Products designed for video game console platforms accounted for 87.5% of publishing revenues as compared to 87.3% for the comparable period last year. Products designed for PC platforms accounted for 11.1% of publishing revenues as compared to 11.0% for the prior comparable period.
Distribution revenues increased by $69,679, or 42.5%, to $233,529 for the nine months ended July 31, 2003 from $163,850 for the nine months ended July 31, 2002. The increase was primarily attributable to increased sales of third-party titles and reflected our increasing market share for budget titles in North American retail channels. Distribution revenues represented 30.8% and 28.5% of net sales for the nine months ended July 31, 2003 and 2002, respectively.
Royalties increased $12,888, or 23.9%, to $66,782 for the nine months ended July 31, 2003 from $53,894 for the prior comparable period but decreased as a percentage of net sales to 8.8% from 9.4%. The increase in absolute dollars was primarily due to significant royalty expense under a royalty program for certain of our internal development personnel partly offset by lower amortization of prepaid royalties and lower royalties to third-parties. Our royalty program may continue to be a significant expense in future periods.
Software development costs increased $2,540, or 42.2% to $8,558 for the nine months ended July 31, 2003 from $6,018 for the nine months ended July 31, 2002 and remained relatively constant as a percentage of sales at 1.0%. The increase in absolute dollars was due to the release of a greater number of internally developed titles during this period resulting in higher amortization in the current period.
In future periods, cost of sales may be adversely affected by manufacturing and other costs, price competition and by changes in product and sales mix and distribution channels.
Back to Contents
TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)
(Dollars in thousands, except per share amounts)
Selling and Marketing. Selling and marketing expenses increased by $18,499, or 31.7%, to $76,928 for the nine months ended July 31, 2003 from $58,429 for the nine months ended July 31, 2002. The increase was attributable to increased levels of advertising and promotional support for existing and new titles as well as higher personnel expenses. Selling and marketing expenses as a percentage of net sales for the nine months ended July 31, 2003 and for the nine months ended July 31, 2002 remained constant at 10.1%.
General and Administrative. General and administrative expenses increased by $12,390, or 22.4%, to $67,701 for the nine months ended July 31, 2003 from $55,311 for the nine months ended July 31, 2002, but decreased as a percentage of net sales to 8.9% from 9.6%. The increase in absolute dollars was attributable to costs associated with the consolidation of our distribution operations, as well as increased personnel expenses (including bonuses, severance payments and the issuance of restricted stock), higher rent and bad debt expenses, partly offset by lower professional fees, including the reimbursement of $1,100 of legal fees from insurance proceeds this year relating to costs recorded in the prior year and costs related to the settlement of the Ubi Soft litigation in the prior year. The current year’s net consolidation charge of $7,028 consisted of: lease termination costs, representing the fair value of remaining lease payments, net of estimated sublease rent; disposition of fixed assets, representing the net book value of fixed assets and leasehold improvements; and other exit costs. Bad debt expense increased as a result of customer bankruptcies during the current year.
Research and Development. Research and development costs increased by $9,716, or 126.1%, to $17,419 for the nine months ended July 31, 2003 from $7,703 for the nine months ended July 31, 2002, principally due to the recent acquisitions of development studios and increased personnel costs. Research and development costs as a percentage of net sales increased to 2.3% for the nine months ended July 31, 2003 from 1.3% for the nine months ended July 31, 2002.
Depreciation and Amortization. Depreciation and amortization expense increased $7,075, or 107.0%, to $13,689 for the nine months ended July 31, 2003 from $6,614 for the prior comparable period. The increase includes $4,407 related to the impairment of a customer list from a previous acquisition as a result of the consolidation of our distribution operations, higher amortization of intangible assets as a result of acquisitions and higher depreciation related to the implementation of accounting software systems. Depreciation and amortization expenses as a percentage of net sales increased to 1.8% for the nine months ended July 31, 2003 from 1.1% for the nine months ended July 31, 2002.
Income from Operations. Income from operations increased by $38,665, or 46.1%, to $122,533 for the nine months ended July 31, 2003 from $83,868 for the nine months ended July 31, 2002, due to the changes referred to above.
Interest (Income) Expense, net. Interest income of $1,713 during the nine months ended July 31, 2003 was attributable to interest earned on the invested cash. Interest expense of $728 for the nine months ended July 31, 2002 reflected borrowings from our credit facilities, which were repaid in early fiscal 2002.
Class Action Settlement Costs. During the three months ended July 31, 2002, we recorded $1,468 of class action settlement costs, which represents a settlement of $7,500 and related legal fees, net of $6,145 of insurance proceeds.
Provision for Income Taxes. Income tax expense was $50,935 for the nine months ended July 31, 2003 as compared to $32,599 for the nine months ended July 31, 2002. The increase was primarily attributable to increased taxable income. The effective tax rate was 41.0% for the nine months ended July 31, 2003, as compared to an effective tax rate of 39.8% for the 2002 period. The effective income tax rate differs from the statutory rate as a result of non-deductible expenses and the mix of foreign and domestic taxes as applied to the income.
At October 31, 2002, we had capital loss carryforwards totaling approximately $21,000. The capital loss carryforwards expire in fiscal 2006. Failure to achieve sufficient levels of taxable income from capital transactions might affect the ultimate realization of the capital loss carryforwards. If this were to occur, management is committed to implementing tax planning strategies, such as the sale of our net appreciated assets to the extent required (if any) to generate sufficient taxable income prior to the expiration of these benefits.
