Activision Blizzard, Inc.
ACTIVISION INC /NY (Form: 10-Q, Received: 06/07/2007 06:04:23)

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

 

(Mark one)

x

 

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

 

 

EXCHANGE ACT OF 1934

 

 

 

For the Quarterly Period Ended September 30, 2006

 

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 001-15839

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 x   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  x       Accelerated Filer  o       Non-accelerated filer  o

 

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

 

 

 

The number of shares of the registrant’s Common Stock outstanding as of June 1, 2007 was 283,310,734.

 

 

 

 




ACTIVISION, INC. AND SUBSIDIARIES

INDEX

 

 

 

 

 

 

 

 

 

 

 

Explanatory Note

 

 

 

 

 

 

 

PART I .

 

FINANCIAL INFORMATION

 

 

 

 

 

 

 

Item 1.

 

Financial Statements

 

 

 

 

 

 

 

 

 

Consolidated Balance Sheets as of September 30, 2006 (Unaudited) and March 31, 2006

 

 

 

 

 

 

 

 

 

Consolidated Statements of Operations for the three and six months ended September 30, 2006 (Unaudited) and September 30, 2005, as restated (Unaudited)

 

 

 

 

 

 

 

 

 

Consolidated Statements of Cash Flows for the six months ended September 30, 2006 (Unaudited) and September 30, 2005, as restated (Unaudited)

 

 

 

 

 

 

 

 

 

Consolidated Statement of Changes in Shareholders’ Equity for the six months ended September 30, 2006 (Unaudited)

 

 

 

 

 

 

 

 

 

Notes to Consolidated Financial Statements for the three and six months ended September 30, 2006 (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 1A.

 

Risk Factors

 

 

 

 

 

 

 

Item 4.

 

Submission of Matters to a Vote of Securitiy Holders

 

 

 

 

 

 

 

Item 6.

 

Exhibits

 

 

 

 

 

 

 

SIGNATURES

 

 

 

 

 

 

 

CERTIFICATIONS

 

 


2




CAUTIONARY STATEMENT

This Quarterly Report on Form 10-Q contains, or incorporates by reference, certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements include, but are not limited to, (1) projections of revenues, expenses, income or loss, earnings or loss per share, cash flow projections or other financial items; (2) statements of our plans and objectives, including those relating to product releases; (3) statements of future economic performance; and (4) statements of assumptions underlying such statements. We generally use words such as “anticipate”, “believe”, “could”, “estimate”, “expect”, “forecast”, “future”, “intend”, “may”, “plan”, “positioned”, “potential”, “project”, “scheduled”, “set to”, “subject to”, “upcoming” and other similar expressions to help identify forward-looking statements. These forward-looking statements are subject to business and economic risk, reflect management’s current expectations, estimates and projections about our business, and are inherently uncertain and difficult to predict. Our actual results could differ materially. The forward-looking statements contained herein speak only as of the date on which they were made, and we disclaim any obligation to update any forward-looking statements to reflect events or circumstances after the date of this Quarterly Report. Risks and uncertainties that may affect our future results include, but are not limited to, those discussed under the heading “Risk Factors”, included in Part II, Item 1A. All references to “we”, “us”, “our”, “Activision” or “the Company” in the following discussion and analysis mean Activision, Inc. and its subsidiaries.

EXPLANATORY NOTE

Restatement of Consolidated Financial Results

We recently completed a voluntary review of our historical stock option granting practices and a restatement of our consolidated financial statements as of and for the fiscal years ended March 31, 2006, 2005 and 2004 and related disclosures and a restatement of our selected consolidated financial data as of and for the fiscal years ended March 31, 2006, 2005, 2004, 2003 and 2002 and our unaudited quarterly financial data for each of the quarters in the fiscal years ended March 31, 2006 and 2005.  The impacts of the restatement adjustments extend to periods from the fiscal year ended March 31, 1994 through the fiscal quarter ended June 30, 2006.

The restatement reflected the findings of a special subcommittee of independent members of our Board of Directors, which was established in July 2006 to review our historical stock option granting practices (the “Special Subcommittee”).  The Special Subcommittee conducted its investigation with the assistance of Munger Tolles & Olson LLP as its independent counsel and Deloitte & Touche USA LLP (“Deloitte”) as forensic accounting experts retained by counsel.  The Special Subcommittee found that 3,450 of the option grants reviewed, covering 148,747,202 shares, required measurement date corrections.  As a result, we recorded approximately $66.7 million in additional pre-tax ($45.4 million after-tax) non-cash stock-based compensation expense over the thirteen year period from April 1, 1993 through March 31, 2006 in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”), and $0.6 million in additional pre-tax non-cash stock-based compensation expense during the quarter ended June 30, 2006 in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share-Based Payment”.  More than 80% or $55.4 million of the $66.7 million relates to periods through March 31, 2003 and 4% or $2.6 million of the non-cash pre-tax expense relates to the year ended March 31, 2006.  Separately, the restatement reflects an additional $1.7 million pre-tax charge ($1.1 million after-tax) related to recently identified insufficient payroll tax withholdings in fiscal 2005.

This Quarterly Report on Form 10-Q should be read in conjunction with our Amended Annual Report on Form 10-K/A for the year ended March 31, 2006 filed with the SEC on May 25, 2007 and our Amended Quarterly Report on Form 10-Q/A for the three months ended June 30, 2006 filed with the SEC on June 7, 2007. Information regarding the effect of the restatement on our financial position and results of operations is provided in Note 2 of the Unaudited Consolidated Financial Statements included in Part I, Item 1 of this Report and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part I, Item 2 of this Report.

Financial information included in our previously filed reports on Form 10-K and Form 10-Q, the related opinions of our independent registered public accounting firm, and all earnings press releases and similar communications issued by us, for all periods ended on or before June 30, 2006 should not be relied upon and are superseded in their entirety by the information in our Amended Annual Report on Form 10-K/A for the year ended March 31, 2006 filed

3




with the SEC on May 25, 2007 and our amended Quarterly Report on Form 10-Q/A for the three months ended June 30, 2006 and our Quarterly Report on Form 10-Q for the three months ended September 30, 2006 filed with the SEC on June 7, 2007.

