Activision Blizzard, Inc.
ACTIVISION INC /NY (Form: 10-Q, Received: 08/07/2007 16:40:33)

 

 

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 June 30, 2007

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  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 August 1, 2007 was 285,478,565.

 

 




ACTIVISION, INC. AND SUBSIDIARIES

INDEX

PART I.

 

FINANCIAL INFORMATION

 

 

 

 

 

 

 

 

 

Item 1.

 

Financial Statements

 

 

 

 

 

 

 

 

 

 

 

Consolidated Balance Sheets as of June 30, 2007 (Unaudited) and March 31, 2007

 

 

 

 

 

 

 

 

 

 

 

Consolidated Statements of Operations for the three months ended June 30, 2007 and 2006 (Unaudited)

 

 

 

 

 

 

 

 

 

 

 

Consolidated Statements of Cash Flows for the three months ended June 30, 2007 and 2006 (Unaudited)

 

 

 

 

 

 

 

 

 

 

 

Consolidated Statement of Changes in Shareholders’ Equity for the three months ended June 30, 2007 (Unaudited)

 

 

 

 

 

 

 

 

 

 

 

Notes to Consolidated Financial Statements for the three months ended June 30, 2007 (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 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”, “will”, “would”, 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 I Item 1A. of our Annual Report on Form 10-K for the fiscal year ended March 31, 2007.  All references to “we”, “us”, “our”, “Activision” or “the Company” in the following discussion and analysis mean Activision, Inc. and its subsidiaries.

 

3




FINANCIAL INFORMATION.
I
tem 1.   F inancial S tatements .

ACTIVISION, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)

 

 

June 30,
2007

 

March 31,
2007

 

 

 

(Unaudited)

 

 

 

Assets

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

343,981

 

$

384,409

 

Short-term investments

 

619,815

 

570,440

 

Accounts receivable, net of allowances of $115,560 and $91,418 at June 30, 2007 and March 31, 2007, respectively

 

197,964

 

148,694

 

Inventories

 

92,529

 

91,231

 

Software development

 

104,944

 

107,779

 

Intellectual property licenses

 

13,143

 

27,784

 

Deferred income taxes

 

50,197

 

51,564

 

Other current assets

 

20,507

 

19,332

 

 

 

 

 

 

 

Total current assets

 

1,443,080

 

1,401,233

 

 

 

 

 

 

 

Software development

 

9,180

 

23,143

 

Intellectual property licenses

 

68,645

 

72,490

 

Property and equipment, net

 

48,706

 

46,540

 

Deferred income taxes

 

41,933

 

48,791

 

Other assets

 

6,473

 

6,376

 

Goodwill

 

221,049

 

195,374

 

 

 

 

 

 

 

Total assets

 

$

1,839,066

 

$

1,793,947

 

 

 

 

 

 

 

Liabilities and Shareholders’ Equity

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

109,662

 

$

136,517

 

Accrued expenses

 

249,940

 

204,652

 

 

 

 

 

 

 

Total current liabilities

 

359,602

 

341,169

 

 

 

 

 

 

 

Other liabilities

 

17,971

 

41,246

 

 

 

 

 

 

 

Total liabilities

 

377,573

 

382,415

 

 

 

 

 

 

 

Commitments and contingencies (Note 13)

 

 

 

 

 

 

 

 

 

 

 

Shareholders’ equity:

 

 

 

 

 

Preferred stock, $.000001 par value, 3,750,000 shares authorized, no shares issued at June 30, 2007 and March 31, 2007

 

 

 

Series A Junior Preferred stock, $.000001 par value, 1,250,000 shares authorized, no shares issued at June 30, 2007 and March 31, 2007

 

 

 

Common stock, $.000001 par value, 450,000,000 shares authorized, 284,621,350 and 283,310,734 shares issued and outstanding at June 30, 2007 and March 31, 2007, respectively

 

 

 

Additional paid-in capital

 

983,373

 

963,553

 

Retained earnings

 

455,603

 

427,777

 

Accumulated other comprehensive income

 

22,517

 

20,202

 

 

 

 

 

 

 

Total shareholders’ equity

 

1,461,493

 

1,411,532

 

 

 

 

 

 

 

Total liabilities and shareholders’ equity

 

$

1,839,066

 

$

1,793,947

 

 

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

 

4




ACTIVISION, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)
(In thousands, except per share data)

 

 

For the three months
ended June 30,

 

 

 

2007

 

2006

 

 

 

 

 

 

 

Net revenues

 

$

495,455

 

$

188,069

 

 

 

 

 

 

 

Costs and expenses:

 

 

 

 

 

Cost of sales — product costs

 

217,229

 

108,623

 

Cost of sales — software royalties and amortization

 

78,252

 

19,261

 

Cost of sales — intellectual property licenses

 

32,479

 

9,916

 

Product development

 

32,897

 

25,625

 

Sales and marketing

 

68,712

 

36,179

 

General and administrative

 

35,794

 

21,914

 

 

 

 

 

 

 

Total costs and expenses

 

465,363

 

221,518

 

 

 

 

 

 

 

Operating income (loss)

 

30,092

 

(33,449)

 

 

 

 

 

 

 

Investment income, net

 

11,562

 

8,275

 

 

 

 

 

 

 

Income (loss) before income tax provision (benefit)

 

41,654

 

(25,174)

 

 

 

 

 

 

 

Income tax provision (benefit)

 

13,828

 

(6,865)

 

 

 

 

 

 

 

Net income (loss)

 

$

27,826

 

$

(18,309)

 

 

 

 

 

 

 

Basic earnings (loss) per share

 

$

0.10

 

$

(0.07)

 

 

 

 

 

 

 

Weighted-average common shares outstanding

 

283,563

 

278,335

 

 

 

 

 

 

 

Diluted earnings (loss) per share

 

$

0.09

 

$

(0.07)

 

 

 

 

 

 

 

Weighted-average common shares outstanding assuming dilution

 

311,993

 

278,335

 

 

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

 

5




ACTIVISION, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)
(In thousands)

 

 

For the three months
ended June 30,

 

 

 

2007

 

2006

 

Cash flows from operating activities:

 

 

 

 

 

Net income (loss)

 

$

27,826

 

$

(18,309

)

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

 

 

 

 

 

Deferred income taxes

 

7,306

 

(6,797

)

Realized gain on sale of short-term investments

 

 

(2

)

Depreciation and amortization

 

8,730

 

4,421

 

Amortization of capitalized software development costs and intellectual property licenses (1)

 

77,661

 

21,116

 

Stock-based compensation expense (2)

 

8,160

 

5,849

 

Tax benefit of stock options

 

400

 

2,763

 

Excess tax benefit from stock option exercises

 

(370

)

(2,005

)

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

 

 

 

 

 

Accounts receivable

 

(49,165

)

(25,469

)

Inventories

 

(1,298

)

1,012

 

Software development and intellectual property licenses

 

(42,299

)

(44,862

)

Other assets

 

(2,931

)

637

 

Accounts payable

 

(26,731

)

(22,058

)

Accrued expenses and other liabilities

 

(783

)

(19,969

)

 

 

 

 

 

 

Net cash provided by (used in) operating activities

 

6,506

 

(103,673

)

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Capital expenditures

 

(7,348

)

(2,631

)

Cash payments to effect business combinations, net of cash acquired

 

(3,659

)

(30,500

)

Increase in restricted cash

 

(8,413

)

 

Purchases of short-term investments

 

(187,495

)

(63,455

)

Proceeds from sales and maturities of short-term investments

 

145,864

 

80,967

 

 

 

 

 

 

 

Net cash used in investing activities

 

(61,051

)

(15,619

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Proceeds from issuance of common stock to employees

 

11,182

 

4,837

 

Excess tax benefit from stock option exercises

 

370

 

2,005

 

 

 

 

 

 

 

Net cash provided by financing activities

 

11,552

 

6,842

 

 

 

 

 

 

 

Effect of exchange rate changes on cash

 

2,565

 

3,142

 

 

 

 

 

 

 

Net decrease in cash and cash equivalents

 

(40,428

)

(109,308

)

 

 

 

 

 

 

Cash and cash equivalents at beginning of period

 

384,409

 

354,331

 

 

 

 

 

 

 

Cash and cash equivalents at end of period

 

$

343,981

 

$

245,023

 


(1)              Excludes amortization of stock-based compensation expense.

(2)              Includes the net effects of capitalization and amortization of stock-based compensation expense.