Net Income. Net income increased $24,118, or 49.0%, to $73,350 for the nine months ended July 31, 2003 from $49,232 for the nine months ended July 31, 2002, due to the changes referred to above.
25
Back to Contents
TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)
(Dollars in thousands, except per share amounts)
Diluted Net Income per Share. Diluted net income per share increased $0.46, or 36.5%, to $1.72 for the nine months ended July 31, 2003 from $1.26 for the nine months ended July 31, 2002, as the increase in net income was partly offset by the higher weighted average shares outstanding. The increase in weighted shares outstanding resulted from the issuance of shares underlying stock options and to the acquisitions of the Max Payne intellectual property and the development studios.
Liquidity and Capital Resources
Our primary cash requirements have been and will continue to be to fund developing, manufacturing, publishing and distributing our and third-party products. We have historically satisfied our working capital requirements primarily through cash flow from operations, the issuance of debt and equity securities and bank borrowings. At July 31, 2003, we had working capital of $298,805 as compared to working capital of $197,453 at October 31, 2002.
Cash and cash equivalents increased $117,490 to $225,859 at July 31, 2003, from $108,369 at October 31, 2002. The increase is primarily attributable to $124,508 of cash provided by operating activities and $30,061 provided by financing activities, partly offset by $39,701 used in investing activities.
Cash provided by operating activities for the nine months ended July 31, 2003 was $124,508, as compared to $118,818 for the nine months ended July 31, 2002, as the increase in net income, higher non-cash adjustments and increased tax benefit from stock options were partly offset by a lower benefit from changes in operating assets and liabilities. We anticipate negative cash from operating activities in the quarter ending October 31, 2003 due to the timing of product releases.
Net cash used in investing activities for the nine months ended July 31, 2003 was $39,701 as compared to net cash used in investing activities of $13,071 for the nine months ended July 31, 2002. The increase is primarily attributable to the acquisition of Angel in the current period and the lower proceeds from sale of investments.
Net cash provided by financing activities for the nine months ended July 31, 2003 was $30,061, as compared to net cash used in financing activities of $43,304 for the nine months ended July 31, 2002. The change was primarily attributable to the absence of repayment of indebtedness during the current period and higher proceeds from the exercise of stock options.
In December 1999, we entered into a credit agreement, as amended and restated in August 2002, with a group of lenders led by Bank of America, N.A., as agent. The agreement provides for borrowings of up to $40,000 through the expiration of the line of credit on August 28, 2005. Generally, advances under the line of credit are based on a borrowing formula equal to 75% of eligible accounts receivable plus 35% of eligible inventory. Interest accrues on such advances at the bank’s prime rate plus 0.25% to 1.25%, or at LIBOR plus 2.25% to 2.75% depending on our consolidated leverage ratio (as defined). We are required to pay a commitment fee to the bank equal to 0.5% of the unused loan balance. Borrowings under the line of credit are collateralized by our accounts receivable, inventory, equipment, general intangibles, securities and other personal property, including the capital stock of our domestic subsidiaries. Available borrowings under the agreement are reduced by the amount of outstanding letters of credit, which were $5,546 at July 31, 2003. The loan agreement contains certain financial and other covenants, including the maintenance of consolidated net worth, consolidated leverage ratio and consolidated fixed charge coverage ratio. As of July 31, 2003, we were in compliance with such covenants. The loan agreement limits or prohibits us from declaring or paying cash dividends, merging or consolidating with another corporation, selling assets (other than in the ordinary course of business), creating liens and incurring additional indebtedness. We had no outstanding borrowings under the revolving line of credit as of July 31, 2003.
In February 2001, our United Kingdom subsidiary entered into a credit facility agreement, as amended in March 2002, with Lloyds TSB Bank plc (“Lloyds”) under which Lloyds agreed to make available borrowings of up to approximately $21,090. Advances under the credit facility bear interest at the rate of 1.25% per annum over the bank’s base rate, and are guaranteed by us. Available borrowings under the agreement are reduced by the amount of outstanding guarantees. The facility expires on March 31, 2004. We had no outstanding guarantees or borrowings under this facility as of July 31, 2003.
26
Back to Contents
TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)
(Dollars in thousands, except per share amounts)
For the nine months ended July 31, 2003 and 2002, we received proceeds of $30,341 and $11,346, respectively, relating to the exercise of stock options and warrants.
Our accounts receivable, less an allowance for doubtful accounts, returns and sales allowances at July 31, 2003 was $65,996. Of such receivables, each of four retail customers accounted for more than 10% of the receivable balance (62.4% in aggregate) at July 31, 2003. Most of our receivables are covered by insurance, with certain limits and deductibles, in the event of a customer’s bankruptcy or insolvency. Generally, we have been able to collect our receivables in the ordinary course of business. We do not hold any collateral to secure payment from customers. As a result, we are subject to credit risks, particularly in the event that any of the receivables represent a limited number of retailers or are concentrated in foreign markets. If we are unable to collect our accounts receivable as they become due and such accounts are not covered by insurance, we could be required to increase our allowance for doubtful accounts, which could adversely affect our liquidity and working capital position.
Our allowance for doubtful accounts, returns and sales allowances increased during the nine months ended July 31, 2003 as a result of additional price protection for our published products and included additional bad debt expense, net of deductibles and insurance proceeds, related to the bankruptcy of two customers, the losses from which were not entirely covered by insurance. We had accounts receivable days outstanding of 38 days for the three months ended July 31, 2003, as compared to 48 days for the three months ended July 31, 2002.
