Activision Blizzard, Inc.
ACTIVISION INC /NY (Form: 10-Q, Received: 02/08/2006 15:08:12)

 

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, 2005

 

 

 

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 a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.  (Check One):

 

Large accelerated filer ý

Accelerated filer o

Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act).  Yes o   No ý

 

The number of shares of the registrant’s Common Stock outstanding as of February 3, 2006 was 276,541,773.

 

 



 

ACTIVISION, INC. AND SUBSIDIARIES

 

INDEX

 

PART I.

FINANCIAL INFORMATION

 

 

 

 

Item 1.

Financial Statements

 

 

 

 

 

Consolidated Balance Sheets as of December 31, 2005 (Unaudited) and
March 31, 2005

 

 

 

 

 

Consolidated Statements of Operations for the three and nine months
ended December 31, 2005 and 2004 (Unaudited)

 

 

 

 

 

Consolidated Statements of Cash Flows for the nine months
ended December 31, 2005 and 2004 (Unaudited)

 

 

 

 

 

Consolidated Statement of Changes in Shareholders’ Equity
for the nine months ended December 31, 2005 (Unaudited)

 

 

 

 

 

Notes to Consolidated Financial Statements for the three and nine months
ended December 31, 2005 (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 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,
2005

 

March 31,
2005

 

 

 

(Unaudited)

 

 

 

Assets

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

267,069

 

$

313,608

 

Short-term investments

 

497,537

 

527,256

 

Accounts receivable, net of allowances of $175,280 and $69,191 at December 31, 2005 and March 31, 2005, respectively

 

414,492

 

109,144

 

Inventories

 

84,828

 

48,018

 

Software development

 

24,528

 

73,096

 

Intellectual property licenses

 

5,382

 

21,572

 

Deferred income taxes

 

8,861

 

6,760

 

Other current assets

 

23,751

 

23,010

 

 

 

 

 

 

 

Total current assets

 

1,326,448

 

1,122,464

 

 

 

 

 

 

 

Software development

 

11,799

 

18,518

 

Intellectual property licenses

 

80,073

 

14,154

 

Property and equipment, net

 

39,180

 

30,490

 

Deferred income taxes

 

36,758

 

28,041

 

Other assets

 

1,234

 

1,635

 

Goodwill

 

100,462

 

91,661

 

 

 

 

 

 

 

Total assets

 

$

1,595,954

 

$

1,306,963

 

 

 

 

 

 

 

Liabilities and Shareholders’ Equity

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

213,874

 

$

108,984

 

Accrued expenses

 

171,384

 

98,067

 

 

 

 

 

 

 

Total current liabilities

 

385,258

 

207,051

 

 

 

 

 

 

 

Other liabilities

 

1,216

 

 

 

 

 

 

 

 

Total liabilities

 

386,474

 

207,051

 

 

 

 

 

 

 

Commitments and contingencies (Note 13)

 

 

 

 

 

 

 

 

 

 

 

Shareholders’ equity:

 

 

 

 

 

Preferred stock, $.000001 par value, 3,750,000 shares authorized, no shares issued at December 31, 2005 and March 31, 2005

 

 

 

Series A Junior Preferred stock, $.000001 par value, 1,250,000 shares authorized, no shares issued at December 31, 2005 and March 31, 2005

 

 

 

Common stock, $.000001 par value, 450,000,000 and 225,000,000 shares authorized, 275,932,907 and 268,040,831 shares issued and outstanding at December 31, 2005 and March 31, 2005, respectively

 

 

 

Additional paid-in capital

 

812,435

 

741,680

 

Retained earnings

 

397,732

 

346,614

 

Accumulated other comprehensive income

 

2,521

 

11,618

 

Unearned compensation

 

(3,208

)

 

 

 

 

 

 

 

Total shareholders’ equity

 

1,209,480

 

1,099,912

 

 

 

 

 

 

 

Total liabilities and shareholders’ equity

 

$

1,595,954

 

$

1,306,963

 

 

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,

 

 

 

2005

 

2004

 

2005

 

2004

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

$

816,242

 

$

680,094

 

$

1,279,875

 

$

1,201,996

 

 

 

 

 

 

 

 

 

 

 

Costs and expenses:

 

 

 

 

 

 

 

 

 

Cost of sales – product costs

 

367,685

 

316,494

 

617,021

 

528,759

 

Cost of sales – software royalties and amortization

 

104,264

 

58,200

 

139,267

 

116,846

 

Cost of sales – intellectual property licenses

 

26,376

 

22,598

 

55,765

 

57,797

 

Product development

 

53,139

 

25,068

 

99,013

 

66,054

 

Sales and marketing

 

155,999

 

105,248

 

258,957

 

200,216

 

General and administrative

 

24,712

 

15,407

 

65,780

 

44,854

 

 

 

 

 

 

 

 

 

 

 

Total costs and expenses

 

732,175

 

543,015

 

1,235,803

 

1,014,526

 

 

 

 

 

 

 

 

 

 

 

Operating income

 

84,067

 

137,079

 

44,072

 

187,470

 

 

 

 

 

 

 

 

 

 

 

Investment income, net

 

9,162

 

3,197

 

22,840

 

7,954

 

 

 

 

 

 

 

 

 

 

 

Income before income tax provision

 

93,229

 

140,276

 

66,912

 

195,424

 

 

 

 

 

 

 

 

 

 

 

Income tax provision

 

25,284

 

43,014

 

15,794

 

60,662

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

67,945

 

$

97,262

 

$

51,118

 

$

134,762

 

 

 

 

 

 

 

 

 

 

 

Basic earnings per share

 

$

0.25

 

$

0.39

 

$

0.19

 

$

0.55

 

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding

 

274,965

 

248,569

 

272,089

 

246,577

 

 

 

 

 

 

 

 

 

 

 

Diluted earnings per share

 

$

0.23

 

$

0.35

 

$

0.17

 

$

0.49

 

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding assuming dilution

 

298,752

 

276,608

 

295,963

 

274,521

 

 

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,

 

 

 

2005

 

2004

 

Cash flows from operating activities:

