Activision Blizzard, Inc.
ACTIVISION INC /NY (Form: 10-Q, Received: 11/05/2004 17:30:40)      

UNITED STATES
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, 2004

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
(State or other jurisdiction of
incorporation or organization)

95-4803544
(I.R.S. Employer Identification No.)

3100 Ocean Park Boulevard, Santa Monica, CA
(Address of principal executive offices)

90405
(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 for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  ý   No  o

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

The number of shares of the registrant's Common Stock outstanding as of November 1, 2004 was 139,149,612.


ACTIVISION, INC. AND SUBSIDIARIES

INDEX

 

 

 

PART I.

FINANCIAL INFORMATION

 

Item 1.

Financial Statements

 

 

Consolidated Balance Sheets as of September 30, 2004 (Unaudited) and March 31, 2004

3

 

Consolidated Statements of Operations for the three and six months ended September 30, 2004 and 2003 (Unaudited)

4

 

Consolidated Statements of Cash Flows for the six months ended September 30, 2004 and 2003 (Unaudited)

5

 

Consolidated Statement of Changes in Shareholders’ Equity for the six months ended September 30, 2004 (Unaudited)

6

 

Notes to Consolidated Financial Statements for the three and six months ended September 30, 2004 (Unaudited)

7

Item 2.

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

20

Item 3.

Quantitative and Qualitative Disclosures about Market Risk

44

Item 4.

Controls and Procedures

45

PART II.

OTHER INFORMATION

47

Item 1.

Legal Proceedings

47

Item 4.

Submission of Matters to a Vote of Security Holders

47

Item 6.

Exhibits

48

SIGNATURES

50

CERTIFICATIONS

 

 

 

2


 


 

Part I.  Financial Information .  

 

Item 1.  Financial Statements.  

ACTIVISION, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)

 

 

September 30,
2004

 

March 31,
2004

 

 

 

(Unaudited)

 

 

 

Assets

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

389,791

 

$

466,552

 

Short-term investments

 

216,296

 

121,097

 

Accounts receivable, net of allowances of $61,679 and $47,028 at September 30, 2004 and March 31, 2004, respectively

 

138,586

 

62,577

 

Inventories

 

63,690

 

26,427

 

Software development

 

79,432

 

58,320

 

Intellectual property licenses

 

15,945

 

32,115

 

Deferred income taxes

 

21,203

 

26,127

 

Other current assets

 

29,930

 

18,660

 

 

 

 

 

 

 

Total current assets

 

954,873

 

811,875

 

 

 

 

 

 

 

Software development

 

21,023

 

28,386

 

Intellectual property licenses

 

19,885

 

16,380

 

Property and equipment, net

 

24,712

 

25,539

 

Deferred income taxes

 

5,056

 

9,064

 

Other assets

 

1,018

 

1,080

 

Goodwill

 

77,602

 

76,493

 

 

 

 

 

 

 

Total assets

 

$

1,104,169

 

$

968,817

 

 

 

 

 

 

 

Liabilities and Shareholders’ Equity

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

103,001

 

$

72,874

 

Accrued expenses

 

113,341

 

63,205

 

 

 

 

 

 

 

Total current liabilities

 

216,342

 

136,079

 

 

 

 

 

 

 

Commitments and contingencies (Note 13)

 

 

 

 

 

 

 

 

 

 

 

Shareholders’ equity:

 

 

 

 

 

Preferred stock, $.000001 par value, 3,750,000 shares authorized, no shares issued at September 30, 2004 and March 31, 2004

 

 

 

Series A Junior Preferred stock, $.000001 par value, 1,250,000 shares authorized, no shares issued at September 30, 2004 and March 31, 2004

 

 

 

Common stock, $.000001 par value, 225,000,000 shares authorized, 168,443,592 and 166,876,567 shares issued and 138,898,268 and 137,331,242 shares outstanding at September 30, 2004 and March 31, 2004, respectively

 

 

 

Additional paid-in capital

 

777,337

 

758,626

 

Retained earnings

 

245,779

 

208,279

 

Less: Treasury stock, at cost, 29,545,325 and 29,545,325 shares at September 30, 2004 and March 31, 2004, respectively

 

(144,128

)

(144,128

)

Accumulated other comprehensive income

 

8,839

 

9,961

 

 

 

 

 

 

 

Total shareholders’ equity

 

887,827

 

832,738

 

 

 

 

 

 

 

Total liabilities and shareholders’ equity

 

$

1,104,169

 

$

968,817

 

 

 

 

 

 

 

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,

 

 

 

2004

 

2003

 

2004

 

2003

 

Net revenues

 

$

310,626

 

$

117,523

 

$

521,902

 

$

276,248

 

 

 

 

 

 

 

 

 

 

 

Costs and expenses:

 

 

 

 

 

 

 

 

 

Cost of sales — product costs

 

123,177

 

72,391

 

212,265

 

149,001

 

Cost of sales — software royalties and amortization

 

46,363

 

11,397

 

58,646

 

26,895

 

Cost of sales — intellectual property licenses

 

17,551

 

7,401

 

35,199

 

17,544

 

Product development

 

19,881

 

15,894

 

40,986

 

29,474

 

Sales and marketing

 

53,234

 

17,237

 

94,968

 

43,522

 

General and administrative

 

15,762

 

10,136

 

29,447

 

21,599

 

 

 

 

 

 

 

 

 

 

 

Total costs and expenses

 

275,968

 

134,456

 

471,511

 

288,035

 

 

 

 

 

 

 

 

 

 

 

Operating income (loss)

 

34,658

 

(16,933

)

50,391

 

(11,787

)

 

 

 

 

 

 

 

 

 

 

Investment income, net

 

2,645

 

1,404

 