In September 2002, we relocated our principal executive offices to 622 Broadway, New York, New York. We have recently leased additional space at 622 Broadway to accommodate our expanded operations. We estimate that as of July 31, 2003 we will incur an additional $3,000 in capital expenditures for continuing renovations and leasehold improvements for this space. In connection with signing a ten year lease, we provided a standby letter of credit of $1,560, expiring December 31, 2003. As a result of the relocation, during the nine months ended July 31, 2003, we recorded expenses of $363 related to lease costs with regard to our former executive offices. In addition, we expect to spend an additional $670 in connection with the implementation of accounting software systems for our international operations. As of the date of this report, we have no other material commitments for capital expenditures.
Our Board of Directors authorized a stock repurchase program under which we may repurchase up to $25,000 of our common stock from time to time in the open market or in privately negotiated transactions. We have not repurchased any shares under this program.
We have incurred and may continue to incur significant legal, accounting and other professional fees and expenses in connection with pending regulatory matters.
Based on our currently proposed operating plans and assumptions, we believe that projected cash flow from operations and available cash resources will be sufficient to satisfy our cash requirements for the reasonably foreseeable future.
Contractual Obligations and Contingent Liabilities and Commitments
Our offices and warehouse facilities are occupied under non-cancelable operating leases expiring at various times from October 2003 to October 2011. We also lease certain furniture, equipment and automobiles under non-cancelable leases expiring through September 2007.
We have entered into distribution agreements under which we purchase various software games. These agreements, which expire between October 1, 2003 and February 1, 2005, require remaining aggregate minimum guaranteed payments of $7,888 at July 31, 2003. These agreements are collateralized by standby letters of credit of $3,986 at July 31, 2003. Additionally, assuming performance by third-party developers, we have outstanding commitments under various software development agreements to pay developers an aggregate of $16,917 over the twelve months ending July 31, 2004.
27
Back to Contents
TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)
(Dollars in thousands, except per share amounts)
In connection with our acquisition of the publishing rights to the Duke Nukem franchise for PC and video games in December 2000, we are contingently obligated to pay $6,000 in cash upon delivery of the final version of Duke Nukem Forever for the PC. In addition, in connection with our acquisition of the Max Payne product franchise in May 2002, we are contingently obligated to make aggregate payments of up to $8,000 in cash upon the timely delivery of the final version of Max Payne 2 for the PC and the achievement of certain sales targets for the PC and console versions of the title. In May 2003, we agreed to make further payments of up to $6,000 in cash upon the timely commercial release of console versions of Max Payne 2 and the achievement of certain additional sales targets. We also agreed to make additional payments of up to $2,500 to the former owners of Cat Daddy based on a percentage of Cat Daddy’s future profits. The payables will be recorded when the contingencies are resolved.
Fluctuations in Operating Results and Seasonality
We have experienced fluctuations in quarterly operating results as a result of the timing of the introduction of new titles; variations in sales of titles developed for particular platforms; market acceptance of our titles; development and promotional expenses relating to the introduction of new titles, sequels or enhancements of existing titles; projected and actual changes in platforms; the timing and success of title introductions by our competitors; product returns; changes in pricing policies by us and our competitors; the accuracy of retailers’ forecasts of consumer demand; the size and timing of acquisitions; the timing of orders from major customers; and order cancellations and delays in product shipment. Sales of our titles are also seasonal, with peak shipments typically occurring in the fourth calendar quarter (our fourth and first fiscal quarters) as a result of increased demand for titles during the holiday season. Quarterly comparisons of operating results are not necessarily indicative of future operating results.
International Operations
Sales in international markets, principally in the United Kingdom and other countries in Europe, have accounted for a significant portion of our net sales. For the nine months ended July 31, 2003 and 2002, sales in international markets accounted for approximately 27.7% and 21.7%, respectively, of our net sales. We are subject to risks inherent in foreign trade, including increased credit risks, tariffs and duties, fluctuations in foreign currency exchange rates, shipping delays and international political, regulatory and economic developments, all of which can have a significant impact on our operating results.
Recently Adopted Accounting Pronouncements
In August 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 143, “Accounting for Obligations Associated with the Retirement of Long-Lived Assets” (“SFAS 143”). The objective of SFAS 143 is to provide accounting guidance for legal obligations associated with the retirement of long-lived assets. The provisions of SFAS 143 are effective for financial statements issued for fiscal years beginning after June 15, 2002. The adoption of SFAS 143 in fiscal 2003 did not have an impact on our financial condition, cash flows and results of operations.
In October 2001, the FASB issued Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”). The objectives of SFAS 144 are to address significant issues relating to the implementation of Statement of Financial Accounting Standards No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of” (“SFAS 121”) and to develop a single accounting model, based on the framework established in SFAS 121, for the long-lived assets to be disposed of by sale, whether previously held and used or newly acquired. The provisions of SFAS 144 are effective for financial statements issued for fiscal years beginning after December 15, 2001. The adoption of SFAS 144 in the first quarter of fiscal 2003 did not have a material impact on our financial condition and results of operations.