All share and per share information presented in this report has been adjusted to reflect splits and dividends of our common stock.

4




PART I.  Financial Information .
Item 1.  Financial Statements.

ACTIVISION, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)

 

 

September 30,
2006
(Unaudited)

 

March 31,
2006

 

Assets

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

189,721

 

$

354,331

 

Short-term investments

 

557,674

 

590,629

 

Accounts receivable, net of allowances of $76,734 and
$98,253 at September 30, 2006 and March 31, 2006, respectively

 

97,086

 

28,782

 

Inventories

 

71,063

 

61,483

 

Software development

 

95,694

 

40,260

 

Intellectual property licenses

 

23,996

 

4,973

 

Deferred income taxes

 

6,484

 

9,664

 

Other current assets

 

37,917

 

25,933

 

 

 

 

 

 

 

Total current assets

 

1,079,635

 

1,116,055

 

 

 

 

 

 

 

Software development

 

22,094

 

20,359

 

Intellectual property licenses

 

71,100

 

82,073

 

Property and equipment, net

 

45,185

 

45,368

 

Deferred income taxes

 

121,085

 

52,545

 

Other assets

 

5,676

 

1,409

 

Goodwill

 

188,254

 

100,446

 

 

 

 

 

 

 

Total assets

 

$

1,533,029

 

$

1,418,255

 

 

 

 

 

 

 

Liabilities and Shareholders’ Equity

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

83,418

 

$

88,994

 

Accrued expenses

 

169,195

 

104,862

 

 

 

 

 

 

 

Total current liabilities

 

252,613

 

193,856

 

 

 

 

 

 

 

Other liabilities

 

41,070

 

1,776

 

 

 

 

 

 

 

Total liabilities

 

293,683

 

195,632

 

 

 

 

 

 

 

Commitments and contingencies (Note 14)

 

 

 

 

 

 

 

 

 

 

 

Shareholders’ equity:

 

 

 

 

 

Preferred stock, $.000001 par value, 3,750,000 shares authorized, no shares issued at September 30, 2006 and March 31, 2006

 

 

 

Series A Junior Preferred stock, $.000001 par value, 1,250,000 shares authorized, no shares issued at September 30, 2006 and March 31, 2006

 

 

 

Common stock, $.000001 par value, 450,000,000 shares authorized, 281,509,470 and 277,020,898 shares issued and outstanding at September 30, 2006 and March 31, 2006, respectively

 

 

 

Additional paid-in capital

 

927,392

 

867,297

 

Retained earnings

 

299,379

 

341,990

 

Accumulated other comprehensive income

 

12,575

 

16,369

 

Unearned compensation (Note 1)

 

 

(3,033

)

 

 

 

 

 

 

Total shareholders’ equity

 

1,239,346

 

1,222,623

 

 

 

 

 

 

 

Total liabilities and shareholders’ equity

 

$

1,533,029

 

$

1,418,255

 

 

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

5




ACTIVISION, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(In thousands, except per share data)

 

 

For the three months ended 
September 30,

 

For the six months ended 
September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

 

 

As restated (1)

 

 

 

As restated (1)

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

$

188,172

 

$

222,540

 

$

376,241

 

$

463,633

 

 

 

 

 

 

 

 

 

 

 

Costs and expenses:

 

 

 

 

 

 

 

 

 

Cost of sales — product costs

 

127,374

 

112,582

 

235,997

 

249,336

 

Cost of sales — software royalties and amortization

 

9,348

 

20,427

 

28,609

 

35,003

 

Cost of sales — intellectual property licenses

 

4,356

 

8,449

 

14,272

 

29,389

 

Product development

 

25,608

 

28,366

 

51,233

 

46,444

 

Sales and marketing

 

32,550

 

56,730

 

68,729

 

103,097

 

General and administrative

 

26,346

 

23,774

 

48,260

 

42,471

 

 

 

 

 

 

 

 

 

 

 

Total costs and expenses

 

225,582

 

250,328

 

447,100

 

505,740

 

 

 

 

 

 

 

 

 

 

 

Operating loss

 

(37,410

)

(27,788

)

(70,859

)

(42,107

)

 

 

 

 

 

 

 

 

 

 

Investment income, net

 

8,032

 

6,330

 

16,307

 

13,678

 

 

 

 

 

 

 

 

 

 

 

Loss before income tax benefit

 

(29,378

)

(21,458

)

(54,552

)

(28,429

)

 

 

 

 

 

 

 

 

 

 

Income tax benefit

 

(5,076

)

(7,228

)

(11,941

)

(9,952

)

 

 

 

 

 

 

 

 

 

 

Net loss

 

$

(24,302

)

$

(14,230

)

$

(42,611

)

$

(18,477

)

 

 

 

 

 

 

 

 

 

 

Basic loss per share

 

$

(0.09

)

$

(0.05

)

$

(0.15

)

$

(0.07

)

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding

 

280,627

 

272,129

 

279,487

 

270,643

 

 

 

 

 

 

 

 

 

 

 

Diluted loss per share

 

$

(0.09

)

$

(0.05

)

$

(0.15

)

$

(0.07

)

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding assuming dilution

 

280,627

 

272,129

 

279,487

 

270,643

 


(1) See Note 2 “Restatement of Unaudited Consolidated Financial Statements.”  

