Activision Blizzard, Inc.
ACTIVISION INC /NY (Form: 10-Q, Received: 02/12/2004 17:06:27)      

 

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 December 31, 2003

 

 

 

OR

 

 

 

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 February 6, 2004 was 90,026,834.

 

 



 

ACTIVISION, INC. AND SUBSIDIARIES

 

INDEX

 

PART I.     FINANCIAL INFORMATION

 

 

 

 

 

 

Item 1.

Financial Statements

 

 

 

 

 

 

 

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

 

 

 

 

 

 

 

Consolidated Statements of Operations for the three and nine months
ended December 31, 2003 and 2002 (Unaudited)

 

 

 

 

 

 

 

Consolidated Statements of Cash Flows for the nine months
ended December 31, 2003 and 2002 (Unaudited)

 

 

 

 

 

 

 

Consolidated Statement of Changes in Shareholders’ Equity
for the nine months ended December 31, 2003 (Unaudited)

 

 

 

 

 

 

 

Notes to Consolidated Financial Statements for the three and nine months
ended December 31, 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)

 

 

 

December 31,
2003

 

March 31,
2003

 

 

 

(Unaudited)

 

 

 

Assets

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

425,424

 

$

285,554

 

Short-term investments

 

126,253

 

121,400

 

Accounts receivable, net of allowances of  $68,944 and $57,356 at December 31, 2003 and March 31, 2003, respectively

 

241,929

 

15,822

 

Inventories

 

35,506

 

19,577

 

Software development

 

43,469

 

26,791

 

Intellectual property licenses

 

26,614

 

8,906

 

Deferred income taxes

 

36,170

 

38,290

 

Other current assets

 

14,217

 

10,565

 

 

 

 

 

 

 

Total current assets

 

949,582

 

526,905

 

 

 

 

 

 

 

Software development

 

27,394

 

35,281

 

Intellectual property licenses

 

22,882

 

36,943

 

Property and equipment, net

 

26,375

 

22,265

 

Deferred income taxes

 

 

10,322

 

Other assets

 

844

 

5,081

 

Goodwill

 

74,214

 

68,019

 

 

 

 

 

 

 

Total assets

 

$

1,101,291

 

$

704,816

 

 

 

 

 

 

 

Liabilities and Shareholders’ Equity

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Current portion of long-term debt

 

$

 

$

147

 

Accounts payable

 

170,936

 

45,602

 

Accrued expenses

 

128,687

 

58,656

 

 

 

 

 

 

 

Total current liabilities

 

299,623

 

104,405

 

 

 

 

 

 

 

Long-term debt, less current portion

 

 

2,671

 

Deferred income taxes

 

5,381

 

 

 

 

 

 

 

 

Total liabilities

 

305,004

 

107,076

 

 

 

 

 

 

 

Commitments and contingencies (Note 14)

 

 

 

 

 

 

 

 

 

 

 

Shareholders’ equity:

 

 

 

 

 

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

 

 

 

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

 

 

 

Common stock, $.000001 par value, 225,000,000 and 125,000,000 shares authorized, 108,950,649 and 107,372,727 shares issued and 89,253,766 and 90,084,245 shares outstanding at December 31, 2003 and March 31, 2003, respectively

 

 

 

Additional paid-in capital

 

731,345

 

592,295

 

Retained earnings

 

201,615

 

130,564

 

Less:  Treasury stock, at cost, 19,696,883 and 17,288,482 shares at December 31, 2003 and March 31, 2003, respectively

 

(144,128

)

(121,685

)

Accumulated other comprehensive income (loss)

 

7,455

 

(3,434

)

 

 

 

 

 

 

Total shareholders’ equity

 

796,287

 

597,740

 

 

 

 

 

 

 

Total liabilities and shareholders’ equity

 

$

1,101,291

 

$

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
December 31,

 

For the nine months ended
December 31,

 

 

 

2003

 

2002

 

2003

 

2002

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

$

508,511

 

$

378,685

 

$

784,759

 

$

739,115

 

 

 

 

 

 

 

 

 

 

 

Costs and expenses:

 

 

 

 

 

 

 

 

 

Cost of sales – product costs

 