28
Back to Contents
TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)
(Dollars in thousands, except per share amounts)
In April 2002, the FASB issued Statement of Financial Accounting Standards No. 145, “Rescission of FASB Statements No. 4, 44 and 64, Amendment to FASB Statement No. 13, and Technical Corrections” (“SFAS 145”). SFAS 145 eliminates the requirement (in SFAS No. 4) that gains and losses from the extinguishments of debt be aggregated and classified as extraordinary items, net of the related income tax. The rescission of SFAS No. 4 is effective for fiscal years beginning after May 15, 2002, which for us was November 1, 2002. Under this pronouncement, the $1,948 net loss on extinguishment of debt for the year ended October 31, 2001 classified as an extraordinary item will be reclassified as follows: $3,165 of loss on extinguishment to non-operating expenses and $1,217 of tax benefit to provision for income taxes in our Annual Report on Form 10-K for the year ending October 31, 2003. We do not expect that the rescission of SFAS No. 4 will have a material impact on our financial condition, cash flows and results of operations.
In January 2002, the FASB issued Statement of Financial Accounting Standards No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS 146”). SFAS 146 requires the recognition of such costs when they are incurred rather than at the date of a commitment to an exit or disposal plan. The provisions of SFAS 146 are to be applied prospectively to exit or disposal activities initiated after December 31, 2002. The adoption of SFAS 146 in the first quarter of fiscal 2003 did not have a material impact on our financial condition and results of operations.
In December 2002, the FASB issued Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure” (“SFAS 148”). SFAS 148 amends the transition provisions of FASB No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), for entities that voluntarily change to the fair value method of accounting for stock-based employee compensation. We do not currently intend to change our accounting to the fair value method. SFAS 148 also amends the disclosure provisions of SFAS 123 to require prominent disclosure about the effects on reported net income of an entity’s accounting policy decisions with respect to stock-based employee compensation and amends APB Opinion No. 28, “Interim Financial Reporting” (“APB 28”) to require disclosures about such effects in interim financial information. The amendments to FASB 123 are effective for years ending after December 15, 2002. The disclosures required by the amendments to APB 28 for interim disclosure of pro forma results are contained in this Report.
In November 2002, the FASB issued Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”). FIN 45 expands previously issued accounting guidance and disclosure requirements for certain guarantees and requires recognition of an initial liability for the fair value of an obligation assumed by issuing a guarantee. The provision for initial recognition and measurement of liability will be applied on a prospective basis to guarantees issued or modified after December 31, 2002. The adoption of FIN 45 in the first quarter of fiscal 2003 did not have a material impact on our financial condition or results of operations.
In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”). FIN 46 requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or is entitled to receive a majority of the entity’s residual return or both. FIN 46 also provides criteria for determining whether an entity is a variable interest entity subject to consolidation. FIN 46 requires immediate consolidation of variable interest entities created after January 31, 2003. For variable interest entities created prior to February 1, 2003, consolidation is required on July 1, 2003. The adoption of FIN 46 in the third quarter of fiscal 2003 did not have a material impact on our financial condition or results of operations (see Note 4.).
In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” In general, SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The adoption of SFAS 149 did not have a material impact on our financial condition or results of operations.
Recently Issued Accounting Pronouncements
In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS 150 establishes standards for how an issuer classifies and measures in its statement of financial position certain financial instruments with characteristics of both liabilities and equity. In accordance with SFAS 150, financial instruments that embody obligations for the issuer are required to be classified as liabilities. SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise shall be effective at the beginning of the first interim period beginning after June 15, 2003. We do not expect the provisions of this pronouncement to have a material impact on our financial condition.
29
Back to Contents
TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)
(Dollars in thousands, except per share amounts)
Cautionary Statement and Risk Factors
Safe Harbor Statement under the Securities Litigation Reform Act of 1995: We make statements in this report that are considered forward-looking statements under federal securities laws. Such forward-looking statements are based on the beliefs of management as well as assumptions made by and information currently available to them. The words “expect,” “anticipate,” “believe,” “may,” “estimate,” “intend” and similar expressions are intended to identify such forward-looking statements. Forward-looking statements involve risks, uncertainties and assumptions including, but not limited to, the following which could cause our actual results, performance or achievements to be materially different from results, performance or achievements, expressed or implied by such forward-looking statements:
The market for interactive entertainment software titles is characterized by short product life cycles. The interactive entertainment software market is characterized by short product life cycles and frequent introductions of new products. New products introduced by us may not achieve significant market acceptance or achieve sufficient sales to permit us to recover development, manufacturing and marketing costs. Historically, few interactive entertainment software products have achieved sustained market acceptance. Even the most successful titles remain popular for only limited periods of time, often less than nine months. The life cycle of a game generally involves a relatively high level of sales during the first few months after introduction followed by a decline in sales. Because revenues associated with the initial shipments of a new product generally constitute a high percentage of the total revenues associated with the life of a product, any delay in the introduction of one or more new products could harm our operating results. Additionally, because we introduce a relatively limited number of new products in any period, the failure of one or more of our products to achieve market acceptance could result in losses.
A significant portion of our revenues is derived from a limited number of titles. For the nine months ended July 31, 2003, our ten best selling titles accounted for approximately 60.9% of our revenues, with Grand Theft Auto: Vice City for PlayStation 2 accounting for 43.7% of our revenues, Midnight Club 2 for PlayStation 2 accounting for 5.1% of our revenues and Grand Theft Auto: Vice City for PC accounting for 3.6% of our revenues. Our ten best selling titles accounted for approximately 63.5% of our revenues for the nine months ended July 31, 2002. For this period, Grand Theft Auto 3 for PlayStation 2 accounted for 37.2% of our revenues and Max Payne for PlayStation 2 accounted for 8.7% of our revenues. Our ten best selling titles accounted for approximately 59.9% of our revenues for the fiscal year ended October 31, 2002. Our future titles may not be commercially viable. If we fail to continue to develop and sell new, commercially successful titles, our revenues and profits may decrease substantially and we may incur losses.
