellectual property licenses

 

7,401

 

5,143

 

17,544

 

17,786

 

Product development

 

15,894

 

13,259

 

29,474

 

25,010

 

Sales and marketing

 

17,237

 

28,776

 

43,522

 

50,769

 

General and administrative

 

10,136

 

11,826

 

21,599

 

26,319

 

 

 

 

 

 

 

 

 

 

 

Total costs and expenses

 

134,456

 

157,838

 

288,035

 

317,900

 

 

 

 

 

 

 

 

 

 

 

Operating income (loss)

 

(16,933

)

11,334

 

(11,787

)

42,530

 

 

 

 

 

 

 

 

 

 

 

Investment income, net

 

1,404

 

2,865

 

2,661

 

4,021

 

 

 

 

 

 

 

 

 

 

 

Income (loss) before income tax provision (benefit)

 

(15,529

)

14,199

 

(9,126

)

46,551

 

 

 

 

 

 

 

 

 

 

 

Income tax provision (benefit)

 

(5,436

)

5,113

 

(3,196

)

16,761

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

(10,093

)

$

9,086

 

$

(5,930

)

$

29,790

 

 

 

 

 

 

 

 

 

 

 

Basic earnings (loss) per share

 

$

(0.11

)

$

0.09

 

$

(0.07

)

$

0.31

 

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding

 

88,162

 

100,172

 

88,105

 

94,587

 

 

 

 

 

 

 

 

 

 

 

Diluted earnings (loss) per share

 

$

(0.11

)

$

0.08

 

$

(0.07

)

$

0.29

 

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding assuming dilution

 

88,162

 

108,731

 

88,105

 

103,916

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

4



   

ACTIVISION, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(In thousands)

 

 

 

For the six months ended
September 30,

 

 

 

2003

 

2002

 

Cash flows from operating activities:

 

 

 

 

 

Net income (loss)

 

$

(5,930

)

$

29,790

 

Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:

 

 

 

 

 

Deferred income taxes

 

(4,063

)

5,745

 

Depreciation and amortization

 

4,889

 

4,545

 

Amortization and write-offs of capitalized software development costs and intellectual property licenses

 

32,364

 

34,658

 

Tax benefit of stock options and warrants exercised

 

958

 

15,479

 

Changes in operating assets and liabilities (net of effects of acquisitions):

 

 

 

 

 

Accounts receivable

 

(13,580

)

16,349

 

Inventories

 

(1,586

)

(4,382

)

Software development and intellectual property licenses

 

(53,443

)

(78,692

)

Other assets

 

(9,430

)

2,595

 

Accounts payable

 

3,413

 

(7,180

)

Accrued expenses and other liabilities

 

(5,681

)

3,173

 

 

 

 

 

 

 

Net cash provided by (used in) operating activities

 

(52,089

)

22,080

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Capital expenditures

 

(8,215

)

(4,775

)

Proceeds from disposal of property and equipment

 

 

505

 

Purchases of short-term investments

 

(77,311

)

(308,164

)

Proceeds from sales and maturities of short-term investments

 

100,691

 

93,652

 

Cash payment to effect business combinations, net of cash acquired

 

 

(12,091

)

Minority capital investment

 

 

(1,500

)

 

 

 

 

 

 

Net cash provided by (used in) investing activities

 

15,165

 

(232,373

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Proceeds from issuance of common stock to employees

 

4,778

 

17,567

 

Other borrowings, net

 

(2,818

)

121

 

Proceeds from issuance of common stock pursuant to underwritten public offering, net of offering costs

 

 

248,102

 

Purchase of structured stock repurchase transactions

 

(42,621

)

 

Settlement of structured stock repurchase transactions

 

120,823

 

 

Purchase of treasury stock

 

(18,814

)

 

 

 

 

 

 

 

Net cash provided by financing activities

 

61,348

 

265,790

 

 

 

 

 

 

 

Effect of exchange rate changes on cash

 

3,468

 

4,867

 

 

 

 

 

 

 

Net increase in cash and cash equivalents

 

27,892

 

60,364

 

 

 

 

 

 

 

Cash and cash equivalents at beginning of period

 

285,554

 

279,007

 

 

 

 

 

 

 

Cash and cash equivalents at end of period

 

$

313,446

 

$

339,371

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

5



   

ACTIVISION, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY
For the six months ended September 30, 2003
(Unaudited)
(In thousands)

 

 

 




Common Stock

 

Additional
Paid-In
Capital

 

Retained
Earnings

 




Treasury Stock

 

Accumulated
Other
Comprehensive
Income
(Loss)

 

Shareholders’ Equity

 

Shares

 

Amount

Shares

 

Amount

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, March 31, 2003

 

107,373

 

$

 

$

592,295

 

$

130,564

 

(17,288

)

$

(121,685

)

$

(3,434

)

$

597,740

 

Components of comprehensive loss:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

 

 

 

(5,930

)

 

 

 

(5,930

)

Unrealized depreciation on short-term investments

 

 

 

 

 

 

 

(14

)

(14

)

Foreign currency translation adjustment

 

 

 

 

 

 

 

4,621

 

4,621

 

Total comprehensive loss

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(1,323

)

Issuance of common stock pursuant to employee stock option and stock purchase plans and common stock warrants

 

700

 

 

4,778

 

 

 

 

 

4,778

 

Tax benefit attributable to employee stock options and common stock warrants

 

 

 

958

 

 

 

 

 

958

 

Purchase of structured stock repurchase transactions

 

 

 

(47,621

)

 

 

 

 

(47,621

)

Settlement of structured stock repurchase transactions

 

 

 

130,823

 

 

(1,144

)

(10,000

)

 

120,823

 

Purchase of treasury stock

 

 

 

 

 

(1,165

)

(11,261

)

 

(11,261

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, September 30, 2003

 

108,073

 

$

 

$

681,233

 

$

124,634

 

(19,597

)

$

(142,946

)

$

1,173

 

$

664,094

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

6



 

ACTIVISION, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
For the three and six months ended September 30, 2003

 

1.               Summary of Significant Accounting Policies

 

Basis of Presentation

 

The accompanying consolidated financial statements include the accounts of Activision, Inc. and its subsidiaries (“Activision” or “we”).  The information furnished is unaudited and reflects all adjustments that, in the opinion of management, are necessary to provide a fair statement of the results for the interim periods presented.  The consolidated financial statements should be read in conjunction with the consolidated financial statements included in our Annual Report on Form 10-K for the year ended March 31, 2003 as filed with the Securities and Exchange Commission (“SEC”).

 

Software Development Costs and Intellectual Property Licenses

 

Software development costs include payments made to independent software developers under development agreements, as well as direct costs incurred for internally developed products.

