Activision Blizzard, Inc.
ACTIVISION INC /NY (Form: 10-Q, Received: 02/08/2005 06:36:11)      

 

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 December 31, 2004

 

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

(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 Act).  Yes  ý   No o

The number of shares of the registrant’s Common Stock outstanding as of February 1, 2005 was 142,323,269.

 



 

ACTIVISION, INC. AND SUBSIDIARIES

 

INDEX

 

 

PART I.      FINANCIAL INFORMATION

 

 

 

 

Item 1.

Financial Statements

 

 

 

 

 

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

 

 

 

 

 

Consolidated Statements of Operations for the three and nine months ended December 31, 2004 and 2003 (Unaudited)

 

 

 

 

 

Consolidated Statements of Cash Flows for the nine months ended December 31, 2004 and 2003 (Unaudited)

 

 

 

 

 

Consolidated Statement of Changes in Shareholders’ Equity for the nine months ended December 31, 2004 (Unaudited)

 

 

 

 

 

Notes to Consolidated Financial Statements for the three and nine months ended December 31, 2004 (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 5.

Other Information

 

 

 

 

Item 6.

Exhibits

 

 

 

 

 

 

 

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, 2004 (Unaudited)

 

March 31, 2004

 

Assets

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

402,530

 

$

466,552

 

Short-term investments

 

310,650

 

121,097

 

Accounts receivable, net of allowances of $83,209 and $47,028 at December 31, 2004 and March 31, 2004, respectively

 

344,894

 

62,577

 

Inventories

 

41,656

 

26,427

 

Software development

 

61,550

 

58,320

 

Intellectual property licenses

 

19,908

 

32,115

 

Deferred income taxes

 

13,689

 

26,127

 

Other current assets

 

17,424

 

18,660

 

 

 

 

 

 

 

Total current assets

 

1,212,301

 

811,875

 

 

 

 

 

 

 

Software development

 

13,384

 

28,386

 

Intellectual property licenses

 

11,624

 

16,380

 

Property and equipment, net

 

26,798

 

25,539

 

Deferred income taxes

 

 

9,064

 

Other assets

 

2,530

 

1,080

 

Goodwill

 

77,992

 

76,493

 

 

 

 

 

 

 

Total assets

 

$

1,344,629

 

$

968,817

 

 

 

 

 

 

 

Liabilities and Shareholders’ Equity

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

156,376

 

$

72,874

 

Accrued expenses

 

155,057

 

63,205

 

 

 

 

 

 

 

Total current liabilities

 

311,433

 

136,079

 

 

 

 

 

 

 

Deferred income taxes

 

12,712

 

 

 

 

 

 

 

 

Total liabilities

 

324,145

 

136,079

 

 

 

 

 

 

 

Commitments and contingencies (Note 13)

 

 

 

 

 

 

 

 

 

 

 

Shareholders’ equity:

 

 

 

 

 

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

 

 

 

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

 

 

 

Common stock, $.000001 par value, 225,000,000 shares authorized, 171,000,166 and 166,876,567 shares issued and 141,454,841 and 137,331,242 shares outstanding at December 31, 2004 and March 31, 2004, respectively

 

 

 

Additional paid-in capital

 

803,753

 

758,626

 

Retained earnings

 

343,041

 

208,279

 

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

 

(144,128

)

(144,128

)

Accumulated other comprehensive income

 

17,818

 

9,961

 

 

 

 

 

 

 

Total shareholders’ equity

 

1,020,484

 

832,738

 

 

 

 

 

 

 

Total liabilities and shareholders’ equity

 

$

1,344,629

 

$

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
December 31,

 

For the nine months ended
December 31,

 

 

 

2004

 

2003

 

2004

 

2003

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

$

680,094

 

$

508,511

 

$

1,201,996

 

$

784,759

 

 

 

 

 

 

 

 

 

 

 

Costs and expenses:

 

 

 

 

 

 

 

 

 

Cost of sales — product costs

 

316,494

 

235,301

 

528,759

 

384,302

 

Cost of sales — software royalties and amortization

 

58,200

 

23,680

 

116,846

 

50,575

 

Cost of sales — intellectual property licenses

 

22,598

 

9,464

 

57,797

 

27,008

 

Product development

 

25,068

 

50,354

 

66,054

 

79,828

 

Sales and marketing

 

105,248

 

58,503

 

200,216

 

102,025

 