 

 

 

 

 

Net income

 

$

51,118

 

$

134,762

 

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

 

 

 

 

 

Deferred income taxes

 

(10,819

)

34,214

 

Realized gain on investments

 

(4,295

)

(471

)

Depreciation and amortization

 

10,228

 

7,742

 

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

 

168,351

 

125,682

 

Amortization of stock compensation expense

 

292

 

 

Tax benefit of stock options and warrants exercised

 

26,612

 

13,802

 

Changes in operating assets and liabilities:

 

 

 

 

 

Accounts receivable

 

(305,305

)

(282,317

)

Inventories

 

(36,810

)

(15,229

)

Software development and intellectual property licenses

 

(162,793

)

(96,947

)

Other assets

 

321

 

(214

)

Accounts payable

 

104,895

 

83,502

 

Accrued expenses and other liabilities

 

74,273

 

91,852

 

 

 

 

 

 

 

Net cash provided by (used in) operating activities

 

(83,932

)

96,378

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Capital expenditures

 

(20,174

)

(8,030

)

Cash payment to effect business combinations, net of cash acquired

 

(7,081

)

 

Increase in restricted cash

 

(7,500

)

 

Purchases of short-term investments

 

(143,162

)

(457,828

)

Proceeds from sales and maturities of short-term investments

 

182,504

 

458,760

 

 

 

 

 

 

 

Net cash provided by (used in) investing activities

 

4,587

 

(7,098

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Proceeds from issuance of common stock to employees

 

37,850

 

30,134

 

 

 

 

 

 

 

Net cash provided by financing activities

 

37,850

 

30,134

 

 

 

 

 

 

 

Effect of exchange rate changes on cash

 

(5,044

)

7,757

 

 

 

 

 

 

 

Net (decrease) increase in cash and cash equivalents

 

(46,539

)

127,171

 

 

 

 

 

 

 

Cash and cash equivalents at beginning of period

 

313,608

 

165,120

 

 

 

 

 

 

 

Cash and cash equivalents at end of period

 

$

267,069

 

$

292,291

 

 

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, 2005
(Unaudited)
(In thousands)

 

 

 

Common Stock

 

Additional
Paid-In

 

Retained

 

Accumulated
Other
Comprehensive

 

Unearned

 

Shareholders’

 

 

 

Shares

 

Amount

 

Capital

 

Earnings

 

Income

 

Compensation

 

Equity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, March 31, 2005

 

268,041

 

$

 

$

741,680

 

$

346,614

 

$

11,618

 

$

 

$

1,099,912

 

Components of comprehensive income:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

 

51,118

 

 

 

51,118

 

Unrealized loss on short-term investments

 

 

 

 

 

(2,172

)

 

(2,172

)

Foreign currency translation adjustment

 

 

 

 

 

(6,925

)

 

(6,925

)

Total comprehensive income

 

 

 

 

 

 

 

 

 

 

 

 

 

42,021

 

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

 

7,694

 

 

37,950

 

 

 

 

37,950

 

Tax benefit attributable to employee stock options

 

 

 

26,612

 

 

 

 

26,612

 

Issuance of stock to effect business combination

 

205

 

 

2,793

 

 

 

 

2,793

 

Restricted stock grant

 

 

 

3,500

 

 

 

(3,500

)

 

Cash distribution for fractional shares

 

(7

)

 

(100

)

 

 

 

(100

)

Amortization of unearned compensation

 

 

 

 

 

 

292

 

292

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, December 31, 2005

 

275,933

 

$

 

$

812,435

 

$

397,732

 

$

2,521

 

$

(3,208

)

$

1,209,480

 

 

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, 2005

 

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, 2005 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

 

7



 

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, 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.

 

8



 

Allowances for Returns, Price Protection, Doubtful Accounts and Inventory Obsolescence

 

In determining the appropriate unit shipments to our customers, we benchmark our titles using historical and industry data.  We closely monitor and analyze the historical performance of our various titles, the performance of products released by other publishers and the anticipated timing of other releases in order to assess future demands of current and upcoming titles.  Initial volumes shipped upon title launch and subsequent reorders are evaluated to ensure that quantities are sufficient to meet the demands from the retail markets but at the same time, are controlled to prevent excess inventory in the channel.

 

We may permit product returns from, or grant price protection to, our customers under certain conditions.  In general, price protection refers to the circumstances when we elect to decrease the wholesale price of a product by a certain amount and, when granted and applicable, allows customers a credit against amounts owed by such customers to us 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, our 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 factors or market conditions change or 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 affect 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.

 

9



 

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, 2005, 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, 2005 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,

 

 

 

2005

 

2004

 

2005

 

2004

 

Net income, as reported

 

$

67,945

 

$

97,262

 

$

51,118

 

$

134,762

 

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

 

(4,841

)

(3,242

)

(11,517

)

(11,667

)

Pro forma net income

 

$

63,104

 

$

94,020

 

$

39,601

 

$

123,095

 

 

 

 

 

 

 

 

 

 

 

Earnings per share:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic – as reported

 

$

0.25

 

$

0.39

 

$

0.19

 

$

0.55

 

 

 

 

 

 

 

 

 

 

 

Basic – pro forma

 

$

0.23

 

$

0.38

 

$

0.15

 

$

0.50

 

 

 

 

 

 

 

 

 

 

 

Diluted – as reported

 

$

0.23

 

$

0.35

 

$

0.17

 

$

0.49

 

 

 

 

 

 

 

 

 

 

 

Diluted – pro forma

 

$

0.21

 

$

0.34

 

$

0.13

 

$

0.45

 

 

Prior to April 1, 2005, the fair value of options granted was estimated at the date of grant using the Black-Scholes option pricing model. As of April 1, 2005, we switched to a binomial-lattice model to estimate the fair value of options granted after that date.  Both models require the input of highly subjective assumptions, including the expected stock price volatility.  T o estimate volatility for the binomial-lattice model, we use the implied volatility method based upon the volatilities for exchange-traded options on our stock to estimate short-term volatility, the historical method (annualized standard deviation of the instantaneous returns on Activision’s stock) to estimate long-term volatility and a statistical model to estimate the transition or “mean reversion” from short-term volatility to long-term volatility.  Based on these methods, for options granted during the three months ended December 31, 2005, the expected stock price volatility ranged from 37% to 64%, with a weighted average volatility of 49%.  For the Black-Scholes option pricing model, we used the historical stock price volatility of our common stock over the most recent period that is generally commensurate with the expected option life as the basis for estimating expected stock price volatility.  For options granted during the three months ended December 31, 2004, the historical stock price volatility used was based on a weekly stock price observation, using an average of the

 

10



 

high and low stock prices of our common stock, which resulted in an expected stock price volatility of 46%.  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.