 

We account for software development costs in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 86, “Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed.”  Software development costs are capitalized once technological feasibility of a product is established and such costs are determined to be recoverable. Technological feasibility of a product encompasses both technical design documentation and game design documentation.  For products where proven technology exists, this may occur early in the development cycle. Technological feasibility is evaluated on a product-by-product basis.  Prior to a product’s release, we expense, as part of cost of sales – software royalties and amortization, capitalized costs when we believe such amounts are not recoverable.  Capitalized costs for those products that are cancelled or abandoned are charged to product development expense in the period of cancellation.  Amounts related to software development which are not capitalized are charged immediately to product development expense.  We evaluate the future recoverability of capitalized amounts on a quarterly basis.  The recoverability of capitalized software development costs is evaluated based on the expected performance of the specific products for which the costs relate.  Criteria used to evaluate expected product performance include: historical performance of comparable products using comparable technology; orders for the product prior to its release; and estimated performance of a sequel product based on the performance of the product on which the sequel is based.

 

Commencing upon product release, capitalized software development costs are amortized to cost of sales — software royalties and amortization based on the ratio of current revenues to total projected revenues, generally resulting in an amortization period of six months or less.   For products that have been released in prior periods, we evaluate the future recoverability of capitalized amounts on a quarterly basis.  The primary evaluation criterion is actual title performance.

 

Intellectual property license costs represent license fees paid to intellectual property rights holders for use of their trademarks or copyrights in the development of our products.  Depending upon the agreement with the rights holder, we may obtain the rights to use acquired intellectual property in multiple products over multiple years, or alternatively, for a single product.

 

We evaluate the future recoverability of capitalized intellectual property licenses on a quarterly basis.  The recoverability of capitalized intellectual property license costs is evaluated based on the expected performance of the specific products in which the licensed trademark or copyright is to be used.  As many of our intellectual property licenses extend for multiple products over multiple years, we also assess the recoverability of capitalized intellectual property license costs based on certain qualitative factors such as the success of other products and/or entertainment vehicles utilizing the intellectual property, whether there are any future planned theatrical releases or television series based on the intellectual property and the rights holder’s continued promotion and exploitation of the intellectual property.  Prior to the related product’s release, we expense, as part of cost of sales – intellectual property licenses, capitalized intellectual property costs when we believe such amounts are not recoverable.  Capitalized intellectual property costs for those products that are cancelled or abandoned are charged to product development expense in the period of cancellation.  Criteria used to evaluate expected product performance include: historical performance of comparable products using comparable

 

7



 

technology; orders for the product prior to its release; and estimated performance of a sequel product based on the performance of the product on which the sequel is based.

 

Commencing upon the related product’s release, capitalized intellectual property license costs are amortized to cost of sales – intellectual property licenses based on the ratio of current revenues for the specific product to total projected revenues for all products in which the licensed trademark or copyright will be utilized.  As intellectual property license contracts may extend for multiple years, the amortization of capitalized intellectual property license costs relating to such contracts may extend beyond one year.  For intellectual property included in products that have been released, we evaluate the future recoverability of capitalized amounts on a quarterly basis.  The primary evaluation criterion is actual title performance.

 

Revenue Recognition

 

We recognize revenue from the sale of our products upon the transfer of title and risk of loss to our customers.  We may permit product returns from, or grant price protection to, our customers on unsold merchandise under certain conditions.  Price protection, when granted and applicable, allows customers a credit against amounts they owe us with respect to merchandise unsold by them.  Typically, these credits are applied against future invoices.  With respect to license agreements that provide customers the right to make multiple copies in exchange for guaranteed amounts, revenue is recognized upon delivery of such copies.  Per copy royalties on sales that exceed the guarantee are recognized as earned.  In addition, in order to recognize revenue for both product sales and licensing transactions, persuasive evidence of an arrangement must exist and collection of the related receivable must be probable.

 

Revenue from product sales is reflected after deducting the estimated allowance for returns and price protection.  Management must make estimates of potential future product returns and price protection related to current period product revenue.  We estimate the amount of future returns and price protection based upon historical experience, customer inventory levels and changes in the demand and acceptance of our products by the end consumer.

 

Sales incentives or other consideration given by us to our customers is accounted for in accordance with Emerging Issues Task Force (“EITF”) Issue 01-9, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products).”  In accordance with EITF Issue 01-9, sales incentives and other consideration that are considered adjustments of the selling price of our products, such as rebates and product placement fees, are reflected as reductions of revenue.  Sales incentives and other consideration that represent costs incurred by us for assets or services received, such as the appearance of our products in a customer’s national circular ad, are reflected as sales and marketing expenses.

 

Stock-Based Compensation and Pro Forma Information

 

Under SFAS No. 123, “Accounting for Stock-Based Compensation,” compensation expense is recorded for the issuance of stock options and other stock-based compensation based on the fair value of the stock options and other stock-based compensation on the date of grant or measurement date.  Alternatively, SFAS No. 123 allows companies to continue to account for the issuance of stock options and other stock-based compensation in accordance with Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.”  Under APB No. 25, compensation expense is recorded for the issuance of stock options and other stock-based compensation based on the intrinsic value of the stock options and other stock-based compensation on the date of grant or measurement date.  Under the intrinsic value method, compensation expense is recorded on the date of grant or measurement date only if the current market price of the underlying stock exceeds the stock option or other stock-based compensation exercise price.  At September 30, 2003, we had several stock-based employee compensation plans, which are described more fully in Note 14 to the Notes to Consolidated Financial Statements included in Item 8 of our Annual Report on Form 10-K for the year ended March 31, 2003 filed with the SEC. We account for those plans under the recognition and measurement principles of APB Opinion No. 25 and related Interpretations. No stock-based employee compensation cost is reflected in net income (loss) for any periods presented, as all options granted under those plans had an exercise price equal to or greater than the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income (loss) and earnings (loss) per share if we had applied the fair value

 

8



 

recognition provisions of SFAS No. 123 to stock-based employee compensation (amounts in thousands, except per share data):

 

 

 

 

Three months ended September 30,

 

Six months ended September 30,

 

 

 

2003

 

2002

 

2003

 

2002

 

Net income (loss), as reported

 

$

(10,093

)

$

9,086

 

$

(5,930

)

$

29,790

 

Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects

 

(4,205

)

(5,445

)

(9,740

)

(10,214

)

Pro forma net income (loss)

 

$

(14,298

)

$

3,641

 

$

(15,670

)

$

19,576

 

 

 

 

 

 

 

 

 

 

 

Earnings (loss) per share:

 

 

 

 

 

 

 

 

 

Basic – as reported

 

$

(0.11

)

$

0.09

 

$

(0.07

)

$

0.31

 

Basic – pro forma

 

$

(0.16

)

$

0.04

 

$

(0.18

)

$

0.21

 

 

 

 

 

 

 

 

 

 

 

Diluted – as reported

 

$

(0.11

)

$

0.08

 

$

(0.07

)

$

0.29

 

Diluted – pro forma

 

$

(0. 16

)

$

0.03

 

$

(0.18

)

$

0.19

 

 

The fair value of options granted is estimated at the date of grant using the Black-Scholes option pricing model. The Black-Scholes option pricing model requires the input of highly subjective assumptions, including the expected stock price volatility.  We use the historical stock price volatility of our common stock over the most recent period that is generally commensurate with the expected option life as the basis for estimating expected stock price volatility.  In prior fiscal years, the historical stock price volatility used was based on the daily, low stock price of our common stock, which, in recent years, resulted in an expected volatility ranging from approximately 65% to 70%.  For options granted during the three months ended June 30, 2003 and September 30, 2003, the historical stock price volatility used was based on a weekly stock price observation, using an average of the high and low stock prices of our common stock, which resulted in an expected stock price volatility of approximately 47% and 52%, respectively.  Management believes such amounts are more representative of prospective trends.  For purposes of the above pro forma disclosure, the fair value of options granted is amortized to stock-based employee compensation cost over the period(s) in which the related employee services are rendered.  Accordingly, the pro forma stock-based compensation cost for any period will typically relate to options granted in both the current period and prior periods.