235,301

 

204,881

 

384,302

 

369,004

 

Cost of sales – software royalties and amortization

 

23,680

 

33,503

 

50,575

 

67,396

 

Cost of sales – intellectual property licenses

 

9,464

 

14,918

 

27,008

 

32,704

 

Product development

 

50,354

 

13,758

 

79,828

 

38,768

 

Sales and marketing

 

58,503

 

33,875

 

102,025

 

84,644

 

General and administrative

 

14,248

 

10,989

 

35,847

 

37,308

 

 

 

 

 

 

 

 

 

 

 

Total costs and expenses

 

391,550

 

311,924

 

679,585

 

629,824

 

 

 

 

 

 

 

 

 

 

 

Operating income

 

116,961

 

66,761

 

105,174

 

109,291

 

 

 

 

 

 

 

 

 

 

 

Investment income, net

 

1,464

 

2,533

 

4,125

 

6,554

 

 

 

 

 

 

 

 

 

 

 

Income before income tax provision

 

118,425

 

69,294

 

109,299

 

115,845

 

 

 

 

 

 

 

 

 

 

 

Income tax provision

 

41,444

 

24,947

 

38,248

 

41,708

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

76,981

 

$

44,347

 

$

71,051

 

$

74,137

 

 

 

 

 

 

 

 

 

 

 

Basic earnings per share

 

$

0.87

 

$

0.44

 

$

0.80

 

$

0.77

 

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding

 

88,763

 

100,209

 

88,325

 

96,839

 

 

 

 

 

 

 

 

 

 

 

Diluted earnings per share

 

$

0.79

 

$

0.42

 

$

0.74

 

$

0.71

 

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding assuming dilution

 

97,351

 

106,223

 

95,786

 

104,822

 

 

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 nine months ended
December 31,

 

 

 

2003

 

2002

 

Cash flows from operating activities:

 

 

 

 

 

Net income

 

$

71,051

 

$

74,137

 

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

 

Deferred income taxes

 

18,626

 

12,817

 

Depreciation and amortization

 

7,711

 

7,050

 

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

 

76,276

 

75,800

 

Tax benefit of stock options and warrants exercised

 

3,567

 

24,053

 

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

 

 

 

 

 

Accounts receivable

 

(226,007

)

(80,649

)

Inventories

 

(15,929

)

(16,548

)

Software development and intellectual property licenses

 

(88,714

)

(123,366

)

Other assets

 

(968

)

4,970

 

Accounts payable

 

125,225

 

41,984

 

Accrued expenses and other liabilities

 

75,496

 

28,802

 

 

 

 

 

 

 

Net cash provided by operating activities

 

46,334

 

49,050

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Capital expenditures

 

(9,455

)

(6,941

)

Proceeds from disposal of property and equipment

 

 

505

 

Purchases of short-term investments

 

(131,058

)

(384,117

)

Proceeds from sales and maturities of short-term investments

 

126,136

 

214,817

 

Cash payment to effect business combinations, net of cash acquired

 

(3,480

)

(21,199

)

Minority capital investment

 

 

(1,500

)

 

 

 

 

 

 

Net cash used in investing activities

 

(17,857

)

(198,435

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Proceeds from issuance of common stock and common stock options to employees

 

11,389

 

18,862

 

Other borrowings, net

 

(2,818

)

(717

)

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

 

 

248,072

 

Purchase of structured stock repurchase transactions

 

(52,621

)

(25,000

)

Settlement of structured stock repurchase transactions

 

166,521

 

 

Purchase of treasury stock

 

(19,996

)

(18,929

)

 

 

 

 

 

 

Net cash provided by financing activities

 

102,475

 

222,288

 

 

 

 

 

 

 

Effect of exchange rate changes on cash

 

8,918

 

7,074

 

 

 

 

 

 

 

Net increase in cash and cash equivalents

 

139,870

 

79,977

 

 

 

 

 

 

 

Cash and cash equivalents at beginning of period

 

285,554

 

279,007

 

 

 

 

 

 

 

Cash and cash equivalents at end of period

 

$

425,424

 

$

358,984

 

 

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 nine months ended December 31, 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 income:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

 

71,051

 