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

 

6




ACTIVISION, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY

For the three months ended June 30, 2007
(Unaudited)
(In thousands)

 

 

Common Stock

 

Additional
Paid-In

 

Retained

 

Accumulated
Other
Comprehensive

 

Shareholders’

 

 

 

Shares

 

Amounts

 

Capital

 

Earnings

 

Income

 

Equity

 

Balance, March 31, 2007

 

283,311

 

$

 

$

963,553

 

$

427,777

 

$

20,202

 

$

1,411,532

 

Components of comprehensive income:

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

 

27,826

 

 

27,826

 

Unrealized depreciation on short-term investments, (net of tax benefit of $262)

 

 

 

 

 

(407

)

(407

)

Foreign currency translation adjustment

 

 

 

 

 

2,722

 

2,722

 

Total comprehensive income

 

 

 

 

 

 

 

 

 

 

 

30,141

 

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

 

1,310

 

 

11,182

 

 

 

11,182

 

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

 

 

 

8,238

 

 

 

8,238

 

Tax benefit attributable to employee stock options and common stock warrants

 

 

 

400

 

 

 

400

 

Balance, June 30, 2007

 

284,621

 

$

 

$

983,373

 

$

455,603

 

$

22,517

 

$

1,461,493

 

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

7




ACTIVISION, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Unaudited)
For the three months ended June 30, 2007

 

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 fiscal year ended March 31, 2007 as filed with the Securities and Exchange Commission (“SEC”) on June 14, 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 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.

8




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, 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.  Some of the Company’s software products provide limited online functionality at no additional cost to the consumer. Currently, none of the Company’s products require an internet connection for use, and online functionality is perceived to be of only incidental value to the software product itself.  Accordingly, the Company considers such features to be an insignificant deliverable and does not defer revenue related to products containing online features.  In instances where online functionality is not incidental, the deferral of revenue recognition is a consideration, however, there

9




have been no instances of deferral to date as a result of online functionality.  Over time, online service, cost, and usage may become a non-incidental part of gameplay, and the Company will continue to evaluate, for each future game title, its revenue recognition policy in accordance with Statement of Position 97-2, “Software Revenue Recognition” (“SOP 97-2”). With respect to online transactions, such as electronic downloads of titles or product add-ons, revenue is recognized when the fee is paid by the online 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 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

10




management makes different judgments or utilizes different estimates in determining the allowances for returns and price protection.  For example, a 1% change in our June 30, 2007 allowance for returns and price protection would impact net revenues by $1.1 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.


Stock-Based Compensation Expense

On April 1, 2006, we adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” (“SFAS No. 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 No. 123R supersedes our previous accounting under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”).  In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS No. 123R. We have applied the provisions of SAB 107 in our adoption of SFAS No. 123R.

Stock-based compensation expense recognized under SFAS No. 123R for the three months ended June 30, 2007 and 2006 was $8.2 million and $5.8 million, respectively.  See Note 14 for additional information.

SFAS No. 123R requires companies to estimate the fair value of share-based payment awards on the measurement date 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.  See Note 14 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 Statement of Operations for the first quarter 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 No. 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 No. 123R. Stock-based compensation expense recognized in the Consolidated Statement of Operations is based on awards ultimately expected to vest and has been reduced for estimated forfeitures. SFAS No. 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.

We estimate the value of employee stock options on the date of grant using a binomial-lattice model.  For additional information, see Note 14.  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

11




expected stock price volatility over the term of the awards, and actual and projected employee stock option exercise behaviors.

2.               Acquisitions

DemonWare

On May 11, 2007, Activision completed its acquisition of DemonWare, the leading provider of network middleware technologies for console and PC games headquartered in Dublin, Ireland. The acquisition is expected to enable Activision to gain efficiencies related to online game development and to position the company to take advantage of the growth in online gameplay that is expected to be driven by the next-generation consoles.  The acquisition is expected to be immaterial to fiscal 2008 earnings per share and cash flow. Additionally, pro forma consolidated statements of operations for this acquisition are not shown, as they would not differ materially from reported results.

RedOctane, Inc.

Activision acquired RedOctane, Inc. (“RedOctane”) on June 6, 2006.  RedOctane is a publisher, developer, and distributor of interactive entertainment software and peripherals, including the popular Guitar Hero music-based gaming franchise.  Under the terms of the merger agreement, additional contingent purchase consideration of $22.5 million was earned on June 30, 2007, as a result of the achievement of targeted net income levels.  This additional consideration has been recorded as an accrued liability as of the period ended June 30, 2007, and is payable in 1,214,864 shares of Activision common stock to be issued within 90 days to the former shareholders of RedOctane.  The additional purchase consideration of $22.5 million has been recorded as an increase to Goodwill.

3.               Cash, Cash Equivalents, and Short-Term Investments

Short-term investments generally mature between three and thirty months.  Investments with maturities beyond one year are 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.

12




The following table summarizes our investments in securities as of June 30, 2007 (amounts in thousands):

 

Amortized
Cost

 

Gross
Unrealized
Gains

 

Gross
Unrealized
Losses

 

Fair
Value

 

Cash and cash equivalents:

 

 

 

 

 

 

 

 

 

Cash and time deposits

 

$

249,853

 

$

 

$

 

$

249,853

 

Money market funds

 

55,903

 

 

 

55,903

 

Commercial paper

 

38,240

 

 

(15

)

38,225

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

343,996

 

 

(15

)

343,981

 

 

 

 

 

 

 

 

 

 

 

Short-term investments:

 

 

 

 

 

 

 

 

 

U.S. agency issues

 

213,084

 

 

(855

)

212,229

 

Corporate bonds

 

185,969

 

5

 

(943

)

185,031

 

Auction rate notes

 

90,704

 

 

 

90,704

 

Commercial paper

 

64,983

 

 

(40

)

64,943

 

Mortgage-backed securities

 

24,532

 

 

(223

)

24,309

 

Certificate of deposit

 

22,925

 

 

(12

)

22,913

 

Restricted cash

 

15,913

 

 

 

15,913

 

Asset-backed securities

 

3,776

 

1

 

(4

)

3,773

 

 

 

 

 

 

 

 

 

 

 

Short-term investments

 

621,886

 

6

 

(2,077

)

619,815

 

 

 

 

 

 

 

 

 

 

 

Cash, cash equivalents, restricted cash, and short-term investments

 

$

965,882

 

$

6

 

$

(2,092

)

$

963,796

 

 

The following table summarizes the legal stated maturities of our investments in corporate bonds, commercial paper, and U.S. agency issues as of June 30, 2007 (amounts in thousands):

 

Amortized
Cost

 

Fair
Value

 

Due in one year or less

 

$

304,169

 

$

303,699

 

Due after one year through two years

 

186,132

 

185,138

 

Due after two years through three years

 

11,975

 

11,591

 

Due in three years or more

 

 

 

Total

 

$

502,276

 

$

500,428

 

For the three months ended June 30, 2007, there were no gross realized gains or losses.  For the three months ended June 30, 2006, there were $2,000 of gross realized gains 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 $528.5 million and $496.2 million at June 30, 2007 and March 31, 2007, respectively, with related gross unrealized losses of $2.1 million and $1.5 million, respectively.  At June 30, 2007, the gross unrealized losses were comprised mostly of unrealized losses on U.S. agency issues, corporate bonds, and mortgage-backed securities with $0.9 million of unrealized loss being in a continuous unrealized loss position for twelve months or greater. At March 31, 2007, the gross unrealized losses were comprised mostly of unrealized losses on U.S. agency issues, corporate bonds, and

13




mortgage-backed securities with $1.1 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. 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.

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):

 

June 30, 2007

 

March 31, 2007

 

Finished goods

 

$

85,261

 

$

89,048

 

Purchased parts and components

 

7,268

 

2,183

 

 

 

$

92,529

 

$

91,231

 

 

5.               Goodwill

The changes in the carrying amount of goodwill for the three months ended June 30, 2007 are as follows (amounts in thousands):

 

Publishing

 

Distribution

 

Total

 

 

 

 

 

 

 

 

 

Balance as of March 31, 2007

 

$

189,342

 

$

6,032

 

$

195,374

 

Goodwill acquired during the period

 

2,775

 

 

2,775

 

Issuance of contingent consideration

 

22,521

 

 

22,521

 

Effect of foreign currency exchange rates

 

263

 

116

 

379

 

Balance as of June 30, 2007

 

$

214,901

 

$

6,148

 

$

221,049

 

Goodwill acquired during the period represents goodwill related to the acquisition of DemonWare of $2.8 million.  Issuance of contingent consideration of $22.5 million primarily represents additional purchase consideration related to the acquisition of RedOctane.  See Note 2 for additional information.

6.               Income Taxes

The income tax expense of $13.8 million for the three months ended June 30, 2007 reflects our effective income tax rate for the quarter of 33.2%.  The significant items that generated the variance between our effective rate and our statutory rate of 35% were federal and state research and development tax credits, the impact of foreign tax rate differentials, and the federal deduction for domestic production activities, partially offset by state taxes.

14




The aforementioned effective income tax rate for the quarter of 33.2% differs from our effective income tax rate of 27.3% for the three months ended June 30, 2006 due to an increase in anticipated pretax income for fiscal year 2008 determined at June 30, 2007 versus the anticipated pretax income for fiscal year 2007 determined at June 30, 2006, without a corresponding increase in the benefit of book/tax differences.