4,757

 

2,661

 

 

 

 

 

 

 

 

 

 

 

Income (loss) before income tax provision (benefit)

 

37,303

 

(15,529

)

55,148

 

(9,126

)

 

 

 

 

 

 

 

 

 

 

Income tax provision (benefit)

 

11,760

 

(5,436

)

17,648

 

(3,196

)

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

25,543

 

$

(10,093

)

$

37,500

 

$

(5,930

)

 

 

 

 

 

 

 

 

 

 

Basic earnings (loss) per share

 

$

0.18

 

$

(0.08

)

$

0.27

 

$

(0.04

)

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding

 

138,505

 

132,243

 

138,137

 

132,158

 

 

 

 

 

 

 

 

 

 

 

Diluted earnings (loss) per share

 

$

0.17

 

$

(0.08

)

$

0.24

 

$

(0.04

)

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding assuming dilution

 

152,685

 

132,243

 

153,127

 

132,158

 

 

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,

 

 

 

2004

 

2003

 

Cash flows from operating activities:

 

 

 

 

 

Net income (loss)

 

$

37,500

 

$

(5,930

)

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

 

 

 

 

 

Deferred income taxes

 

8,932

 

(4,063

)

Realized gain on short term investments

 

(471

)

(16

)

Depreciation and amortization

 

5,132

 

4,905

 

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

 

65,246

 

32,364

 

Tax benefit of stock options and warrants exercised

 

4,918

 

958

 

Changes in operating assets and liabilities:

 

 

 

 

 

Accounts receivable

 

(76,009

)

(13,580

)

Inventories

 

(37,263

)

(1,586

)

Software development and intellectual property licenses

 

(66,330

)

(53,443

)

Other assets

 

(11,208

)

(9,430

)

Accounts payable

 

30,127

 

3,413

 

Accrued expenses and other liabilities

 

50,136

 

(5,681

)

Net cash provided by (used in) operating activities

 

10,710

 

(52,089

)

Cash flows from investing activities:

 

 

 

 

 

Capital expenditures

 

(4,443

)

(8,215

)

Purchases of short-term investments

 

(121,635

)

(77,311

)

Proceeds from sales and maturities of short-term investments

 

27,237

 

100,691

 

Net cash (used in) provided by investing activities

 

(98,841

)

15,165

 

Cash flows from financing activities:

 

 

 

 

 

Proceeds from issuance of common stock to employees

 

12,602

 

4,778

 

Other borrowings, net

 

-

 

(2,818

)

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

 

12,602

 

61,348

 

Effect of exchange rate changes on cash

 

(1,232

)

3,468

 

Net (decrease) increase in cash and cash equivalents

 

(76,761

)

27,892

 

Cash and cash equivalents at beginning of period

 

466,552

 

285,554

 

Cash and cash equivalents at end of period

 

$

389,791

 

$

313,446

 

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, 2004
(Unaudited)
(In thousands)

 

 

Common Stock

 

Additional Paid-In

 

Retained

 

Treasury Stock

 

Accumulated Other Comprehensive

 

Shareholders’

 

 

 

Shares

 

Amount

 

Capital

 

Earnings

 

Shares

 

Amount

 

Income (Loss)

 

Equity

 

Balance, March 31, 2004

 

166,877

 

$

 

$

758,626

 

$

208,279

 

(29,546

)

$

(144,128

)

$

9,961

 

$

832,738

 

Components of comprehensive income:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net Income

 

 

 

 

37,500

 

 

 

 

37,500

 

Unrealized gain on short-term investments

 

 

 

 

 

 

 

330

 

330

 

Foreign currency translation adjustment

 

 

 

 

 

 

 

(1,452

)

(1,452

)

Total comprehensive income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

36,378

 

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

 

1,485

 

 

12,602

 

 

 

 

 

12,602

 

Tax benefit attributable to employee stock options and common stock warrants

 

 

 

4,918

 

 

 

 

 

4,918

 

Issuance of stock to effect business combination

 

82

 

 

 

1,191

 

 

 

 

 

 

 

 

 

1,191

 

Balance, September 30, 2004

 

168,444

 

$

 

$

777,337

 

$

245,779

 

(29,546

)

$

(144,128

)

$

8,839

 

$

887,827

 

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, 2004

 

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 consists of only normal recurring adjustments that, in the opinion of management, are necessary to provide a fair statement of the results for the interim periods presented.  Certain prior period amounts have been reclassified to conform with the current period presentation.  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, 2004 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 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.

 

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.  In evaluating the recoverability of capitalized costs, the assessment of expected product performance utilizes forecasted sales amounts and estimates of additional development costs to be incurred.  If revised forecasted or actual product sales are less than and/or revised forecasted or actual costs are greater than the original forecasted amounts utilized in the initial recoverability analysis, the actual impairment charge may be larger than originally estimated in any given quarter.

 

Intellectual property license costs represent license fees paid to intellectual property rights holders for use of their trademarks, copyrights, software, technology or other intellectual property or proprietary rights 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

 

7



 

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 property 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.  In evaluating the recoverability of capitalized costs, the assessment of expected product performance utilizes forecasted sales amounts and estimates of additional development costs to be incurred.  If revised forecasted or actual product sales are less than, and/or revised forecasted or actual costs are greater than, the original forecasted amounts utilized in the initial recoverability analysis, the actual impairment charge may be larger than originally estimated in any given quarter.  Additionally, as noted above, 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.  Material differences may result in the amount and timing of charges for any period if management makes different judgments or utilizes different estimates in evaluating these qualitative factors.

Revenue Recognition

We recognize revenue from the sale of our products upon the transfer of title and risk of loss to our customers.  Certain products are sold to customers with a street date (the date that products are made widely available by retailers).  For these products we recognize revenue on the street date.  Revenue from product sales is recognized after deducting the estimated allowance for returns and price protection.  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.