 

 

 

71,051

 

Unrealized depreciation on short-term investments

 

 

 

 

 

 

 

(52

)

(52

)

Foreign currency forward contracts

 

 

 

 

 

 

 

(458

)

(458

)

Foreign currency translation adjustment

 

 

 

 

 

 

 

11,399

 

11,399

 

Total comprehensive income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

81,940

 

Issuance of common stock and common stock options to employees

 

1,578

 

 

11,583

 

 

 

 

 

11,583

 

Tax benefit attributable to employee stock options

 

 

 

3,567

 

 

 

 

 

3,567

 

Purchase of structured stock repurchase transactions

 

 

 

(52,621

)

 

 

 

 

(52,621

)

Settlement of structured stock repurchase transactions

 

 

 

176,521

 

 

(1,144

)

(10,000

)

 

166,521

 

Purchase of treasury stock

 

 

 

 

 

(1,265

)

(12,443

)

 

(12,443

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, December 31, 2003

 

108,951

 

$

 

$

731,345

 

$

201,615

 

(19,697

)

$

(144,128

)

$

7,455

 

$

796,287

 

 

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 nine months ended December 31, 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 December 31, 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.  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):

 

8



 

 

 

 

Three months ended December 31,

 

Nine months ended December 31,

 

 

 

2003

 

2002

 

2003

 

2002

 

Net income, as reported

 

$

76,981

 

$

44,347

 

$

71,051

 

$

74,137

 

Add: Stock-based employee compensation expense included in reported net income, net of related tax effects

 

126

 

 

126

 

 

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

 

(3,693

)

(5,011

)

(13,432

)

(15,225

)

Pro forma net income

 

$

73,414

 

$

39,336

 

$

57,745

 

$

58,912

 

 

 

 

 

 

 

 

 

 

 

Earnings per share:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic – as reported

 

$

0.87

 

$

0.44

 

$

0.80

 

$

0.77

 

 

 

 

 

 

 

 

 

 

 

Basic – pro forma

 

$

0.83

 

$

0.39

 

$

0.65

 

$

0.61

 

 

 

 

 

 

 

 

 

 

 

Diluted – as reported

 

$

0.79

 

$

0.42

 

$

0.74

 

$

0.71

 

 

 

 

 

 

 

 

 

 

 

Diluted – pro forma

 

$

0.75

 

$

0.37

 

$

0.60

 

$

0.56

 

 

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 each of the quarters in the nine months ended December 31, 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 ranging from 47% to 52%.  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.      Acquisitions

 

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 for cash of approximately $3.5 million.  This acquisition

 

9



 

further enables us to implement our multi-platform development strategy by augmenting our internal product development capabilities for the PC.

 

A significant portion of the purchase price for this acquisition was assigned to goodwill as the primary asset we acquired in the transaction was an assembled workforce with proven technical and design talent with a history of high quality product creation.  Goodwill has been included in the publishing segment of our business and is non-deductible for tax purposes.  The results of operations of Infinity Ward are included in our consolidated statement of operations beginning October 24, 2003.  Pro forma consolidated statements of operations are not shown, as they would not differ materially from reported results.

 

4.      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 December 31, 2003 (amounts in thousands):

 

 

 

 

Amortized
Cost

 

Gross
Unrealized
Gains

 

Gross
Unrealized
Losses

 

Fair
Value

 

Cash and cash equivalents:

 

 

 

 

 

 

 

 

 

Cash and time deposits

 

$

201,944

 

$

 

$

 

$

201,944

 

Money market instruments

 

33,915

 

 

 

33,915

 

Auction rate notes

 

189,565

 

 

 

189,565

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

425,424

 

 

 

425,424

 

 

 

 

 

 

 

 

 

 

 

Short-term investments:

 

 

 

 

 

 

 

 

 

Corporate bonds

 

16,781

 

4

 

(33

)

16,752

 

Taxable municipal bonds

 

5,004

 

 

 

5,004

 

Taxable preferred bonds

 

3,779

 

 

 

3,779

 

U.S. agency issues

 

84,512

 

63

 

(32

)

84,543

 

Asset-backed securities

 

16,095

 

90

 

(10

)