 

Restricted Stock

 

In June 2005, we issued the rights to 155,763 shares of restricted stock to an employee.  Additionally, in October 2005 we issued the rights to 96,712 shares of restricted stock to an employee.  These shares vest over a five-year period and remain subject to forfeiture if vesting conditions are not met.  In accordance with APB No. 25, we recognize unearned compensation in connection with the grant of restricted shares equal to the fair value of our common stock on the date of grant.  The fair value of these shares when issued was approximately $12.84 and $15.51 per share, respectively, and resulted in a total increase in “Additional paid-in capital” and “Unearned compensation” on the accompanying balance sheet of $3.5 million.  Over the vesting period, we reduce unearned compensation and recognize compensation expense.  For the third quarter of fiscal 2006, we recorded expense related to these shares of approximately $175,000 in “General and administrative” on the accompanying statements of operations.  Since the issuance dates, we have recognized $292,000 of the $3.5 million of unearned compensation.

 

Reclassifications

 

Certain amounts in the consolidated financial statements have been reclassified to conform with the current year’s presentation.

 

We have reclassified certain auction rate securities from cash and cash equivalents to short-term investments.  Auction rate securities are variable rate bonds tied to short-term interest rates with maturities on the face of the underlying security in excess of 90 days.  Auction rate securities have interest rate resets through a modified Dutch auction at predetermined short-term intervals, typically every 7, 28, or 35 days.  Interest paid during a given period is based upon the interest rate determined during the prior auction.

 

Although these securities are issued and rated as long-term bonds, they are priced and traded as short-term instruments because of the liquidity provided through the interest rate reset.  We had historically classified these instruments as cash and cash equivalents if the reset period between interest rate resets was 90 days or less, which was based on our ability to liquidate our holdings or roll our investment over to the next reset period.  Our re-evaluation of the maturity dates and other provisions associated with the underlying bonds resulted in a reclassification from cash and cash equivalents to short-term investments of approximately $110.2 million on the December 31, 2004 balance sheet.  As a result of this balance sheet reclassification, certain amounts were reclassified in the accompanying consolidated statement of cash flows for the nine months ended December 31, 2004 to reflect the gross purchases and sales of these securities as investing activities rather than as a component of cash and cash equivalents.  This change in classification does not affect previously reported cash flows from operating or from financing activities in the previously reported consolidated statements of cash flows or the previously reported consolidated statements of operations.  For the nine months ended December 31, 2004, as a result of these revisions in classification, net cash provided by investing activities related to these current investments increased $191.2 million.

 

2.               Stock Split

 

In February 2005, the Board of Directors approved a four-for-three split of our outstanding common shares effected in the form of a 33-1/3% stock dividend.  The split was paid March 22, 2005 to shareholders of record as of March 7, 2005.  In September 2005, the Board of Directors approved a four-for-three split of our outstanding common shares effected in the form of a 33-1/3% stock dividend.  The split was paid October 24, 2005 to shareholders of record as of October 10, 2005.  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 splits had occurred as of the earliest period presented.

 

11



 

On March 7, 2005, in connection with our stock split, all shares of common stock held as treasury stock were formally cancelled and restored to the status of authorized but unissued shares of common stock.

 

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 (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.

 

Restricted Cash – Compensating Balances

 

As of December 31, 2005, we maintained a $7.5 million irrevocable standby letter of credit.  The standby letter of credit is required by one of our inventory manufacturers to qualify for payment terms on our inventory purchases.  Under the terms of this arrangement, we are required to maintain on deposit with the bank a compensating balance, restricted as to use, of not less than the sum of the available amount of the letter of credit plus the aggregate amount of any drawings under the letter of credit that have been honored thereunder but not reimbursed.   At December 31, 2005, the $7.5 million deposit is included in short-term investments as restricted cash.

 

The following table summarizes our investments in securities as of December 31, 2005 (amounts in thousands):

 

 

 

Amortized
Cost

 

Gross
Unrealized
Gains

 

Gross
Unrealized
Losses

 

Fair
Value

 

Cash and cash equivalents:

 

 

 

 

 

 

 

 

 

Cash and time deposits

 

$

153,986

 

$

 

$

 

$

153,986

 

Commercial paper

 

44,576

 

 

(24

)

44,552

 

Money market instruments

 

68,531

 

 

 

68,531

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

267,093

 

 

(24

)

267,069

 

 

 

 

 

 

 

 

 

 

 

Short-term investments:

 

 

 

 

 

 

 

 

 

Restricted cash

 

7,500

 

 

 

7,500

 

Corporate bonds

 

171,217

 

2

 

(1,660

)

169,559

 

Certificate of deposit

 

4,475

 

 

(16

)

4,459

 

U.S. agency issues

 

249,525

 

 

(3,110

)

246,415

 

Asset-backed securities

 

7,803

 

 

(35

)

7,768

 

Commercial paper

 

2,212

 

 

(5

)

2,207

 

Mortgage-backed securities

 

60,173

 

 

(544

)

59,629

 

 

 

 

 

 

 

 

 

 

 

Short-term investments

 

502,905

 

2

 

(5,370

)

497,537

 

 

 

 

 

 

 

 

 

 

 

Cash, cash equivalents and short-term investments

 

$

769,998

 

$

2

 

$

(5,394

)

$

764,606

 

 

12



 

The following table summarizes the contractual maturities of our investments in debt securities as of December 31, 2005 (amounts in thousands):