The income tax benefit of $6.9 million for the three months ended June 30, 2006 reflects our effective income tax rate for the quarter of 27.3%, which differs from our effective tax rate of 21.9% for the year ended March 31, 2007 due to (1) an increase in the federal research and development credit for the full year ended March 31, 2007 over the amount originally anticipated for the year at June 30 2006 due to the Congressional reinstatement of the federal R&D credit in quarter ended December 31, 2006; and (2) the elimination of the valuation allowance for research and development tax credits, partially offset by the nondeductible portion of annual cash bonuses determined in the three months ended March 31, 2007 under Section 162(m), and the establishment of tax reserves for these credits and other deferred tax assets.  The significant items that generated the variance between our effective rate and our statutory rate of 35% for the three months ended June 30, 2006 were research and development tax credits for state purposes and the impact of foreign tax rate differentials, partially offset by state taxes.

We adopted the provisions of Financial Accounting Standards Board Interpretation No. 48 “Accounting for Uncertainty in Income Taxes” (“FIN 48”) an interpretation of FASB Statement No. 109 (“SFAS 109”) on April 1, 2007.  As a result of the implementation of FIN 48, we recognized no material adjustment in the liability for unrecognized income tax benefits.  At the adoption date of April 1, 2007, we had $65.5 million of unrecognized tax benefits, of which $26.2 million would affect our effective tax rate if recognized.

In addition, consistent with the provisions of FIN 48, we reclassified $15.6 million of income tax liabilities from current to non-current liabilities because payment of cash is not anticipated within one year of the balance sheet date.  These non-current income tax liabilities are recorded in other liabilities in the Consolidated Balance Sheet, and the current income tax liabilities are recorded in accrued expenses.

We recognize interest and penalties related to uncertain tax positions in income tax expense.  As of April 1, 2007, we have approximately $296,000 of accrued interest related to uncertain tax positions.

The tax years 2002 through 2007 remain open to examination by the major taxing jurisdictions to which we are subject, including U.S. and non-U.S. locations.  We are currently under audit by the Internal Revenue Service and California Franchise Tax Board, and it is reasonably possible that the current portion of our recognized tax benefits will significantly decrease within the next twelve months.

7.               Software Development Costs and Intellectual Property Licenses

As of June 30, 2007, capitalized software development costs included $76.3 million of internally developed software costs and $37.8 million of payments made to third-party software developers.  As of March 31, 2007, capitalized software development costs included $94.3 million of internally developed software costs and $36.6 million of payments made to third-party software developers.  Capitalized intellectual property licenses were $81.8 million and $100.3 million as of June 30, 2007 and March 31, 2007, respectively.  Amortization and write-offs of capitalized software development costs and intellectual property licenses were $77.7 million and $21.1 million for the three months ended June 30, 2007 and 2006, respectively.

15




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

Comprehensive Income (Loss)

The components of comprehensive income (loss) for the three months ended June 30, 2007 and 2006 were as follows (amounts in thousands):

 

Three months ended
June 30,

 

 

 

2007

 

2006

 

 

 

 

 

 

 

Net income (loss)

 

$

27,826

 

$

(18,309

)

 

 

 

 

 

 

Other comprehensive income (loss)

 

 

 

 

 

Foreign currency translation adjustment

 

2,722

 

3,578

 

Unrealized depreciation on short-term investments, net of taxes

 

(407

)

(18,482

)

 

 

 

 

 

 

Other comprehensive income (loss)

 

2,315

 

(14,904

)

 

 

 

 

 

 

Comprehensive income (loss)

 

$

30,141

 

$

(33,213

)

 

Accumulated Other Comprehensive Income (Loss)

For the three months ended June 30, 2007, the components of accumulated other comprehensive income (loss) were as follows (amounts in thousands):

 

Foreign
Currency

 

Unrealized
Depreciation on
Investments

 

Accumulated
Other
Comprehensive
Income

 

 

 

 

 

 

 

 

 

Balance, March 31, 2007

 

$

21,070

 

$

(868

)

$

20,202

 

Other comprehensive income (loss)

 

2,722

 

(407

)

2,315

 

 

 

 

 

 

 

 

 

Balance, June 30, 2007

 

$

23,792

 

$

(1,275

)

$

22,517

 

 

Comprehensive income is presented net of taxes of $262,000 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.

9.               Investment Income, Net

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

 

Three months ended
June 30,

 

 

 

2007

 

2006

 

Interest income

 

$

11,586

 

$

8,356

 

Interest expense

 

(24

)

(83

)

Net realized gain on investments

 

 

2

 

Investment income, net

 

$

11,562

 

$

8,275

 

 

16




10.        Supplemental Cash Flow Information

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

 

Three months ended
June 30,

 

 

 

2007

 

2006

 

 

 

 

 

 

 

Non-cash operating, investing, and financing activities:

 

 

 

 

 

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

 

$

(407

)

$

(18,482

)

Subsidiaries acquired with common stock

 

 

30,000

 

Common stock payable related to acquisition

 

22,521

 

39,000

 

Capitalization of stock option expense

 

1,923

 

1,905

 

Amortization of stock option expense

 

(1,845

)

(36

)

Adjustment-prior period purchase allocation

 

 

37

 

 

 

 

 

 

 

Supplemental cash flow information:

 

 

 

 

 

Cash paid for income taxes

 

$

3,572

 

$

2,639

 

Cash paid for interest

 

24

 

92

 

 

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, 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 United Kingdom, the Netherlands, and Germany that provide logistical and sales services to third-party publishers of interactive entertainment software, our own publishing operations, and manufacturers of interactive entertainment hardware.

Resources are allocated to each of these segments using information on their respective net revenues and operating profits before interest and taxes.

The accounting policies of these segments are the same as those described in the Summary of Significant Accounting Policies in our Annual Report on Form 10-K for the year ended March 31, 2007.  Revenue derived from sales between segments is eliminated in consolidation.

17




Information on the reportable segments for the three months ended June 30, 2007 and 2006 is as follows (amounts in thousands):

 

Three months ended June 30, 2007

 

 

 

Publishing

 

Distribution

 

Total

 

 

 

 

 

 

 

 

 

Total segment revenues

 

$

429,222

 

$

66,233

 

$

495,455

 

Revenues from sales between segments

 

(22,847

)

22,847

 

 

 

 

 

 

 

 

 

 

Revenues from external customers

 

$

406,375

 

$

89,080

 

$

495,455

 

 

 

 

 

 

 

 

 

Operating income

 

$

29,117

 

$

975

 

$

30,092

 

 

 

 

 

 

 

 

 

Total assets

 

$

1,700,149

 

$

138,917

 

$

1,839,066

 

 

 

Three months ended June 30, 2006

 

 

 

Publishing

 

Distribution

 

Total

 

 

 

 

 

 

 

 

 

Total segment revenues

 

$

134,762

 

$

53,307

 

$

188,069

 

Revenues from sales between segments

 

(6,430

)

6,430

 

 

 

 

 

 

 

 

 

 

Revenues from external customers

 

$

128,332

 

$

59,737

 

$

188,069

 

 

 

 

 

 

 

 

 

Operating loss

 

$

(31,519

)

$

(1,930

)

$

(33,449

)

 

 

 

 

 

 

 

 

Total assets

 

$

1,334,320

 

$

101,856

 

$

1,436,176

 

Geographic information for the three months ended June 30, 2007 and 2006 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
June 30,

 

 

 

2007

 

2006

 

 

 

 

 

 

 

North America

 

$

309,536

 

$

99,610

 

Europe

 

170,014

 

81,816

 

Other

 

15,905

 

6,643

 

 

 

 

 

 

 

Total

 

$

495,455

 

$

188,069

 

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

 

Three months ended
June 30,

 

 

 

2007

 

2006

 

 

 

 

 

 

 

Console

 

$

401,874

 

$

118,977

 

Hand-held

 

75,732

 

44,797

 

PC

 

17,849

 

24,295

 

 

 

 

 

 

 

Total

 

$

495,455

 

$

188,069

 

 

18




We had two customers that accounted for 21% and 15% of consolidated net revenues for the three months ended June 30, 2007, and 27% and 10% of consolidated accounts receivable, gross at June 30, 2007.  These customers were customers of both our publishing and distribution businesses.  We had two customers that accounted for 28% and 10% of consolidated net revenues for the three months ended June 30, 2006, and 33% and 7% of consolidated accounts receivable, gross at June 30, 2006.

12.        Computation of Income (Loss) Per Share

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

 

Three months ended
June 30,

 

 

 

2007

 

2006

 

 

 

 

 

 

 

Numerator:

 

 

 

 

 

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

 

$

27,826

 

$

(18,309

)

 

 

 

 

 

 

Denominator:

 

 

 

 

 

Denominator for basic income (loss) per share - weighted-average common shares outstanding

 

283,563

 

278,335

 

 

 

 

 

 

 

Effect of dilutive securities:

 

 

 

 

 

Employee stock options, and stock purchase plan, and stock awards

 

24,378

 

 

Warrants to purchase common stock and other dilutive common stock equivalents

 

4,052

 

 

Potential dilutive common shares

 

28,430

 

 

 

 

 

 

 

 

Denominator for diluted income (loss) per share - weighted-average common shares outstanding plus assumed conversions

 

311,993

 

278,335

 

 

 

 

 

 

 

Basic income (loss) per share

 

$

0.10

 

$

(0.07

)

 

 

 

 

 

 

Diluted income (loss) per share

 

$

0.09

 

$

(0.07

)

Options to purchase 1,163,523 and 31,765,161 shares of common stock for the three months ended June 30, 2007 and 2006, respectively, were not included in the calculation of diluted earnings per share because their effect would be antidilutive.