General and administrative

 

15,407

 

14,248

 

44,854

 

35,847

 

 

 

 

 

 

 

 

 

 

 

Total costs and expenses

 

543,015

 

391,550

 

1,014,526

 

679,585

 

 

 

 

 

 

 

 

 

 

 

Operating income

 

137,079

 

116,961

 

187,470

 

105,174

 

 

 

 

 

 

 

 

 

 

 

Investment income, net

 

3,197

 

1,464

 

7,954

 

4,125

 

 

 

 

 

 

 

 

 

 

 

Income before income tax provision

 

140,276

 

118,425

 

195,424

 

109,299

 

 

 

 

 

 

 

 

 

 

 

Income tax provision

 

43,014

 

41,444

 

60,662

 

38,248

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

97,262

 

$

76,981

 

$

134,762

 

$

71,051

 

 

 

 

 

 

 

 

 

 

 

Basic earnings per share

 

$

0.70

 

$

0.58

 

$

0.97

 

$

0.54

 

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding

 

139,820

 

133,145

 

138,700

 

132,488

 

 

 

 

 

 

 

 

 

 

 

Diluted earnings per share

 

$

0.63

 

$

0.53

 

$

0.87

 

$

0.49

 

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding assuming dilution

 

155,592

 

146,027

 

154,418

 

143,679

 

 

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,

 

 

 

2004

 

2003

 

Cash flows from operating activities:

 

 

 

 

 

Net income

 

$

134,762

 

$

71,051

 

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

 

 

 

 

 

Deferred income taxes

 

34,214

 

18,626

 

Realized gain on short term investments

 

(471

)

 

Depreciation and amortization

 

7,742

 

7,711

 

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

 

125,682

 

76,276

 

Tax benefit of stock options and warrants exercised

 

13,802

 

3,567

 

Changes in operating assets and liabilities:

 

 

 

 

 

Accounts receivable

 

(282,317

)

(226,007

)

Inventories

 

(15,229

)

(15,929

)

Software development and intellectual property licenses

 

(96,947

)

(88,714

)

Other assets

 

(214

)

(968

)

Accounts payable

 

83,502

 

125,225

 

Accrued expenses and other liabilities

 

91,852

 

75,496

 

 

 

 

 

 

 

Net cash provided by operating activities

 

96,378

 

46,334

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Capital expenditures

 

(8,030

)

(9,455

)

Purchases of short-term investments

 

(242,039

)

(131,058

)

Proceeds from sales and maturities of short-term investments

 

51,778

 

126,136

 

Cash payment to effect business combinations, net of cash acquired

 

 

(3,480

)

 

 

 

 

 

 

Net cash used in investing activities

 

(198,291

)

(17,857

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Proceeds from issuance of common stock to employees

 

30,134

 

11,389

 

Other borrowings, net

 

 

(2,818

)

Purchase of structured stock repurchase transactions

 

 

(52,621

)

Settlement of structured stock repurchase transactions

 

 

166,521

 

Purchase of treasury stock

 

 

(19,996

)

 

 

 

 

 

 

Net cash provided by financing activities

 

30,134

 

102,475

 

 

 

 

 

 

 

Effect of exchange rate changes on cash

 

7,757

 

8,918

 

 

 

 

 

 

 

Net (decrease) increase in cash and cash equivalents

 

(64,022

)

139,870

 

 

 

 

 

 

 

Cash and cash equivalents at beginning of period

 

466,552

 

285,554

 

 

 

 

 

 

 

Cash and cash equivalents at end of period

 

$

402,530

 

$

425,424

 

 

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, 2004

(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, 2004

 

166,877

 

$

 

$

758,626

 

$

208,279

 

(29,546

)

$

(144,128

)

$

9,961

 

$

832,738

 

Components of comprehensive income:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

 

134,762

 

 

 

 

134,762

 

Unrealized loss on short-term investments

 

 

 

 

 

 

 

(1,179

)

(1,179

)

Foreign currency translation adjustment

 

 

 

 

 

 

 

9,036

 

9,036

 

Total comprehensive income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

142,619

 

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

 

4,041

 

 

30,134

 

 

 

 

 

30,134

 

Issuance of stock to effect business combination

 

82

 

 

1,191

 

 

 

 

 

1,191

 

Tax benefit attributable to employee stock options

 

 

 

13,802

 

 

 

 

 

13,802

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, December 31, 2004

 

171,000

 

$

 

$

803,753

 

$

343,041

 

(29,546

)

$

(144,128

)

$

17,818

 

$

1,020,484

 

 

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, 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. 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 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 net realizable value may be lower than originally estimated in any given quarter, which could result in an impairment charge.