 

2.               Stock Split

 

In April 2003, the Board of Directors approved a three-for-two split of our outstanding common shares effected in the form of a 50% stock dividend.  The split was paid on June 6, 2003 to shareholders of record as of May 16, 2003.  The par value of our common stock was maintained at the pre-split amount of $.000001.  The consolidated financial statements and Notes thereto, including all share and per share data, have been restated as if the stock split had occurred as of the earliest period presented.

 

3 .               Cash, Cash Equivalents and Short-term Investments

 

Short-term investments generally mature between three months and two years.  Investments with maturities beyond one year may be classified as short-term based on their liquid nature and because such securities represent the investment of cash that is available for current operations.  All of our short-term investments are classified as available-for-sale and are carried at fair market value with unrealized appreciation (depreciation) reported as a separate component of accumulated other comprehensive income (loss) in shareholders’ equity.

 

9



 

The specific identification method is used to determine the cost of securities disposed with realized gains and losses reflected in investment income, net.

 

The following table summarizes our investments in securities as of September 30, 2003 (amounts in thousands):

 

 

 

 

Amortized
Cost

 

Gross
Unrealized
Gains

 

Gross
Unrealized
Losses

 

Fair
Value

 

Cash and cash equivalents:

 

 

 

 

 

 

 

 

 

Cash and time deposits

 

$

61,591

 

$

 

$

 

$

61,591

 

Money market instruments

 

38,005

 

 

 

38,005

 

Commercial paper

 

3,305

 

 

 

3,305

 

Auction rate notes

 

210,545

 

 

 

210,545

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

313,446

 

 

 

313,446

 

 

 

 

 

 

 

 

 

 

 

Short-term investments:

 

 

 

 

 

 

 

 

 

Corporate bonds

 

14,369

 

23

 

(5

)

14,387

 

Taxable municipal bonds

 

17,959

 

 

 

17,959

 

U.S. agency issues

 

50,416

 

84

 

(70

)

50,430

 

Asset-backed securities

 

15,126

 

103

 

(15

)

15,214

 

 

 

 

 

 

 

 

 

 

 

Short-term investments

 

97,870

 

210

 

(90

)

97,990

 

 

 

 

 

 

 

 

 

 

 

Cash, cash equivalents and short-term investments

 

$

411,316

 

$

210

 

$

(90

)

$

411,436

 

 

The following table summarizes the maturities of our investments in debt securities as of September 30, 2003 (amounts in thousands):

 

 

 

 

Amortized
Cost

 

Fair
Value

 

Due in one year or less

 

$

245,509

 

$

245,520

 

Due after one year through two years

 

51,085

 

51,106

 

 

 

296,594

 

296,626

 

Asset-backed securities

 

15,126

 

15,214

 

 

 

 

 

 

 

Total

 

$

311,720

 

$

311,840

 

 

For the three months ended September 30, 2003, net realized gains on short-term investments consisted of $20,000 of gross realized gains and no gross realized losses.  For the six months ended September 30, 2003, net realized gains on short-term investments consisted of $20,000 of gross realized gains and $4,000 of gross realized losses.  For the three and six months ended September 30, 2002, net realized losses on short-term investments consisted of $2,000 of gross realized gains and $60,000 of gross realized losses.

 

4.               Inventories

 

Inventories are valued at the lower of cost (first-in, first-out) or market.  Our inventories consist of the following (amounts in thousands):

 

 

 

 

September 30, 2003

 

March 31, 2003

 

Purchased parts and components

 

$

1,033

 

$

1,129

 

Finished goods

 

20,130

 

18,448

 

 

 

 

 

 

 

 

 

$

21,163

 

$

19,577

 

 

10



 

5.               Goodwill and Other Intangible Assets

 

The changes in the carrying amount of goodwill for the six months ended September 30, 2003 are as follows (amounts in thousands):

 

 

 

 

Publishing

 

Distribution

 

Total

 

 

 

 

 

 

 

 

 

Balance as of March 31, 2003

 

$

63,194

 

$

4,825

 

$

68,019

 

Adjustment to original purchase allocation

 

(575

)

 

(575

)

Effect of foreign currency exchange rates

 

 

282

 

282

 

Balance as of September 30, 2003

 

$

62,619

 

$

5,107

 

$

67,726

 

 

Goodwill on one of our acquisitions could be subject to change by up to $2.4 million pending the final evaluation of certain tax liabilities acquired as part of the business combination.

 

6.               Income Taxes

 

The income tax benefit of $5.4 million and $3.2 million for the three and six months ended September 30, 2003, respectively, reflect our effective income tax rate of approximately 35%.  The income tax provision of $5.1 million and $16.8 million for the three and six months ended September 30, 2002, respectively, reflect our effective income tax rate of approximately 36%.  For both periods, the significant items that generated variances between our effective rate and our statutory rate of 35% were state taxes, offset by research and development tax credits.

 

7.               Software Development Costs and Intellectual Property Licenses

 

As of September 30, 2003, capitalized software development costs included $41.8 million of internally developed software costs and $45.0 million of payments made to third-party software developers.  As of March 31, 2003, capitalized software development costs included $26.0 million of internally developed software costs and $36.1 million of payments made to third-party software developers.  Capitalized intellectual property licenses were $42.2 million and $45.8 million as of September 30, 2003 and March 31, 2003, respectively.  Amortization and write-offs of capitalized software development costs and intellectual property licenses were $32.4 million and $34.7 million for the six months ended September 30, 2003 and 2002, respectively.