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

 

6




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

 

 

For the six months ended
September 30,

 

 

 

2006

 

2005

 

 

 

 

 

As restated (1)

 

Cash flows from operating activities:

 

 

 

 

 

Net loss

 

$

(42,611

)

$

(18,477

)

Adjustments to reconcile net loss to net cash used in operating activities:

 

 

 

 

 

Deferred income taxes

 

(70,149

)

(21,579

)

Realized gain on short-term investments

 

(2

)

(1,347

)

Depreciation and amortization

 

8,519

 

6,593

 

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

 

26,283

 

43,827

 

Stock-based compensation expense

 

10,740

 

2,184

 

Tax benefit of stock options and warrants exercised

 

5,888

 

11,589

 

Excess tax benefit from stock option exercises

 

(4,405

)

 

Changes in operating assets and liabilities:

 

 

 

 

 

Accounts receivable

 

(57,194

)

(7,692

)

Inventories

 

(5,956

)

(4,017

)

Software development and intellectual property licenses

 

(84,630

)

(68,716

)

Other assets

 

1,377

 

(6,624

)

Accounts payable

 

(11,984

)

(18,141

)

Accrued expenses and other liabilities

 

54,853

 

(11,868

)

 

 

 

 

 

 

Net cash used in operating activities

 

(169,271

)

(94,268

)

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Capital expenditures

 

(7,540

)

(12,723

)

Cash payment to effect business combinations, net of cash acquired

 

(30,545

)

(6,933

)

Increase in restricted cash

 

(12,500

)

(20,000

)

Purchases of short-term investments

 

(147,278

)

(132,662

)

Proceeds from sales and maturities of short-term investments

 

180,993

 

132,856

 

 

 

 

 

 

 

Net cash used in investing activities

 

(16,870

)

(39,462

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Proceeds from issuance of common stock to employees

 

11,922

 

27,364

 

Excess tax benefit from stock option exercises

 

4,405

 

 

 

 

 

 

 

 

Net cash provided by financing activities

 

16,327

 

27,364

 

 

 

 

 

 

 

Effect of exchange rate changes on cash

 

5,204

 

(4,157

)

 

 

 

 

 

 

Net decrease in cash and cash equivalents

 

(164,610

)

(110,523

)

 

 

 

 

 

 

Cash and cash equivalents at beginning of period

 

354,331

 

313,608

 

 

 

 

 

 

 

Cash and cash equivalents at end of period

 

$

189,721

 

$

203,085

 

 

 

 

 

 

 


(1) See Note 2 “Restatement of Unaudited Consolidated Financial Statements.”

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



7




ACTIVISION, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY
For the Six Months ended September 30, 2006
(Unaudited)
(In thousands)

 

 

 

Common Stock

 

Additional

 

 

 

Accumulated
Other

 

 

 

 

 

 

 

Shares

 

Amount

 

Paid-In
Capital

 

Retained
Earnings

 

Comprehensive
Income

 

Unearned
Compensation

 

Shareholders’
Equity

 

Balance, March 31, 2006

 

277,021

 

$

 

$

867,297

 

$

341,990

 

$

16,369

 

$

(3,033

)

$

1,222,623

 

Components of comprehensive income:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

 

 

 

(42,611

)

 

 

(42,611

)

Unrealized loss on short-term investments (net of tax benefit of $1.7 million)

 

 

 

 

 

(10,035

)

 

(10,035

)

Foreign currency translation adjustment

 

 

 

 

 

6,241

 

 

6,241

 

Total comprehensive loss

 

 

 

 

 

 

 

 

 

 

 

 

 

(46,405

)

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

 

2,106

 

 

11,922

 

 

 

 

11,922

 

Issuance of stock to effect business combination

 

2,382

 

 

30,000

 

 

 

 

30,000

 

Stock based compensation expense related to employee stock options, restricted stock, and employee stock purchases

 

 

 

15,318

 

 

 

 

15,318

 

Tax benefit attributable to employee stock options and common stock warrants

 

 

 

5,888

 

 

 

 

5,888

 

Reclassification of unearned compensation

 

 

 

(3,033

)

 

 

3,033

 

 

Balance, September 30, 2006

 

281,509

 

$

 

$

927,392

 

$

299,379

 

$

12,575

 

$

 

$

1,239,346

 

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

8




ACTIVISION, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
For the Three and Six Months ended September 30, 2006

1.     Summary of Significant Accounting Policies

Basis of Presentation

The accompanying consolidated financial statements include the accounts of Activision, Inc. and its subsidiaries (“Activision,” the “Company,” 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 Amended Annual Report on Form 10-K/A for the year ended March 31, 2006 as filed with the Securities and Exchange Commission (“SEC”) on May 25, 2007.

Software Development Costs and Intellectual Property Licenses

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

We account for software development costs in accordance with Statement of Financial Accounting Standards No. 86, “Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed.”  Software development costs are capitalized once the 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

9




ACTIVISION, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
For the Three and Six Months ended September 30, 2006

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, 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 (i.e., a date on which 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.  With respect to on-line transactions, such as electronic downloads of titles or product add-ons, revenue is recognized when the fee is paid by the on-line customer to purchase online content and we are notified by the online retailer that the product has been downloaded.  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

10




ACTIVISION, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
For the Three and Six Months ended September 30, 2006

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 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 September 30, 2006 allowance for returns and price protection would impact net revenues by $0.7 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.

 

11




ACTIVISION, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
For the Three and Six Months ended September 30, 2006

Stock-Based Compensation

On April 1, 2006, we adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors including employee stock options and employee stock purchases related to the Employee Stock Purchase Plan (“employee stock purchases”) based on estimated fair values. SFAS 123R supersedes our previous accounting under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”).  In March 2005, the SEC issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS 123R. We have applied the provisions of SAB 107 in our adoption of SFAS 123R.

We adopted SFAS 123R using the modified prospective transition method, which requires the application of the accounting standard as of April 1, 2006, the first day of our fiscal year 2007. The Company’s Consolidated Financial Statements as of and for the three and six months ended September 30, 2006 reflect the impact of SFAS 123R. In accordance with the modified prospective transition method, the Company’s Consolidated Financial Statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123R.  Stock-based compensation expense recognized under SFAS 123R for the three and six months ended September 30, 2006 was $4.9 million and $10.7 million, respectively.  See Note 15 for additional information.

SFAS 123R requires companies to estimate the fair value of share-based payment awards on the measurement date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in our Consolidated Statement of Operations. Prior to the adoption of SFAS 123R, the Company accounted for stock-based awards to employees and directors using the intrinsic value method in accordance with APB 25 as allowed under Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). Under APB 25, compensation expense was 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 was recorded on the date of grant or measurement date only if the current market price of the underlying stock exceeded the stock option or other stock-based award’s exercise price.  For the three and six months ended September 30, 2005, we recognized $1.3 million and $2.2 million, respectively, in stock-based compensation expense related to employee stock options and restricted stock under APB 25.  See Notes 2 and 15 for additional information.