 

 

 

Amortized
Cost

 

Fair
Value

 

Due in one year or less

 

$

207,770

 

$

206,393

 

Due after one year through two years

 

240,103

 

237,346

 

Due after two years through three years

 

4,064

 

4,036

 

Due in three years or more

 

20,068

 

19,417

 

 

 

472,005

 

467,192

 

Asset-backed securities

 

67,976

 

67,397

 

 

 

 

 

 

 

Total

 

$

539,981

 

$

534,589

 

 

For the three months ended December 31, 2005, there were no gross realized gains and $2,000 of gross realized losses on the sale or maturity of short-term investments.  For the nine months ended December 31, 2005, there were $1.3 million of gross realized gains and $2,000 of gross realized losses on the sale or maturity of short-term investments.  For the three months ended December 31, 2004 there were no gross realized gains or losses on short-term investments on the sale or maturity of short-term investments.  For the nine months ended December 31, 2004, gross realized gains on short-term investments consisted of $471,000 of gross realized gains and no gross realized losses on the sale or maturity of short-term investments.

 

In accordance with EITF 03-1, “ The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” the fair value of investments in an unrealized loss position for which an other-than-temporary impairment has not been recognized was $530.2 million at December 31, 2005 with related gross unrealized losses of $5.4 million.  At December 31, 2005, the gross unrealized losses were comprised mostly of unrealized losses on corporate bonds, U.S. agency issues, and mortgage-backed securities with $1.5 million of unrealized loss being in a continuous unrealized loss position for twelve months or greater.

 

Our investment portfolio consists of government and corporate securities with effective maturities 30 months or less.  The longer the term of the securities, the more susceptible they are to changes in market rates of interest and yields on bonds.  Investments are reviewed periodically to identify possible impairment.  When evaluating the investments, we review factors such as the length of time and extent to which fair value has been below cost basis, the financial condition of the issuer, and our ability and intent to hold the investment for a period of time which may be sufficient for anticipated recovery in market value.  We have the intent and ability to hold these securities for a reasonable period of time sufficient for a forecasted recovery of fair value up to (or beyond) the initial cost of the investment.  We expect to realize the full value of all of these investments upon maturity or sale.

 

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, 2005

 

March 31, 2005

 

Finished goods

 

$

76,384

 

$

45,926

 

Purchased parts and components

 

8,444

 

2,092

 

 

 

 

 

 

 

 

 

$

84,828

 

$

48,018

 

 

For the three and nine months ended December 31, 2005 we had write-downs of inventory costs for certain titles in the amount of $11.1 million and $15.2 million, respectively.

 

13



 

5.               Goodwill and Other Intangible Assets

 

The changes in the carrying amount of goodwill for the nine months ended December 31, 2005 are as follows (amounts in thousands):

 

 

 

Publishing

 

Distribution

 

Total

 

 

 

 

 

 

 

 

 

Balance as of March 31, 2005

 

$

85,899

 

$

5,762

 

$

91,661

 

Goodwill acquired during the period

 

6,260

 

 

6,260

 

Issuance of contingent consideration

 

2,793

 

 

2,793

 

Adjustment to prior period purchase allocation

 

35

 

 

35

 

Effect of foreign currency exchange rates

 

192

 

(479

)

(287

)

 

 

 

 

 

 

 

 

Balance as of December 31, 2005

 

$

95,179

 

$

5,283

 

$

100,462

 

 

6.               Income Taxes

 

The income tax provision of $25.3 million for the three months ended December 31, 2005 reflects our effective income tax rate for the quarter of 27.1%.  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 $15.8 million for the nine months ended December 31, 2005 reflects our effective income tax rate of approximately 23.6%.  The significant items that generated variances between our effective rate and our statutory rate of 35% were a one-time international tax benefit for the release of certain reserves due to the expiration of a tax statute of limitations, research, and development tax credits and the impact of foreign tax rate differentials, partially offset by state taxes.

 

7.     Software Development Costs and Intellectual Property Licenses

 

As of December 31, 2005, capitalized software development costs included $26.2 million of internally developed software costs and $10.1 million of payments made to third-party software developers.  As of March 31, 2005, capitalized software development costs included $61.3 million of internally developed software costs and $30.3 million of payments made to third-party software developers.  Capitalized intellectual property licenses were $85.5 million and $35.7 million as of December 31, 2005 and March 31, 2005, respectively.  Amortization and write-offs of capitalized software development costs and intellectual property licenses were $168.4 million and $125.7 million for the nine months ended December 31, 2005 and 2004, respectively.  Amortization and write-offs of capitalized software development costs and intellectual property licenses for the nine months ended December 31, 2005 included p roduct cancellation charges of $10.3 million, impairment charges of $8.8 million, and recoverability write-offs of $3.8 million.

 

14



 

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

 

Comprehensive Income (Loss)

 

The components of comprehensive income (loss) for the three and nine months ended December 31, 2005 and 2004 were as follows (amounts in thousands):

 

 

 

Three months ended December 31,

 

Nine months ended December 31,

 

 

 

2005

 

2004

 

2005

 

2004

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

67,945

 

$

97,262

 

$

51,118

 

$

134,762

 

 

 

 

 

 

 

 

 

 

 

Other comprehensive income (loss):

 

 

 

 

 

 

 

 

 

Foreign currency translation adjustment

 

(937

)

10,488

 

(6,925

)

9,036

 

Unrealized depreciation on short-term investments

 

(1,432

)

(1,509

)

(2,172

)

(1,179

)

 

 

 

 

 

 

 

 

 

 

Other comprehensive income (loss)

 

(2,369

)

8,979

 

(9,097

)

7,857

 

 

 

 

 

 

 

 

 

 

 

Comprehensive income

 

$

65,576

 

$

106,241

 

$

42,021

 

$

142,619

 

 

Accumulated Other Comprehensive Income (Loss)

 

The components of accumulated other comprehensive income (loss) for the nine months ended December 31, 2005 and 2004 were as follows (amounts in thousands):

 

 

 

Foreign

 

Unrealized

 

Accumulated

 

 

 

Currency

 

Depreciation

 

Other

 

 

 

Translation

 

On

 

Comprehensive

 

 

 

Adjustment

 

Investments

 

Income (Loss)

 

 

 

 

 

 

 

 

 

Balance, March 31, 2005

 

$

14,838

 

$

(3,220

)

$

11,618

 

Other comprehensive loss

 

(6,925

)

(2,172

)

(9,097

)

 

 

 

 

 

 

 

 

Balance, December 31, 2005

 

$

7,913

 

$

(5,392

)

$

2,521

 

 

The income taxes related 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.