 

11



 

8.               Comprehensive Income (Loss) and Accumulated Other Comprehensive Income (Loss)

   

Comprehensive Income (Loss)

 

The components of comprehensive income (loss) for the three and six months ended September 30, 2003 and 2002 were as follows (amounts in thousands):

 

 

 

Three months ended September 30,

 

Six months ended September 30,

 

 

 

2003

 

2002

 

2003

 

2002

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

(10,093

)

$

9,086

 

$

(5,930

)

$

29,790

 

 

 

 

 

 

 

 

 

 

 

Other comprehensive income:

 

 

 

 

 

 

 

 

 

Foreign currency translation adjustment

 

896

 

796

 

4,621

 

6,176

 

Unrealized appreciation (depreciation) on short-term investments

 

10

 

(126

)

(14

)

(126

)

 

 

 

 

 

 

 

 

 

 

Other comprehensive income

 

906

 

670

 

4,607

 

6,050

 

 

 

 

 

 

 

 

 

 

 

Comprehensive income (loss)

 

$

(9,187

)

$

9,756

 

$

(1,323

)

$

35,840

 

   

Accumulated Other Comprehensive Income (Loss)

 

The components of accumulated other comprehensive income (loss) were as follows (amounts in thousands):

 

 

 

Foreign
Currency

 

Unrealized
Appreciation
(Depreciation)
on Investments

 

Accumulated
Other
Comprehensive

Income (Loss)

 

Balance, March 31, 2003

 

$

(3,568

)

$

134

 

$

(3,434

)

Other comprehensive income (loss)

 

4,621

 

(14

)

4,607

 

 

 

 

 

 

 

 

 

Balance, September 30, 2003

 

$

1,053

 

$

120

 

$

1,173

 

 

The amounts above are shown net of taxes.  The income taxes related to other comprehensive income (loss) were not significant, as income taxes were not provided for foreign currency translation items as these are considered indefinite investments in non-U.S. subsidiaries.

 

12



 

9.               Investment Income, Net

 

Investment income, net is comprised of the following (amounts in thousands):

 

 

 

 

Three months ended September 30,

 

Six months ended September 30,

 

 

 

2003

 

2002

 

2003

 

2002

 

Interest expense

 

$

(88

)

$

(136

)

$

(283

)

$

(672

)

Interest income

 

1,472

 

3,059

 

2,928

 

4,751

 

Net realized gain (loss) on investments

 

20

 

(58

)

16

 

(58

)

 

 

 

 

 

 

 

 

 

 

Investment income, net

 

$

1,404

 

$

2,865

 

$

2,661

 

$

4,021

 

 

10.        Supplemental Cash Flow Information

 

Non-cash investing and financing activities and supplemental cash flow information is as follows (amounts in thousands):

 

 

 

 

Six months ended September 30,

 

 

 

2003

 

2002

 

Non-cash investing and financing activities:

 

 

 

 

 

Subsidiaries acquired with common stock

 

$

 

$

10,861

 

Issuance of options and common stock warrants

 

 

2,184

 

Stock offering costs

 

 

781

 

Change in unrealized depreciation on short-term investments

 

14

 

126

 

 

 

 

 

 

 

Supplemental cash flow information:

 

 

 

 

 

Cash paid for income taxes

 

$

4,457

 

$

1,799

 

Cash paid (received) for interest, net

 

(2,844

)

(2,334

)

 

11.        Operations by Reportable Segments and Geographic Area

 

Based upon our organizational structure, we operate two business segments: (i) publishing of interactive entertainment software and (ii) distribution of interactive entertainment software and hardware products.

 

Publishing refers to the development, marketing and sale of products, either directly, by license or through our affiliate label program with third-party publishers.  In the United States, our products are sold primarily on a direct basis to mass-market retailers, consumer electronics stores, discount warehouses and office super-stores.  We conduct our international publishing activities through offices in the United Kingdom, Germany, France, Italy, Australia, Sweden, Canada and Japan.  Our products are sold internationally on a direct-to-retail basis, through third-party distribution and licensing arrangements and through our wholly-owned distribution subsidiaries located in the United Kingdom, the Netherlands and Germany.

 

Distribution refers to our European operations located in the United Kingdom, the Netherlands and Germany that provide logistical and sales services to third-party publishers of interactive entertainment software, our own publishing operations and manufacturers of interactive entertainment hardware.

 

Resources are allocated to each of these segments using information on their respective net revenues and operating profits before interest and taxes.

 

The accounting policies of these segments are the same as those described in the Summary of Significant Accounting Policies in our Annual Report on Form 10-K for the year ended March 31, 2003.  Revenue derived from sales between segments is eliminated in consolidation.

 

13



 

Information on the reportable segments for the three and six months ended September 30, 2003 and 2002 is as follows (amounts in thousands):

 

 

 

 

Three months ended September 30, 2003

 

 

 

Publishing

 

Distribution

 

Total

 

 

 

 

 

 

 

 

 

Total segment revenues

 

$

71,796

 

$

45,727

 

$

117,523

 

Revenues from sales between segments

 

(4,534

)

4,534

 

 

 

 

 

 

 

 

 

 

Revenues from external customers

 

$

67,262

 

$

50,261

 

$

117,523

 

 

 

 

 

 

 

 

 

Operating income (loss)

 

$

(16,894

)

$

(39

)

$

(16,933

)

 

 

 

 

 

 

 

 

Total assets

 

$

682,804

 

$

80,252

 

$

763,056

 

 

 

 

Three months ended September 30, 2002

 

 

 

Publishing

 

Distribution

 

Total

 

 

 

 

 

 

 

 

 

Total segment revenues

 

$

127,098

 

$

42,074

 

$

169,172

 

Revenues from sales between segments

 

(9,538

)

9,538

 

 

 

 

 

 

 

 

 

 

Revenues from external customers

 

$

117,560

 

$

51,612

 

$

169,172

 

 

 

 

 

 

 

 

 

Operating income

 

$

9,273

 

$

2,061

 

$

11,334

 

 

 

 

 

 

 

 

 

Total assets

 

$

808,243

 

$

74,871

 

$

883,114

 

 

 

 

Six months ended September 30, 2003

 

 

 

Publishing

 

Distribution

 

Total

 

 

 

 

 

 

 

 

 

Total segment revenues

 

$

186,201

 

$

90,047

 

$

276,248

 

Revenues from sales between segments

 

(14,204

)

14,204

 

 

 

 

 

 

 

 

 

 

Revenues from external customers

 

$

171,997

 

$

104,251

 

$

276,248

 

 

 

 

 

 

 

 

 

Operating income (loss)

 

$

(11,724

)

$

(63

)

$

(11,787

)

 

 

 

 

 

 

 

 

Total assets

 

$

682,804

 

$

80,252

 

$

763,056

 

 

14



 

 

 

 

Six months ended September 30, 2002

 

 

 

Publishing

 

Distribution

 

Total

 

 

 

 

 

 

 

 

 

Total segment revenues

 

$

280,243

 

$

80,187

 

$

360,430

 

Revenues from sales between segments

 

(25,189

)

25,189

 

 

 

 

 

 

 

 

 

 

Revenues from external customers

 

$

255,054

 

$

105,376

 

$

360,430

 

 

 

 

 

 

 

 

 

Operating income

 

$

41,733

 

$

797

 

$

42,530

 

 

 

 

 

 

 

 

 

Total assets

 

$

808,243

 

$

74,871

 

$

883,114

 

 

Geographic information for the three and six months ended September 30, 2003 and 2002 is based on the location of the selling entity.  Revenues from external customers by geographic region were as follows (amounts in thousands):

 

 

 

 

Three months ended September 30,

 

Six months ended September 30,

 

 

 

2003

 

2002

 

2003

 

2002

 

 

 

 

 

 

 

 

 

 

 

United States

 

$

46,450

 

$

93,298

 

$

129,189

 

$

200,402

 

Europe

 

66,292

 

72,540

 

139,033

 

152,532

 

Other

 

4,781

 