16,175

 

 

 

 

 

 

 

 

 

 

 

Short-term investments

 

126,171

 

157

 

(75

)

126,253

 

 

 

 

 

 

 

 

 

 

 

Cash, cash equivalents and short-term investments

 

$

551,595

 

$

157

 

$

(75

)

$

551,677

 

 

10



 

The following table summarizes the maturities of our investments in debt securities as of December 31, 2003 (amounts in thousands):

 

 

 

 

Amortized
Cost

 

Fair
Value

 

Due in one year or less

 

$

221,616

 

$

221,613

 

Due after one year through two years

 

78,025

 

78,030

 

 

 

299,641

 

299,643

 

Asset-backed securities

 

16,095

 

16,175

 

 

 

 

 

 

 

Total

 

$

315,736

 

$

315,818

 

 

For the three months ended December 31, 2003, net realized gains on short-term investments consisted of $1,000 of gross realized gains and no gross realized losses.  For the nine months ended December 31, 2003, net realized gains on short-term investments consisted of $21,000 of gross realized gains and $4,000 of gross realized losses.

 

For the three months ended December 31, 2002, net realized gains on short-term investments consisted of $188,000 of gross realized gains and $56,000 of gross realized losses.  For the nine months ended December 31, 2002, net realized gains on short-term investments consisted of $191,000 of gross realized gains and $116,000 of gross realized losses.

 

5.      Inventories

 

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

 

 

 

 

December 31, 2003

 

March 31, 2003

 

Purchased parts and components

 

$

825

 

$

1,129

 

Finished goods

 

34,681

 

18,448

 

 

 

 

 

 

 

 

 

$

35,506

 

$

19,577

 

 

6.      Goodwill and Other Intangible Assets

 

The changes in the carrying amount of goodwill for the nine months ended December 31, 2003 are as follows (amounts in thousands):

 

 

 

 

Publishing

 

Distribution

 

Total

 

 

 

 

 

 

 

 

 

Balance as of March 31, 2003

 

$

63,194

 

$

4,825

 

$

68,019

 

Goodwill acquired

 

3,763

 

 

3,763

 

Adjustment to original purchase allocation

 

1,808

 

 

1,808

 

Effect of foreign currency exchange rates

 

 

624

 

624

 

 

 

 

 

 

 

 

 

Balance as of December 31, 2003

 

$

68,765

 

$

5,449

 

$

74,214

 

 

7.      Income Taxes

 

The income tax provision of $41.4 million and $38.2 million for the three and nine months ended December 31, 2003, respectively, reflect our effective income tax rate of approximately 35%.  The income tax provision of $24.9 million and $41.7 million for the three and nine months ended December 31, 2002, respectively, reflect

 

11



 

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.

 

8.      Software Development Costs and Intellectual Property Licenses

 

As of December 31, 2003, capitalized software development costs included $26.7 million of internally developed software costs and $44.2 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 $49.5 million and $45.8 million as of December 31, 2003 and March 31, 2003, respectively.  Amortization and write-offs of capitalized software development costs and intellectual property licenses were $76.3 million and $75.8 million for the nine months ended December 31, 2003 and 2002, respectively.

 

During the three months ended December 31, 2003, 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 related to our slate of high-potential projects.  Accordingly, in the three months ended 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 recorded a pre-tax charge of approximately $21 million in the quarter ended December 31, 2003.

 

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

   

Comprehensive Income

 

The components of comprehensive income for the three and nine months ended December 31, 2003 and 2002 were as follows (amounts in thousands):

 

 

 

Three months ended December 31,

 

Nine months ended December 31,

 

 

 

2003

 

2002

 

2003

 

2002

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

76,981

 

$

44,347

 

$

71,051

 

$

74,137

 

 

 

 

 

 

 

 

 

 

 

Other comprehensive income (loss):

 

 

 

 

 

 

 

 

 

Foreign currency forward contracts

 

(458

)

 

(458

)

 

Foreign currency translation adjustment

 

6,778

 

2,529

 

11,399

 

8,705

 

Unrealized appreciation (depreciation) on short-term investments

 

(38

)

624

 

(52

)

498

 

 

 

 

 

 

 