Our quarterly operating results may vary significantly, which could cause our stock price to decline. We have experienced and may continue to experience wide fluctuations in quarterly operating results. The interactive entertainment industry is highly seasonal, with sales typically higher during the fourth and first calendar quarters, due primarily to the increased demand for games during and immediately following the holiday buying season. Our failure or inability to introduce products on a timely basis to meet seasonal fluctuations in demand will harm our business and operating results. These fluctuations could also cause our stock price to decline. Other factors that cause fluctuations include:
| | • | delays in the introduction of new titles; |
| | • | the size and timing of product and business acquisitions; |
| | • | variations in sales of titles designed to operate on particular platforms; |
| | • | development and promotional expenses relating to the introduction of new titles; |
| | • | availability of hardware platforms; |
| | • | the timing and success of title introductions by our competitors; |
| | • | product returns; |
| | • | the accuracy of retailers’ forecasts of consumer demand; and |
| | • | the timing of orders from major customers. |
| | | |
30
Back to Contents
TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)
(Dollars in thousands, except per share amounts)
Our expense levels are based, in part, on our expectations regarding future sales and therefore our operating results would be harmed by a decrease in sales or a failure to meet our sales expectations. The uncertainties associated with interactive entertainment software development, lengthy manufacturing lead times, production delays and the approval process for products by hardware manufacturers and other licensors make it difficult to predict the quarter in which our products will ship and therefore may cause us to fail to meet financial expectations. In future quarters our operating results may fall below the expectations of securities analysts and investors. In this event, the trading price of our common stock could significantly decline.
The interactive entertainment software industry is cyclical, and we may fail to anticipate changing consumer preferences. Our business is subject to all of the risks generally associated with the interactive entertainment software industry, which has been cyclical in nature and has been characterized by periods of significant growth followed by rapid declines. Our future operating results will depend on numerous factors beyond our control, including:
| | • | the popularity, price and timing of new software and hardware platforms being released and distributed by us and our competitors; |
| | • | international, national and regional economic conditions, particularly economic conditions adversely affecting discretionary consumer spending; |
| | • | war, acts of terrorism and military action, which could adversely affect consumer preferences in entertainment; |
| | • | changes in consumer demographics; |
| | • | the availability and popularity of other forms of entertainment; and |
| | • | critical reviews and public tastes and preferences, all of which change rapidly and cannot be predicted. |
In order to plan for acquisition and promotional activities we must anticipate and respond to rapid changes in consumer tastes and preferences. A decline in the popularity of interactive entertainment software or particular platforms could cause sales of our titles to decline dramatically. The period of time necessary to develop new game titles, obtain approvals of manufacturers and produce finished products is unpredictable. During this period, consumer appeal of a particular title may decrease, causing product sales to fall short of expectations.
Rapidly changing technology and platform shifts could hurt our operating results. The interactive entertainment industry in general is associated with rapidly changing technology, which often leads to software and platform obsolescence and significant price erosion over the life of a product. The introduction of new platforms and technologies can render existing software titles obsolete or unmarketable. As more advanced platforms achieve market acceptance, consumer demand for software for older platforms declines. Obsolescence of software or platforms could leave us with increased inventories of unsold titles and limited amounts of new titles to sell to consumers, which would have a material adverse effect on our operating results.
We are devoting significant development resources primarily on products designed for Sony’s PlayStation 2 and Microsoft’s Xbox. If consumer demand for these platforms declines generally or as a result of the next hardware transition cycle, we may experience lower than expected sales or losses from products designed for these platforms.
A number of software publishers who compete with us have developed or are currently developing software for use by consumers over the Internet. Future increases in the availability of such software or technological advances in such software or the Internet could result in a decline in platform-based software and impact our sales. Direct sales of software by major publishers over the Internet would materially adversely affect our distribution business.
Our business is dependent on licensing and publishing arrangements with third parties. Our success depends on our ability to identify and develop new titles on a timely basis. We have entered into agreements with third parties to acquire the rights to publish and distribute interactive entertainment software. These agreements typically require us to make advance payments, pay royalties and satisfy other conditions. Our advance payments may not be sufficient to permit developers to develop new software successfully. In addition, software development costs, promotion and marketing expenses and royalties payable to software developers have increased significantly in recent years and reduce the potential profits derived from sales of our software. Future sales of our titles may not be sufficient to recover advances to software developers, and we may not have adequate financial and other resources to satisfy our contractual commitments. If we fail to satisfy our obligations under these license agreements, the agreements may be terminated or modified in ways that may be burdensome to us.
31
Back to Contents
TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)
(Dollars in thousands, except per share amounts)
Returns of our published titles and price protection may adversely affect our operating results. We are exposed to the risk of product returns and price protection with respect to our customers. Our distribution arrangements with customers generally do not give them the right to return titles to us or to cancel firm orders; however, at our discretion, we may accept product returns for stock balancing or defective products. In addition, we sometimes negotiate accommodations to customers, including price discounts, credits and product returns, when demand for specific products falls below expectations. We generally accept returns and grant price protection in connection with our publishing arrangements. We establish a reserve for future returns and price protection for published titles based primarily on these return policies and historical return rates, and we report our revenues net of returns and price protection. If return rates and price protection for our published titles significantly exceed our reserves, our revenues will decline and we could incur losses.