3,334

 

8,026

 

7,496

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

117,523

 

$

169,172

 

$

276,248

 

$

360,430

 

 

Revenues by platform were as follows (amounts in thousands):

 

 

 

 

Three months ended September 30,

 

Six months ended September 30,

 

 

 

2003

 

2002

 

2003

 

2002

 

 

 

 

 

 

 

 

 

 

 

Console

 

$

79,207

 

$

117,366

 

$

203,033

 

$

261,632

 

Hand-held

 

8,917

 

17,938

 

16,425

 

31,227

 

PC

 

29,399

 

33,868

 

$

56,790

 

67,571

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

117,523

 

$

169,172

 

$

276,248

 

$

360,430

 

 

As of and for the three and six months ended September 30, 2003, we had one customer that accounted for 18% and 17% of consolidated net revenues, respectively, and 38% of consolidated accounts receivable, net.    As of and for the three and six months ended September 30, 2002, we had one customer that accounted for 15% and 16%, respectively, of consolidated net revenues and 27% of consolidated accounts receivable, net.  This customer was the same customer in all periods and was a customer of both our publishing and distribution businesses.

 

15



 

12.        Computation of Earnings Per Share

 

The following table sets forth the computations of basic and diluted earnings (loss) per share (amounts in thousands, except per share data):

 

 

 

 

Three months ended
September 30,

 

Six months ended
September 30,

 

 

 

2003

 

2002

 

2003

 

2002

 

 

 

 

 

 

 

 

 

 

 

Numerator:

 

 

 

 

 

 

 

 

 

Numerator for basic and diluted earnings per share – income (loss) available to common shareholders

 

$

(10,093

)

$

9,086

 

$

(5,930

)

$

29,790

 

 

 

 

 

 

 

 

 

 

 

Denominator:

 

 

 

 

 

 

 

 

 

Denominator for basic earnings per share-  weighted average common shares  outstanding

 

88,162

 

100,172

 

88,105

 

94,587

 

 

 

 

 

 

 

 

 

 

 

Effect of dilutive securities:

 

 

 

 

 

 

 

 

 

Employee stock options and stock  purchase plan

 

 

8,177

 

 

8,912

 

Warrants to purchase common stock

 

 

382

 

 

417

 

 

 

 

 

 

 

 

 

 

 

Potential dilutive common shares

 

 

8,559

 

 

9,329

 

 

 

 

 

 

 

 

 

 

 

Denominator for diluted earnings per   share - weighted average common shares outstanding plus assumed conversions

 

88,162

 

108,731

 

88,105

 

103,916

 

 

 

 

 

 

 

 

 

 

 

Basic earnings (loss) per share

 

$

(0.11

)

$

0.09

 

$

(0.07

)

$

0.31

 

 

 

 

 

 

 

 

 

 

 

Diluted earnings (loss) per share

 

$

(0.11

)

$

0.08

 

$

(0.07

)

$

0.29

 

 

Options to purchase 13,458,548 shares of common stock at exercise prices ranging from $2.11 to $22.16 and options to purchase 13,486,923 shares of common stock at exercise prices ranging from $2.11 to $22.16 were outstanding for the three and six months ended September 30, 2003, respectively, but were not included in the calculation of diluted earnings (loss) per share because their effect would be antidilutive.

 

Options to purchase 3,232,835 shares of common stock at exercise prices ranging from $17.56 to $22.16 and options to purchase 240,882 shares of common stock at exercise prices ranging from $18.78 to $22.16 were outstanding for the three and six months ended September 30, 2002, respectively, but were not included in the calculation of diluted earnings (loss) per share because their effect would be antidilutive.

 

13.        Commitments and Contingencies

 

Credit Facilities

 

We have revolving credit facilities with our Centresoft subsidiary located in the United Kingdom (the “UK Facility”) and our NBG subsidiary located in Germany (the “German Facility”).  As of September 30, 2003, the UK Facility provided Centresoft with the ability to borrow up to Great British Pounds (“GBP”) 8.6 million ($14.3 million), including issuing letters of credit, on a revolving basis. Furthermore, as of September 30, 2003, under the UK Facility, Centresoft provided a GBP 0.6 million ($1.0 million) guarantee for the benefit of our CD Contact subsidiary.  The UK Facility bears interest at LIBOR plus 1.5%, is collateralized by substantially all of the assets of the subsidiary and expires in October 2004.  The UK Facility also contains various covenants that require the subsidiary to maintain specified financial ratios related to, among others, fixed charges.  As of

 

16



 

September 30, 2003, we were in compliance with these covenants.  No borrowings were outstanding against the UK Facility as of September 30, 2003.  The German Facility provided for revolving loans up to EUR 0.5 million ($0.6 million) as of September 30, 2003, bears interest at a Eurocurrency rate plus 2.5%, is collateralized by certain of the subsidiary’s property and equipment and has no expiration date.  No borrowings were outstanding against the German Facility as of September 30, 2003.

 

Developer and Intellectual Property Contracts

 

In the normal course of business, we enter into contractual arrangements with third parties for the development of products, as well as for the rights to intellectual property.  Under these agreements, we commit to provide specified payments to a developer or intellectual property holder based upon contractual arrangements.  Assuming all contractual provisions are met, the total future minimum contract commitment for contracts in place as of September 30, 2003 is approximately $124.3 million and is scheduled to be paid as follows (amounts in thousands):

 

 

Fiscal year ending March 31,

 

 

 

 

 

 

 

2004

 

$

58,163

 

2005

 

44,132

 

2006

 

13,111

 

2007

 

4,517

 

2008 and thereafter

 

4,376

 

 

 

 

 

Total

 

$

124,299

 

 

The commitment schedule above excludes approximately $9.3 million of commitments originally scheduled to be paid between fiscal 2004 through fiscal 2007 relating to an intellectual property rights agreement with a third party.  Effective June 30, 2003, we terminated the agreement and filed a breach of contract suit against the third party.

 

Legal and Regulatory Proceedings

 

We are party to routine claims and suits brought by us and against us in the ordinary course of business, including disputes arising over the ownership of intellectual property rights, contractual claims and collection matters.  In the opinion of management, the outcome of such routine claims will not have a material adverse effect on our business, financial condition, results of operations or liquidity.

 

On June 30, 2003, we terminated our Star Trek Merchandising License Agreement with Viacom Consumer Products, Inc. and filed a complaint for breach of contract and constructive trust against Viacom Consumer Products and Viacom International, Inc. (“Viacom”). On August 15, 2003, Viacom filed its response to our complaint as well as a cross-complaint alleging, among other matters, a breach of contract by Activision and seeking claimed damages in excess of $50 million. We strongly dispute the claims by Viacom, consider the damages alleged by Viacom to be speculative and without merit, and intend to defend vigorously and aggressively against the cross-complaint.