 

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

 

7



 

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 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 net realizable value may be lower than originally estimated in any given quarter, which could result in an impairment charge. 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 no earlier than 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.

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

8



stock option or other stock-based compensation exercise price. At December 31, 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 December 31,

 

Nine months ended December 31,

 

 

 

2004

 

2003

 

2004

 

2003

 

Net income, as reported

 

$

97,262

 

$

76,981

 

$

134,762

 

$

71,051

 

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

 

(3,242

)

(3,693

)

(11,667

)

(13,432

)

Pro forma net income

 

$

94,020

 

$

73,414

 

$

123,095

 

$

57,745

 

 

 

 

 

 

 

 

 

 

 

Earnings per share:

 

 

 

 

 

 

 

 

 

Basic — as reported

 

$

0.70

 

$

0.58

 

$

0.97

 

$

0.54

 

Basic — pro forma

 

$

0.67

 

$

0.55

 

$

0.89

 

$

0.44

 

 

 

 

 

 

 

 

 

 

 

Diluted — as reported

 

$

0.63

 

$

0.53

 

$

0.87

 

$

0.49

 

Diluted — pro forma

 

$

0.60

 

$

0.50

 

$

0.80

 

$

0.40

 

 

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 in each of the quarters in the nine months ended December 31, 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 ranging from 45% to 48% and 47% to 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.

 

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.

9



3.     Cash, Cash Equivalents and Short-term Investments

Short-term investments generally mature between three and thirty months. 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 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, 2004 (amounts in thousands):

 

 

 

Amortized Cost

 

Gross Unrealized Gains

 

Gross Unrealized Losses

 

Fair Value

 

Cash and cash equivalents:

 

 

 

 

 

 

 

 

 

Cash and time deposits

 

$

201,929

 

$

 

$

 

201,929

 

Money market instruments

 

90,362

 

 

 

90,362

 

Auction rate notes

 

110,239

 

 

 

110,239

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

402,530

 

 

 

402,530

 

 

 

 

 

 

 

 

 

 

 

Short-term investments:

 

 

 

 

 

 

 

 

 

Corporate bonds

 

93,081

 

 

(650

)

92,431

 

Taxable senior debt

 

15,019

 

1

 

 

15,020

 

U.S. agency issues

 

161,854

 

 

(951

)

160,903

 

Asset-backed securities

 

40,601

 

23

 

(609

)

40,015

 

Common stock

 

167

 

1,104

 

 

1,271

 

Municipal bonds

 

1,010

 

 

 

1,010

 

 

 

 

 

 

 

 

 

 

 

Short-term investments

 

311,732

 

1,128

 

(2,210

)

310,650

 

 

 

 

 

 

 

 

 

 

 

Cash, cash equivalents and short-term investments

 

$

714,262

 

$

1,128

 

$

(2,210

)

$

713,180

 

 

The following table summarizes the maturities of our investments in debt securities as of December 31, 2004 (amounts in thousands):

 

 

 

Amortized Cost

 

Fair Value

 

Due in one year or less

 

$

271,182

 

$

270,405

 

Due after one year through thirty months

 

110,021

 

109,198

 

 

 

381,203

 

379,603

 

Asset-backed securities

 

40,601

 

40,015

 

Total

 

$

421,804

 

$

419,618

 

For the three months ended December 31, 2004, there were no gross realized gains or losses on short-term investments. For the nine months ended December 31, 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 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.

10



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):

 

 

 

December 31, 2004

 

March 31, 2004

 

Purchased parts and components

 

$

1,224

 

$

392

 

Finished goods

 

40,432

 

26,035

 

 

 

 

 

 

 

 

 

$

41,656

 

$

26,427

 

5.     Goodwill and Other Intangible Assets

The changes in the carrying amount of goodwill for the nine months ended December 31, 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

 

 

308

 

308

 

Balance as of December 31, 2004

 

$

72,089

 

$

5,903

 

$

77,992

 

 

 

6.     Income Taxes

The income tax provision of $43.0 million and $60.7 million for the three and nine months ended December 31, 2004, respectively, reflect our effective income tax rate of approximately 31%. 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 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 significant items that generated variances between our effective rate and our statutory rate of 35% were state taxes, offset by research and development tax credits.