13.        Commitments and Contingencies

Credit Facilities

We have revolving credit facilities with our Centresoft subsidiary located in the UK (the “UK Facility”) and our NBG subsidiary located in Germany (the “German Facility”). The UK Facility provided Centresoft with the ability to borrow up to GBP 12.0 million ($24.1 million), including issuing letters of credit, on a revolving basis as of June 30, 2007.  The UK Facility bore interest at LIBOR plus 2.0% as of June 30,

19




2007, is collateralized by substantially all of the assets of the subsidiary and expires in January 2008.  The UK Facility also contains various covenants that require the subsidiary to maintain specified financial ratios related to, among others, fixed charges.   The German Facility provided for revolving loans up to EUR 0.5 million ($0.7 million) as of June 30, 2007, 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 June 30, 2007.

As of June 30, 2007, we maintained a $15.0 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 June 30, 2007, the $15.0 million deposit is included in short-term investments as restricted cash. No borrowings were outstanding as of June 30, 2007.

As of June 30, 2007, our publishing subsidiary located in the UK maintained a EUR 4.0 million ($5.4 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 in February 2008. No borrowings were outstanding as of June 30, 2007.

Commitments

In the normal course of business, we enter into contractual arrangements with third parties for non-cancellable 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 June 30, 2007, are scheduled to be paid as follows (amounts in thousands):

20




 

 

Contractual Obligations(1)

 

 

 

Facility and

 

 

 

 

 

 

 

 

 

Equipment
Leases

 

Developer
and IP

 

Marketing

 

Total

 

Fiscal year ending March 31,

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2008 (remaining nine months)

 

$

12,168

 

$

54,258

 

$

7,874

 

$

74,300

 

2009

 

16,154

 

32,536

 

31,510

 

80,200

 

2010

 

14,162

 

31,086

 

100

 

45,348

 

2011

 

11,865

 

30,586

 

13,100

 

55,551

 

2012

 

7,078

 

16,586

 

 

23,664

 

Thereafter

 

18,988

 

47,587

 

 

66,575

 

Total

 

$

80,415

 

$

212,639

 

$

52,584

 

$

345,638

 


(1)             We have omitted FIN 48 liabilities from this table due to the inherent uncertainty regarding the timing of potential issue resolution.  Specifically, either (a) the underlying positions have not been fully enough developed under audit to quantify at this time or, (b) the years relating to the issues for certain jurisdictions are not currently under audit. At the adoption date of April 1, 2007, the Company had $65.5 million of unrecognized tax benefits.

Compensation Guarantee

In June 2005, we entered into an employment agreement with the President and Chief Executive Officer of Activision Publishing, Inc. 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 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 Proceedings

In July 2006, individuals and/or entities claiming to be stockholders of the Company have filed derivative lawsuits, purportedly on behalf of the Company, against certain current and former members of the Company’s Board of Directors as well as several current and former officers of the Company. Three derivative actions have been filed in Los Angeles Superior Court: Vazquez v. Kotick, et al . , L.A.S.C. Case No. BC355327 (filed July 12, 2006); Greuer v. Kotick, et al.,  L.A.S.C. Case No. SC090343 (filed July 12, 2006); and Amalgamated Bank v. Baker, et al., L.A.S.C. Case No. BC356454 (filed August 3, 2006). These actions have been consolidated by the court under the caption In re Activision Shareholder Derivative Litigation, L.A.S.C. Master File No. SC090343 (West, J.). Two derivative actions have been filed in the United States District Court for the Central District of California: Pfeiffer v. Kotick, et al., C.D. Cal. Case No. CV06-4771 MRP (JTLx) (filed July 31, 2006); and Hamian v. Kotick, et al . ,  C.D. Cal. Case No. CV06-5375 MRP (JLTx) (filed August 25, 2006). These actions have also been consolidated, under the caption In re Activision, Inc. Shareholder Derivative Litigation, C.D. Cal. Case No. CV06-4771 MRP (JTLx) (Pfaelzer, J.). The consolidated complaints allege, among other things, purported improprieties in the Company’s issuance of stock options. Plaintiffs seek various relief on behalf of the Company, including damages, restitution of benefits obtained from the alleged misconduct, equitable relief, including an accounting and rescission of option contracts; and various corporate governance reforms. The Company expects that defense expenses associated with the matters will be covered by its directors and officers insurance, subject to the terms and conditions of the applicable policies.

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On May 24, 2007, the Superior Court granted the Company’s motion to stay the state action. The court’s order stays the action pending the resolution of motions to dismiss in the federal action, but is without prejudice to any party’s right to seek modification of the stay upon a showing of good cause, including a showing that matters may be addressed in the Superior Court without the potential for conflict with or duplication of the federal court proceedings.  On June 29, 2007, the Superior Court held a status conference and issued an order permitting Plaintiffs to file a second amended complaint and requiring the parties to meet and confer to discuss threshold issues to be included in any joint statement or stipulation by July 31, 2007.  The Superior Court further ordered a case review on August 1, 2007. On July 13, 2007, Plaintiffs filed their second amended complaint, which alleges substantially the same claims as the previous complaints, with new allegations related to Plaintiffs’ standing, recent public facts and additional analyses.

The Company filed motions to dismiss in the federal action on June 1, 2007.   A hearing on the motions is set for August 27, 2007.

The Company was also informed that, on June 1, 2007, a derivative case, Abdelnur vs. Kotick et al., was filed in the United States District Court for the Central District of California, C.D. Case No. CV07-3575 AHM (PJWx), by the same law firm that previously filed the Hamian case, alleging substantially the same claims.  The action has now been consolidated with the existing federal consolidated action and the motions to dismiss filed June 1, 2007 have been deemed to have also been filed in response to the Abdelnur complaint.

Furthermore, on July 18, 2007, the Company was informed that another derivative case, Scarborough v. Kotick et al., was filed in the United States District Court for the Central District of California, Case No. CV07-4602 SVW (PLAx), also by the same law firm that previously filed the Hamian case, alleging substantially the same claims.

On July 24, 2006, the Company received a letter of informal inquiry from the SEC requesting certain documents and information relating to the Company’s historical stock option grant practices.  Thereafter, the SEC issued a formal order of non-public investigation, pursuant to which it has subpoenaed documents from the Company related to the investigation, and has subpoenaed testimony and documents from certain current and former directors, officers and employees of the Company.

The Company is cooperating with the SEC’s investigation, and representatives of the special subcommittee of independent members of our Board of Directors established in July 2006 to review our historical stock option granting practices (the “Special Subcommittee”) and its legal counsel have met with members of the staff of the SEC on several occasions, in person and by telephone (as has the Company’s outside legal counsel), to discuss the progress of the Special Subcommittee’s investigation and to brief the SEC staff on the Special Subcommittee’s findings and recommendations. A representative of the U.S. Department of Justice has attended certain of these meetings and requested copies of certain documents that we have provided to the staff of the SEC. At this time, the Company has not received any grand jury subpoenas or written requests from the Department of Justice.

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, employment relationships, and collection matters. In the opinion of management, after consultation with legal counsel, the outcome of such routine claims and lawsuits will not have a material adverse effect on our business, financial condition, results of operations, or liquidity.

14.        Stock Compensation and Employee Benefit Plans

We have a stock-based compensation program that provides our Board of Directors broad discretion in creating employee equity incentives. This program allows the Board of Directors to grant our employees

22




incentive and non-qualified stock options and restricted stock awards under various plans, the majority of which are stockholder approved.  Such awards generally have time-based vesting schedules, vesting  annually over periods of three to five years, or cliff vest on an anniversary of the grant date subject to possible earlier vesting if certain performance measures are met, and all such options generally expire ten years from the grant date.  Additionally, we have an Employee Stock Purchase Plan (“ESPP”) that allows employees to purchase shares of common stock at 85% of the fair market value at the lower of either the date of enrollment or the date of purchase. Shares issued as a result of stock option exercises and our ESPP are generally issued as new stock issuances. As of June 30, 2007, we had approximately 11.3 million shares of common stock reserved for future issuance under our stock option plans and ESPP.

Under the terms of the plans, the exercise price for awards issued under the 1991 Plan, 1998 Plan, 1999 Plan, 2001 Plan, 2002 Plan, 2002 Executive Plan, 2002 Studio Plan, and 2003 Plan (collectively, the “Plans”) is determined at the discretion of the Board of Directors (or the Compensation Committee of the Board of Directors, which administers the Plans), and under the terms of the plans, the exercise price for ISOs is not to be less than the fair market value of our common stock at the date of grant, and in the case of non-qualified options, the exercise price must exceed or be equal to 85% of the fair market value of our common stock at the date of grant.  Options typically become exercisable in installments over a period not to exceed seven years and must be exercised within 10 years of the date of grant.

