UNITED STATES

SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

FORM 10-Q

 

(Mark one)

 

 

For the transition period from              to             

 

Commission File Number 0-12699

 

ACTIVISION, INC.
(Exact name of registrant as specified in its charter)

Delaware		95-4803544
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)
3100 Ocean Park Boulevard, Santa Monica, CA		90405
(Address of principal executive offices)		(Zip Code)

 

(310) 255-2000
(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  ý  No o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).  Yes  ý  No  o

 

The number of shares of the registrant’s Common Stock outstanding as of July 26, 2004 was 138,392,458.

 

 

ACTIVISION, INC. AND SUBSIDIARIES

 

INDEX

 

PART I.  FINANCIAL INFORMATION
Item 1.	Financial Statements
	Consolidated Balance Sheets as of June 30, 2004 (Unaudited) and March 31, 2004
	Consolidated Statements of Operations for the three months ended June 30, 2004 and 2003 (Unaudited)
	Consolidated Statements of Cash Flows for the three months ended June 30, 2004 and 2003 (Unaudited)
	Consolidated Statement of Changes in Shareholders’ Equity for the three months ended June 30, 2004 (Unaudited)
	Notes to Consolidated Financial Statements for the three months ended June 30, 2004 (Unaudited)
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosures about Market Risk
Item 4.	Controls and Procedures
PART II.  OTHER INFORMATION
Item 1.	Legal Proceedings
Item 6.	Exhibits and Reports on Form 8-K
SIGNATURES
CERTIFICATIONS

 

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Part I.  Financial Information.

Item 1.  Financial Statements.

 

ACTIVISION, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)

 

		June 30, 2004			March 31, 2004
Assets		(Unaudited)
Current assets:
Cash and cash equivalents		$	339,735		$	466,552
Short-term investments		199,411			121,097
Accounts receivable, net of allowances of $48,279 and $47,028 at June 30, 2004 and March 31, 2004, respectively		123,048			62,577
Inventories		39,635			26,427
Software development		75,696			58,320
Intellectual property licenses		15,159			32,115
Deferred income taxes		23,497			26,127
Other current assets		21,184			18,660
Total current assets		837,365			811,875
Software development		21,660			28,386
Intellectual property licenses		17,630			16,380
Property and equipment, net		24,841			25,539
Deferred income taxes		6,666			9,064
Other assets		1,243			1,080
Goodwill		76,436			76,493
Total assets		$	985,841		$	968,817
Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable		$	75,558		$	72,874
Accrued expenses		56,534			63,205
Total current liabilities		132,092			136,079
Commitments and contingencies (Note 14)
Shareholders’ equity:
Preferred stock, $.000001 par value, 3,750,000 shares authorized, no shares issued at June 30, 2004 and March 31, 2004		—			—
Series A Junior Preferred stock, $.000001 par value, 1,250,000 shares authorized, no shares issued at June 30, 2004 and March 31, 2004		—			—
Common stock, $.000001 par value, 225,000,000 shares authorized, 167,809,185 and 166,876,567 shares issued and 138,263,860 and 137,331,242 shares outstanding at June 30, 2004 and March 31, 2004, respectively		—			—
Additional paid-in capital		770,257			758,626
Retained earnings		220,236			208,279
Less:  Treasury stock, at cost, 29,545,325 shares at June 30, 2004 and March 31, 2004		(144,128		)	(144,128		)
Accumulated other comprehensive income		7,384			9,961
Total shareholders’ equity		853,749			832,738
Total liabilities and shareholders’ equity		$	985,841		$	968,817

 

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

 

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ACTIVISION, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(In thousands, except per share data)

 

		For the three months ended June 30,
		2004			2003
Net revenues		$	211,276		$	158,725
Costs and expenses:
Cost of sales – product costs		89,088			76,610
Cost of sales – software royalties and amortization		12,283			15,498
Cost of sales – intellectual property licenses		17,648			10,143
Product development		21,105			13,580
Sales and marketing		41,734			26,285
General and administrative		13,685			11,463
Total costs and expenses		195,543			153,579
Operating income		15,733			5,146
Investment income, net		2,112			1,257
Income before income tax provision		17,845			6,403
Income tax provision		5,888			2,240
Net income		$	11,957		$	4,163
Basic earnings per share		$	0.09		$	0.03
Weighted average common shares outstanding		137,765			132,069
Diluted earnings per share		$	0.08		$	0.03
Weighted average common shares outstanding assuming dilution		153,407			140,655

 

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

 

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

 

		For the three months ended June 30,
		2004			2003
Cash flows from operating activities:
Net income		$	11,957		$	4,163
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Deferred income taxes		5,028			1,441
Depreciation and amortization		2,579			2,251
Amortization of capitalized software development costs and intellectual property licenses		31,750			19,045
Tax benefit of stock options		3,597			512
Changes in operating assets and liabilities (net of effects of acquisitions):
Accounts receivable		(60,471		)	(17,406		)
Inventories		(13,208		)	(5,530		)
Software development and intellectual property licenses		(26,694		)	(28,244		)
Other assets		(2,687		)	(3,102		)
Accounts payable		2,684			5,738
Accrued expenses and other liabilities		(6,671		)	(2,566		)
Net cash (used in) operating activities		(52,136		)	(23,698		)
Cash flows from investing activities:
Capital expenditures		(1,881		)	(5,671		)
Purchases of short-term investments		(95,493		)	(24,500		)
Proceeds from sales and maturities of short-term investments		15,962			46,930
Net cash provided by (used in) investing activities		(81,412		)	16,759
Cash flows from financing activities:
Proceeds from issuance of common stock to employees		8,034			1,423
Other borrowings, net		—			(2,818		)
Purchase of structured stock repurchase transactions		—			(36,420		)
Settlement of structured stock repurchase transactions		—			65,903
Purchase of treasury stock		—			(18,814		)
Net cash provided by financing activities		8,034			9,274
Effect of exchange rate changes on cash		(1,303		)	2,944
Net increase (decrease) in cash and cash equivalents		(126,817		)	5,279
Cash and cash equivalents at beginning of period		466,552			285,554
Cash and cash equivalents at end of period		$	339,735		$	290,833

 

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

 

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ACTIVISION, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY
For the three months ended June 30, 2004
(Unaudited)
(In thousands)

 