The interactive entertainment software industry is highly competitive. We compete for both licenses to properties and the sale of interactive entertainment software with Sony, Microsoft and Nintendo, each of which is a large developer and marketer of software for its own platforms. Each of these competitors has the financial resources to withstand significant price competition and to implement extensive advertising campaigns, particularly for prime-time television spots. These companies may also increase their own software development efforts or focus on developing software products for third-party platforms. We also compete with domestic companies such as Electronic Arts, Activision, THQ, Midway Games and Acclaim Entertainment and international companies such as Sega, Vivendi, Ubi Soft, Atari, Eidos, Capcom, Konami and Namco. Some of our competitors have greater financial, technical, personnel and other resources than we do, and are able to carry larger inventories, adopt more aggressive pricing policies and make higher offers to licensors and developers for commercially desirable properties than we can. Our titles also compete with other forms of entertainment such as motion pictures, television and audio and video products featuring similar themes, online computer programs and forms of entertainment which may be less expensive or provide other advantages to consumers.
Our distribution business also operates in a highly competitive environment. The intense competition that characterizes our industry is based primarily on breadth, availability and quality of product lines; price; terms and conditions of sale; credit terms and availability; speed and accuracy of delivery; and effectiveness of sales and marketing programs. Our competitors include regional, national and international distributors, as well as hardware manufacturers and software publishers. We may lose market share or be forced in the future to reduce our prices in response to the actions of our competitors, and thereby experience a reduction in our gross margins.
Increased competition for limited shelf space and promotional support from retailers could affect the success of our business and require us to incur greater expenses to market our titles. Retailers have limited shelf space and promotional resources, and competition is intense among an increasing number of newly introduced interactive entertainment software titles for adequate levels of shelf space and promotional support. Competition for retail shelf space is expected to increase, which may require us to increase our marketing expenditures just to maintain current levels of sales of our titles. Competitors with more extensive lines and popular titles frequently have greater bargaining power with retailers. Accordingly, we may not be able to achieve the levels of promotional support and shelf space that such competitors receive.
A limited number of customers may account for a significant portion of our sales. Sales to our five largest customers accounted for approximately 40.3% and 31.7%, respectively, of our revenues for the nine months ended July 31, 2003 and 2002. Sales to our five largest customers accounted for approximately 31.4% of our revenues for the fiscal year ended October 31, 2002. Our sales are made primarily pursuant to purchase orders without long-term agreements or other commitments. Our customers may terminate their relationship with us at any time. The loss of our relationships with principal customers or a decline in sales to principal customers could harm our operating results. Bankruptcies or consolidations of certain large retail customers could also seriously hurt our business.
We are subject to credit and collection risks. Our sales are typically made on credit, with terms that vary depending upon the customer and the demand for the particular title being sold. We do not hold any collateral to secure payment by our customers. As a result, we are subject to credit risks, particularly in the event that any of our receivables represent sales to a limited number of retailers or are concentrated in foreign markets. If we are unable to collect our accounts receivable as they become due and such accounts are not covered by insurance, it could adversely affect our financial condition.
32
Back to Contents
TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)
(Dollars in thousands, except per share amounts)
Rating systems for interactive entertainment software, potential legislation and consumer opposition could inhibit sales of our products. Trade organizations within the video game industry require interactive entertainment software publishers to provide consumers with information relating to graphic violence, profanity or sexually explicit material contained in software titles. Certain countries have also established similar rating systems as prerequisites for sales of interactive entertainment software in such countries. In some instances, we may be required to modify our products to comply with the requirements of such rating systems, which could delay the release of those products in such countries. Historically, our software titles received a rating of “E” (age 6 and older) or “T” (age 13 and over), although many of our new titles (including Grand Theft Auto 3, Grand Theft Auto: Vice City, Max Payne and State of Emergency) have received a rating of “M” (age 17 and over). We believe that we comply with such rating systems and properly display the ratings and content descriptions received for our titles.
Several proposals have been made for federal legislation to regulate the interactive entertainment software, motion picture and recording industries, including a proposal to adopt a common rating system for interactive entertainment software, television and music containing violence or sexually explicit material, and the Federal Trade Commission has adopted rules with respect to the marketing of such material to minors. Consumer advocacy groups have also opposed sales of interactive entertainment software containing graphic violence or sexually explicit material by pressing for legislation in these areas (including legislation prohibiting the sale of certain “M” rated video games to minors) and by engaging in public demonstrations and media campaigns. Retailers may decline to sell interactive entertainment software containing graphic violence or sexually explicit material, which may limit the potential market for our “M” rated products, and adversely affect our operating results. If any groups (including international and domestic political and regulatory bodies) were to target our “M” rated titles, we might be required to significantly change or discontinue a particular title, which in the case of our best selling titles could seriously hurt our business. Although lawsuits seeking damages for injuries allegedly suffered by third parties as a result of video games have been unsuccessful, such lawsuits may be threatened or asserted against us.
We cannot publish our console titles without the approval of hardware manufacturers. We are required to obtain a license from Sony, Microsoft and Nintendo, our principal competitors, to develop and publish titles for their respective hardware platforms. Our existing hardware console platform licenses require that we obtain approval for the publication of new titles on a title-by-title basis. As a result, the number of titles we are able to publish for these hardware platforms, along with our ability to time the release of these titles and, accordingly, our revenues from titles for these hardware platforms, may be limited. If any manufacturer chooses not to renew or extend our license agreement at the end of its current term, or if the manufacturer were to terminate our license for any reason, we would be unable to publish additional titles for that manufacturer’s hardware platform.