Other Employee Stock Options

In connection with prior employment agreements between Activision and Robert A. Kotick, Activision’s Chairman and Chief Executive Officer, and Brian G. Kelly, Activision’s Co-Chairman, Mr. Kotick and Mr. Kelly were granted options to purchase common stock.  The Board of Directors approved the granting of these options.  Relating to such grants, as of June 30, 2007, approximately 8,304,800 options were outstanding with a weighted-average exercise price of $1.74.

We additionally have approximately 4,500 options outstanding to employees as of June 30, 2007, with a weighted-average exercise price of $3.48.  The Board of Directors approved the granting of these options.  Such options have terms similar to those options granted under the Plans.

Employee Stock Purchase Plan

On April 1, 2005, the Board of Directors approved the Second Amended and Restated 2002 Employee Stock Purchase Plan (the “Amended 2002 Purchase Plan”) for eligible employees.  Under the Amended 2002 Purchase Plan, up to 4,000,000 shares of our common stock may be purchased by eligible employees during two six-month offering periods that commence each April 1 and October 1 (the “Offering Period”).  The first day of each Offering Period is referred to as the “Offering Date.”  Common stock is purchased by the Amended 2002 Purchase Plans participants at 85% of the lesser of fair market value on the Offering Date for the Offering Period that includes the common stock purchase date or the fair market value on the common stock purchase date.  Employees may purchase shares having a value not exceeding 15% of their gross compensation during an Offering Period, limited to a maximum of $10,000 in value for any two purchases within the same calendar year.  On June 13, 2007, the most recent purchase date, employees purchased 228,242 shares of our common stock at a purchase price of $12.8350 per share.

Non-Employee Warrants

In prior years, we have granted stock warrants to third parties in connection with the development of software and the acquisition of licensing rights for intellectual property.  The warrants generally vest upon grant and are exercisable over the term of the warrant.  The exercise price of third-party warrants is generally greater than or equal to the fair market value of our common stock at the date of grant.  No third-party warrants were granted during the quarters ended June 30, 2007 and 2006.  As of June 30, 2007 and 2006, 936,000 third-party warrants to purchase common stock were outstanding with a weighted-average exercise price of $4.54 per share.

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In accordance with EITF 96-18, we measure the fair value of the securities on the measurement date.  The fair value of each warrant is capitalized and amortized to expense when the related product is released and the related revenue is recognized.  Additionally, as more fully described in Note 1, the recoverability of capitalized software development costs and intellectual property licenses is evaluated on a quarterly basis with amounts determined as not recoverable being charged to expense.  In connection with the evaluation of capitalized software development costs and intellectual property licenses, any capitalized amounts for related third-party warrants are additionally reviewed for recoverability with amounts determined as not recoverable being amortized to expense.  As of March 31, 2006, capitalized amounts of third-party warrants had been fully amortized.

Employee Retirement Plan

We have a retirement plan covering substantially all of our eligible employees.  The retirement plan is qualified in accordance with Section 401(k) of the Internal Revenue Code.  Under the plan, employees may defer up to 92% of their pre-tax salary and the maximum amount allowed by law.  We contribute 20% of each dollar contributed by a participant.  Our matching contributions to the plan were approximately $589,600 and $488,500 during the quarters ended June 30, 2007 and 2006, respectively.

Restricted Stock

During the first quarter of fiscal 2008, we issued the rights to 8,000 shares of restricted stock to an employee with a total grant date fair value of $163,000. The value of the shares is based on the closing market price of the Company’s common stock on the date of grant. In accordance with SFAS No. 123R we will recognize compensation expense and increase additional paid in capital related to restricted stock shares over the requisite service period. For the quarters ended June 30, 2007 and 2006, we recorded expenses related to total restricted stock shares of approximately $331,000 and $175,000, 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 $1.8 million of the $4.9 million total fair value, with the remainder to be recognized over a weighted-average period of 2.66 years.

The following table sets forth the total stock-based compensation expense resulting from stock options, restricted stock awards, and ESPP included in our Consolidated Statements of Operations for the three months ended June 30, 2007 and 2006 (in thousands):

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Three months ended
June 30,

 

 

 

2007

 

2006

 

Cost of sales - software royalties and amortization

 

$

1,845

 

$

36

 

Product development

 

1,507

 

1,679

 

Sales and marketing

 

1,771

 

1,040

 

General and administrative

 

3,037

 

3,094

 

 

 

 

 

 

 

Stock-based compensation expense before income taxes

 

8,160

 

5,849

 

Income tax benefit

 

(3,191

)

(2,287

)

 

 

 

 

 

 

Total stock-based compensation expense after income taxes

 

$

4,969

 

$

3,562

 

 

Additionally, stock option expenses are capitalized in accordance with SFAS No. 86, “Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed” as discussed in Note 1.  The following table summarizes stock option expense included in our Consolidated Balance Sheets as a component of software development (in thousands):

 

Software
Development

 

 

 

 

 

Balance, March 31, 2007

 

$

6,566

 

Stock option expense capitalized during period

 

1,923

 

Amortization of capitalized stock option expense

 

(1,845

)

Balance, June 30, 2007

 

$

6,644

 

 

Net cash proceeds from the exercise of stock options were $11.2 million and $4.8 million for the three months ended June 30, 2007 and 2006, respectively. Tax benefits attributable to employee stock option exercises were $4.0 million for the three months ended June 30, 2007, and offset by adjustments to deferred income taxes and additional paid-in capital of $3.6 million.  For the period ending June 30, 2006, tax benefits attributable to employee stock option exercises were $2.8 million.  In accordance with SFAS No. 123R, we present excess tax benefits from the exercise of stock options, if any, as financing cash flows rather than operating cash flows.

Consistent with SFAS No. 123R, we have attempted to reflect expected future changes in model inputs during the option’s contractual term.  The inputs required by our binomial lattice model include expected volatility, risk-free interest rate, risk-adjusted stock return, dividend yield, contractual term, and vesting schedule, as well as measures of employees’ forfeiture, exercise, and post-vesting termination behavior.   Statistical methods were used to estimate employee type specific termination rates.  These termination rates, in turn, were used to model the number of options that are expected to vest and post-vesting termination behavior.  Employee type specific estimates of Expected Time-To-Exercise (“ETTE”) were used to reflect employee exercise behavior.  ETTE was estimated by using statistical procedures to first estimate the conditional probability of exercise occurring during each time period, conditional on the option surviving to that time period.  These probabilities are then used to estimate ETTE.  The model was calibrated by adjusting parameters controlling exercise and post-vesting termination behavior so that the

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measures output by the model matched values of these measures that were estimated from historical data.  The weighted-average estimated value of employee stock options granted during the three months ended June 30, 2007 and 2006 was $9.05 and $5.42 per share, respectively, using the binomial-lattice model with the following weighted-average assumptions:

 

Employee and Director Options
and Warrants

 

Employee Stock
Purchase Plan

 

 

 

June 30,
2007

 

June 30, 
2006

 

June 30, 
2007

 

June 30, 
2006

 

Expected Term (in years)

 

5.57

 

4.55

 

0.5

 

0.5

 

Risk-free Interest rate

 

4.77%

 

5.05%

 

5.07%

 

4.68%

 

Volatility

 

51.38%

 

54.30%

 

34.58%

 

41.40%

 

Dividend yield

 

 

 

 

 

Weighted-average fair value at grant date

 

$9.05

 

$5.42

 

$4.58

 

$3.55

 

 

T o estimate volatility for the binomial-lattice model, we use methods or capabilities that are discussed in SFAS No. 123R and SAB No. 107.  These methods included 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) during the option’s contractual term 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 June 30, 2007, the expected stock price volatility ranged from 39.08% to 52.65%, with a weighted-average volatility of 51.38% for options granted during the quarter ended June 30, 2007.  For options granted during the three months ended June 30, 2006, the expected stock price volatility ranged from 42.67% to 55.99%, with a weighted-average volatility of 54.30% for options granted during the three months ended June 30, 2006.

As was the case for volatility, the risk-free rate is assumed to change during the option’s contractual term.  Consistent with the calculation required by a binomial lattice model, the risk-free rate reflects the interest from one time period to the next (“forward rate”) as opposed to the interest rate from the grant date to the given time period (“spot rate”).  Since we do not currently pay dividends and are not expected to pay them in the future, we have assumed that the dividend yield is zero.

The expected life of employee stock options represents the weighted-average period the stock options are expected to remain outstanding and is, as required by SFAS No. 123R, an output by the binomial-lattice model. The expected life of employee stock options depends on all of the underlying assumptions and calibration of our model. A binomial-lattice model can be viewed as assuming that employees will exercise their options when the stock price equals or exceeds an exercise boundary.  The exercise boundary is not constant but continually declines as one approaches the option’s expiration date.  The exact placement of the exercise boundary depends on all of the model inputs as well as the measures that are used to calibrate the model to estimated measures of employees’ exercise and termination behavior.

Stock-based compensation expense recognized in the Consolidated Statement of Operations is based on awards ultimately expected to vest and has been reduced for estimated forfeitures. SFAS No. 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.

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Accuracy of Fair Value Estimates

The Company uses third-party analyses to assist in developing the assumptions used in the binomial lattice model, including model inputs and measures of employees’ exercise and post-vesting termination behavior.  However, we are responsible for the assumptions used to estimate the fair value of our share-based payment awards.