		Common Stock					Additional Paid-In			Retained			Treasury Stock					Accumulated Other Comprehensive			Shareholders’
		Shares		Amounts			Capital			Earnings			Shares		Amounts			Income (Loss)			Equity
Balance, March 31, 2004		166,877		$	—		$	758,626		$	208,279		(29,546	)	$	(144,128	)	$	9,961		$	832,738
Components of comprehensive income:
Net income		—		—			—			11,957			—		—			—			11,957
Unrealized depreciation on short-term investments		—		—			—			—			—		—			(1,217		)	(1,217		)
Foreign currency translation adjustment		—		—			—			—			—		—			(1,360		)	(1,360		)
Total comprehensive income																					9,380
Issuance of common stock pursuant to employee stock option and stock purchase plans		933		—			8,034			—			—		—			—			8,034
Tax benefit attributable to employee stock options		—		—			3,597			—			—		—			—			3,597
Balance, June 30, 2004		167,810		$	—		$	770,257		$	220,236		(29,546	)	$	(144,128	)	$	7,384		$	853,749

 

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

 

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ACTIVISION, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

For the three months ended June 30, 2004

 

1.     Summary of Significant Accounting Policies

 

Basis of Presentation

 

The accompanying consolidated financial statements include the accounts of Activision, Inc. and its subsidiaries (“Activision” or “we”).  The information furnished is unaudited and consists of only normal recurring adjustments that, in the opinion of management, are necessary to provide a fair statement of the results for the interim periods presented.  The Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended March 31, 2004 as filed with the Securities and Exchange Commission (“SEC”).

 

Software Development Costs and Intellectual Property Licenses

 

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

 

We account for software development costs in accordance with SFAS No. 86, “Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed.”  Software development costs are capitalized once technological feasibility of a product is established and such costs are determined to be recoverable.  Technological feasibility of a product encompasses both technical design documentation and game design documentation.  For products where proven technology exists, this may occur early in the development cycle. Technological feasibility is evaluated on a product-by-product basis.  Prior to a product’s release, we expense, as part of cost of sales – software royalties and amortization, capitalized costs when we believe such amounts are not recoverable.  Capitalized costs for those products that are cancelled or abandoned are charged to product development expense in the period of cancellation.  Amounts related to software development which are not capitalized are charged immediately to product development expense.  We evaluate the future recoverability of capitalized amounts on a quarterly basis.  The recoverability of capitalized software development costs is evaluated based on the expected performance of the specific products for which the costs relate.  Criteria used to evaluate expected product performance include: historical performance of comparable products using comparable technology; orders for the product prior to its release; and estimated performance of a sequel product based on the performance of the product on which the sequel is based.

 

Commencing upon product release, capitalized software development costs are amortized to cost of sales – software royalties and amortization based on the ratio of current revenues to total projected revenues, generally resulting in an amortization period of six months or less.  For products that have been released in prior periods, we evaluate the future recoverability of capitalized amounts on a quarterly basis.  The primary evaluation criterion is actual title performance.

 

Significant management judgments and estimates are utilized in the assessment of when technological feasibility is established, as well as in the ongoing assessment of the recoverability of capitalized costs.  In evaluating the recoverability of capitalized costs, the assessment of expected product performance utilizes forecasted sales amounts and estimates of additional development 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 actual impairment charge may be larger than originally estimated in any given quarter.

 

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.

 

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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 development 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 actual impairment charge may be larger than originally estimated in any given quarter.  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 on the street date.  Revenue from product sales is recognized after deducting the estimated allowance for returns and price protection.  With respect to license agreements that provide customers the right to make multiple copies in exchange for guaranteed amounts, revenue is recognized upon delivery of such copies. Per copy royalties on sales that exceed the guarantee are recognized as earned.  In addition, in order to recognize revenue for both product sales and licensing transactions, persuasive evidence of an arrangement must exist and collection of the related receivable must be probable.  Revenue recognition also determines the timing of certain expenses, including cost of sales – intellectual property licenses and cost of sales – software royalties and amortization.

 

Sales incentives or other consideration given by us to our customers is accounted for in accordance with the Financial Accounting Standards Board’s Emerging Issues Task Force (“EITF”) Issue 01-9, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products).”  In accordance with EITF Issue 01-9, sales incentives and other consideration that are considered adjustments

 

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of the selling price of our products, such as rebates and product placement fees, are reflected as reductions of revenue.  Sales incentives and other consideration that represent costs incurred by us for assets or services received, such as the appearance of our products in a customer’s national circular ad, are reflected as sales and marketing expenses.

 

Stock-Based Compensation and Pro Forma Information

 

Under SFAS No. 123 “Accounting for Stock-Based Compensation,” compensation expense is recorded for the issuance of stock options and other stock-based compensation based on the fair value of the stock options and other stock-based compensation on the date of grant or measurement date.  Alternatively, SFAS No. 123 allows companies to continue to account for the issuance of stock options and other stock-based compensation in accordance with Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.”  Under APB No. 25, compensation expense is recorded for the issuance of stock options and other stock-based compensation based on the intrinsic value of the stock options and other stock-based compensation on the date of grant or measurement date.  Under the intrinsic value method, compensation expense is recorded on the date of grant or measurement date only if the current market price of the underlying stock exceeds the stock option or other stock-based compensation exercise price.  At June 30, 2004, we had several stock-based employee compensation plans, which are described more fully in Note 15 to the Notes to Consolidated Financial Statements included in Item 8 of our Annual Report on Form 10-K for the year ended March 31, 2004 filed with the SEC. We account for those plans under the recognition and measurement principles of APB Opinion No. 25 and related Interpretations.  The following table illustrates the effect on net income and earnings per share if we had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation (amounts in thousands, except per share data):

 

		Three months ended June 30,
		2004			2003
Net income, as reported		$	11,957		$	4,163
Deduct:  Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(4,866		)	(5,535		)
Pro forma net income (loss)		$	7,091		$	(1,372	)
Earnings (loss) per share
Basic - as reported		$	0.09		$	0.03
Basic - pro forma		$	0.05		$	(0.01	)
Diluted - as reported		$	0.08		$	0.03
Diluted - pro forma		$	0.05		$	(0.01	)

 

The fair value of options granted is estimated at the date of grant using the Black-Scholes option pricing model. The Black-Scholes option pricing model requires the input of highly subjective assumptions, including the expected stock price volatility.  We use the historical stock price volatility of our common stock over the most recent period that is generally commensurate with the expected option life as the basis for estimating expected stock price volatility.  For options granted during the three months ended June 30, 2004 and 2003, the historical stock price volatility used was based on a weekly stock price observation, using an average of the high and low stock prices of our common stock, which resulted in an expected stock price volatility of 48%.  For purposes of the above pro forma disclosure, the fair value of options granted is amortized to stock-based employee compensation cost over the period(s) in which the related

 

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employee services are rendered.  Accordingly, the pro forma stock-based compensation cost for any period will typically relate to options granted in both the current period and prior periods.