License agreements relating to these rights generally extend for a term of three years. The agreements are terminable upon the occurrence of a number of factors, including: (1) breach of the agreement by us; (2) our bankruptcy or insolvency; or (3) our entry into a relationship with, or acquisition by, a competitor of the manufacturer. We cannot assure you that we will be able to obtain new or maintain existing licenses on acceptable terms, or at all.
We are dependent upon a license agreement with Sony to publish titles for PlayStation 2. The term of this license agreement is automatically extended, unless terminated by one of the parties, for successive one-year terms. Termination of such agreement would seriously hurt our business.
Sony and Nintendo are the sole manufacturers of the titles we publish under license from them. Games for the Xbox must be manufactured by pre-approved manufacturers. Each platform license provides that the manufacturer may raise prices for the titles at any time and grants the manufacturer substantial control over the release of new titles. Each of these manufacturers also publishes software for its own platforms and manufactures titles for all of its other licensees and may choose to give priority to its own titles or those of other publishers if it has insufficient manufacturing capacity or if there is increased demand for its products.
In addition, these manufacturers may not have sufficient production capacity to satisfy our scheduling requirements during any period of sustained demand. If manufacturers do not supply us with finished titles on favorable terms without delays, our operations would be materially interrupted, and we would be unable to obtain sufficient amounts of our product to sell to our customers. If we cannot obtain sufficient product supplies, our revenues will decline and we could incur losses.
33
Back to Contents
TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)
(Dollars in thousands, except per share amounts)
We may not be able to protect our proprietary rights or avoid claims that we infringe on the proprietary rights of others. We develop proprietary software and have obtained the rights to publish and distribute software developed by third parties. We attempt to protect our software and production techniques under copyright, trademark and trade secret laws as well as through contractual restrictions on disclosure, copying and distribution. Interactive entertainment software is susceptible to unauthorized copying. Unauthorized third parties may be able to copy or to reverse engineer our software to obtain and use programming or production techniques that we regard as proprietary.
As the amount of interactive entertainment software titles in the market increases and the functionality of this software further overlaps, we believe that interactive entertainment software will increasingly become the subject of claims that such software infringes the copyrights or patents of others. From time to time, we receive notices from third parties alleging infringement of their proprietary rights. Although we believe that our software and technologies and the software and technologies of third-party developers and publishers with whom we have contractual relations do not and will not infringe or violate proprietary rights of others, it is possible that infringement of proprietary rights of others has or may occur. Any claims of infringement, with or without merit, could be time consuming, costly and difficult to defend. Moreover, intellectual property litigation or claims could require us to discontinue the distribution of products, obtain a license or redesign our products, which could result in additional substantial costs and material delays.
We are dependent on third-party software developers to complete certain of our titles. We rely on third-party software developers for the development of certain of our titles. Quality third-party developers are continually in high demand. Software developers who have developed titles for us in the past may not be available to develop software for us in the future. Due to the limited number of third-party software developers and the limited control that we exercise over them, these developers may not be able to complete titles for us on a timely basis or within acceptable quality standards, if at all.
We depend on third-party software developers and our internal development studios to develop new interactive entertainment software within anticipated release schedules and cost projections. The development cycle for new titles is long, typically ranging from twelve to twenty-four months. After development of a product, it may take between nine to twelve additional months to develop the product for other hardware platforms. If developers experience financial difficulties, additional costs or unanticipated development delays, we will not be able to release titles according to our schedule.
Our software is susceptible to errors, which can harm our financial results and reputation. The technological advancements of new hardware platforms allow more complex software products. As software products become more complex, the risk of undetected errors in products when first introduced increases. If, despite testing, errors are found in new products or releases after shipments have been made, we could experience a loss of or delay in timely market acceptance, product returns, loss of revenues and damage to our reputation.
Gross margins relating to our distribution business have been historically narrow which increases the impact of variations in costs on our operating results. As a result of intense price competition, our gross margins in our distribution business have historically been narrow and we expect them to continue to be narrow in the future. We receive purchase discounts from suppliers based on various factors, including volume purchases. These purchase discounts directly affect our gross margins. It may become more difficult for us to achieve the percentage growth in sales required to continue to receive volume purchase discounts.
We may not be able to adequately adjust our cost structure in a timely fashion in response to a sudden decrease in demand. A significant portion of our selling and general and administrative expense is comprised of personnel and facilities. In the event of a significant decline in revenues, we may not be able to exit facilities, reduce personnel, or make other significant changes to our cost structure without significant disruption to our operations or without significant termination and exit costs. Management may not be able to implement such actions in a timely manner, if at all, to offset an immediate shortfall in revenues and gross profit.
34
Back to Contents
TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
Management’s Discussion and Analysis of Financial Condition and Results of Operations (concluded)
(Dollars in thousands, except per share amounts)
Our distribution business is dependent on suppliers to maintain an adequate supply of products to fulfill customer orders on a timely basis. Our ability to obtain particular products in required quantities and to fulfill customer orders on a timely basis is critical to our success. In most cases, we have no guaranteed price or delivery agreements with suppliers. In certain product categories, limited price protection or return rights offered by manufacturers may have a bearing on the amount of product we may be willing to purchase. Our industry may experience significant hardware supply shortages from time to time due to the inability of certain manufacturers to supply certain products on a timely basis. As a result, we have experienced, and may in the future continue to experience, short-term hardware inventory shortages. In addition, manufacturers who currently distribute their products through us may decide to distribute, or to substantially increase their existing distribution, through other distributors, or directly to retailers.