7.     Software Development Costs and Intellectual Property Licenses

As of December 31, 2004, capitalized software development costs included $39.9 million of internally developed software costs and $35.1 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 $31.5 million and $48.5 million as of December 31, 2004 and March 31, 2004, respectively. Amortization and write-offs of capitalized software development costs and intellectual property licenses were $125.7 million and $76.3 million for the nine months ended December 31, 2004 and 2003, respectively.

During the three months ended December 31, 2003, 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 at the time, we found that we had 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 which is included in the consolidated statement of operations in product development expense.

11



8.     Comprehensive Income and Accumulated Other Comprehensive Income  

Comprehensive Income

The components of comprehensive income for the three and nine months ended December 31, 2004 and 2003 were as follows (amounts in thousands):

 

 

Three months ended December 31,

 

Nine months ended December 31,

 

 

 

2004

 

2003

 

2004

 

2003

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

97,262

 

$

76,981

 

$

134,762

 

$

71,051

 

 

 

 

 

 

 

 

 

 

 

Other comprehensive income:

 

 

 

 

 

 

 

 

 

Foreign currency forward contracts

 

 

(458

)

 

(458

)

Foreign currency translation adjustment

 

10,488

 

6,778

 

9,036

 

11,399

 

Unrealized depreciation on short-term investments

 

(1,509

)

(38

)

(1,179

)

(52

)

 

 

 

 

 

 

 

 

 

 

Other comprehensive income

 

8,979

 

6,282

 

7,857

 

10,889

 

 

 

 

 

 

 

 

 

 

 

Comprehensive income

 

$

106,241

 

$

83,263

 

$

142,619

 

$

81,940

 

   

Accumulated Other Comprehensive Income

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

 

 

 

 

Unrealized

 

 

 

 

 

Foreign

 

Appreciation

 

Accumulated

 

 

 

Currency

 

(Depreciation)

 

Other

 

 

 

Translation

 

on

 

Comprehensive

 

 

 

Adjustment

 

Investments

 

Income (Loss)

 

 

 

 

 

 

 

 

 

Balance, March 31, 2004

 

$

9,864

 

$

97

 

$

9,961

 

Other comprehensive income (loss)

 

9,036

 

(1,179

)

7,857

 

 

 

 

 

 

 

 

 

Balance, December 31, 2004

 

$

18,900

 

$

(1,082

)

$

17,818

 

 

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.

9.               Investment Income, Net

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

 

 

 

Three months ended December 31,

 

Nine months ended December 31,

 

 

 

2004

 

2003

 

2004

 

2003

 

Interest expense

 

$

(61

)

$

(43

)

$

(207

)

$

(285

)

Interest income

 

3,258

 

1,506

 

7,690

 

4,393

 

Net realized gain on investments

 

 

1

 

471

 

17

 

 

 

 

 

 

 

 

 

 

 

Investment income, net

 

$

3,197

 

$

1,464

 

$

7,954

 

$

4,125

 

 

 

12



 

10.  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,

 

 

 

2004

 

2003

 

Non-cash investing and financing activities:

 

 

 

 

 

Issuance of options and common stock warrants

 

$

 

$

377

 

Issuance of stock to effect business combination

 

1,191

 

 

Change in unrealized depreciation on short-term investments

 

1,179

 

52

 

 

 

 

 

 

 

Supplemental cash flow information:

 

 

 

 

 

Cash paid for income taxes

 

$

8,678

 

$

7,156

 

Cash received for interest, net

 

6,489

 

4,276

 

 

 

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.

Information on the reportable segments for the three and nine months ended December 31, 2004 and 2003 is as follows (amounts in thousands):

 

 

 

Three months ended December 31, 2004

 

 

 

Publishing

 

Distribution

 

Total

 

 

 

 

 

 

 

 

 

Total segment revenues

 

$

514,053

 

$

166,041

 

$

680,094

 

Revenues from sales between segments

 

(51,408

)

51,408

 

 

 

 

 

 

 

 

 

 

Revenues from external customers

 

$

462,645

 

$

217,449

 

$

680,094

 

 

 

 

 

 

 

 

 

Operating income

 

$

120,608

 

$

16,471

 

$

137,079

 

 

 

 

 

 

 

 

 

Total assets

 

$

1,149,736

 