 

2.     Stock Split

 

In April 2003, the Board of Directors approved a three-for-two split of our outstanding common shares effected in the form of a 50% stock dividend.  The split was paid on June 6, 2003 to shareholders of record as of May 16, 2003.  In February 2004, the Board of Directors approved a second three-for-two split of our outstanding common shares effected in the form of a 50% stock dividend.  The split was paid on March 15, 2004 to shareholders of record as of February 23, 2004.  The par value of our common stock was maintained at the pre-split amount of $.000001.  The Consolidated Financial Statements and Notes thereto, including all share and per share data, have been restated as if the stock splits had occurred as of the earliest period presented.

 

3.     Acquisitions

 

In May 2002, we acquired a 30% interest in the outstanding capital stock of Infinity Ward, Inc. (“Infinity Ward”), a privately held interactive software development company, as well as an option to purchase the remaining 70% of outstanding capital stock.  In October 2003, we exercised our option to acquire the remaining 70% of the outstanding capital stock of Infinity Ward for cash of approximately $3.5 million. This acquisition further enables us to implement our multi-platform development strategy by augmenting our internal product development capabilities for the PC.

 

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

 

4.     Cash, Cash Equivalents and Short-Term Investments

 

Short-term investments generally mature between three months and two years.  Investments with maturities beyond one year may be classified as short-term based on their liquid nature and because such securities represent the investment of cash that is available for current operations.  All of our short-term investments are classified as available-for-sale and are carried at fair market value with unrealized appreciation (depreciation) reported as a separate component of accumulated other comprehensive income (loss) in shareholders’ equity.  The specific identification method is used to determine the cost of securities disposed with realized gains and losses reflected in investment income, net.

 

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The following table summarizes our investments in securities as of June 30, 2004 (amounts in thousands):

 

		Amortized Cost			Gross Unrealized Gains			Gross Unrealized Losses			Fair Value
Cash and cash equivalents:
Cash and time deposits		$	93,570		$	—		$	—		$	93,570
Money market funds		49,754			—			—			49,754
Auction rate notes		196,411			—			—			196,411
Cash and cash equivalents		339,735			—			—			339,735
Short-term investments:
Corporate bonds		21,147			—			(108		)	21,039
Taxable senior debt		17,019			2			—			17,021
U.S. agency issues		141,652			1			(996		)	140,657
Asset-backed securities		17,712			30			(49		)	17,693
Municipal bonds		3,001			—			—			3,001
Short-term investments		200,531			33			(1,153		)	199,411
Cash, cash equivalents and short-term investments		$	540,266		$	33		$	(1,153	)	$	539,146

 

The following table summarizes the maturities of our investments in debt securities as of June 30, 2004 (amounts in thousands):

 

		Amortized Cost			Fair Value
Due in one year or less		$	292,277		$	291,933
Due after one year through two years		86,953			86,196
		379,230			378,129
Asset-backed securities		17,712			17,693
Total		$	396,942		$	395,822

 

For the three months ended June 30, 2004, there were no gross realized gains and no gross realized losses.  For the three months ended June 30, 2003, net realized gains on short-term investments consisted of no gross realized gains and $4,000 of gross realized losses.

 

5.     Inventories

 

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

 

 

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6.     Goodwill

 

The changes in the carrying amount of goodwill for the three months ended June 30, 2004 are as follows (amounts in thousands):

 

		Publishing			Distribution			Total
Balance as of March 31, 2004		$	70,898		$	5,595		$	76,493
Effect of foreign currency exchange rates		—			(57		)	(57		)
Balance as of June 30, 2004		$	70,898		$	5,538		$	76,436

 

7.     Income Taxes

 

The income tax provision of $5.9 million for the three months ended June 30, 2004 reflects our effective income tax rate of 33%.  The significant items that generated the variance between our effective rate and our statutory rate of 35% were research and development tax credits and the impact of foreign tax rate differentials, partially offset by state taxes.  The income tax provision of $2.2 million for the three months ended June 30, 2003 reflects our effective income tax rate of approximately 35%.  State taxes, offset by research and development tax credits and the impact of foreign tax rate differentials, resulted in an effective income tax rate equal to our statutory rate of 35% for the three months ended June 30, 2003.

 

8.     Software Development Costs and Intellectual Property Licenses

 

As of June 30, 2004, capitalized software development costs included $37.2 million of internally developed software costs and $60.2 million of payments made to third-party software developers.  As of March 31, 2004, capitalized software development costs included $35.3 million of internally developed software costs and $51.5 million of payments made to third-party software developers.  Capitalized intellectual property licenses were $32.8 million and $48.5 million as of June 30, 2004 and March 31, 2004, respectively.  Amortization and write-offs of capitalized software development costs and intellectual property licenses were $31.8 million and $19.0 million for the three months ended June 30, 2004 and 2003, respectively.

 

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

 

Comprehensive Income

 

The components of comprehensive income for the three months ended June 30, 2004 and 2003 were as follows (amounts in thousands):

 

		Three months ended June 30,
		2004			2003
Net income		$	11,957		$	4,163
Other comprehensive income (loss)
Foreign currency translation adjustment		(1,360		)	3,725
Unrealized depreciation on short-term investments		(1,217		)	(24		)
Other comprehensive income (loss)		(2,577		)	3,701
Comprehensive income		$	9,380		$	7,864

 

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Accumulated Other Comprehensive Income (Loss)

 

For the three months ended June 30, 2004, the components of accumulated other comprehensive income were as follows (amounts in thousands):

 

		Foreign Currency			Unrealized Appreciation (Depreciation) on Investments			Accumulated Other Comprehensive Income (Loss)
Balance, March 31, 2004		$	9,864		$	97		$	9,961
Other comprehensive loss		(1,360		)	(1,217		)	(2,577		)
Balance, June 30, 2004		$	8,504		$	(1,120	)	$	7,384

 

The income tax benefit related to other comprehensive loss was not significant.

 

10.  Investment Income, Net

 

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

 

		Three months ended June 30,
		2004			2003
Interest expense		$	(88	)	$	(195	)
Interest income		2,200			1,456
Net realized loss on investments		—			(4		)
Investment income, net		$	2,112		$	1,257

 

11.  Supplemental Cash Flow Information

 

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

 

		Three months ended June 30,
		2004			2003
Non-cash investing and financing activities:
Change in unrealized depreciation on short-term investments		$	1,217		$	24
Supplemental cash flow information:
Cash paid for income taxes		$	2,621		$	3,349
Cash paid (received) for interest, net		(2,015		)	(1,743		)

 

12.  Operations by Reportable Segments and Geographic Area

 

Based upon our organizational structure, we operate two business segments: (i) publishing of interactive entertainment software and (ii) distribution of interactive entertainment software and hardware products.