Our ability to accurately estimate the fair value of share-based payment awards as of the grant date depends upon the accuracy of the model and our ability to accurately forecast model inputs as long as ten years into the future.  These inputs include, but are not limited to, expected stock price volatility, risk-free rate, dividend yield, and employee termination rates.  Although the fair value of employee stock options is determined in accordance with SFAS No. 123R and SAB 107 using an option-pricing model, the estimates that are produced by this model may not be indicative of the fair value observed between a willing buyer/willing seller.  Unfortunately, it is difficult to determine if this is the case, because markets do not currently exist that permit the active trading of employee stock option and other share-based instruments.

Stock option activity for the three months ended June 30, 2007, is as follows (in thousands, except per share amounts):

 

 

 

Shares

 

Weighted-Average 
Exercise Price

 

Weighted-
Average
Remaining 
Contractual
Term

 

Aggregate
Intrinsic Value

 

Outstanding at March 31, 2007

 

49,429

 

$

7.18

 

 

 

 

 

Granted

 

926

 

19.59

 

 

 

 

 

Exercised

 

(1,082

)

7.62

 

 

 

 

 

Forfeiture

 

(1,056

)

10.74

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Outstanding at June 30, 2007

 

48,217

 

$

7.32

 

5.75

 

$

547,966

 

 

 

 

 

 

 

 

 

 

 

Exercisable at June 30, 2007

 

34,730

 

$

5.27

 

4.78

 

$

465,386

 

The aggregate intrinsic value in the table above represents the total pretax intrinsic value (i.e., the difference between our closing stock price on the last trading day of our first quarter of fiscal 2008 and the exercise price, times the number of shares) that would have been received by the option holders had all option holders exercised their options on June 30, 2007.  This amount changes based on the fair market value of our stock.  Total intrinsic value of options exercised is $12.2 million for the three months ended June 30, 2007.

As of June 30, 2007, $33.9 million of total unrecognized compensation cost related to stock options is expected to be recognized over a weighted-average period of 1.8 years.

On June 8, 2007, with respect to unexercised options subject to Section 409A of the Internal Revenue Code held by employees who are not executive officers, Activision commenced an offer to amend the exercise

27




price of these options to eliminate the grantee’s Section 409A tax liability consistent with Internal Revenue Service guidance. Pursuant to the offer, which closed on July 6, 2007, the Company will make a cash payment in January 2008 to employees who have accepted the offer, for approximately $4.1 million, which represents the difference between the original exercise price of each amended option and the amended exercise price of each amended option. The offer with respect to all eligible options is considered a modification of those options for financial reporting purposes. Pursuant to the accounting standards in effect under SFAS No. 123R, the incremental fair value, created as a result of cash payments that become payable pursuant to the terms of the offer, will be recognized as compensation expense at the expiration of the offer period on July 6, 2007. In addition, a portion of the compensation costs associated with the original award may be accelerated and recognized as compensation expense at the expiration of the offer period as a result of the cash payment.

15.        Recently Issued Accounting Standards

In February 2006, the FASB issued Statement No. 155 (“SFAS No. 155”), Accounting for Certain Hybrid Financial Instruments — An amendment of FASB Statements No. 133 and 140. SFAS No. 155 amends FASB Statements No. 133, Accounting for Derivative Instruments and Hedging Activities, and No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities to resolve issues addressed in Statement 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.” SFAS No. 155 permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation; clarifies which interest-only strips and principal-only strips are not subject to the requirements of Statement 133; establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation; clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and amends Statement 140 to eliminate the prohibition on a qualifying special purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS No. 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. The adoption of SFAS No. 155 did not have a material effect on our financial position or results of operations.

In March 2006, the FASB issued Statement No. 156 (“SFAS No. 156”), Accounting for Servicing of Financial Assets — an amendment of FASB Statement No. 140. SFAS No. 156 amends Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, with respect to the accounting for separately recognized servicing assets and servicing liabilities. SFAS No. 156 requires an entity to recognize a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract in certain situations; requires all separately recognized servicing assets and servicing liabilities to be initially measured at fair value, if practicable; permits either the “amortization method” or the “fair value measurement method,” as subsequent measurement methods for each class of separately recognized servicing assets and servicing liabilities; permits a one-time reclassification of available-for-sale securities to trading securities by entities with recognized servicing rights; and requires separate presentation of servicing assets and servicing liabilities subsequently measured at fair value in the statement of financial position and additional disclosures for all separately recognized servicing assets and servicing liabilities. SFAS No. 156 is effective in the first fiscal year that begins after September 15, 2006. The adoption of SFAS No. 156 did not have a material effect on our financial position or results of operations.

In July 2006, the FASB issued Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes , an interpretation of SFAS No. 109. FIN 48 clarifies the accounting for income taxes by prescribing the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest, and penalties, accounting in interim periods, disclosure, and transition. In addition, FIN 48 excludes income taxes from the scope of SFAS No. 5, Accounting for Contingencies .  FIN 48 is effective for fiscal years beginning after December 15, 2006.  We adopted the provisions of FIN 48 on April 1, 2007.  As a result of

28




the implementation of FIN 48, we recognized no material adjustment in the liability for unrecognized income tax benefits.  At the adoption date of April 1, 2007, we had $65.5 million of unrecognized tax benefits, of which $26.2 million would affect our effective tax rate if recognized.

In September 2006, the FASB issued Statement No. 157 (“SFAS No. 157”), Fair Value Measurements. SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS No. 157 applies to other accounting pronouncements that require or permit fair value measurements and does not require any new fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. We do not expect that the adoption of SFAS No. 157 will have a material effect on our financial position or results of operations.

In February 2007, the FASB issued Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities — Including an amendment of FASB Statement No. 115 (“SFAS No. 159”). SFAS No. 159 permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. Subsequent unrealized gains and losses on items for which the fair value option has been elected will be reported in earnings. The provisions of SFAS No. 159 are effective for financial statements issued for fiscal years beginning after November 15, 2007. We are evaluating if we will adopt SFAS No. 159 and what impact the adoption will have on our Consolidated Financial Statements if we adopt.

 

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

Overview

Our Business

We are a leading international publisher of interactive entertainment software products. We have built a company with a diverse portfolio of products that spans a wide range of categories and target markets and that are 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 fiscal 2008 product portfolio includes titles such as Guitar Hero II for the Microsoft Xbox 360 , Spider-Man 3, Shrek The Third, TRANSFORMERS: The Game, Enemy Territory: Quake Wars, Call of Duty 4: Modern Warfare, Tony Hawk’s Proving Ground, The Bee Movie, Spider-Man: Friend or Foe, and Guitar Hero III.

Our products cover diverse game categories including action/adventure, action sports, racing, role-playing, simulation, first-person action, music-based gaming, 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”), the Sony PlayStation 3 (“PS3”), the Nintendo Wii (“Wii”), and the Microsoft Xbox 360 (“Xbox360”) console systems, the Nintendo Game Boy Advance (“GBA”), the Nintendo Dual Screen (“NDS”), and the Sony PlayStation Portable (“PSP”) hand-held devices, and the personal computer (“PC”). The installed base for the previous generation of hardware platforms (e.g., PS2, Xbox) is significant and the fiscal 2006 release of the Xbox360 and the fiscal 2007 releases of the PS3 and the Wii will further expand the software market. During the third quarter of fiscal 2007, we had a successful and significant presence at the launches of the PS3 and the Wii with three launch titles for the PS3, Call of Duty 3, Marvel: Ultimate Alliance, and Tony Hawk’s Project 8, and five launch titles for the Wii, Call of Duty 3, Marvel: Ultimate Alliance, World Series of Poker: Tournament of Champions, Rapala Tournament Fishing, and Tony Hawk’s Downhill Jam.   In the first quarter of fiscal 2008, we had strong releases of Guitar Hero II for the Xbox360, and multi platform releases of Spider-Man 3 , Shrek The Third , and TRANSFORMERS: The Game .  Our plan is to continue to build on our significant launch presence on the PS3, Wii, and Xbox360 (“the next-generation platforms”) by continuing to expand the number of titles released on the next generation and hand-held platforms while continuing to market 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 North America, 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, Scandinavia, Australia, Canada, South Korea, and Japan. Our products are sold internationally on a direct-to-retail basis, through third party distribution and licensing arrangements, and through our wholly owned European distribution subsidiaries. Our distribution business consists of operations located in the UK, the Netherlands, and Germany that provide logistical and sales services to third-party publishers of interactive entertainment software, our own publishing operations, and manufacturers of interactive entertainment hardware.

Our profitability is directly affected by the mix of revenues from our publishing and distribution businesses. Operating margins realized from our publishing business are typically substantially higher than margins realized from our distribution business. Operating margins in our publishing business are affected by our ability to release highly successful or “hit” titles. Though many of these titles have substantial production or acquisition costs and marketing budgets, once a title recoups these costs, incremental net revenues directly and positively impact our operating margin. Operating margins in our distribution business are affected by the mix of hardware and software sales, with software typically producing higher margins than hardware.