 

Sales incentives or other consideration given by us to our customers is accounted for in accordance with the Financial Accounting Standards Board’s 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.

 

8



 

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, 2004, we had several stock-based employee compensation plans, which are described more fully in Note 15 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, 2004 filed with the SEC. We account for those plans under the recognition and measurement principles of APB Opinion No. 25 and related Interpretations.  The following table illustrates the effect on net income and earnings per share if we had applied the fair value 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,

 

 

 

2004

 

2003

 

2004

 

2003

 

Net income (loss), as reported

 

$

25,543

 

$

(10,093

)

$

37,500

 

$

(5,930

)

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

 

(3,559

)

(4,205

)

(8,498

)

(9,740

)

Pro forma net income (loss)

 

$

21,984

 

$

(14,298

)

$

29,002

 

$

(15,670

)

 

 

 

 

 

 

 

 

 

 

Earnings (loss) per share:

 

 

 

 

 

 

 

 

 

Basic — as reported

 

$

0.18

 

$

(0.08

)

$

0.27

 

$

(0.04

)

Basic — pro forma

 

$

0.16

 

$

(0.11

)

$

0.21

 

$

(0.12

)

 

 

 

 

 

 

 

 

 

 

Diluted — as reported

 

$

0.17

 

$

(0.08

)

$

0.24

 

$

(0.04

)

Diluted — pro forma

 

$

0. 14

 

$

(0. 11

)

$

0.19

 

$

(0.12

)

 

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.  For options granted during the three months ended September 30, 2004 and 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 45% and 52%, respectively.  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.

 

9



 

2.     Stock Split

 

In February 2004, 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 March 15, 2004 to shareholders of record as of February 23, 2004.  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.  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, 2004 (amounts in thousands):

 

 

 

Amortized
Cost

 

Gross
Unrealized
Gains

 

Gross
Unrealized
Losses

 

Fair
Value

 

Cash and cash equivalents:

 

 

 

 

 

 

 

 

 

Cash and time deposits

 

$

135,668

 

$

 

$

 

$

135,668

 

Money market instruments

 

131,023

 

 

 

131,023

 

Auction rate notes

 

123,100

 

 

 

123,100

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

389,791

 

 

 

389,791

 

 

 

 

 

 

 

 

 

 

 

Short-term investments:

 

 

 

 

 

 

 

 

 

Corporate bonds

 

26,174

 

 

(86

)

26,088

 

Taxable senior debt

 

27,042

 

1

 

 

27,043

 

U.S. agency issues

 

148,768

 

2

 

(699

)

148,071

 

Asset-backed securities

 

12,714

 

14

 

(59

)

12,669

 

Common stock

 

167

 

1,254

 

 

1,421

 

Municipal bonds

 

1,004

 

 

 

1,004

 

 

 

 

 

 

 

 

 

 

 

Short-term investments

 

215,869

 

1,271

 

(844

)

216,296

 

 

 

 

 

 

 

 

 

 

 

Cash, cash equivalents and short-term investments

 

$

605,660

 

$

1,271

 

$

(844

)

$

606,087

 

The following table summarizes the maturities of our investments in debt securities as of September 30, 2004 (amounts in thousands):

 

 

 

Amortized
Cost

 

Fair
Value

 

Due in one year or less

 

$

273,000

 

$

272,511

 

Due after one year through two years

 

53,088

 

52,795

 

 

 

326,088

 

325,306

 

Asset-backed securities

 

12,714

 

12,669

 

Total

 

$

338,802

 

$

337,975

 

 

10



For the three months and six months ended September 30, 2004, net realized gains on short-term investments consisted of $471,000 of gross realized gains and no gross realized losses.  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.

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, 2004

 

March 31, 2004

 

Purchased parts and components

 

$

3,686

 

$

392

 

Finished goods

 

60,004

 

26,035

 

 

 

 

 

 

 

 

 

$

63,690

 

$

26,427

 

5.     Goodwill and Other Intangible Assets

The changes in the carrying amount of goodwill for the six months ended September 30, 2004 are as follows (amounts in thousands):

 

 

 

Publishing

 

Distribution

 

Total

 

Balance as of March 31, 2004

 

$

70,898

 

$

5,595

 

$

76,493

 

Adjustment to original purchase allocation

 

1,191

 

 

1,191

 

Effect of foreign currency exchange rates

 

 

(82

)

(82

)

Balance as of September 30, 2004

 

$

72,089

 

$

5,513

 

$

77,602

 

 

6.     Income Taxes

 

The income tax provision of $11.8 million and $17.6 million for the three and six months ended September 30, 2004, respectively, reflects our effective income tax rate of 32%.  The significant items that generated the variance between our effective rate and our statutory rate of 35% were research and development tax credits and the impact of foreign tax rate differentials, partially offset by state taxes.  The income tax benefit of $5.4 million and $3.2 million for the three and six months ended September 30, 2003, respectively, reflects our effective income tax rate of approximately 35%.  State taxes, offset by research and development tax credits and the impact of foreign tax rate differentials, resulted in an effective income tax rate equal to our statutory rate of 35% for the three and six months ended September 30, 2003.