$

194,893

 

$

1,344,629

 

 

13



 

 

 

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

 

 

 

 

Nine months ended December 31, 2004

 

 

 

Publishing

 

Distribution

 

Total

 

 

 

 

 

 

 

 

 

Total segment revenues

 

$

942,100

 

$

259,896

 

$

1,201,996

 

Revenues from sales between segments

 

(92,186

)

92,186

 

 

 

 

 

 

 

 

 

 

Revenues from external customers

 

$

849,914

 

$

352,082

 

$

1,201,996

 

 

 

 

 

 

 

 

 

Operating income

 

$

168,111

 

$

19,359

 

$

187,470

 

 

 

 

 

 

 

 

 

Total assets

 

$

1,149,736

 

$

194,893

 

$

1,344,629

 

 

 

 

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

 

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

 

Nine months ended December 31,

 

 

 

2004

 

2003

 

2004

 

2003

 

 

 

 

 

 

 

 

 

 

 

United States

 

$

344,342

 

$

252,114

 

$

627,238

 

$

381,303

 

Europe

 

324,360

 

246,919

 

543,480

 

385,952

 

Other

 

11,392

 

9,478

 

31,278

 

17,504

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

680,094

 

$

508,511

 

$

1,201,996

 

$

784,759

 

14



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

 

 

 

Three months ended December 31,

 

Nine months ended December 31,

 

 

 

2004

 

2003

 

2004

 

2003

 

 

 

 

 

 

 

 

 

 

 

Console

 

$

516,903

 

$

407,975

 

$

850,695

 

$

611,008

 

Hand-held

 

71,166

 

20,284

 

120,476

 

36,709

 

PC

 

92,025

 

80,252

 

230,825

 

137,042

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

680,094

 

$

508,511

 

$

1,201,996

 

$

784,759

 

As of and for the three and nine months ended December 31, 2004, we had one customer that accounted for 22% of consolidated net revenues in each period and 32% of consolidated accounts receivable, net.  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. This customer was the same customer in all periods and was a customer of both our publishing and distribution businesses.

12.  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,

 

 

 

2004

 

2003

 

2004

 

2003

 

 

 

 

 

 

 

 

 

 

 

Numerator:

 

 

 

 

 

 

 

 

 

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

 

$

97,262

 

$

76,981

 

$

134,762

 

$

71,051

 

 

 

 

 

 

 

 

 

 

 

Denominator:

 

 

 

 

 

 

 

 

 

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

 

139,820

 

133,145

 

138,700

 

132,488

 

 

 

 

 

 

 

 

 

 

 

Effect of dilutive securities:

 

 

 

 

 

 

 

 

 

Employee stock options and stock purchase plan

 

15,056

 

12,345

 

15,036

 

10,698

 

Warrants to purchase common stock

 

716

 

537

 

682

 

493

 

Potential dilutive common shares

 

15,772

 

12,882

 

15,718

 

11,191

 

 

 

 

 

 

 

 

 

 

 

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

 

155,592

 

146,027

 

154,418

 

143,679

 

 

 

 

 

 

 

 

 

 

 

Basic earnings per share

 

$

0.70

 

$

0.58

 

$

0.97

 

$

0.54

 

 

 

 

 

 

 

 

 

 

 

Diluted earnings per share

 

$

0.63

 

$

0.53

 

$

0.87

 

$

0.49

 

 

 

 

 

 

 

 

 

 

 

 

Options to purchase 115,659 shares of common stock at exercise prices ranging from $15.55 to $19.38 and options to purchase 1,497,602 shares of common stock at exercise prices ranging from $14.92 to $19.38 were outstanding for the three and nine months ended December 31, 2004, respectively, but were not included in the calculation of diluted earnings per share because their effect would be antidilutive.

Options to purchase 8,868,879 shares of common stock at exercise prices ranging from $12.14 to $14.77 and options to purchase 10,423,838 shares of common stock at exercise prices ranging from $12.14 to $14.77 were

15



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.