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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 2008 releases include well-established brands, which are backed by high-profile intellectual property and/or highly anticipated motion picture releases. For example, we have a long-term relationship with Marvel Entertainment, Inc. through an exclusive 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 and movie franchises Spider-Man and X-Men. Through June 30, 2007, games based on the Spider-Man and X-Men franchises have generated approximately $1.0 billion in net revenues worldwide. Under this agreement, in the first quarter of fiscal 2007 we released the video game, X-Men: The Official Game coinciding with the theatrical release of “X-Men: The Last Stand.”  In the third quarter of fiscal 2007, we released Marvel: Ultimate Alliance across multiple platforms and Spider-Man: Battle for New York on the NDS and GBA. In the first quarter of fiscal 2008 we released Spider-Man 3 through our licensing agreement with Spider-Man Merchandising, LP, and we developed and published video games based on Columbia Pictures/Marvel Entertainment, Inc.’s feature film “Spider-Man 3,” which was released in May 2007.  Our agreement with Spider-Man Merchandising, LP grants us 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 June 30, 2007, we have released eight successful titles in the Tony Hawk franchise with cumulative net revenues of $1.2 billion, including the two fiscal 2007 third quarter releases, Tony Hawk’s Project 8, which was released on the PSP, Xbox360, PS2, and PS3, and Tony Hawk’s Downhill Jam which was released on the Wii, NDS, and GBA. According to the NPD Group, which is a provider of consumer and retail market research information for a wide range of industries, for the eighth consecutive year in 2007 the Tony Hawk franchise had a top 10 best-selling game in the U.S. for the month of December. We will continue to build on the highly successful Tony Hawk franchise with future releases currently in development for multiple platforms.

We continue to develop a number of original intellectual properties internally. For example, in the third quarter of fiscal 2007 we released Call of Duty 3 on the PS2, PS3, Xbox, Xbox360, and the Wii. According to the NPD Group, Call of Duty 3 was the #3 best-selling console game in the U.S. Call of Duty 3 was the sixth release based upon this original intellectual property following two PC exclusive titles, Call of Duty and Call of Duty: United Offensive, as well as multi-platform releases of Call of Duty: Finest Hour, Call of Duty: Big Red One, and Call of Duty 2. We expect to continue to develop a variety of games on multiple platforms based on this original intellectual property as well as continue to invest in developing other original intellectual properties.

We have continued our focus on establishing and maintaining relationships with talented and experienced software development and publishing teams. In June 2006, we acquired RedOctane, Inc. (“RedOctane”), the publisher of the popular Guitar Hero franchise. In the third quarter of fiscal 2007 we released Guitar Hero II on the PS2, which according to the NPD Group was the #1 game in dollars for the U.S. for the month of December and the #2 game overall for the third quarter of fiscal 2007.  In the first quarter of fiscal 2008 we also released Guitar Hero II for the Xbox360.  We plan on continuing to build on this franchise by investing in future development of Guitar Hero titles across a variety of platforms. We also have development agreements with other top-level, third-party developers such as id Software, Inc., Splash Damage, Ltd., and Traveller’s Tales.

We will also continue to evaluate and exploit emerging brands that we believe have potential to become successful game franchises. For example, we have a multi-year, multi-property, publishing agreement with DreamWorks Animation LLC that granted us the exclusive rights to publish video games based on DreamWorks Animation SKG’s theatrical release “Shrek 2,” which was released in the first quarter of fiscal 2005, “Shark Tale,” which was released in the second quarter of fiscal 2005, “Madagascar,” which was released in the first quarter of fiscal 2006, “Over the Hedge,” which was released in the first quarter of fiscal 2007, and all of their respective sequels. In the first quarter of fiscal 2008, we had a successful release of Shrek The Third

31




In addition, our multi-year agreement with DreamWorks Animation LLC also grants us the exclusive video game rights to four upcoming feature films, including Bee Movie, as well as potential future films in the “Shrek” franchise beyond “Shrek The Third.”

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 popular World Series of Poker Tournament. In the second quarter of fiscal 2006, we released our first title under this alliance, World Series of Poker, which became the number one poker title of calendar 2005. Further building on this franchise, in the second quarter of fiscal 2007, we released our second title under this alliance, World Series of Poker: Tournament of Champions .

We also continue to build on our portfolio of licensed intellectual property. In February 2006, we signed an agreement with Hasbro Properties Group granting us the exclusive global rights (excluding Japan) to develop console, hand-held, and PC games based on Hasbro’s “Transformers” brand. We had a strong initial release of our first game in late June 2007 concurrently with the early July 2007 movie release of the live action “Transformers” film from DreamWorks Pictures and Paramount Pictures.  In April 2006, we signed an agreement with MGM Interactive and EON Productions Ltd. granting us the exclusive rights to develop and publish interactive entertainment games based on the James Bond license through 2014.  In April 2006, we signed a multi-year agreement with Mattel, Inc. which grants us the exclusive worldwide distribution rights for the catalog of video games based on Mattel, Inc.’s Barbie brand on all platforms. In the third quarter of fiscal 2007, we distributed six Barbie titles: Barbie in the 12 Dancing Princesses, The Barbie Diaries: High School Mystery, Barbie Fashion Show, Barbie Horse Adventures: Mystery Ride, Barbie and the Magic of Pegasus, and Barbie as the Princess and the Pauper. Based on the success of this distribution, we signed multi-year license agreements with Mattel, Inc. in January 2007 which grant us the exclusive worldwide rights to develop and publish new video games based on Mattel Inc.’s Barbie and Hot Wheels brands on all platforms.  In September 2006, we entered into a distribution agreement with MTV Networks Kids and Family Group’s Nickelodeon, a division of Viacom Inc., to be the exclusive distributor of three new Nick Jr. PC CD-ROM titles, published by Nickelodeon and based on the top preschool series on commercial television, Dora The Explorer, The Backyardigans, and Go, Diego, Go!.

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

Critical Accounting Policies

We have identified the policies below as critical to our business operations and the understanding of our financial results. The impact and any associated risks related to these policies on our business operations is discussed throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations where such policies affect our reported and expected financial results. For a detailed discussion on the application of these and other accounting policies, see Note 1 to the Notes to 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 (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. Some of the Company’s software products provide limited online functionality at no additional cost to the consumer. Currently, none of the Company’s products require an internet connection for use, and online functionality is perceived to be of only incidental value to the software product itself.  Accordingly, the Company considers such features to be an insignificant deliverable and does not defer revenue related to products containing online features.  In instances where online

32




functionality is not incidental, the deferral of revenue recognition is a consideration, however, there have been no instances of deferral to date as a result of online functionality.  Over time, online service, cost, and usage may become a non-incidental part of gameplay, and the Company will continue to evaluate, for each future game title, its revenue recognition policy in accordance with Statement of Position 97-2, “Software Revenue Recognition” (“SOP 97-2”). With respect to online transactions, such as electronic downloads of titles or product add-ons, revenue is recognized when the fee is paid by the online 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 are 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, and consistent delivery to us of inventory and sell-through reports. 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 June 30, 2007 allowance for returns and price protection would impact net revenues by $1.1 million.

33




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 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 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

34




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.

Stock-based Compensation Expense

On April 1, 2006, we adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” (“SFAS No. 123R”) which requires the measurement and recognition of compensation expense for all share-based payment awards made to our employees and directors including employee stock options and employee stock purchases related to the Employee Stock Purchase Plan based on estimated fair values.  Stock-based compensation expense recognized under SFAS No. 123R for the three months ended June 30, 2007 and 2006 was $8.2 million and $5.8 million, respectively. See Note 14 to the Consolidated Financial Statements for additional information.

The Company estimates the value of employee stock options on the date of grant using a binomial-lattice model.  The fair value of a share-based payment as of the grant date estimated by an option pricing model depends upon our future stock price as well as assumptions concerning expected volatility, risk-free interest rate, and risk-adjusted stock return, as well as measures of employees’ forfeiture, exercise, and post-vesting termination behavior.  Statistical methods were used to estimate employee type specific termination rates.  These termination rates, in turn, were used to model the number of options that are expected to vest and post-vesting termination behavior.  Employee type specific estimates of Expected Time-To-Exercise (“ETTE”) were used to reflect employee exercise behavior.  ETTE was estimated by using statistical procedures to first estimate the conditional probability of exercise occurring during each time period, conditional on the option surviving to that time period.  These probabilities were then used to estimate ETTE.  The model was calibrated by adjusting parameters controlling exercise and post-vesting termination behavior so that the measures output by the model matched values of these measures that were estimated from historical data.  The weighted-average estimated value of employee stock options granted during the three months ended June 30, 2007 was $9.05 per share using the binomial-lattice model with the following weighted-average assumptions:

35




 

 

Three Months Ended
June 30, 2007

 

Expected volatility

 

51.38%

 

Risk-free interest rate

 

4.77%

 

Expected dividends

 

 

 

T o estimate volatility for the binomial-lattice model, we use methods or capabilities that are discussed in SFAS No. 123R and SAB No. 107.  These methods included 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) during the option’s contractual term 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 quarter ended June 30, 2007, the expected stock price volatility ranged from 39.08% to 52.65%, with a weighted-average volatility of 51.38% for options granted during the quarter ended June 30, 2007.  For options granted during the three months ended June 30, 2006, the expected stock price volatility ranged from 42.67% to 55.99%, with a weighted-average volatility of 54.30% for options granted during the quarter ended June 30, 2006.