7.     Software Development Costs and Intellectual Property Licenses

 

As of September 30, 2004, capitalized software development costs included $40.1 million of internally developed software costs and $60.3 million of payments made to third-party software developers.  As of March 31, 2004, capitalized software development costs included $35.3 million of internally developed software costs and $51.5 million of payments made to third-party software developers.  Capitalized intellectual property licenses were $35.8 million and $48.5 million as of September 30, 2004 and March 31, 2004, respectively.  Amortization of capitalized software development costs and intellectual property licenses were $65.2 million and $32.4 million for the six months ended September 30, 2004 and 2003, 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, 2004 and 2003 were as follows (amounts in thousands):

 

 

Three months ended September 30,

 

Six months ended September 30,

 

 

 

2004

 

2003

 

2004

 

2003

 

Net income (loss)

 

$

25,543

 

$

(10,093

)

$

37,500

 

$

(5,930

)

 

 

 

 

 

 

 

 

 

 

Other comprehensive income:

 

 

 

 

 

 

 

 

 

Foreign currency translation adjustment

 

(92

)

896

 

(1,452

)

4,621

 

Unrealized appreciation (depreciation) on short-term investments

 

1,547

 

10

 

330

 

(14

)

 

 

 

 

 

 

 

 

 

 

Other comprehensive income

 

1,455

 

906

 

(1,122

)

4,607

 

 

 

 

 

 

 

 

 

 

 

Comprehensive income (loss)

 

$

26,998

 

$

(9,187

)

$

36,378

 

$

(1,323

)

   

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, 2004

 

$

9,864

 

$

97

 

$

9,961

 

Other comprehensive income (loss)

 

(1,452

)

330

 

(1,122

)

 

 

 

 

 

 

 

 

Balance, September 30, 2004

 

$

8,412

 

$

427

 

$

8,839

 

 

The income taxes related to unrealized appreciation (depreciation) on investments were not significant. 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,

 

 

 

2004

 

2003

 

2004

 

2003

 

Interest expense

 

$

(58

)

$

(88

)

$

(146

)

$

(283

)

Interest income

 

2,232

 

1,472

 

4,432

 

2,928

 

Net realized gain on investments

 

471

 

20

 

471

 

16

 

Investment income, net

 

$

2,645

 

$

1,404

 

$

4,757

 

$

2,661

 

 

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,

 

 

 

2004

 

2003

 

Non-cash investing and financing activities:

 

 

 

 

 

Issuance of stock to effect business combination

 

$

1,191

 

-

 

Change in unrealized (appreciation)/ depreciation on short-term investments

 

(330

)

14

 

 

 

 

 

 

 

Supplemental cash flow information:

 

 

 

 

 

Cash paid for income taxes

 

$

5,018

 

$

4,457

 

Cash paid (received) for interest, net

 

(4,231

)

(2,844

)

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 certain 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 game specialty stores.  We conduct our international publishing activities through offices in the United Kingdom, Germany, France, Italy, Spain, Australia, Sweden, Canada and Japan.  Our products are sold internationally on a direct-to-retail basis and through third-party distribution and licensing arrangements and through our wholly-owned distribution subsidiaries.

Distribution refers to our operations 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, 2004.  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, 2004 and 2003 is as follows (amounts in thousands):

 

 

 

Three months ended September 30, 2004

 

 

 

Publishing

 

Distribution

 

Total

 

Total segment revenues

 

$

266,395

 

$

44,231

 

$

310,626

 

Revenues from sales between segments

 

(32,454

)

32,454

 

-

 

Revenues from external customers

 

$

233,941

 

$

76,685

 

$

310,626

 

Operating income

 

$

31,609

 

$

3,049

 

$

34,658

 

Total assets

 

$

986,966

 

$

117,203

 

$

1,104,169

 

 

 

 

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

 

 

 

 

Six months ended September 30, 2004

 

 

 

Publishing

 

Distribution

 

Total

 

Total segment revenues

 

$

428,047

 

$

93,855

 

$

521,902

 

Revenues from sales between segments

 

(40,778

)

40,778

 

-

 

Revenues from external customers

 

$

387,269

 

$

134,633

 

$

521,902

 

Operating income

 

$

47,503

 

$

2,888

 

$

50,391

 

Total assets

 

$

986,966

 

$

117,203

 

$

1,104,169

 

 

14



 

 

 

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

 

Geographic information for the three and six months ended September 30, 2004 and 2003 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,

 

 

 

2004

 

2003

 

2004

 

2003

 

United States

 

$

157,705

 

$

46,450

 

$

282,896

 

$

129,189

 

Europe

 

141,019

 

66,292

 

219,120

 

139,033

 

Other

 

11,902

 

4,781

 

19,886

 

8,026

 

Total

 

$

310,626

 

$

117,523

 

$

521,902

 

$

276,248

 

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

 

 

 

Three months ended September 30,

 

Six months ended September 30,

 

 

 

2004

 

2003

 

2004

 

2003

 

Console

 

$

175,471

 

$

79,207

 

$

333,792

 

$

203,033

 

Hand-held

 

27,225

 

8,917

 

49,310

 

16,425

 

PC

 

107,930

 

29,399

 

$

138,800

 

$

56,790

 

Total

 

$

310,626

 

$

117,523

 

$

521,902

 

$

276,248

 

As of and for the three and six months ended September 30, 2004, we had one customer that accounted for 19% and 22% of consolidated net revenues, respectively, and 27% of consolidated accounts receivable, net at September 30, 2004.    As of and for the three and six months ended September 30, 2003, we had one customer that accounted for 18% and 17%, respectively, of consolidated net revenues and 38% of consolidated accounts receivable, net at September 30, 2003.  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,

 

 

 

2004

 

2003

 

2004

 

2003

 

Numerator:

 

 

 

 

 

 

 

 

 

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

 

$

25,543

 

$

(10,093

)

$

37,500

 

$

(5,930

)

 

 

 

 

 

 

 

 

 

 

Denominator:

 

 

 

 

 

 

 

 

 

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

 

138,505

 

132,243

 

138,137

 

132,158

 

 

 

 

 

 

 

 

 

 

 