 

15



 

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,

 

 

 

2005

 

2004

 

2005

 

2004

 

Interest expense

 

$

(85

)

$

(61

)

$

(198

)

$

(207

)

Interest income

 

6,299

 

3,258

 

18,743

 

7,690

 

Net realized gain on investments

 

2,948

 

 

4,295

 

471

 

 

 

 

 

 

 

 

 

 

 

Investment income, net

 

$

9,162

 

$

3,197

 

$

22,840

 

$

7,954

 

 

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,

 

 

 

2005

 

2004

 

Non-cash investing and financing activities:

 

 

 

 

 

Subsidiaries acquired with common stock

 

$

2,793

 

$

1,191

 

Change in unrealized depreciation on short-term investments

 

2,172

 

1,179

 

 

 

 

 

 

 

Supplemental cash flow information:

 

 

 

 

 

Cash paid for income taxes

 

$

4,469

 

$

8,678

 

Cash received for interest, net

 

16,956

 

6,489

 

 

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 and Canada, 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 and through third-party distribution and licensing arrangements and through our wholly-owned distribution subsidiaries.

 

Distribution refers to our operations 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.

 

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, 2005.  Revenue derived from sales between segments is eliminated in consolidation.

 

16



 

Information on the reportable segments for the three and nine months ended December 31, 2005 and 2004 is as follows (amounts in thousands):

 

 

 

Three months ended December 31, 2005

 

 

 

Publishing

 

Distribution

 

Total

 

 

 

 

 

 

 

 

 

Total segment revenues

 

$

667,500

 

$

148,742

 

$

816,242

 

Revenues from sales between segments

 

(87,652

)

87,652

 

 

 

 

 

 

 

 

 

 

Revenues from external customers

 

$

579,848

 

$

236,394

 

$

816,242

 

 

 

 

 

 

 

 

 

Operating income

 

$

65,708

 

$

18,359

 

$

84,067

 

 

 

 

 

 

 

 

 

Total assets

 

$

1,398,362

 

$

197,592

 

$

1,595,954

 

 

 

 

 

 

 

 

 

 

 

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

 

 

 

 

 

 

 

 

 

 

 

Nine months ended December 31, 2005

 

 

 

Publishing

 

Distribution

 

Total

 

 

 

 

 

 

 

 

 

Total segment revenues

 

$

1,028,458

 

$

251,417

 

$

1,279,875

 

Revenues from sales between segments

 

(124,530

)

124,530

 

 

 

 

 

 

 

 

 

 

Revenues from external customers

 

$

903,928

 

$

375,947

 

$

1,279,875

 

 

 

 

 

 

 

 

 

Operating income

 

$

24,219

 

$

19,853

 

$

44,072

 

 

 

 

 

 

 

 

 

Total assets

 

$

1,398,362

 

$

197,592

 

$

1,595,954

 

 

 

 

 

 

 

 

 

 

 

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

 

 

17



 

Geographic information for the three and nine months ended December 31, 2005 and 2004 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,

 

 

 

2005

 

2004

 

2005

 

2004

 

 

 

 

 

 

 

 

 

 

 

North America

 

$

402,314

 

$

344,342

 

$

626,538

 

$

627,238

 

Europe

 

397,356

 

324,360

 

622,035

 

543,480

 

Other

 

16,572

 

11,392

 

31,302

 

31,278

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

816,242

 

$

680,094

 

$

1,279,875

 

$

1,201,996

 

 

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

 

 

 

Three months ended December 31,

 

Nine months ended December 31,

 

 

 

2005

 

2004

 

2005

 

2004

 

 

 

 

 

 

 

 

 

 

 

Console

 

$

575,094

 

$

516,903

 

$

893,417

 

$

850,695

 

Hand-held

 

111,186

 

71,166

 

203,879

 

120,476

 

PC

 

129,962

 

92,025

 

182,579

 

230,825

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

816,242

 

$

680,094

 

$

1,279,875

 

$

1,201,996

 

 

We had two customers that accounted for 21% and 12% of consolidated net revenues for the three month period ended December 31, 2005, 22% and 11% of consolidated net revenues for the nine month period ended December 31, 2005, and 30% and 14% of consolidated accounts receivable, net at December 31, 2005.  These customers were customers of both our publishing and distribution businesses.  As of and for the three and nine months ended December 31, 2004, one of those same customers accounted for 22% of consolidated net revenues in both periods and 32% of consolidated accounts receivable, net.

 

18



 

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,

 

 

 

2005

 

2004

 

2005

 

2004

 

 

 

 

 

 

 

 

 

 

 

Numerator:

 

 

 

 

 

 

 

 

 

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

 

$

67,945

 

$

97,262

 

$

51,118

 

$

134,762

 

 

 

 

 

 

 

 

 

 

 

Denominator:

 

 

 

 

 

 

 

 

 

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

 

274,965

 

248,569

 

272,089

 

246,577

 

 

 

 

 

 

 

 

 

 

 

Effect of dilutive securities:

 

 

 

 

 

 

 

 

 

Employee stock options and stock purchase plan

 

23,172

 

26,766

 

23,279

 

26,731

 

Warrants to purchase common stock

 

615

 

1,273

 

595

 

1,213

 

 

 

 

 

 

 

 

 

 

 

Potential dilutive common shares

 

23,787

 

28,039

 

23,874

 

27,944

 

 

 

 

 

 

 

 

 

 

 

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

 

298,752

 

276,608

 

295,963

 

274,521

 

 

 

 

 

 

 

 

 

 

 

Basic earnings per share

 

$

0.25

 

$

0.39

 

$

0.19

 

$

0.55

 

 

 

 

 

 

 

 

 

 

 

Diluted earnings per share

 

$

0.23

 

$

0.35

 

$

0.17

 

$

0.49

 

 

Options to purchase 1,466,319 shares of common stock at exercise prices ranging from $14.70 to $17.21 and options to purchase 632,102 shares of common stock at exercise prices ranging from $13.72 to $17.21 were outstanding for the three and nine months ended December 31, 2005, respectively, but were not included in the calculation of diluted earnings per share because their effect would be antidilutive.