 

On July 11, 2003, we were informed by the staff of the SEC that the SEC has commenced a non-public formal investigation captioned “In the Matter of Certain Video Game Manufacturers and Distributors.” The investigation appears to be focused on certain accounting practices common to the interactive entertainment industry, with specific emphasis on revenue recognition.  In connection with this inquiry, the SEC submitted to us a request for information.  We responded to this inquiry on September 2, 2003.  The SEC staff also informed us that other companies in the video game industry received similar requests for information. The SEC has advised us that this request for information should not be construed as an indication from the SEC or its staff that any violation of the law has occurred, nor should it reflect negatively on any person, entity or security. We have cooperated and intend to continue to cooperate fully with the SEC in the conduct of this inquiry.

 

17



 

14.        Capital Transactions

 

During fiscal 2003, our Board of Directors authorized a buyback program under which we can repurchase up to $350.0 million of our common stock.  Under the program, shares may be purchased as determined by management and within certain guidelines, from time to time, in the open market or in privately negotiated transactions, including privately negotiated structured option transactions, and through transactions in the options markets.  Depending on market conditions and other factors, these purchases may be commenced or suspended at any time or from time to time without prior notice.

 

During the six months ended September 30, 2003, we repurchased approximately 1.2 million shares of our common stock for $11.3 million.  In addition, approximately 1.1 million shares of common stock were acquired in the six months ended September 30, 2003 as a result of the settlement of a structured stock repurchase transaction entered into in fiscal 2003.  As of September 30, 2003, we had outstanding structured stock repurchase transactions in the aggregate amount of approximately $36.4 million. These transactions may be settled in cash or stock based on the market price of our common stock on the date of the settlement. Upon settlement, we will either have our capital investment returned with a premium or receive up to approximately 4.1 million shares of our common stock, depending, respectively, on whether the market price of our common stock is above or below a pre-determined price agreed in connection with each such transaction.  These transactions are recorded in shareholders’ equity in the accompanying consolidated balance sheet as of September 30, 2003.  In any period, cash provided by or used in financing activities related to common stock repurchase transactions may differ from the comparable change in shareholders’ equity, reflecting timing differences between the recognition of share repurchase transactions and their settlement for cash.

 

15.        Related Parties

 

In August 2001, we elected to our Board of Directors an individual who is a partner in a law firm that has provided legal services to Activision for more than ten years.  For the three and six months ended September 30, 2003 and 2002, the fees we paid to the law firm account for less than 1% of the firm’s total revenues.  We believe that the fees charged to us by the law firm are competitive with the fees charged by other law firms.

 

16.        Subsequent Events

 

In the third quarter of fiscal 2004, we executed a realignment of our product portfolio driven by the evolution of the video game market, which is increasingly dominated by high quality products that are based on recognizable franchises and supported with big marketing programs.  We completed a comprehensive review of our product portfolio in which we evaluated each product based on a number of criteria, including:  the strength of the franchise, the projected product quality, the potential responsiveness of the product to aggressive marketing support and the financial risk in the event of product failure.  As a result of this review, we found that we have an extensive slate of high-potential properties in development.  However, we also found that certain projects had a lower likelihood of achieving acceptable levels of operating performance and that continued pursuit of these projects would create a substantial opportunity cost as it relates to our slate of high-potential projects.  Accordingly, in the three months ending December 31, 2003, we canceled the development of ten products which we believed were unlikely to produce an acceptable level of return on our investment.  In connection with the cancellation of these products, we will record a pre-tax charge of approximately $23 million, $15 million after-tax, in the quarter ending December 31, 2003.  The developer contractual commitments relating to those products will also be canceled.  The cancellation of those commitments will reduce the total future minimum contract commitments as of September 30, 2003, as detailed in Note 13 by  $6.0 million in fiscal 2004, $6.1 million in fiscal 2005 and $0.2 million in fiscal 2006.

 

In May 2002, we acquired a 30% interest in the outstanding capital stock of Infinity Ward, Inc. (“Infinity Ward”), a privately-held interactive software development company, as well as an option to purchase the remaining 70% of outstanding capital stock.  In October 2003, we exercised our option to acquire the remaining 70% of the outstanding capital stock of Infinity Ward.

 

Additionally, in the third quarter of fiscal 2004, our Activision Publishing business unit modified its operations, consolidating its worldwide studio and brand management operations under Kathy Vrabeck, who was promoted to President of this newly formed unit. Formerly, Ms. Vrabeck held the position of Executive Vice President, Global Publishing and Brand Management of Activision Publishing, Inc. Ms. Vrabeck will

 

18



 

continue to report to Ron Doornink, President of Activision, Inc.  Lawrence Goldberg, Executive Vice President, Worldwide Studios of Activision Publishing, Inc., will be exiting the company effective April 1, 2004.

 

19



 

 

Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

OVERVIEW

 

We are a leading international publisher of interactive entertainment software products.  We have built a company with a diverse portfolio of products that spans a wide range of categories and target markets and that is used on a variety of game hardware platforms and operating systems.  We have created, licensed and acquired a group of highly recognizable brands, which we market to a growing variety of consumer demographics.

 

Our products cover game categories such as action/adventure, action sports, racing, role-playing, simulation, first-person action and strategy.  We currently offer our products in versions that operate on the Sony PlayStation 2 (“PS2”), Sony PlayStation (“PS1”), Nintendo GameCube (“GameCube”) and Microsoft Xbox (“Xbox”) console systems, Nintendo Game Boy Advance (“GBA”) hand-held device and the personal computer (“PC”).  In prior years, we have also offered our products on the Nintendo 64 (“N64”) console system and Nintendo Game Boy Color (“GBC”) hand-held device.  Sony recently announced that it would be entering the hand-held hardware market with the introduction of its hand-held gaming device, PlayStation Portable (“PSP”).  PSP is currently expected to be released in the fourth quarter of calendar 2004.  We expect that we will develop titles for this new platform.

 

Our publishing business involves the development, marketing and sale of products, either directly, by license or through our affiliate label program with third-party publishers.  In the United States, we primarily sell our products on a direct basis to mass-market retailers, consumer electronics stores, discount warehouses and office super-stores.  We conduct our international publishing activities through offices in the United Kingdom (“UK”), Germany, France, Italy, Australia, Sweden, Canada and Japan.  Our products are sold internationally on a direct-to-retail basis, through third-party distribution and licensing arrangements and through our wholly-owned European distribution subsidiaries.  Our distribution business consists of operations located in the UK, the Netherlands and Germany that provide logistical and sales services to third-party publishers of interactive entertainment software, our own publishing operations and manufacturers of interactive entertainment hardware.

 

Our profitability is directly affected by the mix of revenues from our publishing and distribution businesses. Operating margins realized from our publishing business are substantially higher than margins realized from our distribution business.  Operating margins in our publishing business are affected by our ability to release highly successful or “hit” titles.  Though many of these titles have substantial production or acquisition costs and marketing budgets, once a title recoups these costs, incremental net revenues directly and positively impact our operating margin. Operating margins in our distribution business are affected by the mix of hardware and software sales, with software producing higher margins than hardware.