Effect of dilutive securities:

 

 

 

 

 

 

 

 

 

Employee stock options and stock purchase plan

 

13,559

 

-

 

14,327

 

-

 

Warrants to purchase common stock

 

621

 

-

 

663

 

-

 

Potential dilutive common shares

 

14,180

 

-

 

14,990

 

-

 

 

 

 

 

 

 

 

 

 

 

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

 

152,685

 

132,243

 

153,127

 

132,158

 

 

 

 

 

 

 

 

 

 

 

Basic earnings (loss) per share

 

$

0.18

 

$

(0.08

)

$

0.27

 

$

(0.04

)

Diluted earnings (loss) per share

 

$

0.17

 

$

(0.08

)

$

0.24

 

$

(0.04

)

Options to purchase 2,050,357 shares of common stock at exercise prices ranging from $13.47 to $16.66 and options to purchase 1,462,784 shares of common stock at exercise prices ranging from $13.47 to $16.66 were outstanding for the three and six months ended September 30, 2004, respectively, but were not included in the calculation of diluted earnings per share because their effect would be antidilutive.

Options to purchase 20,187,822 shares of common stock at exercise prices ranging from $1.41 to $14.77 and options to purchase 20,230,385 shares of common stock at exercise prices ranging from $1.41 to $14.77 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.

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”).  The UK Facility provides Centresoft with the ability to borrow up to Great Britain Pounds (“GBP”) 8.0 million ($14.3 million), including issuing letters of credit, on a revolving basis as of September 30, 2004. In addition, under the UK Facility, Centresoft provided a GBP 0.6 million ($1.1 million) guarantee for the benefit of our CD Contact subsidiary as of September 30, 2004.  The UK Facility bore interest at LIBOR plus 2.0% as of September 30, 2004, is collateralized by substantially all of the assets of the subsidiary and expires in November 2005.  The UK Facility also contains various covenants that require the subsidiary to maintain specified financial ratios related

16



to, among other things, fixed charges.  As of September 30, 2004, we were in compliance with these covenants.  No borrowings were outstanding against the UK Facility as of September 30, 2004.  The German Facility provided for revolving loans up to EUR 0.5 million ($0.6 million) as of September 30, 2004, bore 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 under the German Facility as of September 30, 2004. 

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, 2004 is approximately $70.4 million and is scheduled to be paid as follows (amounts in thousands):

 

Fiscal year ending March 31,

 

 

 

2005

 

$

35,750

 

2006

 

21,451

 

2007

 

8,475

 

2008

 

1,775

 

2009 and thereafter

 

2,900

 

Total

 

$

70,351

 

The commitment schedule above excludes approximately $9.3 million of commitments originally scheduled to be paid from 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.

Marketing Commitments

In connection with certain intellectual property right acquisitions and development agreements, we will commit to spend specified amounts for marketing support for the related game(s) which is to be developed or in which the intellectual property will be utilized.  Assuming all contractual provisions are met, the total future minimum marketing commitment for contracts in place as of September 30, 2004 is approximately $41.4 million, which is scheduled to be paid as follows (amounts in thousands):

 

Fiscal Year ending March 31,

 

 

 

2005

 

$

14,872

 

2006

 

11,500

 

2007

 

10,000

 

2008

 

5,000

 

Total

 

$

41,372

 

17



 

Lease Obligations

We lease certain of our facilities under non-cancelable operating lease agreements.  Total future minimum lease commitments as of September 30, 2004 are as follows (amounts in thousands):

 

Fiscal Year ending March 31,

 

 

 

2005

 

$

4,930

 

2006

 

9,058

 

2007

 

8,175

 

2008

 

5,341

 

2009

 

4,476

 

Thereafter

 

18,914

 

Total

 

$

50,894

 

Legal and Regulatory Proceedings

On March 5, 2004, a class action lawsuit was filed against us and certain of our current and former officers and directors.  The complaint, which asserts claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 based on allegations that our revenues and assets were overstated during the period between February 1, 2001 and December 17, 2002, was filed in the United States District Court, Central District of California by the Construction Industry and Carpenters Joint Pension Trust for Southern Nevada purporting to represent a class of purchasers of Activision stock.  Five additional purported class actions have subsequently been filed by Gianni Angeloni, Christopher Hinton, Stephen Anish, the Alaska Electrical Pension Fund, and Joseph A. Romans asserting similar claims.  Five of the six actions have been transferred to the same court where the first-filed complaint was pending.  In addition, on March 12, 2004, a shareholder derivative lawsuit was filed which asserts the same claims set forth in the federal class action lawsuit.  That complaint was filed in Superior Court for the County of Los Angeles.  We strongly deny these allegations and will vigorously defend these cases.

On July 11, 2003, we were informed by the staff of the Securities and Exchange Commission that the Securities and Exchange Commission 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 Securities and Exchange Commission submitted to us a request for information.  We responded to this inquiry on September 2, 2003.  To date, we have not received a request from the Securities and Exchange Commission for any additional information.  The Securities and Exchange Commission staff also informed us that other companies in the video game industry received similar requests for information. The Securities and Exchange Commission has advised us that this request for information should not be construed as an indication from the Securities and Exchange Commission 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 Securities and Exchange Commission in the conduct of this inquiry.

On June 30, 2003, we terminated our Star Trek Merchandising License Agreement with Viacom Consumer Products, Inc. and filed a complaint in the Superior Court of the State of California 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.

18



In addition, we are party to other 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, after consultation with legal counsel, the outcome of such routine claims will not have a material adverse effect on our business, financial condition, results of operations or liquidity.

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 of which $123.5 million has been repurchased to date. 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 three months ended September 30, 2004, we did not repurchase any of our common stock or enter into any structured stock repurchase transactions.  As of September 30, 2004, we had no outstanding structured stock repurchase transactions.