 

Options to purchase 205,616 shares of common stock at exercise prices ranging from $8.75 to $10.90 and options to purchase 2,662,404 shares of common stock at exercise prices ranging from $8.39 to $10.90 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.

 

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13.  Commitments and Contingencies

 

Credit Facilities

 

We have revolving credit facilities with our Centresoft distribution subsidiary located in the UK (the “UK Facility”) and our NBG distribution subsidiary located in Germany (the “German Facility”).  The UK Facility provided Centresoft with the ability to borrow up to Great British Pounds (“GBP”) 8.0 million ($13.8 million), including issuing letters of credit, on a revolving basis as of December 31, 2005.  Furthermore, under the UK Facility, Centresoft provided a GBP 0.6 million ($1.0 million) guarantee for the benefit of our CD Contact distribution subsidiary as of December 31, 2005.  The UK Facility bore interest at LIBOR plus 2.0% as of December 31, 2005, is collateralized by substantially all of the assets of the subsidiary and expires in May 2006.  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, 2005, we were in compliance with these covenants.  No borrowings were outstanding against the UK Facility as of December 31, 2005.  The German Facility provided for revolving loans up to Euro (“EUR”) 0.5 million ($0.6 million) as of December 31, 2005, bore interest at a Eurocurrency rate plus 2.5%, is collateralized by certain of the subsidiary’s property and equipment and has no expiration date.  No borrowings were outstanding against the German Facility as of December 31, 2005.

 

As of December 31, 2005, we maintained a $7.5 million irrevocable standby letter of credit.  The standby letter of credit is required by one of our inventory manufacturers to qualify for payment terms on our inventory purchases.  Under the terms of this arrangement, we are required to maintain on deposit with the bank a compensating balance, restricted as to use, of not less than the sum of the available amount of the letter of credit plus the aggregate amount of any drawings under the letter of credit that have been honored thereunder but not reimbursed.   At December 31, 2005, the $7.5 million deposit is included in short-term investments as restricted cash.

 

As of December 31, 2005, our publishing subsidiary located in the UK maintained a EUR 10.0 million ($11.8 million) irrevocable standby letter of credit.  The standby letter of credit is required by one of our inventory manufacturers to qualify for payment terms on our inventory purchases.  The standby letter of credit does not require a compensating balance and is collateralized by substantially all of the assets of the subsidiary and expires on April 15, 2006.  As of December 31, 2005, we had EUR 0.7 million ($0.8 million) of outstanding amounts against this letter of credit.

 

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Commitments

 

In the normal course of business, we enter into contractual arrangements with third parties for non-cancelable operating lease agreements for our offices, 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 lessor, developer or intellectual property holder, based upon contractual arrangements.  Typically, the payments to third-party developers are conditioned upon the achievement by the developers of contractually specified development milestones.  These payments to third-party developers and intellectual property holders typically are deemed to be advances and are recoupable against future royalties earned by the developer or intellectual property holder based on the sale of the related game. Additionally, 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.  Additionally, we lease certain of our facilities under non-cancelable operating lease agreements.  Assuming all contractual provisions are met, the total future minimum commitments for these and other contractual arrangements in place as of December 31, 2005, are scheduled to be paid as follows (amounts in thousands):

 

 

 

Contractual Obligations

 

 

 

Facility

 

Developer

 

 

 

 

 

 

 

Leases

 

and IP

 

Marketing

 

Total

 

Fiscal year ending March 31,

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2006

 

$

3,122

 

$

12,183

 

$

1,642

 

$

16,947

 

2007

 

12,175

 

20,811

 

15,910

 

48,896

 

2008

 

8,721

 

10,593

 

24,260

 

43,574

 

2009

 

7,415

 

16,300

 

12,100

 

35,815

 

2010

 

6,517

 

23,300

 

100

 

29,917

 

Thereafter

 

27,046

 

54,900

 

100

 

82,046

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

64,996

 

$

138,087

 

$

54,112

 

$

257,195

 

 

Compensation Guarantee

 

In June 2005, we entered into an employment agreement with the President and Chief Executive Officer of Activision Publishing containing a guarantee related to total compensation.  The agreement guarantees that in the event that on May 15, 2010 total compensation has not exceeded $20.0 million, we will make a payment for the amount of the shortfall.  The $20.0 million guarantee will be recognized as compensation expense evenly over the term of the employment agreement comprising of salary payments, bonus payments, restricted stock expense, stock option expense, and an accrual for any anticipated remaining portion of the guarantee.  The remaining portion of the guarantee is accrued over the term of the agreement in “Other liabilities” and will remain accrued until the end of the employment agreement at which point it will be used to make a payment for any shortfall or reclassified into shareholders’ equity.

 

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 were subsequently filed by Gianni Angeloni, Christopher Hinton, Stephen Anish, the Alaska Electrical Pension Fund, and Joseph A. Romans asserting the same claims.  Consistent with the Private Securities Litigation Reform Act (“PSLRA”), the court appointed lead plaintiffs consolidating the six putative securities class actions into a single case.  In an Order dated May 16, 2005, the court dismissed the

 

21



 

consolidated complaint because the plaintiffs failed to satisfy the heightened pleading standards of the PSLRA.  The court did, however, give the lead plaintiffs leave to file an amended consolidated complaint within 30 days of the order.  Rather than file a new complaint, the Plaintiff agreed to dismiss the entire case with prejudice.  The Order dismissing the action with prejudice was entered on June 17, 2005.