 

Publishing refers to the development, marketing and sale of products, either directly, by license or through our affiliate label program with certain third-party publishers.  In the United States, we primarily sell our products on a direct basis to mass-market retailers, consumer electronics stores, discount warehouses and game specialty stores.  We conduct our international publishing activities through offices in the United

 

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Kingdom, Germany, France, Italy, Australia, Sweden, Canada and Japan.  Our products are sold internationally on a direct-to-retail basis and through third-party distribution and licensing arrangements and through our wholly-owned distribution subsidiaries.

 

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

 

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

 

The accounting policies of these segments are the same as those described in the Summary of Significant Accounting Policies in our Annual Report on Form 10-K for the year ended March 31, 2004.  Revenue derived from sales between segments is eliminated in consolidation.

 

Information on the reportable segments for the three months ended June 30, 2004 and 2003 is as follows (amounts in thousands):

 

		Three months ended June 30, 2004
		Publishing			Distribution			Total
Total segment revenues		$	161,652		$	49,624		$	211,276
Revenues from sales between segments		(8,324		)	8,324			—
Revenues from external customers		$	153,328		$	57,948		$	211,276
Operating income (loss)		$	15,894		$	(161	)	$	15,733
Total assets		$	880,041		$	105,800		$	985,841

 

		Three months ended June 30, 2003
		Publishing			Distribution			Total
Total segment revenues		$	114,405		$	44,320		$	158,725
Revenues from sales between segments		(9,670		)	9,670			—
Revenues from external customers		$	104,735		$	53,990		$	158,725
Operating income (loss)		$	5,170		$	(24	)	$	5,146
Total assets		$	643,200		$	87,557		$	730,757

 

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Geographic information for the three months ended June 30, 2004 and 2003 is based on the location of the selling entity.  Revenues from external customers by geographic region were as follows (amounts in thousands):

 

		Three months ended June 30,
		2004			2003
United States		$	125,191		$	82,739
Europe		78,101			72,740
Other		7,984			3,246
Total		$	211,276		$	158,725

 

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

 

		Three months ended June 30,
		2004			2003
Console		$	158,321		$	123,826
Hand-held		22,085			7,508
PC		30,870			27,391
Total		$	211,276		$	158,725

 

As of and for the three months ended June 30, 2004, we had one customer that accounted for 26% of consolidated net revenues and 33% of consolidated accounts receivable, net.  As of and for the three months ended June 30, 2003 we had one customer that accounted for 16% of consolidated net revenues and 29% of consolidated accounts receivable, net.  This customer was the same customer in both periods and was a customer of both our publishing and distribution businesses.

 

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13.  Computation of Earnings Per Share

 

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

 

		Three months ended June 30,
		2004			2003
Numerator:
Numerator for basic and diluted earnings per share - income available to common shareholders		$	11,957		$	4,163
Denominator:
Denominator for basic earnings per share-weighted average common shares outstanding		137,765			132,069
Effect of dilutive securities:
Employee stock options and stock purchase plan		14,939			8,139
Warrants to purchase common stock		703			447
Potential dilutive common shares		15,642			8,586
Denominator for diluted earnings per share - weighted average common shares outstanding plus assumed conversions		153,407			140,655
Basic earnings per share		$	0.09		$	0.03
Diluted earnings per share		$	0.08		$	0.03

 

Options to purchase 63,700 shares of common stock at exercise prices ranging from $15.53 to $16.66 and options to purchase 12,963,024 shares of common stock at exercise prices ranging from $7.23 to $14.77 were outstanding for the three months ended June 30, 2004 and 2003, respectively, but were not included in the calculation of diluted earnings per share because their effect would be antidilutive.

 

14.  Commitments and Contingencies

 

Credit Facilities

 

We have revolving credit facilities with our Centresoft subsidiary located in the United Kingdom (the “UK Facility”) and our NBG subsidiary located in Germany (the “German Facility”).  The UK Facility provides Centresoft with the ability to borrow up to Great Britain Pounds (“GBP”) 8.0 million ($14.5 million), including issuing letters of credit, on a revolving basis as of June 30, 2004. Furthermore, under the UK Facility, Centresoft provided a GBP 0.6 million ($1.1 million) guarantee for the benefit of our CD Contact subsidiary as of June 30, 2004.  The UK Facility bore interest at LIBOR plus 2.0% as of June 30, 2004, is collateralized by substantially all of the assets of the subsidiary and expires in November 2005.  The UK Facility also contains various covenants that require the subsidiary to maintain specified financial ratios related to, among others, fixed charges.  As of June 30, 2004, we were in compliance with these covenants.  No borrowings were outstanding against the UK Facility as of June 30, 2004.  The German Facility provided for revolving loans up to EUR 0.5 million ($0.6 million) as of June 30, 2004, bore interest at a

 

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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 under the German Facility as of June 30, 2004.

 

Developer and Intellectual Property Contracts

 

In the normal course of business, we enter into contractual arrangements with third parties for the development of products, as well as for the rights to intellectual property.  Under these agreements, we commit to provide specified payments to a developer or intellectual property holder based upon contractual arrangements.  Assuming all contractual provisions are met, the total future minimum contract commitment for contracts in place as of June 30, 2004 is approximately $85.9 million and is scheduled to be paid as follows (amounts in thousands):

 

 

The commitment schedule above excludes approximately $9.3 million of commitments originally scheduled to be paid between fiscal 2004 through fiscal 2007 relating to an intellectual property rights agreement with a third party.  Effective June 30, 2003, we terminated the agreement and filed a breach of contract suit against the third party.

 

Marketing Commitments

 

In connection with certain intellectual property right acquisitions and development agreements, we will commit to spend specified amounts for marketing support for the related game(s) which is to be developed or in which the intellectual property will be utilized.  Assuming all contractual provisions are met, the total future minimum marketing commitment for contracts in place as of June 30, 2004 is approximately $49.9 million, which is scheduled to be paid as follows (amounts in thousands):

 

 

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Lease Obligations

 

We lease certain of our facilities under non-cancelable operating lease agreements.  Total future minimum lease commitments as of June 30, 2004 are as follows (amounts in thousands):

 

 

Legal and Regulatory Proceedings

 

On March 5, 2004, a class action lawsuit was filed against us and certain of our current and former officers and directors.  The complaint, which asserts claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 based on allegations that our revenues and assets were overstated during the period between February 1, 2001 and December 17, 2002, was filed in the United States District Court, Central District of California by the Construction Industry and Carpenters Joint Pension Trust for Southern Nevada purporting to represent a class of purchasers of Activision stock.  Five additional purported class actions have subsequently been filed by Gianni Angeloni, Christopher Hinton, Stephen Anish, the Alaska Electrical Pension Fund, and Joseph A. Romans asserting similar claims.  Five of the six actions have been transferred to the same court where the first-filed complaint was pending.  In addition, on March 12, 2004, a shareholder derivative lawsuit was filed, purportedly on behalf of Activision, which in large measure asserts the identical claims set forth in the federal class action lawsuit.  That complaint was filed in Superior Court for the County of Los Angeles.  We strongly deny these allegations and will vigorously defend these cases.