Stock-based compensation expense recognized during the period is based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. Stock-based compensation expense recognized in our Consolidated Statements of Operations for the first and second quarters of fiscal 2007 included compensation expense for share-based payment awards granted prior to, but not yet vested as of April 1, 2006, based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS 123, and compensation expense for the share-based payment awards granted subsequent to April 1, 2006 based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. As stock-based compensation expense recognized in the Consolidated Statements of Operations for the first and second quarters of fiscal 2007 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

As of April 1, 2005, we changed our method of valuation for share-based awards to a binomial-lattice model from the Black-Scholes option-pricing model (“Black-Scholes model”) which was used for options granted prior to April 1, 2005.  For additional information, see Note 15.  Our determination of fair value of share-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to our expected stock price volatility over the term of the awards, and actual and projected employee stock option exercise behaviors.

12




ACTIVISION, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
For the Three and Six Months ended September 30, 2006

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 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” of $2.0 million and $1.5 million on the respective balance sheets at the times of grant.  Prior to the adoption of SFAS 123R, we reduced unearned compensation and recognized compensation expense over the vesting periods.  Upon adoption of SFAS 123R, unearned compensation was reclassified against additional paid in capital and we will increase additional paid in capital and recognize compensation expense over the respective remaining vesting periods.  In accordance with SFAS 123R we will recognize compensation expense and increase additional paid in capital related to these restricted stock shares over the requisite service period.  For the three and six months ended September 30, 2006, we recorded expenses related to these shares of approximately $175,000 and $350,000, respectively, which was included as a component of stock-based compensation expense within “General and administrative” on the accompanying Consolidated Statements of Operations.  Since the issuance dates, we have recognized $817,000 of the $3.5 million of unearned compensation, with the remainder to be recognized over a weighted-average period of 3.8 years.

2.     Restatement of Unaudited Consolidated Financial Statements

 

We recently completed a voluntary review of our historical stock option granting practices and a restatement of our consolidated financial statements as of and for the fiscal years ended March 31, 2006, 2005 and 2004 and related disclosures and a restatement of our selected consolidated financial data as of and for the fiscal years ended March 31, 2006, 2005, 2004, 2003 and 2002 and our unaudited quarterly financial data for each of the quarters in the fiscal years ended March 31, 2006 and 2005, and for the fiscal quarter ended June 30, 2006.  The impacts of the restatement adjustments extend to periods from the fiscal year ended March 31, 1994 through the fiscal quarter ended June 30, 2006.

The restatement reflected the findings of a special subcommittee of independent members of our Board of Directors, which was established in July 2006 to review our historical stock option granting practices (the “Special Subcommittee”).  The Special Subcommittee conducted its investigation with the assistance of Munger Tolles & Olson LLP as its independent counsel and Deloitte & Touche USA LLP (“Deloitte”) as forensic accounting experts retained by counsel.  The Special Subcommittee found that 3,450 of the option grants reviewed, covering 148,747,202 shares, required measurement date corrections.  As a result, we recorded approximately $66.7 million in additional pre-tax ($45.4 million after-tax) non-cash stock-based compensation expense over the thirteen year period from April 1, 1993 through March 31, 2006 in accordance with APB 25, and $0.6 million in additional pre-tax non-cash stock-based compensation expense during the quarter ended June 30, 2006 in accordance with SFAS 123R.  More than 80% or $55.4 million of the $66.7 million relates to periods through March 31, 2003 and 4% or $2.6 million of the non-cash pre-tax expense relates to the fiscal year ended March 31, 2006.  Separately, the restatement reflected an additional $1.7 million pre-tax charge ($1.1 million after-tax) related to recently identified insufficient payroll tax withholdings in fiscal 2005.

Additional information regarding the restatement is available with the Company’s Amended Annual Report on Form 10-K/A for the period ending March 31, 2006

13




ACTIVISION, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
For the Three and Six Months ended September 30, 2006

The following table summarizes additional pre-tax stock-based compensation expense and related tax adjustments resulting from the review of our equity award practices for the three and six months ended September 30, 2005 (in thousands):

 

 

For the three months
ended 
September 30, 2005 

 

For the six months 
ended
September 30, 2005 

 

 

 

 

 

 

 

Net loss, as previously reported

 

$

(13,242

)

$

(16,827

)

 

 

 

 

 

 

Additional compensation expense resulting from improper
measurement dates for stock option grants (1)

 

1,241

 

2,112

 

 

 

 

 

 

 

 Tax related effects

 

(253

)

(462

)

 

 

 

 

 

 

 Total effect on net loss

 

988

 

1,650

 

 

 

 

 

 

 

Net loss, as restated

 

$

(14,230

)

$

(18,477

)


(1) Also includes an immaterial amount of interest expense related to our $1.7 million charge for insufficient payroll tax withholdings in fiscal 2005.

Certain Tax Consequences :  Certain stock options were granted with an exercise price lower than the fair market value on the actual measurement dates, with vesting occurring after December 31, 2004, which resulted in nonqualified deferred compensation for purposes of Section 409A of the Internal Revenue Code.  Section 409A subjects the option holders to additional income tax, penalties and interest on the value of the options deferred and, in certain cases, exercised each year.  We do not have any tax liability associated with Section 409A. For options that have already been exercised by non-executive officer employees, that are subject to Section 409A consequences, the Company has elected to  participate in the Internal Revenue Service program described in IRS Announcement 2007-18 pursuant to which the Company was able to pay the Section 409A taxes on behalf of its non-executive officer employees, and has incurred $7.3 million in additional pre-tax compensation expense in the fiscal quarter ended March 31, 2007, in absorbing these related costs on behalf of these employees. With respect to unexercised options subject to Section 409A held by such current and former non-executive officer employees, the Company on or about June7, 2007 is commencing an offer to amend the exercise price of these options to eliminate their Section 409A tax liability consistent with Internal Revenue Service guidance.  Pursuant to the offer, the Company will also make a cash payment in January 2008 to employees who accept the offer, in an amount equal to the difference between the original exercise price of each amended option and the amended exercise price of each amended option. This will likely result in additional future compensation expense to the Company once these actions occur.