 

Our focus with respect to future game development will be on big, well-established brands that we believe we can build into successful game franchises such as our superheroes and action sports brands.  With regard to our superheroes brands, Spider-Man: The Movie was a key fiscal 2003 release and has continued to perform strongly into fiscal 2004.  We also have the rights to develop and publish the video games based on the sequel to the “Spider-Man” movie, which is expected to be theatrically released in the summer of 2004.  We have a long-term alliance with Marvel Enterprises through an exclusive, multi-year, licensing agreement that expires in 2009.  The agreement grants us the exclusive rights to develop and publish video games based on Marvel’s comic book franchises Spider-Man, X-MEN, Fantastic Four and Iron Man.  The agreement additionally provides us the rights to develop video games in conjunction with motion pictures and television series involving X-MEN, Fantastic Four and Iron Man.  Further, another of our key strategies is to continue to be a leader in the action sports category.  We will continue to promote our action sports franchises with the release of titles for franchises such as Tony Hawk’s Underground , which was recently released in the third quarter of fiscal 2004, and a new motocross title which will be released in the fourth quarter of fiscal 2004.  We will also continue to develop new intellectual properties, such as the titles True Crime: Streets of L.A. and Call of Duty , which were recently released in the third quarter of fiscal 2004 and which we hope to establish as successful franchise properties.

 

We will also continue to evaluate emerging brands that we believe have potential to become successful game franchises.  For example, we have an exclusive licensing agreement to develop and publish video games for the best-selling children’s book series, Lemony Snicket’s “A Series of Unfortunate Events” which is being

 

20



 

developed for a feature film by Paramount Pictures, Nickelodeon Movies and DreamWorks SKG.  We have a multi-year, multi-property, publishing agreement with DreamWorks SKG that grants us the exclusive rights to publish video games based on DreamWorks SKG’s upcoming computer-animated films, “A Shark Tale,” “Madagascar” and “Over the Hedge,” as well as their sequels.  We additionally have an agreement to license the rights to publish video games based on the upcoming movie “Shrek 2.”

 

In addition to acquiring or creating high profile intellectual property, we have also continued our focus on establishing and maintaining relationships with talented and experienced software development teams.  During fiscal 2003, we bolstered our internal development capabilities with the acquisitions of two privately-held interactive software development companies, Z-Axis and Luxoflux, as well as a 30% capital investment in a third, Infinity Ward.  In October 2003, we exercised our option to acquire the remaining 70% of the outstanding capital of Infinity Ward, the developer of our newly released PC title, Call of Duty . We also have development agreements with other top-level, third-party developers such as id Software, Valve L.L.C., Stainless Steel Studios, Inc., Spark Unlimited, Lionhead Studios and The Creative Assembly.

 

We are utilizing these developer relationships, new intellectual property acquisitions, and our existing library of intellectual property to further focus our game development on big, well-established brands that we believe have the potential to become franchise properties with sustainable consumer appeal and brand recognition.  We are also creating a select number of new intellectual properties that we believe have the potential to join this list of franchise properties.  Additionally, to maintain the competitiveness of our products and to take advantage of increasingly sophisticated technology associated with new hardware platforms, we have increased the amount of time spent play-testing new products, conducted more extensive product quality evaluations and lengthened product development schedules to allow time to make the improvements indicated by our testing and evaluations.  We are focused on improved game quality, and in many cases, this will result in an increase in future product development costs.

 

In the third quarter of fiscal 2004, we executed a realignment of our product portfolio driven by the evolution of the video game market, which is increasingly dominated by high quality products that are based on recognizable franchises and supported with big marketing programs.  We completed a comprehensive review of our product portfolio in which we evaluated each product based on a number of criteria, including:  the strength of the franchise, the projected product quality, the potential responsiveness of the product to aggressive marketing support and the financial risk in the event of product failure.  As a result of this review, we found that we have an extensive slate of high-potential properties in development.  However, we also found that certain projects had a lower likelihood of achieving acceptable levels of operating performance and that continued pursuit of these projects would create a substantial opportunity cost as it relates to our slate of high-potential projects. Accordingly, in the three months ending December 31, 2003, we canceled the development of ten products which we believed were unlikely to produce an acceptable level of return on our investment.  In connection with the cancellation of these products, we will record a pre-tax charge of approximately $23 million, $15 million after-tax, in the quarter ending December 31, 2003.  The developer contractual commitments relating to those products will also be canceled.  The cancellation of those commitments will reduce the total future minimum contract commitments as of September 30, 2003, as detailed below in “Commitments,” by $6.0 million in fiscal 2004, $6.1 million in fiscal 2005 and $0.2 million in fiscal 2006.

 

Critical Accounting Policies

 

We have identified the policies below as critical to our business operations and the understanding of our financial results.  The impact and any associated risks related to these policies on our business operations is discussed throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations where such policies affect our reported and expected financial results.  For a detailed discussion on the application of these and other accounting policies, see Note 1 to the Notes to the Consolidated Financial Statements included in Item 8 of our Annual Report on Form 10-K for the year ended March 31, 2003 as filed with the SEC.  The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates.

 

21



 

Revenue Recognition. We recognize revenue from the sale of our products upon the transfer of title and risk of loss to our customers.  Revenue from product sales is recognized after deducting the estimated allowance for returns and price protection.  We may permit product returns from, or grant price protection to, our customers on unsold merchandise under certain conditions.  Price protection, when granted and applicable, allows customers a credit against amounts they owe us with respect to merchandise unsold by them.  Typically, these credits are applied against future invoices.  With respect to license agreements that provide customers the right to make multiple copies in exchange for guaranteed amounts, revenue is recognized upon delivery of such copies. Per copy royalties on sales that exceed the guarantee are recognized as earned.  In addition, in order to recognize revenue for both product sales and licensing transactions, persuasive evidence of an arrangement must exist and collection of the related receivable must be probable.  Revenue recognition also determines the timing of certain expenses, including cost of sales – intellectual property licenses and cost of sales – software royalties and amortization.

 

Allowances for Returns, Price Protection, Doubtful Accounts and Inventory Obsolescence.  We may permit product returns from, or grant price protection to, our customers under certain conditions.  The conditions our customers must meet to be granted the right to return products or price protection are, among other things, compliance with applicable payment terms, delivery to us of weekly inventory and sell-through reports, and consistent participation in the launches of our premium title releases.  We may also consider other factors, including the facilitation of slow-moving inventory and other market factors. Management must make estimates of potential future product returns and price protection related to current period product revenue.  We estimate the amount of future returns and price protection based upon historical experience, customer inventory levels and changes in the demand and acceptance of our products by the end consumer.  Significant management judgments and estimates must be made and used in connection with establishing the allowance for returns and price protection in any accounting period.  Material differences may result in the amount and timing of our revenue for any period if management makes different judgments or utilizes different estimates.

 

Similarly, management must make estimates of the uncollectibility of our accounts receivable.  In estimating the allowance for doubtful accounts, we analyze the age of current outstanding account balances, historical bad debts, customer concentrations, customer credit worthiness, current economic trends and changes in our customers’ payment terms and their economic condition, as well as whether we can obtain sufficient credit insurance.  Any significant changes in any of these criteria would impact management’s estimates in establishing our allowance for doubtful accounts.