 

On July 11, 2003, we were informed by the staff of the Securities and Exchange Commission that the Securities and Exchange Commission has commenced a non-public formal investigation captioned “In the Matter of Certain Video Game Manufacturers and Distributors.” The investigation appears to be focused on certain accounting practices common to the interactive entertainment industry, with specific emphasis on revenue recognition.  In connection with this inquiry, the Securities and Exchange Commission submitted to us a request for information.  We responded to this inquiry on September 2, 2003.  To date, we have not received a request from the Securities and Exchange Commission for any additional information.  The Securities and Exchange Commission staff also informed us that other companies in the video game industry received similar requests for information. The Securities and Exchange Commission has advised us that this request for information should not be construed as an indication from the Securities and Exchange Commission or its staff that any violation of the law has occurred, nor should it reflect negatively on any person, entity or security. We have cooperated and intend to continue to cooperate fully with the Securities and Exchange Commission in the conduct of this inquiry.

 

On June 30, 2003, we terminated our Star Trek Merchandising License Agreement with Viacom Consumer Products, Inc. and filed a complaint in the Superior Court of the State of California for breach of contract and constructive trust against Viacom Consumer Products and Viacom International, Inc. (“Viacom”). On August 15, 2003, Viacom filed its response to our complaint as well as a cross-complaint alleging, among other matters, a breach of contract by Activision and seeking claimed damages in excess of $50 million. We strongly dispute the claims by Viacom, consider the damages alleged by Viacom to be speculative and without merit, and intend to defend vigorously and aggressively against the cross-complaint.

 

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In addition, we are party to other routine claims and suits brought by us and against us in the ordinary course of business, including disputes arising over the ownership of intellectual property rights, contractual claims and collection matters.  In the opinion of management, after consultation with legal counsel, the outcome of such routine claims will not have a material adverse effect on our business, financial condition, results of operations or liquidity.

 

15.  Capital Transactions

 

During fiscal 2003, our Board of Directors authorized a buyback program under which we can repurchase up to $350.0 million of our common stock. Under the program, shares may be purchased as determined by management and within certain guidelines, from time to time, in the open market or in privately negotiated transactions, including privately negotiated structured option transactions, and through transactions in the options markets. Depending on market conditions and other factors, these purchases may be commenced or suspended at any time or from time to time without prior notice.

 

During the three months ended June 30, 2004, we did not repurchase any of our common stock or enter into any structured stock repurchase transactions.  As of June 30, 2004, we had no outstanding structured stock repurchase transactions.

 

16.  Related Parties

 

In August 2001, we elected to our Board of Directors an individual who is a partner in a law firm that has provided legal services to Activision for more than ten years.  For the three months ended June 30, 2004 and 2003, the fees we paid to the law firm were an insignificant portion of the firm’s total revenues.  We believe that the fees charged to us by the law firm are competitive with the fees charged by other law firms.

 

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

 

Overview

 

Our Business

 

We are a leading international publisher of interactive entertainment software products.  We have built a company with a diverse portfolio of products that spans a wide range of categories and target markets and that is used on a variety of game hardware platforms and operating systems.  We have created, licensed and acquired a group of highly recognizable brands, which we market to a variety of consumer demographics.

 

Our products cover game categories such as action/adventure, action sports, racing, role-playing, simulation, first-person action and strategy.  Our target customer base ranges from game enthusiasts and children to mass-market consumers and “value” buyers.  We currently offer our products primarily in versions that operate on the Sony PlayStation 2 (“PS2”), Nintendo GameCube (“GameCube”) and Microsoft Xbox (“Xbox”) console systems, Nintendo Game Boy Advance (“GBA”) hand-held device and the personal computer (“PC”).  The installed base for this current-generation of hardware platforms is significant and growing.  We believe recent price cuts in calendar 2004 on the Xbox and PS2 hardware should continue to drive the growth of the installed base of these two platforms.  We also expect the installed base of the other current-generation platforms to continue to grow.  In addition, Sony announced that it would be entering the hand-held hardware market with the introduction of its hand-held gaming device, PlayStation Portable (“PSP”).  PSP is currently expected to be released in the United States toward the end of the first quarter of calendar 2005.  Nintendo has also announced that it plans to launch a new dual-screened, portable game system, Nintendo Dual Screen (“NDS”), before the end of calendar 2004.  We are currently developing titles for the PSP and the NDS with the objective of having one or more titles at launch for each of these platforms.  We are also planning to develop titles for the next-generation console systems expected to be developed by Sony, Microsoft and Nintendo for release within the next one to three years.  Though there are still many unknowns relating to these new platforms, our aim is to have a significant presence at the launch of each new platform while being careful not to move away too quickly from the current-generation platforms given their large and growing installed base.

 

Our publishing business involves the development, marketing and sale of products directly, by license or through our affiliate label program with certain third-party publishers.  In the United States, we primarily sell our products on a direct basis to mass-market retailers, consumer electronics stores, discount warehouses and game specialty stores.  We conduct our international publishing activities through offices in the United Kingdom (“UK”), Germany, France, Italy, Australia, Sweden, Canada and Japan.  Our products are sold internationally on a direct-to-retail basis, through third-party distribution and licensing arrangements and through our wholly-owned European distribution subsidiaries.  Our distribution business consists of operations located in the UK, the Netherlands and Germany that provide logistical and sales services to third-party publishers of interactive entertainment software, our own publishing operations and manufacturers of interactive entertainment hardware.

 

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

 

Our Focus

 

With respect to future game development, 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.