 

The following tables reflect the impact of the additional non-cash charges for stock-based compensation expense and related tax effects on:

·                   the Consolidated Statements of Operations for the three and six months ended September 30, 2005 (Unaudited).

·                   the Consolidated Statement of Cash Flows for the six months ended September 30, 2005 (Unaudited).

·                   the pro forma information required by SFAS No. 123 for the three and six months ended September 30, 2005 (Unaudited).

14




ACTIVISION, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
For the Three and Six Months ended September 30, 2006

Consolidated Statement of Operations (Unaudited)

 

 

For the three months ended September 30, 2005

 

(in thousands, except per share data)

 

As previously 
reported

 

Adjustments

 

As restated

 

 

 

 

 

 

 

 

 

Net revenues

 

$

222,540

 

$

 

$

222,540

 

 

 

 

 

 

 

 

 

Costs and expenses:

 

 

 

 

 

 

 

Cost of sales — product costs

 

112,582

 

 

112,582

 

Cost of sales — software royalties and amortization

 

20,427

 

 

20,427

 

Cost of sales — intellectual property licenses

 

8,449

 

 

8,449

 

Product development

 

28,072

 

294

 

28,366

 

Sales and marketing

 

56,640

 

90

 

56,730

 

General and administrative

 

22,917

 

857

 

23,774

 

 

 

 

 

 

 

 

 

Total costs and expenses

 

249,087

 

1,241

 

250,328

 

 

 

 

 

 

 

 

 

Operating loss

 

(26,547

)

(1,241

)

(27,788

)

 

 

 

 

 

 

 

 

Investment income, net

 

6,330

 

 

6,330

 

 

 

 

 

 

 

 

 

Loss before income tax benefit

 

(20,217

)

(1,241

)

(21,458

)

 

 

 

 

 

 

 

 

Income tax benefit

 

(6,975

)

(253

)

(7,228

)

 

 

 

 

 

 

 

 

Net loss

 

$

(13,242

)

$

(988

)

$

(14,230

)

 

 

 

 

 

 

 

 

Basic loss per share

 

$

(0.05

)

$

 

$

(0.05

)

 

 

 

 

 

 

 

 

Weighted average common shares outstanding

 

272,129

 

 

272,129

 

 

 

 

 

 

 

 

 

Diluted loss per share

 

$

(0.05

)

$

 

$

(0.05

)

 

 

 

 

 

 

 

 

Weighted average common shares outstanding

 

272,129

 

 

272,129

 

 

15




ACTIVISION, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
For the Three and Six Months ended September 30, 2006

Consolidated Statement of Operations (Unaudited)

 

 

For the six months ended September 30, 2005

 

(in thousands, except per share data)

 

As previously 
reported

 

Adjustments

 

As restated

 

 

 

 

 

 

 

 

 

Net revenues

 

$

463,633

 

$

 

$

463,633

 

 

 

 

 

 

 

 

 

Costs and expenses:

 

 

 

 

 

 

 

Cost of sales — product costs

 

249,336

 

 

249,336

 

Cost of sales — software royalties and amortization

 

35,003

 

 

35,003

 

Cost of sales — intellectual property licenses

 

29,389

 

 

29,389

 

Product development

 

45,874

 

570

 

46,444

 

Sales and marketing

 

102,958

 

139

 

103,097

 

General and administrative

 

41,068

 

1,403

 

42,471

 

 

 

 

 

 

 

 

 

Total costs and expenses

 

503,628

 

2,112

 

505,740

 

 

 

 

 

 

 

 

 

Operating loss

 

(39,995

)

(2,112

)

(42,107

)

 

 

 

 

 

 

 

 

Investment income, net

 

13,678

 

 

13,678

 

 

 

 

 

 

 

 

 

Loss before income tax benefit

 

(26,317

)

(2,112

)

(28,429

)

 

 

 

 

 

 

 

 

Income tax benefit

 

(9,490

)

(462

)

(9,952

)

 

 

 

 

 

 

 

 

Net loss

 

$

(16,827

)

$

(1,650

)

$

(18,477

)

 

 

 

 

 

 

 

 

Basic loss per share

 

$

(0.06

)

$

(0.01

)

$

(0.07

)

 

 

 

 

 

 

 

 

Weighted average common shares outstanding

 

270,643

 

 

270,643

 

 

 

 

 

 

 

 

 

Diluted loss per share

 

$

(0.06

)

$

(0.01

)

$

(0.07

)

 

 

 

 

 

 

 

 

Weighted average common shares outstanding assuming dilution

 

270,643

 

 

270,643

 

 

 

16




ACTIVISION, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
For the Three and Six Months ended September 30, 2006

Consolidated Statement of Cash Flows (Unaudited)

 

 

For the six months ended
September 30, 2005

 

(in thousands)

 

As previously
reported

 

Adjustments

 

As restated

 

Cash flows from operating activities:

 

 

 

 

 

 

 

Net loss

 

$

(16,827

)

$

(1,650

)

$

(18,477

)

Adjustments to reconcile net loss to net cash used in operating activities:

 

 

 

 

 

 

 

Deferred income taxes

 

(24,997

)

3,418

 

(21,579

)

Realized gain on sale of short term investments

 

(1,347

)

 

(1,347

)

Depreciation and amortization

 

6,593

 

 

6,593

 

Amortization of capitalized software development costs and intellectual property licenses

 

43,827

 

 

43,827

 

Stock-based compensation expense

 

117

 

2,067

 

2,184

 

Tax benefit of stock options and warrants exercised

 

15,468

 

(3,879

)

11,589

 

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

 

 

 

 

 

 

 

Accounts receivable

 

(7,692

)

 

(7,692

)

Inventories

 

(4,017

)

 

(4,017

)

Software development and intellectual property licenses

 

(68,716

)

 

(68,716

)

Other assets

 

(6,624

)

 

(6,624

)

Accounts payable

 

(18,141

)

 

(18,141

)

Accrued expenses and other liabilities

 