 

In addition, on March 12, 2004, a shareholder derivative lawsuit captioned Frank Capovilla, Derivatively on Behalf of Activision, Inc. v. Robert Kotick, et al. was filed, purportedly on behalf of Activision, which in large measure asserts the identical claims set forth in the federal class action lawsuit.  That complaint was filed in California Superior Court for the County of Los Angeles.   On August 11, 2005, in light of the ruling dismissing with prejudice the complaint in the earlier-filed federal securities class action, plaintiffs in the shareholder derivative action filed an amended complaint, dropping most of the causes of action, and focusing only on the allegations of insider trading and breaches of fiduciary duty that were based on the same claimed misrepresentations set forth in the dismissed federal securities class action. On September 15, 2005, Activision and the individual defendants filed separate demurrers to the Derivative Action and a motion to strike plaintiff’s jury demand. Prior to the hearing on the demurrers, the parties came to a resolution of the action and agreed to a stipulation of settlement to be submitted to the court for preliminary approval currently scheduled for hearing on February 8, 2006. Subject to court approval, the settlement will require the dismissal and release of the alleged claims. No cash recovery is to be paid to the plaintiff pursuant to the stipulation of settlement, which also states that the Company vigorously denies any assertion of wrongdoing or liability. In furtherance of the settlement, the Company has agreed to pay $200,000 in plaintiffs’ fees, to be funded by the Company’s D&O insurance carrier. The settlement acknowledges that, after the time the derivative action was filed, the Company has implemented certain enhancements to its corporate governance policies.

 

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.  Recently Issued Accounting Standards and Laws

 

On December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued FASB Statement No. 123 (revised 2004), Share-Based Payment (“SFAS No. 123R”), which is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation (“ SFAS 123”).  SFAS No. 123R supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees , and amends FASB Statement No. 95, Statement of Cash Flows .  Generally, the approach in SFAS No. 123R is similar to the approach described in SFAS 123.  However, SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values.  Pro forma disclosure is no longer an alternative.

 

SFAS No. 123R must be adopted by us no later than April 1, 2006. Early adoption will be permitted in periods in which financial statements have not yet been issued.  We expect to adopt SFAS No. 123R on April 1, 2006.

 

SFAS No. 123R permits public companies to adopt its requirements using one of two methods:

 

      A “modified prospective” method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of SFAS No. 123R for all share-based payments granted after the effective date and (b) based on the requirements of SFAS 123 for all awards granted to employees prior to the effective date of SFAS No. 123R that remain unvested on the effective date.

 

      A “modified retrospective” method which includes the requirements of the modified prospective method described above, but also permits entities to restate based on the amounts previously recognized under SFAS 123 for purposes of pro forma disclosures either (a) all prior periods presented or (b) prior interim periods of the year of adoption.

 

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As permitted by SFAS 123, we currently account for share-based payments to employees using APB No. 25’s intrinsic value method and, as such, generally recognize no compensation cost for employee stock options.  Accordingly, the adoption of SFAS No. 123R’s fair value method will have a significant impact on our results of operations, although it will have no impact on our overall financial position. While management continues to evaluate the impact of SFAS No. 123R, we currently believe that the expensing of stock-based compensation will have an impact on our Consolidated Statement of Operations similar to our pro-forma disclosure under SFAS 123.

 

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.  We expect the adoption of SFAS No. 151 will not have a material impact on our financial position or results of operations.

 

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 was effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005.  The adoption of SFAS No. 153 did not have a material impact on our financial position or results of operations.

 

In May 2005, the FASB issued Statement No. 154 (“SFAS No. 154”), Accounting Changes and Error Corrections – A Replacement of APB Opinion No. 20 and FASB Statement No. 3 .   SFAS No. 154 changes the requirements for the accounting and reporting of a change in accounting principle and correction of errors. Under previous guidance, changes in accounting principle were recognized as a cumulative effect in the net income of the period of the change. The new statement requires retrospective application of changes in accounting principle and correction of errors, limited to the direct effects of the change, to prior periods’ financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change.  SFAS No. 154 is effective for accounting changes and correction of errors made in fiscal years beginning after December 15, 2005. In the event that we have an accounting change or an error correction, SFAS No. 154 could have a material impact on our consolidated financial statements.

 

On October 22, 2004, the President of the United States 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 2006 and 2007 will be limited to 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 (“Homeland Investment Act”). 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 determined 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 have evaluated the Act and have concluded that we will not repatriate foreign earnings under the Homeland Investment Act Provisions.

 

23



 

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 product portfolio includes such best-selling franchises as Spider-Man, Tony Hawk, Call of Duty, True Crime, X-Men, and Shrek.

 

Our products cover diverse game categories including action/adventure, action sports, racing, role-playing, simulation, first-person action, and strategy.  Our target customer base ranges from casual players to game enthusiasts, children to adults, and mass-market consumers to “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”), Nintendo Dual Screen (“NDS”), and Sony PlayStation Portable (“PSP”) hand-held devices, and the personal computer (“PC”).  In addition, we had a significant presence at the November, 2005 launch of Microsoft’s next-generation console, the Xbox 360 (“Xbox360”), with the concurrent release of four titles, Tony Hawk’s American Wasteland (“THAW”), Call of Duty 2, Quake 4, and GUN.   The installed base for the current generation of hardware platforms is significant and the recent releases of the NDS and PSP handheld devices and the next-generation Xbox360 will continue to expand the software market.

 

We also intend to develop titles for the next-generation console systems that are being developed by Sony and Nintendo.  We expect that Sony and Nintendo will release their next-generation consoles, the PlayStation 3 (“PS3”) and Revolution, in calendar 2006.  Our plan is to have a significant presence at the launch of each new platform while marketing to current generation platforms as long as economically attractive given their large installed base.

 

Our publishing business involves the development, marketing, and sale of products directly, by license or through our affiliate label program with certain third-party publishers.  In the United States and Canada, 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, the Netherlands, 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 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 propositions,” products that are backed by strong brands and high quality development, for which we will provide significant marketing support.