 

A number of our fiscal 2005 “big propositions” will include well-established brands, which are backed by high profile intellectual property and/or highly anticipated motion picture releases.  Examples of these brands are our superheroes and skateboarding brands.  We have a long-term relationship with Marvel Enterprises through an exclusive licensing agreement that expires in 2009.  This agreement grants us the

 

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exclusive rights to develop and publish video games based on Marvel’s comic book franchises Spider-Man, X-MEN, Fantastic Four and Iron Man.  Through our long-term relationship with Spider-Man Merchandising, LLP, in the first quarter of fiscal 2005 we released the video game Spider-Man 2, the sequel to the highly successful Spider-Man: The Movie.  The video game release of Spider-Man 2 coincided with the “Spider-Man 2” theatrical release in June 2004.  Also, under our licensing agreement with Spider-Man Merchandising, LLP, we will be developing and publishing video games based on Columbia Pictures/Marvel Enterprises, Inc.’s upcoming feature film “Spider-Man 3,” which is expected to be released in May 2007.  In addition, we have an exclusive licensing agreement with professional skateboarder Tony Hawk that continues until 2015.  The agreement grants us exclusive rights to develop and publish video games using Tony Hawk’s name and his likeness.  Through fiscal 2004, we released five successful titles in the Tony Hawk franchise with cumulative net revenues of over $800 million, including the most recent, Tony Hawk’s Underground, which was released in the third quarter of fiscal 2004.  We will continue to promote our skateboarding franchise with the release in fiscal 2005 of the sequel to the very successful Tony Hawk’s Underground.

 

We also continue to develop new intellectual properties such as True Crime: Streets of L.A. and Call of Duty, which were originally released in the third quarter of fiscal 2004.  These highly successful titles were both ranked by third-party sales tracking agencies as among the top-five selling games for the holiday season.  We expect to develop a variety of games on multiple platforms based on these two new original properties and hope to establish them as a source of recurring revenues.  For example, in fiscal 2005, we are scheduled to release Call of Duty:  Finest Hour which will be released on multiple console platforms.

 

We will also continue to evaluate 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 SKG that grants us the exclusive rights to publish video games based on DreamWorks SKG’s theatrical release “Shrek 2,” which was released in the first quarter of fiscal 2005, as well as upcoming computer-animated films, “Shark Tale,” which is scheduled to be released in the second quarter of fiscal 2005, “Madagascar” and “Over the Hedge,” and their sequels.  We also have an exclusive licensing agreement to develop and publish video games for the best-selling children’s book series, “Lemony Snicket’s A Series of Unfortunate Events” which is being developed as a feature film by Paramount Pictures, Nickelodeon Movies and DreamWorks SKG.

 

In addition to acquiring or creating high profile intellectual property, we have also continued our focus on establishing and maintaining relationships with talented and experienced software development teams.  We have strengthened our internal development capabilities through the acquisition in prior fiscal years of a number of development companies with talented and experienced teams.  We have development agreements with other top-level, third-party developers such as id Software, Valve Corporation, Spark Unlimited, Lionhead Studios and The Creative Assembly.

 

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

 

Critical Accounting Policies

 

We have identified the policies below as critical to our business operations and the understanding of our financial results.  The impact and any associated risks related to these policies on our business operations is discussed throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations where such policies affect our reported and expected financial results.  For a detailed discussion on the application of these and other accounting policies, see Note 1 to the Notes to the Consolidated Financial Statements included in Item 8 of our Annual Report on Form 10-K for the year ended March 31, 2004 filed with the SEC.  The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates.

 

Revenue Recognition.  We recognize revenue from the sale of our products upon the transfer of title and risk of loss to our customers.  Certain products are sold to customers with a street date (the date that products are made widely available for sale by retailers).  For these products we recognize revenue on the street date.

 

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Revenue from product sales is recognized after deducting the estimated allowance for returns and price protection.  With respect to license agreements that provide customers the right to make multiple copies in exchange for guaranteed amounts, revenue is recognized upon delivery of such copies.  Per copy royalties on sales that exceed the guarantee are recognized as earned.  In addition, in order to recognize revenue for both product sales and licensing transactions, persuasive evidence of an arrangement must exist and collection of the related receivable must be probable.  Revenue recognition also determines the timing of certain expenses, including cost of sales – intellectual property licenses and cost of sales – software royalties and amortization.

 

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

 

We may permit product returns from, or grant price protection to, our customers under certain conditions.  In general, price protection refers to the circumstances when we elect to decrease the wholesale price of a product by a certain amount and, when granted and applicable, allows customers a credit against amounts owed by such customers to Activision with respect to open and/or future invoices.  The conditions our customers must meet to be granted the right to return products or price protection are, among other things, compliance with applicable payment terms, delivery to us of weekly inventory and sell-through reports, and consistent participation in the launches of our premium title releases.  We may also consider other factors, including the facilitation of slow-moving inventory and other market factors.  Management must make estimates of potential future product returns and price protection related to current period product revenue.  We estimate the amount of future returns and price protection for current period product revenue utilizing historical experience and information regarding inventory levels and the demand and acceptance of our products by the end consumer.  The following factors are used to estimate the amount of future returns and price protection for a particular title:  historical performance of titles in similar genres, historical performance of the hardware platform, historical performance of the brand, console hardware life cycle, Activision sales force and retail customer feedback, industry pricing, weeks of on-hand retail channel inventory, absolute quantity of on-hand retail channel inventory, Activision warehouse on-hand inventory levels, the title’s recent sell-through history (if available), marketing trade programs and competing titles.  The relative importance of these factors varies among titles depending upon, among other items, genre, platform, seasonality and sales strategy.  Significant management judgments and estimates must be made and used in connection with establishing the allowance for returns and price protection in any accounting period.  Historically, total actual returns and price protection have not exceeded our allowance estimates.  However, actual returns and price protection could vary materially from our allowance estimates due to a number of reasons including, among others, a lack of consumer acceptance of a title, the release in the same period of a similarly themed title by a competitor, or technological obsolescence due to the emergence of new hardware platforms.  Material differences may result in the amount and timing of our revenue for any period if management makes different judgments or utilizes different estimates in determining the allowances for returns and price protection.

 

Similarly, management must make estimates of the uncollectibility of our accounts receivable.  In estimating the allowance for doubtful accounts, we analyze the age of current outstanding account balances, historical bad debts, customer concentrations, customer creditworthiness, current economic trends and changes in our customers’ payment terms and their economic condition, as well as whether we can obtain sufficient credit insurance.  Any significant changes in any of these criteria would impact management’s estimates in establishing our allowance for doubtful accounts.

 

We value inventory at the lower of cost or market.  We regularly review inventory quantities on hand and in the retail channel and record a provision for excess or obsolete inventory based on the future expected demand for our products. Significant changes in demand for our products would impact management’s estimates in establishing our inventory provision.