(11,912

)

44

 

(11,868

)

 

 

 

 

 

 

 

 

Net cash used in operating activities

 

(94,268

)

 

(94,268

)

 

 

 

 

 

 

 

 

Cash flows used in investing activities:

 

 

 

 

 

 

 

Capital expenditures

 

(12,723

)

 

(12,723

)

Cash payments to effect business combinations, net of cash acquired

 

(6,933

)

 

(6,933

)

Increase in restricted cash

 

(20,000

)

 

(20,000

)

Purchases of short-term investments

 

(132,662

)

 

(132,662

)

Proceeds from sales and maturities of short-term investments

 

132,856

 

 

132,856

 

 

 

 

 

 

 

 

 

Net cash used in investing activities

 

(39,462

)

 

(39,462

)

 

 

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

 

 

Proceeds from issuance of common stock to employees

 

27,364

 

 

27,364

 

 

 

 

 

 

 

 

 

Net cash provided by financing activities

 

27,364

 

 

27,364

 

 

 

 

 

 

 

 

 

Effect of exchange rate changes on cash

 

(4,157

)

 

(4,157

)

 

 

 

 

 

 

 

 

Net decrease in cash and cash equivalents

 

(110,523

)

 

(110,523

)

 

 

 

 

 

 

 

 

Cash and cash equivalents at beginning of period

 

313,608

 

 

313,608

 

 

 

 

 

 

 

 

 

Cash and cash equivalents at end of period

 

$

203,085

 

$

 

$

203,085

 

 

17




ACTIVISION, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
For the Three and Six Months ended September 30, 2006

Pro forma information regarding net income and net income per share is required by SFAS No. 123 and has been determined as if the Company had accounted for its employee stock purchase plan and employee stock option plans under the fair value method of SFAS No. 123.  The impact of the restatements on the pro forma information is as follows (in thousands, except per share data):

 

 

 

For the three months ended
September 30, 2005

 

(in thousands, except per share data)

 

As previously
reported

 

Adjustments

 

As restated

 

Net loss, as reported

 

$

(13,242

)

$

(988

)

$

(14,230

)

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

 

 

974

 

974

 

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

 

(3,705

)

(635

)

(4,340

)

 

 

 

 

 

 

 

 

Pro forma net loss

 

$

(16,947

)

$

(649

)

$

(17,596

)

 

 

 

 

 

 

 

 

Loss per share

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic — as reported

 

$

(0.05

)

$

 

$

(0.05

)

Basic — pro forma

 

$

(0.06

)

$

 

$

(0.06

)

 

 

 

 

 

 

 

 

Diluted — as reported

 

$

(0.05

)

$

 

$

(0.05

)

Diluted — pro forma

 

$

(0.06

)

$

 

$

(0.06

)

 

 

 

For the six months ended
September 30, 2005

 

(in thousands, except per share data)

 

As previously
reported

 

Adjustments

 

As restated

 

Net loss, as reported

 

$

(16,827

)

$

(1,650

)

$

(18,477

)

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

 

 

1,623

 

1,623

 

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

 

(6,676

)

(1,289

)

(7,965

)

 

 

 

 

 

 

 

 

Pro forma net loss

 

$

(23,503

)

$

(1,316

)

$

(24,819

)

 

 

 

 

 

 

 

 

Loss per share

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic — as reported

 

$

(0.06

)

$

(0.01

)

$

(0.07

)

Basic — pro forma

 

$

(0.09

)

$

 

$

(0.09

)

 

 

 

 

 

 

 

 

Diluted — as reported

 

$

(0.06

)

$

(0.01

)

$

(0.07

)

Diluted — pro forma

 

$

(0.09

)

$

 

$

(0.09

)

 

18




ACTIVISION, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
For the Three and Six Months ended September 30, 2006

3.               Acquisitions

RedOctane, Inc.

On June 6, 2006, we completed our acquisition of 100% of RedOctane, Inc. (“RedOctane”) for an aggregate accounting purchase price of $99.9 million, including transaction costs, consisting of $30.9 million in cash and 2,382,077 shares of Activision common stock valued at approximately $30.0 million based upon prevailing market prices which was issued on the closing date, and $39.0 million payable in Activision common stock within two years of the closing date, which is recorded in other liabilities. In addition, in the event the adjusted net income of the business over a certain period of time exceeds specified target levels by certain amounts, certain former shareholders of RedOctane will be entitled to an additional amount of up to $51.0 million payable in shares of Activision common stock. The contingent consideration will be recorded as an additional element of the purchase price if those contingencies are achieved. Based in Sunnyvale, California, RedOctane is a publisher, developer, and distributor of interactive entertainment software, hardware, and accessories. RedOctane offers its interactive entertainment products in versions that operate on the Sony PlayStation 2 (“PS2”), the Microsoft Xbox (“Xbox”), and the personal computer (“PC”), and its leading software product offering is Guitar Hero for the PS2. RedOctane also designs, manufactures, and markets high quality video game peripherals and accessories. This acquisition provides Activision with an early leadership position in music-based gaming, which we expect will be one of the fastest growing genres in the coming years.

The results of operations of RedOctane and the estimated fair market values of the acquired assets and liabilities have been included in the Consolidated Financial Statements since the date of acquisition. Pro forma consolidated statements of operations for this acquisition are not shown, as they would not differ materially from reported results. The acquired, finite-lived intangible assets are being amortized over estimated lives ranging from 0.6 to 1.6 years. Goodwill has been included in the publishing segment of our business and is non-deductible for tax purposes.