As was the case for volatility, the risk-free rate is assumed to change during the option’s contractual period.  As required by a binomial lattice model, the risk-free rate reflects the interest from one time period to the next (“forward rate”) as opposed to the interest rate from the grant date to the given time period (“spot rate”).  Since we do not currently pay dividends and are not expected to pay them in the future, we have assumed that the dividend yield is zero.

The expected life of employee stock options represents the weighted-average period the stock options are expected to remain outstanding and is, as required by SFAS No. 123R, output by the binomial-lattice model. The expected life of employee stock options depends on all of the underlying assumptions and calibration of our model. The binomial-lattice model assumes that employees will exercise options when the stock price equals or exceeds an exercise boundary.  The exercise boundary is not constant but continually declines as one approaches the option’s expiration date.  The exact placement of the exercise boundary depends on all of the model inputs as well as the measures that were used to calibrate the model to estimated measures of employees’ exercise and termination behavior.

Stock-based compensation expense recognized in the Consolidated Statement of Operations is based on awards ultimately expected to vest and has been reduced for estimated forfeitures. SFAS No. 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.

If factors change and we employ different assumptions in the application of SFAS No. 123R in future periods, the compensation expense that we record under SFAS No. 123R may differ significantly from what we have recorded in the current period.

 

36




Selected Consolidated Statements of Operations Data

The following table sets forth certain consolidated statements of operations data for the periods indicated as a percentage of total net revenues and also breaks down net revenues by territory, business segment and platform, as well as operating income (loss) by business segment (amounts in thousands):

 

 

Three months ended June 30,

 

 

 

2007

 

2006

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

$

495,455

 

100%

 

$

188,069

 

100%

 

 

 

 

 

 

 

 

 

 

 

Costs and expenses:

 

 

 

 

 

 

 

 

 

Cost of sales — product costs

 

217,229

 

44

 

108,623

 

58

 

Cost of sales — software royalties and amortization

 

78,252

 

16

 

19,261

 

10

 

Cost of sales — intellectual property licenses

 

32,479

 

6

 

9,916

 

5

 

Product development

 

32,897

 

7

 

25,625

 

14

 

Sales and marketing

 

68,712

 

14

 

36,179

 

19

 

General and administrative

 

35,794

 

7

 

21,914

 

12

 

 

 

 

 

 

 

 

 

 

 

Total costs and expenses

 

465,363

 

94

 

221,518

 

118

 

 

 

 

 

 

 

 

 

 

 

Operating income (loss)

 

30,092

 

6

 

(33,449

)

(18)

 

 

 

 

 

 

 

 

 

 

 

Investment income, net

 

11,562

 

2

 

8,275

 

4

 

 

 

 

 

 

 

 

 

 

 

Income (loss) before income tax provision (benefit)

 

41,654

 

8

 

(25,174

)

(14)

 

 

 

 

 

 

 

 

 

 

 

Income tax provision (benefit)

 

13,828

 

2

 

(6,865

)

(4)

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

27,826

 

6%

 

$

(18,309

)

(10)%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net Revenues by Territory:

 

 

 

 

 

 

 

 

 

North America

 

$

309,536

 

62%

 

$

99,610

 

53%

 

Europe

 

170,014

 

35

 

81,816

 

44

 

Other

 

15,905

 

3

 

6,643

 

3

 

 

 

 

 

 

 

 

 

 

 

Total net revenues

 

$

495,455

 

100%

 

$

188,069

 

100%

 

 

 

 

 

 

 

 

 

 

 

Net Revenues by Segment/Platform Mix:

 

 

 

 

 

 

 

 

 

Publishing:

 

 

 

 

 

 

 

 

 

Console

 

$

358,773

 

72%

 

$

90,189

 

48%

 

Hand-held

 

56,616

 

12

 

26,584

 

14

 

PC

 

13,833

 

3

 

17,989

 

10

 

Total publishing net revenues

 

429,222

 

87

 

134,762

 

72

 

 

 

 

 

 

 

 

 

 

 

Distribution:

 

 

 

 

 

 

 

 

 

Console

 

43,101

 

8

 

28,788

 

15

 

Hand-held

 

19,116

 

4

 

18,213

 

10

 

PC

 

4,016

 

1

 

6,306

 

3

 

Total distribution net revenues

 

66,233

 

13

 

53,307

 

28

 

 

 

 

 

 

 

 

 

 

 

Total net revenues

 

$

495,455

 

100%

 

$

188,069

 

100%

 

 

 

 

 

 

 

 

 

 

 

Operating Income (Loss) by Segment:

 

 

 

 

 

 

 

 

 

Publishing

 

$

29,117

 

6%

 

$

(31,519

)

(17)%

 

Distribution

 

975

 

0

 

(1,930

)

(1)

 

 

 

 

 

 

 

 

 

 

 

Total operating income (loss)

 

$

30,092

 

6%

 

$

(33,449

)

(18)%

 

 

37




Results of Operations — Three Months Ended June 30, 2007 and 2006

Net Revenues

We primarily derive revenue from sales of packaged interactive software games designed for play on video game consoles (such as the PS2, PS3, Xbox360 and Wii), PCs and hand-held game devices (such as the GBA, NDS, and PSP).  We also derive revenue from our distribution business in Europe that provides logistical and sales services to third-party publishers of interactive entertainment software, our own publishing operations, and third-party manufacturers of interactive entertainment hardware.

The following table details our consolidated net revenues by business segment and our publishing net revenues by territory for the three months ended June 30, 2007 and 2006 (in thousands):

 

 

Three Months Ended June 30,

 

Increase/

 

Percent

 

 

 

2007

 

2006

 

(Decrease)

 

Change

 

Publishing Net Revenues

 

 

 

 

 

 

 

 

 

North America

 

$

309,536

 

$

99,610

 

$

209,926

 

211%

 

Europe

 

103,781

 

28,509

 

75,272

 

264%

 

Other

 

15,905

 

6,643

 

9,262

 

139%

 

Total International

 

119,686

 

35,152

 

84,534

 

240%

 

Total Publishing Net Revenues

 

429,222

 

134,762

 

294,460

 

219%

 

Distribution Net Revenues

 

66,233

 

53,307

 

12,926

 

24%

 

Consolidated Net Revenues

 

$

495,455

 

$

188,069

 

$

307,386

 

163%

 

 

Consolidated net revenues increased 163% from $188.1 million for the three months ended June 30, 2006 to $495.5 million for the three months ended June 30, 2007.  This increase primarily resulted from the publishing business which more than tripled in net revenues as compared to the first quarter of the prior fiscal year.  Our performance was driven by the following:

·                   The increase in our publishing net revenues of $294.5 million was attributable to the strong performance of our key titles released in the first quarter of fiscal 2008, Spider-Man 3, Guitar Hero II for the Xbox360 , and Shrek The Third .  Each of these titles was released worldwide, and significantly outperformed each of the two titles released in the first quarter of fiscal 2007, Over the Hedge and X-Men: The Official Game TRANSFORMERS: The Game, released in North America and Asia late in the first quarter of fiscal 2008 also contributed to the strong net revenue performance.  According to NPD, Activision was the #1 third party console/hand-held publisher in the United States for the quarter ended June 30, 2007.  In addition, Guitar Hero II was the #1 product by revenue in the United States for the quarter.

·                   International net revenues were impacted by a year over year weakening of the U.S. Dollar in relation to the Great Britain Pound (“GBP”), Euro (“EUR”) and Australian Dollar (“AUD”).  We estimate that foreign exchange rates increased reported consolidated net revenues by approximately $15.1 million.  Excluding the impact of changing foreign currency rates, our consolidated net revenues increased 155% year over year.

38




North America Publishing Net Revenues (in thousands)

 

Three Months
Ended
June 30, 2007 

 

% of
Consolidated
Net Revenues 

 

Three Months
Ended
June 30, 2006 

 

% of
Consolidated
Net Revenues 

 

Increase/
(Decrease) 

 

Percent
Change 

 

$              309,536

 

62%

 

$

99,610

 

53%

 

$

209,926

 

211%

 

 

North America publishing net revenues increased 211% from $99.6 million for the three months ended June 30, 2006, to $309.5 million for the three months ended June 30, 2007.  The increase was due to the strong performance of four key titles released in the first quarter of fiscal 2008, Guitar Hero II for the Xbox360, Spider-Man 3, Shrek The Third and TRANSFORMERS: The Game .  According to NPD, for the quarter ended June 30, 2007, two of the Top 3 products in the United States by revenue were Guitar Hero , ranked #1, and Spider-Man 3 , ranked #3.   The fiscal 2007 first quarter performance included new title releases, Over the Hedge and X-Men: The Official Game and strong performance of certain catalog titles.

International Publishing Net Revenues (in thousands)

Three Months
Ended
June 30, 2007