 

 

 

 

Other comprehensive income

 

6,282

 

3,153

 

10,889

 

9,203

 

 

 

 

 

 

 

 

 

 

 

Comprehensive income

 

$

83,263

 

$

47,500

 

$

81,940

 

$

83,340

 

 

12



   

Accumulated Other Comprehensive Income (Loss)

 

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

 

 

 

Foreign
Currency
Forward
Contracts

 

Foreign
Currency
Translation
Adjustment

 

Unrealized
Appreciation
(Depreciation)
on
Investments

 

Accumulated
Other
Comprehensive
Income (Loss)

 

 

 

 

 

 

 

 

 

 

 

Balance, March 31, 2003

 

$

 

$

(3,568

)

$

134

 

$

(3,434

)

Other comprehensive income (loss)

 

(458

)

11,399

 

(52

)

10,889

 

 

 

 

 

 

 

 

 

 

 

Balance, December 31, 2003

 

$

(458

)

$

7,831

 

$

82

 

$

7,455

 

 

The amounts above are shown net of taxes.  The income taxes related to other comprehensive income 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.

 

10.   Investment Income, Net

 

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

 

 

 

 

Three months ended December 31,

 

Nine months ended December 31,

 

 

 

2003

 

2002

 

2003

 

2002

 

Interest expense

 

$

(43

)

$

(138

)

$

(285

)

$

(810

)

Interest income

 

1,506

 

2,539

 

4,393

 

7,289

 

Net realized gain on investments

 

1

 

132

 

17

 

75

 

 

 

 

 

 

 

 

 

 

 

Investment income, net

 

$

1,464

 

$

2,533

 

$

4,125

 

$

6,554

 

 

11.   Supplemental Cash Flow Information

 

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

 

 

 

 

Nine months ended December 31,

 

 

 

2003

 

2002

 

Non-cash investing and financing activities:

 

 

 

 

 

Subsidiaries acquired with common stock

 

$

 

$

10,861

 

Issuance of options and common stock warrants

 

377

 

2,184

 

Stock offering costs

 

 

781

 

Change in unrealized depreciation on short-term investments

 

52

 

498

 

 

 

 

 

 

 

Supplemental cash flow information:

 

 

 

 

 

Cash paid for income taxes

 

$

7,156

 

$

3,847

 

Cash paid (received) for interest, net

 

(4,276

)

(5,933

)

 

13



 

12.   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 game specialty 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.

 

Information on the reportable segments for the three and nine months ended December 31, 2003 and 2002 is as follows (amounts in thousands):

 

 

 

 

Three months ended December 31, 2003

 

 

 

Publishing

 

Distribution

 

Total

 

 

 

 

 

 

 

 

 

Total segment revenues

 

$

382,921

 

$

125,590

 

$

508,511

 

Revenues from sales between segments

 

(48,801

)

48,801

 

 

 

 

 

 

 

 

 

 

Revenues from external customers

 

$

334,120

 

$

174,391

 

$

508,511

 

 

 

 

 

 

 

 

 

Operating income

 

$

104,964

 

$

11,997

 

$

116,961

 

 

 

 

 

 

 

 

 

Total assets

 

$

883,298

 

$

217,993

 

$

1,101,291

 

 

 

 

Three months ended December 31, 2002

 

 

 

Publishing

 

Distribution

 

Total

 

 

 

 

 

 

 

 

 

Total segment revenues

 

$

256,729

 

$

121,956

 

$

378,685

 

Revenues from sales between segments

 

(26,345

)

26,345

 

 

 

 

 

 

 

 

 

 

Revenues from external customers

 

$

230,384

 

$

148,301

 

$

378,685

 

 

 

 

 

 

 

 

 

Operating income

 

$

54,926

 

$

11,835

 

$

66,761

 

 

 

 

 

 

 

 

 

Total assets

 

$

818,659

 

$

152,458

 

$

971,117

 

 

14



 

 

 

 

Nine months ended December 31, 2003

 

 

 

Publishing

 

Distribution

 

Total

 

 

 

 

 

 

 

 

 

Total segment revenues

 

$

569,122

 

$

215,637

 

$

784,759

 

Revenues from sales between segments

 