Purchase Price Allocation

We accounted for this acquisition in accordance with SFAS No. 141, “Business Combinations.” SFAS No. 141 addresses financial accounting and reporting for business combinations, requiring that the purchase method be used to account and report for all business combinations. The purchase price for the RedOctane transaction was allocated to assets acquired and liabilities assumed as set forth below (in thousands):

Current assets

 

$

17,530

 

Property and equipment, net

 

207

 

Other assets

 

1,033

 

Goodwill

 

87,004

 

Trademark and other intangibles

 

16,700

 

Deferred tax liability

 

(6,496

)

Other liabilities

 

(16,033

)

Total consideration

 

$

99,945

 

 

19




ACTIVISION, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
For the Three and Six Months ended September 30, 2006

Purchased Intangible Assets

The following table presents details of the purchased finite-lived intangible assets acquired in the RedOctane acquisition (in thousands):

Finite-lived intangibles:

 

 

 

Estimated
Useful
Life
(in years)

 

Amount

 

Trademark

 

1.3

 

$

1,000

 

Other intangibles

 

0.6 - 1.6

 

15,700

 

 

 

 

 

 

 

Total finite-lived intangibles

 

 

 

$

16,700

 

 

The following tables present details of our total purchased finite-lived intangible assets as of September 30, 2006 (in thousands):

 

Gross

 

Accumulated
Amortization

 

Net

 

Trademark

 

$

1,000

 

$

50

 

$

950

 

Other intangibles

 

15,700

 

1,813

 

13,887

 

 

 

 

 

 

 

 

 

Total

 

$

16,700

 

$

1,863

 

$

14,837

 

 

The estimated future amortization expense of purchased, finite-lived intangible assets as of September 30, 2006 is as follows (in thousands):

Fiscal year ending March 31,

 

 

 

Amount

 

2007 (remaining six months)

 

$

9,839

 

2008

 

4,998

 

2009

 

 

2010

 

 

2011

 

 

Thereafter

 

 

 

 

 

 

Total

 

$

14,837

 

 

4.               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 if they are liquid and represent the investment of cash that is available for current operations. All of our short-term investments are classified as available-for-sale and are carried at fair market value with unrealized appreciation (depreciation) reported as a separate component of accumulated other comprehensive income in shareholders’ equity. The specific identification method is used to determine the cost of securities disposed with realized gains and losses reflected in investment income, net.

20




ACTIVISION, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
For the Three and Six Months ended September 30, 2006

The following table summarizes our investments in securities as of September 30, 2006 (amounts in thousands):

 

Amortized
Cost

 

Gross
Unrealized
Gains

 

Gross
Unrealized
Losses

 

Fair
Value

 

Cash and cash equivalents:

 

 

 

 

 

 

 

 

 

Cash and time deposits

 

$

87,636

 

$

 

$

 

$

87,636

 

Commercial paper

 

45,077

 

1

 

(9

)

45,069

 

Money market instruments

 

57,016

 

 

 

57,016

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

189,729

 

1

 

(9

)

189,721

 

 

 

 

 

 

 

 

 

 

 

Short-term investments:

 

 

 

 

 

 

 

 

 

Asset-backed securities

 

14,302

 

4

 

(29

)

14,277

 

Certificate of deposit

 

14,088

 

2

 

(11

)

14,079

 

Commercial paper

 

33,031

 

 

(47

)

32,984

 

Common stock

 

47,868

 

 

(1,445

)

46,423

 

Corporate bonds

 

126,286

 

15

 

(365

)

125,936

 

Mortgage-backed securities

 

52,558

 

 

(394

)

52,164

 

Restricted cash

 

20,000

 

 

 

20,000

 

Taxable auction rate notes

 

19,037

 

 

 

19,037

 

U.S. agency issues

 

234,881

 

9

 

(2,116

)

232,774

 

 

 

 

 

 

 

 

 

 

 

Short-term investments

 

562,051

 

30

 

(4,407

)

557,674

 

 

 

 

 

 

 

 

 

 

 

Cash, cash equivalents and short-term investments

 

$

751,780

 

$

31

 

$

(4,416

)

$

747,395

 

 

The following table summarizes the contractual maturities of our investments in debt securities as of September 30, 2006 (amounts in thousands):

 

Amortized
Cost

 

Fair
Value

 

Due in one year or less

 

$

344,609

 

$

342,771

 

Due after one year through two years

 

79,904

 

79,625

 

Due after two years through three years

 

1,532

 

1,533

 

Due in three years or more

 

13,230

 

12,834

 

 

 

439,275

 

436,763

 

Taxable auction rate notes

 

19,037

 

19,037

 

Certificate of deposit

 

14,088

 

14,079

 

Asset and mortgage-backed securities

 

66,860

 

66,441

 

Total

 

$

539,260

 

$

536,320

 

For the three months ended September 30, 2006, there were no gross realized gains or losses.  For the six months ended September 30, 2006, there were $2,000 of gross realized gains and no gross realized losses.  For the three and six months ended September 30, 2005 there were $4,000 and $1.3 million of gross realized gains, respectively, and no gross realized losses.

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 $525.8 million and $672.4 million at September 30, 2006

21




ACTIVISION, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
For the Three and Six Months ended September 30, 2006

and March 31, 2006, respectively, with related gross unrealized losses of $4.4 million and $5.5 million, respectively.  At September 30, 2006, the gross unrealized losses were comprised mostly of unrealized losses on common stock, U.S. agency issues, corporate bonds, and mortgage-backed securities with $2.6 million of unrealized loss being in a continuous unrealized loss position for twelve months or greater. At March 31, 2006, the gross unrealized losses were comprised mostly of unrealized losses on U.S. agency issues, corporate bonds, and mortgage-backed securities with $3.9 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 less than 30 months as well as investments in common stock classified as “available-for-sale.”  The longer the term or holding period of the securities, the more susceptible they are to changes in market rates of interest, yields on bonds, and market price volatility.  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.

5.     Inventories

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

 

September 30, 2006

 

March 31, 2006

 

Finished goods

 

$

63,235

 

$

58,876

 

Purchased parts and components

 

7,828

 

2,607

 

 

 

 

 

 

 

Total inventory

 

$

71,063

 

$

61,483

 

 

6.     Goodwill and Other Intangible Assets

The changes in the carrying amount of goodwill for the six months ended September 30, 2006 are as follows (amounts in thousands):

 

Publishing

 

Distribution

 

Total

 

 

 

 

 

 

 

 

 

Balance as of March 31, 2006

 

$

95,094

 

$

5,352

 

$

100,446

 

Goodwill acquired during the period

 

87,257

 

 

87,257

 

Adjustment to prior period purchase allocation

 

46

 

 

46

 

Effect of foreign currency exchange rates

 

123

 

382

 

505

 

Balance as of September 30, 2006

 

$

182,520

 

$

5,734

 

$

188,254

 

 

Goodwill acquired during the period represents goodwill related to the acquisition of RedOctane of $87.0 million and goodwill related to the acquisition of a recently acquired South Korean publishing company of $253,000.