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, 2004 and 2003, the fees we paid to the law firm were an insignificant portion 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.

19



 

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

Overview

Our Business

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 variety of consumer demographics.

Our products cover game categories such as action/adventure, action sports, racing, role-playing, simulation, first-person action and strategy.  Our target customer base ranges from game enthusiasts and children to mass-market consumers and “value” buyers.  We currently offer our products primarily in versions that operate on the Sony PlayStation 2 (“PS2”), Nintendo GameCube (“GameCube”) and Microsoft Xbox (“Xbox”) console systems, Nintendo Game Boy Advance (“GBA”) hand-held device and the personal computer (“PC”).  The installed base for this current-generation of hardware platforms is significant and growing.  We believe recent price cuts in calendar 2004 on the Xbox, PS2, GameCube, and GBA hardware and a redesign of the PS2 should continue to drive the growth of the installed base of the current-generation platforms.   In addition, Sony has announced that it would be entering the hand-held hardware market with the introduction of its hand-held gaming device, PlayStation Portable (“PSP”).  We are currently developing titles based on the Spider-Man and Tony Hawk franchises for the PSP with the objective of having both ready for release at the launch of the PSP.   Nintendo has also announced that it plans to launch a new dual-screened, portable game system, Nintendo Dual Screen (“NDS”), before the end of calendar 2004.  For the launch of the NDS, we will release Spider-Man 2 with other titles to follow.   We are developing titles for the next-generation console systems being developed by Sony, Microsoft and Nintendo for release within the next one to two years.  Though there are still many unknowns relating to these new platforms, our aim is to have a meaningful launch presence for all new hardware systems with a goal of gaining market share on each platform while continuing to exploit our products on the current-generation platforms given their large and growing installed base.

Our publishing business involves the development, marketing and sale of products directly by us, by license or through our affiliate label program with certain 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 game specialty stores.  We conduct our international publishing activities through offices in the United Kingdom (“UK”), Germany, France, Italy, Spain, 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, we will continue to focus on our “big proposition” titles that are backed by strong brands and high quality development, for which we will provide significant marketing support.

 

A number of our fiscal 2005 “big proposition” titles include well-established brands, which are backed by high profile intellectual property and/or highly anticipated motion picture releases.  Examples of these brands are our superheroes and skateboarding brands.  We have a long-term relationship with Marvel Enterprises through an exclusive licensing agreement that expires in 2009.  This agreement grants us the

 

20



 

exclusive rights to develop and publish video games based on Marvel’s comic book franchises Spider-Man, X-Men, Fantastic Four and Iron Man. Through our long-term relationship with Spider-Man Merchandising, LLP, in the first quarter of fiscal 2005 we released the video game Spider-Man 2 , the sequel to the highly successful Spider-Man: The Movie . The video game release of Spider-Man 2 coincided with the “Spider-Man 2” theatrical release in June 2004. Also, under our licensing agreement with Spider-Man Merchandising, LLP, we will be developing and publishing video games based on Columbia Pictures/Marvel Enterprises, Inc.’s upcoming feature film “Spider-Man 3,” which is expected to be released in May 2007.  We also have an exclusive licensing agreement with professional skateboarder Tony Hawk that continues until 2015. The agreement grants us exclusive rights to develop and publish video games using Tony Hawk’s name and his likeness. Through fiscal 2005, we released five successful titles in the Tony Hawk franchise with cumulative net revenues of over $820 million, including the most recent, Tony Hawk’s Underground , which was released in the third quarter of fiscal 2004. We have continued to promote our skateboarding franchise with the release of Tony Hawk’s Underground 2 in early October 2004.

 

We also continue to develop original intellectual properties such as True Crime: Streets of L.A. and Call of Duty , which were released in the third quarter of fiscal 2004.  These highly successful titles were both ranked by third-party sales tracking agencies, such as NPD, as among the top-five selling games for the 2003 holiday season.  We expect to develop a variety of games on multiple platforms based on these two original properties and hope to establish them as a source of recurring revenues.  In the third quarter of fiscal 2005, we are scheduled to release Call of Duty:  Finest Hour, which will be released on multiple console platforms.

 

We will also continue to evaluate and exploit emerging brands that we believe have potential to become successful game franchises.  For example, 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 theatrical release “Shrek 2,” which was released in the first quarter of fiscal 2005, “Shark Tale”, which was released in the second quarter of fiscal 2005, as well as upcoming computer-animated films, “Madagascar” and “Over the Hedge,” and their sequels.  We also 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 developed as a feature film by Paramount Pictures, Nickelodeon Movies and DreamWorks SKG and will be released in the third quarter of the current fiscal year.

 

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.  We have strengthened our internal development capabilities through the acquisition in prior fiscal years of a number of development companies with talented and experienced teams.  We have development agreements with other top-level, third-party developers such as id Software, Spark Unlimited, Lionhead Studios and The Creative Assembly.

 

We are utilizing these developer relationships, new intellectual property acquisitions, new original intellectual property creations and our existing library of intellectual property to further focus our game development on product lines that will deliver significant, lasting and recurring revenues and operating profits.

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, 2004 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.

 

Revenue Recognition.  We recognize revenue from the sale of our products upon the transfer of title and risk of loss to our customers.  Certain products are sold to customers with a street date (the date that products are

 

21



 

made widely available for sale by retailers).  For these products we recognize revenue on the street date.  Revenue from product sales is recognized after deducting the estimated allowance for returns and price protection.  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.  In determining the appropriate unit shipments to our customers, we benchmark our titles using historical and industry data.  We closely monitor and analyze the historical performance of our various titles, the performance of products released by other publishers and the anticipated timing of other releases in order to assess future demands of current and upcoming titles.  Initial volumes shipped upon title launch and subsequent reorders are evaluated to ensure that quantities are sufficient to meet the demands from the retail markets but at the same time, are controlled to prevent excess inventory in the channel.