(63,005

)

63,005

 

 

 

 

 

 

 

 

 

 

Revenues from external customers

 

$

506,117

 

$

278,642

 

$

784,759

 

 

 

 

 

 

 

 

 

Operating income

 

$

93,240

 

$

11,934

 

$

105,174

 

 

 

 

 

 

 

 

 

Total assets

 

$

883,298

 

$

217,993

 

$

1,101,291

 

 

 

 

Nine months ended December 31, 2002

 

 

 

Publishing

 

Distribution

 

Total

 

 

 

 

 

 

 

 

 

Total segment revenues

 

$

536,972

 

$

202,143

 

$

739,115

 

Revenues from sales between segments

 

(51,535

)

51,535

 

 

 

 

 

 

 

 

 

 

Revenues from external customers

 

$

485,437

 

$

253,678

 

$

739,115

 

 

 

 

 

 

 

 

 

Operating income

 

$

96,659

 

$

12,632

 

$

109,291

 

 

 

 

 

 

 

 

 

Total assets

 

$

818,659

 

$

152,458

 

$

971,117

 

 

Geographic information for the three and nine months ended December 31, 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 December 31,

 

Nine months ended December 31,

 

 

 

2003

 

2002

 

2003

 

2002

 

 

 

 

 

 

 

 

 

 

 

North America

 

$

252,114

 

$

179,643

 

$

381,303

 

$

380,045

 

Europe

 

246,919

 

190,030

 

385,952

 

342,561

 

Other

 

9,478

 

9,012

 

17,504

 

16,509

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

508,511

 

$

378,685

 

$

784,759

 

$

739,115

 

 

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

 

 

 

 

Three months ended December 31,

 

Nine months ended December 31,

 

 

 

2003

 

2002

 

2003

 

2002

 

 

 

 

 

 

 

 

 

 

 

Console

 

$

407,975

 

$

320,528

 

$

611,008

 

$

582,160

 

Hand-held

 

20,284

 

25,632

 

36,709

 

56,859

 

PC

 

80,252

 

32,525

 

137,042

 

100,096

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

508,511

 

$

378,685

 

$

784,759

 

$

739,115

 

 

As of and for the three and nine months ended December 31, 2003, we had one customer that accounted for 19% and 18% of consolidated net revenues, respectively, and 32% of consolidated accounts receivable, net.  As of and for the three and nine months ended December 31, 2002, we had one customer that accounted for

 

15



 

17% of consolidated net revenues and 29% 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.

 

13.   Computation of Earnings Per Share

 

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

 

 

 

 

Three months ended
December 31,

 

Nine months ended
December 31,

 

 

 

2003

 

2002

 

2003

 

2002

 

 

 

 

 

 

 

 

 

 

 

Numerator:

 

 

 

 

 

 

 

 

 

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

 

$

76,981

 

$

44,347

 

$

71,051

 

$

74,137

 

 

 

 

 

 

 

 

 

 

 

Denominator:

 

 

 

 

 

 

 

 

 

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

 

88,763

 

100,209

 

88,325

 

96,839

 

 

 

 

 

 

 

 

 

 

 

Effect of dilutive securities:

 

 

 

 

 

 

 

 

 

Employee stock options and stock purchase plan

 

8,230

 

5,642

 

7,132

 

7,422

 

Warrants to purchase common stock

 

358

 

372

 

329

 

561

 

 

 

 

 

 

 

 

 

 

 

Potential dilutive common shares

 

8,588

 

6,014

 

7,461

 

7,983

 

 

 

 

 

 

 

 

 

 

 

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

 

97,351

 

106,223

 

95,786

 

104,822

 

 

 

 

 

 

 

 

 

 

 

Basic earnings per share

 

$

0.87

 

$

0.44

 

$

0.80

 

$

0.77

 

 

 

 

 

 

 

 

 

 

 

Diluted earnings per share

 

$

0.79

 

$

0.42

 

$

0.74

 

$

0.71

 

 

Options to purchase 5,912,586 shares of common stock at exercise prices ranging from $18.21 to $22.16 and options to purchase 6,949,225 shares of common stock at exercise prices ranging from $18.21 to $22.16 were outstanding for the three and nine months ended December 31, 2003, respectively, but were not included in the calculation of diluted earnings per share because their effect would be antidilutive.