7.     Income Taxes

The income tax benefit of $5.1 million and $11.9 million for the three months and six months ended September 30, 2006 reflects our effective income tax rate of 17.3% and 21.9%, respectively.  This is lower

22




ACTIVISION, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
For the Three and Six Months ended September 30, 2006

than prior year as a result of improved profitability leading to utilization of net operating loss carry forwards and in turn a reduction in valuation allowances related to federal and state research and development tax credits, partially offset by the establishment of tax reserves.  The significant items that generated the variance between our effective rate and our statutory rate of 35% were state research and development tax credits and the impact of foreign tax rate differentials, offset by state taxes.   The realization of deferred tax assets depends primarily on the generation of future taxable income.  We believe that it is more likely than not that we will generate taxable income sufficient to realize the benefit of net deferred tax assets recognized.

The income tax benefit of $7.2 million for the three months ended September 30, 2005 reflects our effective income tax rate for the quarter of 33.7%, which differs from our effective tax rate of 12.2% for the year ended March 31, 2006 primarily due to an increase in federal research and development credit for the full year ended March 31, 2006 over the amount originally anticipated for the year, and a decrease in pretax income for the year versus the amount originally anticipated for the year, without a corresponding decrease in the benefit of book/tax differences.  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.

8.     Software Development Costs and Intellectual Property Licenses

As of September 30, 2006, capitalized software development costs included $87.0 million of internally developed software costs and $30.8 million of payments made to third-party software developers.  As of March 31, 2006, capitalized software development costs included $45.0 million of internally developed software costs and $15.6 million of payments made to third-party software developers.  Capitalized intellectual property licenses were $95.1 million and $87.0 million as of September 30, 2006 and March 31, 2006, respectively.  Amortization and write-offs of capitalized software development costs and intellectual property licenses were $26.3 million and $43.8 million for the six months ended September 30, 2006 and 2005, respectively.

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

Comprehensive Income (Loss)

The components of comprehensive income (loss) for the three and six months ended September 30, 2006 and 2005 were as follows (amounts in thousands):

 

 

Three months ended September 30,

 

Six months ended September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

 

 

As restated

 

 

 

As restated

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

$

(24,302

)

$

(14,230

)

$

(42,611

)

$

(18,477

)

 

 

 

 

 

 

 

 

 

 

Other comprehensive income (loss):

 

 

 

 

 

 

 

 

 

Foreign currency translation adjustment

 

2,663

 

(1,830

)

6,241

 

(5,493

)

Unrealized appreciation (depreciation) on short-term investments

 

8,447

 

(1,023

)

(10,035

)

(1,235

)

 

 

 

 

 

 

 

 

 

 

Other comprehensive income (loss)

 

11,110

 

(2,853

)

(3,794

)

(6,728

)

 

 

 

 

 

 

 

 

 

 

Comprehensive loss

 

$

(13,192

)

$

(17,083

)

$

(46,405

)

$

(25,205

)

 

23




ACTIVISION, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
For the Three and Six Months ended September 30, 2006

Accumulated Other Comprehensive Income (Loss)

For the six months ended September 30, 2006 the components of accumulated other comprehensive income (loss) were as follows (amounts in thousands):

 

Foreign
Currency 

 

Unrealized
Appreciation
(Depreciation)
on Investments

 

Accumulated
Other
Comprehensive
Income (Loss)

 

 

 

 

 

 

 

 

 

Balance, March 31, 2006

 

$

9,013

 

$

7,356

 

$

16,369

 

Other comprehensive income (loss)

 

6,241

 

(10,035

)

(3,794

)

 

 

 

 

 

 

 

 

Balance, September 30, 2006

 

$

15,254

 

$

(2,679

)

$

12,575

 

 

Comprehensive income is presented net of taxes of $1.7 million related to unrealized depreciation on investments.  Income taxes were not provided for foreign currency translation items as these are considered indefinite investments in non-U.S. subsidiaries.

10.  Investment Income, Net

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

 

Three months ended September 30,

 

Six months ended September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Interest income

 

$

8,013

 

$

6,377

 

$

16,369

 

$

12,444

 

Interest expense

 

19

 

(51

)

(64

)

(113

)

Net realized gain on investments

 

 

4

 

2

 

1,347

 

 

 

 

 

 

 

 

 

 

 

Investment income, net

 

$

8,032

 

$

6,330

 

$

16,307

 

$

13,678

 

 

11.  Supplemental Cash Flow Information

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

 

Six months ended September 30,

 

 

 

2006

 

2005

 

Non-cash operating, investing and financing activities:

 

 

 

 

 

Subsidiaries acquired with common stock

 

$

30,000

 

$

942

 

Change in unrealized depreciation on short-term investments, net of taxes

 

(10,035

)

(1,235

)

Common stock payable related to acquisition

 

39,000

 

 

Capitalization of stock option expense

 

4,576

 

 

Adjustment - prior period purchase allocation

 

46

 

 

 

 

 

 

 

 

Supplemental cash flow information:

 

 

 

 

 

Cash (paid) received for income taxes

 

$

(4,259

)

$

1,511

 

Cash received for interest, net

 

16,568

 

12,040

 

 

 

24




ACTIVISION, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
For the Three and Six Months ended September 30, 2006

12.  Operations by Reportable Segments and Geographic Area

Based upon our organizational structure, we operate two business segments: (i) publishing of interactive entertainment software and peripherals 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, the Netherlands, Canada, South Korea, 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 Amended Annual Report on Form 10-K/A for the year ended March 31, 2006.  Revenue derived from sales between segments is eliminated in consolidation.

Information on the reportable segments for the three and six months ended September 30, 2006 and 2005 is as follows (amounts in thousands):

 

Three months ended September 30, 2006

 

 

 

Publishing

 

Distribution

&