 

We may permit product returns from, or grant price protection to, our customers under certain conditions.  In general, price protection refers to the circumstances when we elect to decrease the wholesale price of a product by a certain amount and, when granted and applicable, allows customers a credit against amounts owed by such customers to Activision with respect to open and/or future invoices.  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 for current period product revenue utilizing historical experience and information regarding inventory levels and the demand and acceptance of our products by the end consumer.  The following factors are used to estimate the amount of future returns and price protection for a particular title:  historical performance of titles in similar genres, historical performance of the hardware platform, historical performance of the brand, console hardware life cycle, Activision sales force and retail customer feedback, industry pricing, weeks of on-hand retail channel inventory, absolute quantity of on-hand retail channel inventory, Activision warehouse on-hand inventory levels, the title’s recent sell-through history (if available), marketing trade programs and competing titles.  The relative importance of these factors varies among titles depending upon, among other items, genre, platform, seasonality and sales strategy.  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.  Based upon historical experience we believe our estimates are reasonable.  However, actual returns and price protection could vary materially from our allowance estimates due to a number of reasons including, among others, a lack of consumer acceptance of a title, the release in the same period of a similarly themed title by a competitor, or technological obsolescence due to the emergence of new hardware platforms.  Material differences may result in the amount and timing of our revenue for any period if management makes different judgments or utilizes different estimates in determining the allowances for returns and price protection.

 

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 creditworthiness, 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.

 

22



 

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 Statement of Financial Accounting Standard (“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.

 

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.  In evaluating the recoverability of capitalized costs, the assessment of expected product performance utilizes forecasted sales amounts and estimates of additional development costs to be incurred.  If revised forecasted or actual product sales are less than and/or revised forecasted or actual costs are greater than the original forecasted amounts utilized in the initial recoverability analysis, the actual impairment charge may be larger than originally estimated in any given quarter.  Based upon historical experience we believe our estimates are reasonable.

 

Intellectual Property Licenses.   Intellectual property license costs represent license fees paid to intellectual property rights holders for use of their trademarks, copyrights, software, technology or other intellectual property or proprietary rights 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.

 

23



 

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 property 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 and unreleased products, 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.  In evaluating the recoverability of capitalized costs, the assessment of expected product performance utilizes forecasted sales amounts and estimates of additional development costs to be incurred.  If revised forecasted or actual product sales are less than and/or revised forecasted or actual costs are greater than the original forecasted amounts utilized in the initial recoverability analysis, the actual impairment charge may be larger than originally estimated in any given quarter.  Additionally, as noted above, 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.  Material differences may result in the amount and timing of charges for any period if management makes different judgments or utilizes different estimates in evaluating these qualitative factors.  Based upon historical experience we believe our estimates are reasonable.

 

24



 

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,

 

 

 

2004

 

2003

 

2004

 

2003

 

Net revenues

 

$

310,626

 

100

%

$

117,523

 

100

%

$

521,902

 

100

%

$

276,248

 

100

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Costs and expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cost of sales — product costs

 

123,177

 

40

 

72,391

 

61

 

212,265

 

41

 

149,001

 

54

 

Cost of sales — software royalties and amortization

 

46,363

 

15

 

11,397

 

10

 

58,646

 

11

 

26,895

 

10

 

Cost of sales — intellectual property licenses

 

17,551

 

6

 

7,401

 

6

 

35,199

 

7

 

17,544

 

6

 

Product development

 

19,881

 

6

 

15,894

 

13

 

40,986

 

8

 

29,474

 

10

 

Sales and marketing

 

53,234

 

17

 

17,237

 

15

 

94,968

 

18

 

43,522

 

16

 

General and administrative

 

15,762

 

5

 

10,136

 

9

 

29,447

 

5

 

21,599

 

8

 

Total costs and expenses

 

275,968

 

89

 

134,456

 

114

 

471,511

 

90

 

288,035

 

104

 

Operating income (loss)

 

34,658

 

11

 

(16,933

)

(14

)

50,391

 

10

 

(11,787

)

(4

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Investment income, net

 

2,645

 

1

 

1,404

 

1

 

4,757

 

1

 

2,661

 

1

 

Income (loss) before income tax provision (benefit)

 

37,303

 

12

 

(15,529

)

(13

)

55,148

 

11

 

(9,126

)

(3

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Income tax provision (benefit)

 

11,760

 

4

 

(5,436

)

(4

)

17,648

 

4

 

(3,196

)

(1

)

Net income (loss)

 

$

25,543

 

8

%

$

(10,093

)

(9)

%

$

37,500

 

7

%

$

(5,930

)

(2)

%

Net Revenues by Territory:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

United States

 

$

157,705

 

51

%

$

46,450

 

40

%

$

282,896

 

54

%

$

129,189

 

47

%

Europe

 

141,019

 

45

 

66,292

 

56

 

219,120

 

42

 

139,033

 

50

 

Other

 

11,902

 

4

 

4,781

 

4

 

19,886

 

4

 

8,026

 

3

 

Total net revenues

 

$

310,626

 

100

%

$

117,523

 

100

%

$

521,902

 

100

%

$

276,248

 

100

%

Net Revenues by Segment/Platform Mix Publishing:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Console

 

$

145,542

 

47

%

$

46,019

 

39

%

$

264,669

 

51

%

$

134,503

 

49

%

Hand-held

 

23,669

 

8

 

4,187

 

4

 

42,099

 

8

 

8,783

 

3

 