 

Options to purchase 7,054,122 shares of common stock at exercise prices ranging from $12.41 to $22.16 and options to purchase 3,381,950 shares of common stock at exercise prices ranging from $16.65 to $22.16 were outstanding for the three and nine months ended December 31, 2002, respectively, but were not included in the calculation of diluted earnings per share because their effect would be antidilutive.

 

14.   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 December 31, 2003, the UK Facility provided Centresoft with the ability to borrow up to Great British Pounds (“GBP”) 8.0 million ($14.2 million), including issuing letters of credit, on a revolving basis.  Furthermore, as of December 31, 2003, under the UK Facility, Centresoft provided a GBP 0.6 million ($1.1 million) guarantee for the benefit of our CD Contact subsidiary.  The UK Facility bears interest at LIBOR plus 2.0%, is collateralized by substantially all of the assets of the subsidiary and expires in November 2004.  The UK Facility also contains various covenants

 

16



 

that require the subsidiary to maintain specified financial ratios related to, among others, fixed charges.  As of December 31, 2003, we were in compliance with these covenants.  No borrowings were outstanding against the UK Facility as of December 31, 2003.  The German Facility provided for revolving loans up to EUR 0.5 million ($0.6 million) as of December 31, 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 December 31, 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 December 31, 2003 is approximately $99.1 million and is scheduled to be paid as follows (amounts in thousands):

 

 

Fiscal year ending March 31,

 

 

 

 

 

 

 

2004

 

$

29,827

 

2005

 

41,350

 

2006

 

18,048

 

2007

 

5,560

 

2008 and thereafter

 

4,325

 

 

 

 

 

Total

 

$

99,110

 

 

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, 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.

 

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.

 

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.  To date, we have not received a request from the SEC for additional information.  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



 

15.   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 nine months ended December 31, 2003, we repurchased approximately 1.3 million shares of our common stock for $12.4 million.  In addition, approximately 1.1 million shares of common stock were acquired in the nine months ended December 31, 2003 as a result of the settlement of a structured stock repurchase transaction entered into in fiscal 2003.  As of December 31, 2003, we had no outstanding structured stock repurchase transactions.  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 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 sheets.  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.

 

16.   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 nine months ended December 31, 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.

 

17.   Subsequent Events

 

On February 11, 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 is payable on March 15, 2004 to shareholders of record as of February 23, 2004.  The par value of our common stock will be maintained at the pre-split amount of $.000001.

 

18



 

 

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.  In calendar 2003, Sony 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.  Recently, Nintendo also announced that it plans to launch a new, dual-screened, portable game system before the end of calendar 2004.  We are currently in development of titles for the PSP and are awaiting more information from Nintendo regarding their new hand-held platform.  Although no specific information regarding such matters is available, we also evaluate potential technology for the next generation console systems expected to be developed by Sony, Microsoft and Nintendo for release in the next two to three calendar years.

 

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 game specialty 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.  Examples of these brands are our superheroes and skateboarding brands.  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.  We currently are in development on the video game Spider-Man: The Movie 2 , the sequel to the highly successful Spider-Man: The Movie , a key fiscal 2003 title release that has continued to perform strongly into fiscal 2004.  The video game release of Spider-Man: The Movie 2 is scheduled to coincide with the “Spider-Man 2” theatrical release in the summer of 2004.  Further, another of our key strategies is to continue to be a leader in the skateboarding category.  We have an exclusive, multi-year, licensing agreement with professional skateboarder Tony Hawk that expires in 2015.  The agreement grants us exclusive rights to develop and publish video games using Tony Hawk’s name and his likeness.  We have already released in prior periods five successful titles in the Tony Hawk franchise with cumulative net revenues of $793.9 million, including the most recent, Tony Hawk’s Underground , which was released in the third quarter of fiscal 2004.  We will continue to promote our skateboarding franchise with the release in fiscal 2005 of the sequel to the very successful Tony Hawk’s Underground.