 

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

 

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We account for software development costs in accordance with Statement of Financial Accounting Standard (“SFAS”) No. 86, “Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed.”  Software development costs are capitalized once technological feasibility of a product is established and such costs are determined to be recoverable.  Technological feasibility of a product encompasses both technical design documentation and game design documentation.  For products where proven technology exists, this may occur early in the development cycle.  Technological feasibility is evaluated on a product-by-product basis.  Prior to a product’s release, we expense, as part of cost of sales – software royalties and amortization, capitalized costs when we believe such amounts are not recoverable.  Capitalized costs for those products that are cancelled or abandoned are charged to product development expense in the period of cancellation.  Amounts related to software development which are not capitalized are charged immediately to product development expense.  We evaluate the future recoverability of capitalized amounts on a quarterly basis.  The recoverability of capitalized software development costs is evaluated based on the expected performance of the specific products for which the costs relate.  Criteria used to evaluate expected product performance include:  historical performance of comparable products using comparable technology; orders for the product prior to its release; and estimated performance of a sequel product based on the performance of the product on which the sequel is based.

 

Commencing upon product release, capitalized software development costs are amortized to cost of sales – software royalties and amortization based on the ratio of current revenues to total projected revenues, generally resulting in an amortization period of six months or less.  For products that have been released in prior periods, we evaluate the future recoverability of capitalized amounts on a quarterly basis.  The primary evaluation criterion is actual title performance.

 

Significant management judgments and estimates are utilized in the assessment of when technological feasibility is established, as well as in the ongoing assessment of the recoverability of capitalized costs.  In evaluating the recoverability of capitalized costs, the assessment of expected product performance utilizes forecasted sales amounts and estimates of additional development 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 actual impairment charge may be larger than originally estimated in any given quarter.

 

Intellectual Property Licenses.  Intellectual property license costs represent license fees paid to intellectual property rights holders for use of their trademarks, copyrights, software, technology or other intellectual property or proprietary rights in the development of our products.  Depending upon the agreement with the rights holder, we may obtain the rights to use acquired intellectual property in multiple products over multiple years, or alternatively, for a single product.

 

We evaluate the future recoverability of capitalized intellectual property licenses on a quarterly basis.  The recoverability of capitalized intellectual property license costs is evaluated based on the expected performance of the specific products in which the licensed trademark or copyright is to be used.  As many of our intellectual property licenses extend for multiple products over multiple years, we also assess the recoverability of capitalized intellectual property license costs based on certain qualitative factors such as the success of other products and/or entertainment vehicles utilizing the intellectual property, whether there are any future planned theatrical releases or television series based on the intellectual property and the rights holder’s continued promotion and exploitation of the intellectual property.  Prior to the related product’s release, we expense, as part of cost of sales – intellectual property licenses, capitalized intellectual property costs when we believe such amounts are not recoverable.  Capitalized intellectual property costs for those products that are cancelled or abandoned are charged to product development expense in the period of cancellation.  Criteria used to evaluate expected product performance include: historical performance of comparable products using comparable technology; orders for the product prior to its release; and estimated performance of a sequel product based on the performance of the product on which the sequel is based.

 

Commencing upon the related product’s release, capitalized intellectual property license costs are amortized to cost of sales – intellectual property licenses based on the ratio of current revenues for the specific product to total projected revenues for all products in which the licensed property will be utilized.  As intellectual property license contracts may extend for multiple years, the amortization of capitalized intellectual

 

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property license costs relating to such contracts may extend beyond one year.  For intellectual property 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 development 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 actual impairment charge may be larger than originally estimated in any given quarter.  Additionally, as noted above, as many of our intellectual property licenses extend for multiple products over multiple years, we also assess the recoverability of capitalized intellectual property license costs based on certain qualitative factors such as the success of other products and/or entertainment vehicles utilizing the intellectual property, whether there are any future planned theatrical releases or television series based on the intellectual property and the rights holder’s continued promotion and exploitation of the intellectual property.  Material differences may result in the amount and timing of charges for any period if management makes different judgments or utilizes different estimates in evaluating these qualitative factors.

 

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

 

		Three months ended June 30,
		2004					2003
Net revenues		$	211,276		100	%	$	158,725		100	%
Costs and expenses:
Cost of sales – product costs		89,088			42		76,610			48
Cost of sales – software royalties and amortization		12,283			6		15,498			10
Cost of sales – intellectual property licenses		17,648			8		10,143			6
Product development		21,105			10		13,580			9
Sales and marketing		41,734			20		26,285			17
General and administrative		13,685			7		11,463			7
Total costs and expenses		195,543			93		153,579			97
Operating income		15,733			7		5,146			3
Investment income, net		2,112			1		1,257			1
Income before income tax provision		17,845			8		6,403			4
Income tax provision		5,888			2		2,240			1
Net income		$	11,957		6	%	$	4,163		3	%
Net Revenues by Territory:
United States		$	125,191		59	%	$	82,739		52	%
Europe		78,101			37		72,740			46
Other		7,984			4		3,246			2
Total net revenues		$	211,276		100	%	$	158,725		100	%
Net Revenues by Segment/Platform Mix:
Publishing:
Console		$	119,127		56	%	$	88,484		56	%
Hand-held		18,430			9		4,596			3
PC		24,095			12		21,325			13
Total publishing net revenues		161,652			77		114,405			72
Distribution:
Console		39,194			18		35,342			22
Hand-held		3,655			2		2,912			2
PC		6,775			3		6,066			4
Total distribution net revenues		49,624			23		44,320			28
Total net revenues		$	211,276		100	%	$	158,725		100	%
Operating Income (Loss) by Segment:
Publishing		$	15,894		7	%	$	5,170		3	%
Distribution		(161		)	—		(24		)	—
Total operating income		$	15,733		7	%	$	5,146		3	%

 

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Results of Operations – Three Months Ended June 30, 2004 and 2003

 

Net income for the three months ended June 30, 2004 was $12.0 million or $0.08 per diluted share, as compared to $4.2 million or $0.03 per diluted share for the three months ended June 30, 2003.

 

Net Revenues

 

We primarily derive revenue from sales of packaged interactive software games designed for play on video game consoles (such as the PS2, Xbox and GameCube), PCs and hand-held game devices (such as the GBA).  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, 2004 and 2003 (in thousands):

 

		Three Months ended June 30,						Increase/ (Decrease)			Percent Change
		2004			2003
Publishing Net Revenues
North America		$	125,191		$	82,739		$	42,452		51	%
Europe		28,477			28,420			57			—	%
Other		7,984			3,246			4,738			146	%
Total International		36,461			31,666			4,795			15	%
Total Publishing Net Revenues		161,652			114,405			47,247			41	%
Distribution Net Revenues		49,624			44,320			5,304			12	%
Consolidated Net Revenues		$	211,276		$	158,725		$	52,551		33	%

 

Consolidated net revenues increased 33% from $158.7 million for the three months ended June 30, 2003 to $211.3 million for the three months ended June 30, 2004.  This increase was generated by both our publishing and distribution businesses.  The increase in consolidated net revenue was driven by the following:

 

•      Strong performance of our fiscal 2005 first quarter releases of Spider-Man 2 and Shrek 2 for PS2, Xbox, GameCube, GBA and PC.  In June 2004, according to the NPD Group, a third-party sales tracking agency, Spider-Man 2 and Shrek 2 were the number one and two best selling titles in North America across all platforms.