13.  Commitments and Contingencies

Credit Facilities

We have revolving credit facilities with our Centresoft subsidiary located in the United Kingdom (the “UK Facility”) and our NBG subsidiary located in Germany (the “German Facility”). As of December 31, 2004, the UK Facility provided Centresoft with the ability to borrow up to Great Britain Pounds (“GBP”) 8.0 million ($15.4 million), including issuing letters of credit, on a revolving basis. Furthermore, as of December 31, 2004, under the UK Facility, Centresoft provided a GBP 0.6 million ($1.2 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 2005. The UK Facility also contains various covenants that require the subsidiary to maintain specified financial ratios related to, among others, fixed charges. As of December 31, 2004, we were in compliance with these covenants. No borrowings were outstanding against the UK Facility as of December 31, 2004. The German Facility provided for revolving loans up to EUR 0.5 million ($0.7 million) as of December 31, 2004, 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, 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 December 31, 2004 is approximately $59.0 million and is scheduled to be paid as follows (amounts in thousands):

 

Fiscal year ending March 31,

 

 

 

 

 

 

 

2005

 

$

18,163

 

2006

 

24,226

 

2007

 

7,975

 

2008

 

5,775

 

2009 and thereafter

 

2,900

 

 

 

 

 

Total

 

$

59,039

 

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.

 

16



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 December 31, 2004 is approximately $24.9 million, which is scheduled to be paid as follows (amounts in thousands):

 

Fiscal Year ending March 31,

 

 

2005

 

$

1,000

 

2006

 

13,949

 

2007

 

5,000

 

2008

 

5,000

 

 

 

 

 

Total

 

$

24,949

 

 

 

Lease Obligations

 

We lease certain of our facilities under non-cancelable operating lease agreements.  Total future minimum lease commitments as of December 31, 2004 are as follows (amounts in thousands):

 

 

Fiscal Year ending March 31,

 

 

2005

 

$

3,053

 

2006

 

11,028

 

2007

 

10,282

 

2008

 

7,468

 

2009

 

6,671

 

Thereafter

 

31,412

 

 

 

 

 

Total

 

$

69,914

 

 

 

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

 

17



 

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.

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 December 31, 2004, we did not repurchase any of our common stock or enter into any structured stock repurchase transactions.  As of December 31, 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 nine months ended December 31, 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.

16.  Recently Issued Accounting Standards and Laws

On December 15, 2004, the Financial Accounting Standards Board (“FASB”) released its final revised standard entitled FASB Statement No. 123R, Share-Based Payment (“SFAS No. 123R”).  SFAS No. 123R requires that a public entity measure the cost of equity based service awards based on the grant date fair value of the award (with limited exceptions). That cost will be recognized over the period during which an employee is required to provide service in exchange for the award or the requisite service period.  SFAS No. 123R is effective as of the beginning of the first interim or annual reporting period that begins after June 15, 2005.  We are currently assessing the impact SFAS No. 123R will have on our financial position and results of operations.

On November 24, 2004, the FASB issued Statement No. 151, Inventory Costs, an Amendment of ARB No. 43, Chapter 4 (“SFAS No. 151”). The standard requires that abnormal amounts of idle capacity and spoilage costs within inventory should be excluded from the cost of inventory and expensed when incurred.  The provisions of SFAS No. 151 are applicable to inventory costs incurred during fiscal years beginning after June 15, 2005.  The Company expects the adoption of SFAS No. 151 will not have a material impact on our financial position or results of operations.

18



On December 15, 2004 the FASB issued Statement No. 153 (“SFAS No. 153”), Exchanges of Nonmonetary Assets an Amendment of Accounting Principles Board Opinion No. 29 .   This standard requires exchanges of productive assets to be accounted for at fair value, rather than at carryover basis, unless (1) neither the asset received nor the asset surrendered has a fair value that is determinable within reasonable limits or (2) the transactions lack commercial substance. The new standard is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005.  The Company expects the adoption of SFAS No. 153 will not have a material impact on our financial position or results of operations.