 

We value inventory at the lower of cost or market.  We regularly review inventory quantities on hand and in the retail channel and record a provision for excess or obsolete inventory based on the future expected demand for our products. Significant changes in demand for our products would impact management’s estimates in establishing our inventory provision.

 

Software Development Costs.  Software development costs include payments made to independent software developers under development agreements, as well as direct costs incurred for internally developed products.

 

We account for software development costs in accordance with SFAS No. 86, “Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed.”  Software development costs are capitalized once technological feasibility of a product is established and such costs are determined to be recoverable.  Technological feasibility of a product encompasses both technical design documentation and game design documentation.  For products where proven technology exists, this may occur early in the development cycle. Technological feasibility is evaluated on a product-by-product basis.  Prior to a product’s release, we expense, as part of cost of sales – software royalties and amortization, capitalized costs when we believe such amounts are not recoverable.  Capitalized costs for those products that are cancelled or abandoned are charged to product development expense in the period of cancellation.  Amounts related to software development which are not capitalized are charged immediately to product development expense.  We evaluate the future recoverability of capitalized amounts on a quarterly basis.  The recoverability of capitalized software development costs is evaluated based on the expected performance of the specific products for which the costs relate.   Criteria used to evaluate expected product performance include: historical performance of comparable products using comparable technology; orders for the product prior to its release; and estimated performance of a sequel product based on the performance of the product on which the sequel is based.

 

22



 

Commencing upon product release, capitalized software development costs are amortized to cost of sales — software royalties and amortization based on the ratio of current revenues to total projected revenues, generally resulting in an amortization period of six months or less.  For products that have been released in prior periods, we evaluate the future recoverability of capitalized amounts on a quarterly basis.  The primary evaluation criterion is actual title performance.

 

Significant management judgments and estimates are utilized in the assessment of when technological feasibility is established, as well as in the ongoing assessment of the recoverability of capitalized costs.

 

Intellectual Property Licenses.   Intellectual property license costs represent license fees paid to intellectual property rights holders for use of their trademarks or copyrights in the development of our products.  Depending upon the agreement with the rights holder, we may obtain the rights to use acquired intellectual property in multiple products over multiple years, or alternatively, for a single product.

 

We evaluate the future recoverability of capitalized intellectual property licenses on a quarterly basis.  The recoverability of capitalized intellectual property license costs is evaluated based on the expected performance of the specific products in which the licensed trademark or copyright is to be used.  As many of our intellectual property licenses extend for multiple products over multiple years, we also assess the recoverability of capitalized intellectual property license costs based on certain qualitative factors such as the success of other products and/or entertainment vehicles utilizing the intellectual property, whether there are any future planned theatrical releases or television series based on the intellectual property and the rights holder’s continued promotion and exploitation of the intellectual property.  Prior to the related product’s release, we expense, as part of cost of sales — intellectual property licenses, capitalized intellectual property costs when we believe such amounts are not recoverable.  Capitalized intellectual property costs for those products that are cancelled or abandoned are charged to product development expense in the period of cancellation.  Criteria used to evaluate expected product performance include: historical performance of comparable products using comparable technology; orders for the product prior to its release; and estimated performance of a sequel product based on the performance of the product on which the sequel is based.

 

Commencing upon the related product’s release, capitalized intellectual property license costs are amortized to cost of sales — intellectual property licenses based on the ratio of current revenues for the specific product to total projected revenues for all products in which the licensed trademark or copyright will be utilized.  As intellectual property license contracts may extend for multiple years, the amortization of capitalized intellectual property license costs relating to such contracts may extend beyond one year.  For intellectual property included in products that have been released, we evaluate the future recoverability of capitalized amounts on a quarterly basis.  The primary evaluation criterion is actual title performance.

 

Significant management judgments and estimates are utilized in the assessment of the recoverability of capitalized costs.

 

23



 

The following table sets forth certain consolidated statements of operations data for the periods indicated as a percentage of total net revenues and also breaks down net revenues by territory, business segment and platform, as well as operating income (loss) by business segment (amounts in thousands):

 

 

 

 

Three months ended September 30,

 

Six months ended September 30,

 

 

 

2003

 

2002

 

2003

 

2002

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

$

117,523

 

100

%

$

169,172

 

100

%

$

276,248

 

100

%

$

360,430

 

100

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Costs and expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cost of sales – product costs

 

72,391

 

61

 

80,779

 

48

 

149,001

 

54

 

164,123

 

46

 

Cost of sales – software royalties and amortization

 

11,397

 

10

 

18,055

 

10

 

26,895

 

10

 

33,893

 

9

 

Cost of sales – intellectual property licenses

 

7,401

 

6

 

5,143

 

3

 

17,544

 

6

 

17,786

 

5

 

Product development

 

15,894

 

13

 

13,259

 

8

 

29,474

 

10

 

25,010

 

7

 

Sales and marketing

 

17,237

 

15

 

28,776

 

17

 

43,522

 

16

 

50,769

 

14

 

General and administrative

 

10,136

 

9

 

11,826

 

7

 

21,599

 

8

 

26,319

 

7

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total costs and expenses

 

134,456

 

114

 

157,838

 

93

 

288,035

 

104

 

317,900

 

88

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating income (loss)

 

(16,933

)

(14

)

11,334

 

7

 

(11,787

)

(4

)

42,530

 

12

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Investment income, net

 

1,404

 

1

 

2,865

 

1

 

2,661

 

1

 

4,021

 

1

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Income (loss) before income tax  provision (benefit)

 

(15,529

)

(13

)

14,199

 

8

 

(9,126

)

(3

)

46,551

 

13

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Income tax provision (benefit)

 

(5,436

)

(4

)

5,113

 

3

 

(3,196

)

(1

)

16,761

 

5

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

(10,093

)

(9

)%

$

9,086

 

5

%

$

(5,930

)

(2

)%

$

29,790

 

8

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net Revenues by Territory:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

United States

 

$

46,450

 

40

%

$

93,298

 

55

%

$

129,189

 

47

%

$

200,402

 

56

%

Europe

 

66,292

 

56

 

72,540

 

43

 

139,033

 

50

 

152,532

 

42

 

Other

 

4,781

 

4

 

3,334

 

2

 

8,026

 

3

 

7,496

 

2

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total net revenues

 

$

117,523

 

100

%

$

169,172

 

100

%

$

276,248

 

100

%

$

360,430

 

100

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Segment/Platform Mix:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Publishing:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Console

 

$

46,019

 

64

%

$

83,766

 

66

%

$

134,503

 

72

%

$

197,926

 

71

%

Hand-held

 

4,187

 

6

 

14,797

 

12

 

8,783

 

5

 

25,487

 

9

 

PC

 

21,590

 

30

 

28,535

 

22

 

42,915

 

23

 

56,830

 

20

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total publishing net
revenues

 

71,796

 

61

 

127,098

 

75

 

186,201

 

67

 

280,243

 

78

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Distribution:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Console

 

33,188

 

73

 

33,600

 

80

 

68,530

 

76

 

63,706

 

80

 

Hand-held

 

4,730

 

10

 

3,141

 

7

 

7,642

 

9