PC

 

97,184

 

31

 

21,590

 

18

 

121,279

 

23

 

42,915

 

15

 

Total publishing net revenues

 

266,395

 

86

 

71,796

 

61

 

428,047

 

82

 

186,201

 

67

 

Distribution:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Console

 

29,929

 

10

 

33,188

 

28

 

69,123

 

13

 

68,530

 

25

 

Hand-held

 

3,556

 

1

 

4,730

 

4

 

7,211

 

1

 

7,642

 

3

 

PC

 

10,746

 

3

 

7,809

 

7

 

17,521

 

4

 

13,875

 

5

 

Total distribution net revenues

 

44,231

 

14

 

45,727

 

39

 

93,855

 

18

 

90,047

 

33

 

Total net revenues

 

$

310,626

 

100

%

$

117,523

 

100

%

$

521,902

 

100

%

$

276,248

 

100

%

Operating Income (Loss) by Segment:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Publishing

 

$

31,609

 

10

%

$

(16,894

)

(14)

%

$

47,503

 

9

%

$

(11,724

)

(4)

%

Distribution

 

3,049

 

1

 

(39

)

 

2,888

 

1

 

(63

)

 

Total operating income (loss)

 

$

34,658

 

11

%

$

(16,933

)

(14)

%

$

50,391

 

10

%

$

(11,787

)

(4)

%

 

25


 


Results of Operations — Three and Six Months Ended September 30, 2004 and 2003

 

Net income for the three months ended September 30, 2004 was $25.5 million or $0.17 per diluted share, as compared to a net loss of $(10.1) million or $(0.08) per share for the three months ended September 30, 2003.

Net income for the six months ended September 30, 2004 was $37.5 million or $0.24 per diluted share, as compared to a net loss of $(5.9) million or $(0.04) per share for the six months ended September 30, 2003.

Net Revenues

We primarily derive revenue from sales of packaged interactive software games designed for play on video game consoles (such as the PS2, Xbox and GameCube), PCs and hand-held game devices (such as the GBA).  We also derive revenue from our distribution business in Europe that provides logistical and sales services to third-party publishers of interactive entertainment software, our own publishing operations and third-party manufacturers of interactive entertainment hardware.

The following table details our consolidated net revenues by business segment and our publishing net revenues by territory for the three months ended September 30, 2004 and 2003 (in thousands):

 

 

 

Three Months ended September 30,

 

Increase/
(Decrease)

 

Percent
Change

 

 

 

2004

 

2003

 

 

 

Publishing Net Revenues

 

 

 

 

 

 

 

 

 

North America

 

$

157,705

 

$

46,450

 

$

111,255

 

240

%

Europe

 

96,788

 

20,565

 

76,223

 

371

%

Other

 

11,902

 

4,781

 

7,121

 

149

%

Total International

 

108,690

 

25,346

 

83,344

 

329

%

Total Publishing Net Revenues

 

266,395

 

71,796

 

194,599

 

271

%

Distribution Net Revenues

 

44,231

 

45,727

 

(1,496

)

(3

)%

Consolidated Net Revenues

 

$

310,626

 

$

117,523

 

$

193,103

 

164

%

 

Consolidated net revenues increased 164% from $117.5 million for the three months ended September 30, 2003 to $310.6 million for the three months ended September 30, 2004.  This increase was driven by our publishing business both in North America and internationally.  The increase in consolidated net revenues was driven by the following:

                  In the second quarter of fiscal 2005, we released several “big proposition” titles including the worldwide release of Doom 3, and Call of Duty: United Offensive;  the North American release of  Rome: Total War, X-Men Legends, and Dreamworks’ Shark Tale; and the international release of Spiderman 2 .  This compares to three titles released in the second quarter of fiscal 2004: Disney’s Extreme Skate Adventure, Jedi Knight: Jedi Academy, and Cabela’s Deer Hunt 2004 Season .

                  Continued strong performance of our catalog titles, which are titles released prior to the current quarter, particularly Spider-Man 2, Shrek 2, and our Tony Hawk franchise.   Spider-Man 2 was the number one selling game in the U.S. and the U.K for the month of July.

                  Publishing console net revenues increased by 216% from $46.0 million for the three months ended September 30, 2003 to $145.5 million for the three months ended September 30, 2004.  The increase was driven by strong sales of Spider-Man 2 and three new console releases, Dreamworks’ Shark Tale , X-Men Legends, and Cabela’s Deer Hunt 2005 Season.

 

 

26



 

                  PC net revenues increased 350% from $21.6 million for the three months ended September 30, 2003 compared to $97.2 million for the three months ended September 30, 2004.  This was mainly due to the release of Doom 3, which to date is the number one selling PC title in the United States for the calendar year, Rome: Total War , which is the highest rated PC game in our history, and Call of Duty: United Offensive , an expansion pack to last year’s #1 PC title, Call of Duty.

                  International Publishing and Distribution net revenues benefited from the strong year-over-year strengthening of the Euro (“EUR”) and Great Britain Pound (“GBP”) in relation to the U.S. dollar.  We estimate that foreign exchange rates increased reported net revenue by approximately $16.2 million.  Excluding the impact of changing foreign currency rates, our International Publishing and Distribution net revenue increased 92% year-over-year.

The following table details our consolidated net revenues by business segment and our publishing net revenues by territory for the six months ended September 30, 2004 and 2003 (in thousands):

 

 

 

Six Months ended
September 30,

 

Increase/ (Decrease)

 

Percent Change

 

 

 

2004

 

2003

 

 

 

Publishing Net Revenues

 

 

 

 

 

 

 

 

 

North America

 

$

282,896

 

$

129,189

 

$

153,707

 

119

%

Europe

 

125,265

 

48,986