 

We will also continue to develop new 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 ranked by third-party sales tracking agencies as among the top-five selling games for the holiday season.  We expect to

 

19



 

develop a variety of games on multiple platforms based on these two new original properties and hope to establish them as a source of recurring revenues.

 

We will also continue to evaluate emerging brands that we believe have potential to become successful game franchises.  For example, we expect to release titles in fiscal 2005 for “Lemony Snicket’s A Series of Unfortunate Events,” “Shark Tale” and “Shrek 2.”  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 developed for a feature film by Paramount Pictures, Nickelodeon Movies and DreamWorks SKG.  We also 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, “Shark Tale,” “Madagascar” and “Over the Hedge,” as well as their sequels.  We additionally have an agreement to develop and publish video games based on the upcoming movie “Shrek 2” which is expected to be theatrically released in May 2004.

 

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 talented and experienced development companies.  Most recently, 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 had acquired the initial 30% of Infinity Ward’s outstanding capital stock in May 2002.  We also have development agreements with other top-level, third-party developers such as id Software, Valve L.L.C., 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 large, lasting and recurring revenues and operating profit.

 

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.

 

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

 

20



 

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.

 

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

 

21



 

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.

 

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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 by business segment (amounts in thousands):

 

 

 

 

Three months ended December 31,

 

Nine months ended December 31,

 

 

 

2003

 

2002

 

2003

 

2002

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

$

508,511

 

100

%

$

378,685

 

100

%

$

784,759

 

100

%

$

739,115

 

100

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Costs and expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cost of sales – product costs

 

235,301

 

46

 

204,881

 

54

 

384,302

 

49

 

369,004

 

50

 

Cost of sales – software royalties and amortization

 

23,680

 

5

 

33,503

 

9

 

50,575

 

7

 

67,396

 

9

 

Cost of sales – intellectual property licenses

 

9,464

 

2

 

14,918

 

4

 

27,008

 

3

 

32,704

 

4

 

Product development

 

50,354

 

10

 

13,758

 

3

 

79,828

 

10

 

38,768

 

5

 

Sales and marketing

 

58,503

 

11

 

33,875

 

9

 

102,025

 

13

 

84,644

 

12

 

General and administrative

 

14,248

 

3

 

10,989

 

3

 

35,847

 

5

 

37,308

 

5

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total costs and expenses

 

391,550

 

77

 

311,924

 

82

 

679,585

 

87

 

629,824

 

85

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating income

 

116,961

 

23

 

66,761

 

18

 

105,174

 

13

 

109,291

 

15

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Investment income, net

 

1,464

 

-

 

2,533

 

1

 

4,125

 

1

 

6,554

 

1

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Income before income tax provision

 

118,425

 

23

 

69,294

 

19

 

109,299

 

14

 

115,845

 

16

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Income tax provision

 

41,444

 

8

 

24,947

 

7

 

38,248

 

5

 

41,708

 

6

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

76,981

 

15

%

$

44,347

 

12

%

$

71,051

 

9

%

$

74,137

 

10

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net Revenues by Territory:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

North America

 

$

252,114

 

50

%

$

179,643

 

47

%

$

381,303

 

49

%

$

380,045

 

51

%

Europe

 

246,919

 

48

 

190,030

 

50

 

385,952

 

49

 

342,561

 

47

 

Other

 

9,478

 

2

 

9,012

 

3

 

17,504

 

2

 

16,509

 

2

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total net revenues

 

$

508,511

 

100

%

$

378,685

 

100

%

$

784,759

 

100

%

$

739,115

 

100

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Segment/Platform Mix:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Publishing:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Console

 

$

304,996

 

80

%

$

211,993

 

83

%

$

439,499

 

77

%

$

409,919

 

77

%

Hand-held

 

13,367

 

3

 

19,574

 

7

 

22,150

 

4

 

45,061

 

8

 

PC

 

64,558

 

17

 

25,162

 

10

 

107,473

 

19

 

81,992

 

15

 

Total publishing net revenues

 

382,921

 

75

 

256,729

 

68

 

569,122

 

73

 

536,972

 

73

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Distribution:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Console

 

102,979

 

82

 

108,535

 

89

 

171,509

 

79

 

172,241

 

85

 

Hand-held