 

•      Publishing console net revenues increased by 35% from $88.5 million for the three months ended June 30, 2003 to $119.1 million for the three months ended June 30, 2004.  The increase was driven by our top two releases published on four console platforms.

 

•      International net revenues benefited from the strong year-over-year strengthening of the Euro (“EUR”) and Great Britain Pound (“GBP”) in relation to the U.S. dollar.  We estimate that foreign exchange rates increased reported net revenue by approximately $7.2 million.  Excluding the impact of changing foreign currency rates, our international net revenue increased 4% year-over-year.

 

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North America Publishing Net Revenue (in thousands)

 

June 30, 2004			% of Consolidated Net Revenue		June 30, 2003			% of Consolidated Net Revenue		Increase/ (Decrease)			Percent Change
$	125,191		59	%	$	82,739		52	%	$	42,452		51	%

 

Domestic publishing net revenues increased 51% from $82.7 million for the three months ended June 30, 2003, to $125.2 million for the three months ended June 30, 2004.  The increase reflects the strong performance of our fiscal 2005 first quarter releases of Spider-Man 2 and Shrek 2 for the PS2, Xbox, Gamecube, GBA and PC.  We also had solid catalog sales from a number of our franchises, including Spider-Man and Call of Duty.

 

International Publishing Net Revenue (in thousands)

 

June 30, 2004			% of Consolidated Net Revenue		June 30, 2003			% of Consolidated Net Revenue		Increase/ (Decrease)			Percent Change
$	36,461		17	%	$	31,666		20	%	$	4,795		15	%

 

International publishing net revenues increased by 15% from $31.7 million for the three months ended June 30, 2003, to $36.5 million for the three months ended June 30, 2004.  International publishing also saw strong results from our fiscal 2005 first quarter releases of Shrek 2 and, on a limited territorial release schedule, Spider-Man 2 for PS2, Xbox, GameCube, GBA and PC.  There also was a positive strengthening of the EUR and the GBP in relation to the U.S. dollar of approximately $2.4 million.  Excluding the impact of changing foreign currency rates, our international publishing net revenue increased 8% year-over-year.

 

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Publishing Net Revenue by Platform

 

Publishing net revenues increased 41% from $114.4 million for the three months ended June 30, 2003 to $161.7 million for the three months ended June 30, 2004.  The following table details our publishing net revenues by platform and as a percentage of total publishing net revenues for the three months ended June 30, 2004 and 2003 (in thousands):

 

		Quarter Ended June 30, 2004			% of Publishing Net Revs.		Quarter Ended June 30, 2003			% of Publishing Net Revs.		Increase/ (Decrease)			Percent Change
Publishing Net Revenues
PC		$	24,095		15	%	$	21,325		19	%	$	2,770		13	%
Console
PlayStation 2		68,704			42	%	42,453			37	%	26,251			62	%
Microsoft Xbox		25,836			16	%	35,148			31	%	(9,312		)	(26	)%
Nintendo GameCube		23,752			15	%	6,226			5	%	17,526			281	%
Other		835			1	%	4,657			4	%	(3,822		)	(82	)%
Total Console		119,127			74	%	88,484			77	%	30,643			35	%
Hand-held
Game Boy Advance		18,430			11	%	4,596			4	%	13,834			301	%
Total Publishing Net Revenues		$	161,652		100	%	$	114,405		100	%	$	47,247		41	%

 

Personal Computer Net Revenue (in thousands)

 

June 30, 2004			% of Publishing Net Revenue		June 30, 2003			% of Publishing Net Revenue		Increase/ (Decrease)			Percent Change
$	24,095		15	%	$	21,325		19	%	$	2,770		13	%

 

Net revenue from sales of titles for the PC increased 13% from $21.3 million for the three months ended June 30, 2003 to $24.1 million for the three months ended June 30, 2004.  Our new release titles performed very well in both the domestic and international markets.  In addition, the number of premium PC titles released in the first quarter of fiscal 2005 increased to 3 titles from 1 PC title released in the first quarter of fiscal 2004.  We expect fiscal 2005 PC publishing net revenues to continue to increase as a percentage of total publishing net revenues over fiscal 2004 reflecting the release of more PC titles in fiscal 2005, including the highly anticipated Doom 3 and Rome:  Total War.

 

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PlayStation 2 Net Revenue (in thousands)

 

June 30, 2004			% of Publishing Net Revenue		June 30, 2003			% of Publishing Net Revenue		Increase/ (Decrease)			Percent Change
$	68,704		42	%	$	42,453		37	%	$	26,251		62	%

 

Net revenue from sales of titles for the PS2 increased 62% from $42.5 million for the three months ended June 30, 2003 to $68.7 million for the three months ended June 30, 2004.  Though the number of new PS2 titles decreased in the first quarter of fiscal 2005 to 2 from 4 in fiscal 2004, we were able to increase our PS2 sales in both the domestic and international markets.  The increase is primarily due to strong, worldwide sales of our PS2 titles including Spider-Man 2 and Shrek 2.

 

Microsoft Xbox Net Revenue (in thousands)

 

June 30, 2004			% of Publishing Net Revenue		June 30, 2003			% of Publishing Net Revenue		Increase/ (Decrease)			Percent Change
$	25,836		16	%	$	35,148		31	%	$	(9,312	)	(26	)%

 

Net revenue from sales of titles for the Xbox decreased 26% from $35.1 million for the three months ended June 30, 2003 to $25.8 million for the three months ended June 30, 2004.  The decrease is due to a reduction in the number of Xbox titles released in the first quarter of fiscal 2005 to 2 from 5 in the first quarter of fiscal 2004.  Though the titles released on the Xbox, Spider-Man 2 and Shrek 2, reflect solid sales both in the domestic and international markets, these titles did not perform as well on the Xbox as they did on other platforms as these titles were not as focused toward the demographic of the Xbox audience as compared to the titles released in the three months ended June 30, 2003, X2: Wolverine’s Revenge, Return to Castle Wolfenstein, Wakeboarding Unleashed and Soldier of Fortune II: Double Helix.

 

Nintendo GameCube Net Revenue (in thousands)

 

June 30, 2004