On October 22, 2004, the President signed the American Jobs Creation Act of 2004 (the “Act”). The Act raises a number of issues with respect to accounting for income taxes.  For companies that pay U.S. income taxes on manufacturing activities in the U.S., the Act provides a deduction from taxable income equal to a stipulated percentage of qualified income from domestic production activities.  The manufacturing deduction provided by the Act replaces the extraterritorial income (“ETI”) deduction currently in place.  We currently derive benefits from the ETI exclusion which was repealed by the Act.  Our exclusion for fiscal 2005, 2006, and 2007 will be limited to 95%, 75%, and 45% of the otherwise allowable exclusion and no exclusion will be available in fiscal 2008 and thereafter.  The Act also creates a temporary incentive for U.S. multinationals to repatriate accumulated income earned abroad by providing an 85 percent dividends received deduction for certain dividends from controlled foreign corporations. The deduction is subject to a number of limitations. The Act also provides for other changes in tax law that will affect a variety of taxpayers.  On December 21, 2004, the Financial Accounting Standards Board (“FASB”) issued two FASB Staff Positions (“FSP”) regarding the accounting implications of the Act related to (1) the deduction for qualified domestic production activities and (2) the one-time tax benefit for the repatriation of foreign earnings. The FASB decided that the deduction for qualified domestic production activities should be accounted for as a special deduction under FASB Statement No. 109, Accounting for Income Taxes .  The FASB also confirmed, that upon deciding that some amount of earnings will be repatriated, a company must record in that period the associated tax liability.  The guidance in the FSPs applies to financial statements for periods ending after the date the Act was enacted.  We are evaluating the Act at this time and have not yet determined whether we will avail ourselves of this opportunity.  We plan to complete our assessment before the end of fiscal 2006 and are not currently in a position to estimate a range of possible repatriation amounts.

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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”) and Nintendo Dual Screen (“NDS”) hand-held devices, and the personal computer (“PC”).  The installed base for this current-generation of hardware platforms is significant and growing.  We believe price cuts in calendar 2004 on the Xbox, PS2, GameCube, and GBA hardware, a redesign of the PS2, and the launch of the NDS 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.   We are also 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. This 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. 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. 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 six successful titles in the Tony Hawk franchise with cumulative net revenues of $947.5 million,

 

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including the most recent, Tony Hawk’s Underground 2 (“THUG 2”) , which was released in the third quarter of fiscal 2005.

We also continue to develop a number of original intellectual properties.  In the third quarter we released the highly successful Call of Duty: Finest Hour , on multiple console platforms.  This title was ranked by NPD Funworld (“NPD”) as one of the top-five best selling games for December 2004 and was the third game based upon this original property following the Call of Duty and Call of Duty: United Offensive titles for the PC.  True Crime: Streets of L.A. is another title based upon original intellectual property and was released in the third quarter of fiscal 2004.  This highly successful title was 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.

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 Animation SKG that granted us the exclusive rights to publish video games based on DreamWorks Animation 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”.  In the third quarter of the current fiscal year, we released a video game of the same title to coincide with the release of the feature film by Paramount Pictures, Nickelodeon Movies and DreamWorks SKG.

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 of a number of development companies with talented and experienced teams including, most recently, the acquisition of Vicarious Visions Inc., a leading game development studio, in January 2005.  We have development agreements with other top-level, third-party developers such as id Software, 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 made widely available for sale by retailers).  For these products we recognize revenue no earlier than 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

 

21



 

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.

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

 

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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 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 net realizable value may be lower than originally estimated in any given quarter, which could result in an impairment charge.

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.

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 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 net realizable value may be lower than originally estimated in any given quarter, which could result in an impairment charge.  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.

 

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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,

 

 

 

2004

 

2003

 

2004

 

2003

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

$

680,094

 

100

%

$

508,511

 

100

%

$

1,201,996

 

100

%

$

784,759

 

100

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Costs and expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cost of sales — product costs

 

316,494

 

47

 

235,301

 

46

 

528,759

 

44

 

384,302

 

49

 

Cost of sales — software royalties and amortization

 

58,200

 

9

 

23,680

 

5

 

116,846

 

10

 

50,575

 

7

 

Cost of sales — intellectual property licenses

 

22,598

 

3

 

9,464

 

2

 

57,797

 

5

 

27,008

 

3

 

Product development

 

25,068

 

4

 

50,354

 

10

 

66,054

 

5

 

79,828

 

10

 

Sales and marketing

 

105,248

 

15

 

58,503

 

11

 

200,216

 

16

 

102,025

 

13

 

General and administrative

 

15,407

 

2

 

14,248

 

3

 

44,854

 

4

 

35,847

 

5

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total costs and expenses

 

543,015

 

80

 

391,550

 

77

 

1,014,526

 

84

 

679,585

 

87

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating income

 

137,079

 

20

 

116,961

 

23

 

187,470

 

16

 

105,174

 

13

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Investment income, net

 

3,197

 

 

1,464

 

 

7,954

 

 

4,125

 

1

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Income before income tax provision

 

140,276

 

20

 

118,425

 

23

 

195,424

 

16

 

109,299

 

14

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Income tax provision