 

Our fiscal 2006 “big propositions” have included well-established brands, which were backed by high-profile intellectual property and/or highly anticipated motion picture releases.  We have a long-term relationship with Marvel Enterprises through an exclusive licensing agreement.  During the third quarter of fiscal 2006, we further extended our exclusive licensing agreement with Marvel Enterprises by signing a multi-year extension to our current video game licensing agreement for the Spider-Man and X-Men franchises through 2017.  This agreement grants us the exclusive rights to develop and publish video games based on Marvel’s comic book

 

24



 

franchises Spider-Man and X-Men.  Our fiscal 2006 release schedule included titles based on Marvel’s Spider-Man, X-Men, and Fantastic 4, which was part of our previous licensing agreement.  In the first quarter of fiscal 2006 we released the video game, Fantastic 4, just prior to the theatrical release of “Fantastic 4.”  We also released Ultimate Spider-Man and X-Men Legends II: Rise of the Apocalypse (“X-Men Legends II”) in the second quarter of fiscal 2006 in North America and in the third quarter of fiscal 2006 internationally.     In addition, through our licensing agreement with Spider-Man Merchandising, LP, 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.  In addition, during the third quarter of fiscal 2006, we signed an agreement with Spider-Man Merchandising, LP to extend our exclusive worldwide publishing rights to publish entertainment software products based on subsequent Spider-Man movie sequels or new television series through 2017.  We also have an exclusive licensing agreement with professional skateboarder Tony Hawk.  The agreement grants us exclusive rights to develop and publish video games through 2015 using Tony Hawk’s name and likeness.  Through the third quarter of fiscal 2006, we have released seven successful titles in the Tony Hawk franchise with cumulative net revenues of $1.1 billion, including the most recent, THAW , which was released in the third quarter of fiscal 2006.

 

We continue to develop a number of original intellectual properties which are developed and owned by Activision.  For example, in the third quarter of fiscal 2006 we released Call of Duty 2 on the PC and Xbox360 and Call of Duty 2: Big Red One , on the GameCube, PS2, and Xbox.  According to NPD Funworld, Call of Duty 2 was the top selling Xbox360 title of the holiday season.  These titles were the fourth and fifth releases based upon this original intellectual property following two other PC titles, Call of Duty and Call of Duty: United Offensive, and one other console title, Call of Duty: Finest Hour. In the third quarter of fiscal 2006, we also released True Crime: New York City , which was based upon our fiscal 2004 original intellectual property True Crime: Streets of LA, and GUN, a new original intellectual property.  According to NPD Funworld, we have developed the number one new original intellectual property title in each of the past three years which included True Crime: Streets of LA in calendar 2003, Call of Duty: Finest Hour in calendar 2004, and GUN in calendar 2005.  We expect to develop a variety of games on multiple platforms based on these original properties as well as continue to invest in developing other original intellectual properties.

 

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 LLC that grants 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, “Madagascar,” which was released in the first quarter of fiscal 2006, as well as upcoming computer-animated films “Over the Hedge,” and all of their respective sequels, including “Shrek 3” and “Madagascar 2.”   In addition, during the third quarter of fiscal 2006, we further enhanced our agreement with DreamWorks Animation SKG by signing a multi-year agreement which grants us the exclusive video game rights to potential future films in the “Shrek” franchise beyond “Shrek 3,” upcoming movies, including “Bee Movie” and “Kung Fu Panda,” as well as films currently in development, including “Rex Havoc” and “How to Train Your Dragon.”  Additionally, we have a strategic alliance with Harrah’s Entertainment, Inc. that grants us the exclusive, worldwide interactive rights to develop and publish “World Series of Poker” video games based on the widely popular World Series of Poker Tournament.  We released our first title under this alliance, World Series of Poker, in the second quarter of fiscal 2006.

 

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 several development companies with talented and experienced teams including, most recently, the acquisitions of Vicarious Visions Inc. in January 2005, Toys For Bob, Inc. in April 2005, and Beenox, Inc. in May 2005.  We have development agreements with other top-level, third-party developers such as id Software.

 

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.

 

25



 

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 Consolidated Financial Statements included in Item 1.  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.

 

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.

 

Allowances for Returns, Price Protection, Doubtful Accounts and Inventory Obsolescence.  In determining the appropriate unit shipments to our customers, we benchmark our titles using historical and industry data.  We closely monitor and analyze the historical performance of our various titles, the performance of products released by other publishers and the anticipated timing of other releases in order to assess future demands of current and upcoming titles.  Initial volumes shipped upon title launch and subsequent reorders are evaluated to ensure that quantities are sufficient to meet the demands from the retail markets, but at the same time, are controlled to prevent excess inventory in the channel.

 

We may permit product returns from, or grant price protection to, our customers under certain conditions.  In general, price protection refers to the circumstances when we elect to decrease the wholesale price of a product by a certain amount and, when granted and applicable, allows customers a credit against amounts owed by such customers to us 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, our 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

 

26



 

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 factors or market conditions change or if management makes different judgments or utilizes different estimates in determining the allowances for returns and price protection.  For example, a 1% change in our December 31, 2005 allowance for returns and price protection would impact net revenues by $1.7 million.

 

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 affect 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 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.

 

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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,

 

 

 

2005

 

2004

 

2005

 

2004

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

$

816,242

 

100

%

$

680,094

 

100

%

$

1,279,875

 

100

%

$

1,201,996

 

100

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Costs and expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cost of sales – product costs

 

367,685

 

45

 

316,494

 

47

 

617,021

 

48

 

528,759

 

44

 

Cost of sales – software royalties and amortization

 

104,264

 

13

 

58,200

 

9

 

139,267

 

11

 

116,846

 

10

 

Cost of sales – intellectual property licenses

 

26,376

 

3

 

22,598

 

3

 

55,765

 

5

 

57,797

 

5

 

Product development

 

53,139

 

7

 

25,068

 

4

 

99,013

 

8

 

66,054

 

5

 

Sales and marketing

 

155,999

 

19

 

105,248

 

15

 

258,957

 

20

 

200,216

 

16

 

General and administrative

 

24,712