We are subject to the risk that our inventory values may decline and protective terms under supplier arrangements may not adequately cover the decline in values. The interactive entertainment software and hardware industry is subject to rapid technological change, new and enhanced generations of products, and evolving industry standards. These changes may cause inventory to decline substantially in value or to become obsolete. We are also exposed to inventory risk to the extent that supplier price protections are not available on all products or quantities and are subject to time restrictions. In addition, suppliers may become insolvent and unable to fulfill price protection obligations.
We are subject to risks and uncertainties of international trade. Sales in international markets, primarily in the United Kingdom and other countries in Europe, have accounted for a significant portion of our revenues. Sales in international markets accounted for approximately 27.7% and 21.7%, respectively, of our revenues for the nine months ended July 31, 2003 and 2002. Such sales accounted for 20.1% of our revenues for the fiscal year ended October 31, 2002. We are subject to risks inherent in foreign trade, including increased credit risks; tariffs and duties; fluctuations in foreign currency exchange rates; shipping delays; and international political, regulatory and economic developments, all of which can have a significant impact on our operating results. All of our international sales are made in local currencies.
We depend on skilled personnel. Our success depends on our ability to identify, hire and retain qualified management, creative, development, financial, marketing, sales and technical personnel. If we are unable to continue to attract and retain skilled personnel, our business and prospects would be negatively affected.
The market price for our common stock may be highly volatile. The market price of our common stock has been and may continue to be highly volatile. Factors such as our operating results, announcements by us or our competitors and various factors affecting the interactive entertainment software industry may have a significant impact on the market price of our common stock.
We are subject to rapidly evolving regulation affecting financial reporting, accounting and corporate governance matters. In response to recent corporate events, legislators and government agencies have focused on the integrity of financial reporting, and regulatory accounting bodies have recently announced their intention to issue several new accounting standards, including accounting for stock options as compensation expense, certain of which are significantly different from current accounting standards. We cannot predict the impact of the adoption of any such proposals on our future financial results. Additionally, recently enacted legislation focused on corporate governance, auditing and internal accounting controls imposes compliance burdens on us, and will require us to devote significant financial, technical and personnel resources to address compliance issues.
35
Back to Contents
TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
(Dollars in thousands, except per share amounts)
Item 3. Quantitative and Qualitative Disclosures About Market Risk
We are subject to market risks in the ordinary course of our business, primarily risks associated with interest rate and foreign currency fluctuations.
Historically, fluctuations in interest rates have not had a significant impact on our operating results. At July 31, 2003, we had no outstanding variable rate indebtedness.
We transact business in foreign currencies and are exposed to risks resulting from fluctuations in foreign currency exchange rates. Accounts relating to foreign operations are translated into United States dollars using prevailing exchange rates at the relevant fiscal quarter. Translation adjustments are included as a separate component of stockholders’ equity. For the nine months ended July 31, 2003, our foreign currency translation adjustment gain was $3,525. Foreign exchange transaction gain for the nine months ended July 31, 2003 was $88. A hypothetical 10% change in applicable currency exchange rates at July 31, 2003 would result in a material translation adjustment.
Item 4. Controls and Procedures
Based on their evaluation of the effectiveness of our disclosure controls and procedures as of the end of the quarter ended July 31, 2003, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective for gathering, analyzing and disclosing the information we are required to disclose in our reports filed under the Securities Exchange Act of 1934. In addition, during the quarter ended July 31, 2003, there were no significant changes in our internal controls or in other factors that could significantly affect these controls.
36
Back to Contents
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
The Securities and Exchange Commission has issued a formal order of investigation into, among other things, certain accounting matters relating to the Company’s financial statements, periodic reporting and internal accounting control provisions of the federal securities laws.
The Company is involved in routine litigation in the ordinary course of business which in management’s opinion will not have a material adverse effect on the Company’s financial condition, cash flows or results of operations.
Item 2. Changes in Securities
During the three months ended July 31, 2003, the Company issued 100,000 shares of restricted common stock to five employees under the Company’s Incentive Stock Plan.
In connection with the above securities issuances, the Company relied on Section 4(2) promulgated under the Securities Act of 1933, as amended, as offerings to a limited number of persons.
Item 6. Exhibits and Reports on Form 8-K
| (a) | Exhibits: | |
| | | |
| | 10.1 | Incentive Stock Plan adopted by the Board of Directors on June 12, 2003. |
| | | |
| | 31.1 | Chief Executive Officer Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| | | |
| | 31.2 | Chief Financial Officer Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| | | |
| | 32.1 | Chief Executive Officer Certification pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002. |
| | | |
| | 32.2 | Chief Financial Officer Certification pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002. |
| | | |
| | | |
| | | |
| (b) | Reports on Form 8-K: |
On May 29, 2003, the Company furnished a Current Report on Form 8-K to report the Press Release dated May 29, 2003 relating to the Company’s financial results for the second fiscal quarter ended April 30, 2003. (Items 7, 9 and 12)
37
Back to Contents
SIGNATURES
Pursuant to the requirements the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| | TAKE-TWO INTERACTIVE SOFTWARE, INC. |
| | | (Registrant) |
| | | |
| Date: September 12, 2003 | By: | /s/ Jeffrey C. Lapin |
| | | Jeffrey C. Lapin |
| | | Chief Executive Officer |
| | | (Principal Executive Officer) |
| | | |
| | | |
| Date: September 12, 2003 | By: | /s/ Karl H. Winters |
| | | Karl H. Winters |
| | | Chief Financial Officer |
| | | (Principal Financial Officer) |
38
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF