our research and development costs are capitalized once software development projects reach technological feasibility, which is relatively early in the development process, and subsequently amortized as cost of goods sold.
We are regularly audited by domestic and foreign taxing authorities. Audits may result in tax assessments in excess of amounts claimed and the payment of additional taxes. We believe that our tax positions comply with applicable tax law, and that we have adequately provided for reasonably foreseeable tax assessments.
Our primary cash requirements are to fund the development and marketing of our products. We satisfy our working capital requirements primarily through cash flow from operations. At July 31, 2005, we had working capital of $339,326 as compared to working capital of $398,094 at October 31, 2004.
Cash and cash equivalents increased for the nine months ended July 31, 2005 as follows:
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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)
(Dollars in thousands, except per share amounts)
payment of accounts payable related to inventory purchased prior to October 31, 2004 and the payment of royalties earned under our internal royalty program.
Investing Activities. Net cash used in investing activities for the nine months ended July 31, 2005 was $80,248 compared to $38,651 for the nine months ended July 31, 2004. Net cash used in the current period primarily reflects the acquisition ofCivilization, Gaia Capital Group, Visual Concepts and Kush, and the prior year period reflects the acquisition of TDK. During the current period, we also incurred capital expenditures associated with leasehold improvements at our new warehouse facilities in Cincinnati, Ohio and new offices for our 2K publishing label and expenditures related to the continued improvement of our software systems.
Financing Activities. Net cash provided by financing activities for the nine months ended July 31, 2005 was $14,912 as compared to $11,435 for the nine months ended July 31, 2004. The increase was primarily attributable to higher proceeds from the exercise of stock options offset by the repurchase of 520,341 shares of our common stock in June 2005 at an aggregate cost of $14,998.
Significant Balance Sheet Changes
Accounts Receivable: The decrease of $214,469 in gross accounts receivable, before allowances, from October 31, 2004 to July 31, 2005, was primarily due to a significant product release during the three months ended October 31, 2004 and subsequent receivable collections. Our allowances, which include doubtful accounts, returns, price concessions, rebates and other sales allowances, increased to $81,720 at July 31, 2005 from $72,215 at October 31, 2004 and increased as a percentage of receivables to 57.0% at July 31, 2005 from 20.2% at October 31, 2004. The increase in the allowance is due to additional reserves of approximately $32,637 recorded in anticipation of product returns as a result of the re-rating ofGrand Theft Auto: San Andreas by the ESRB in July 2005. At July 31, 2005, our allowances, excluding the additional reserves related to the re-rating ofGrand Theft Auto: San Andreas, were approximately 34.2% of gross accounts receivables which is consistent with the seasonal fluctuations of our business.
As of July 31, 2005, the receivable balances from our five largest retail customers accounted for approximately 45.6% of our gross receivable balance. Wal-Mart and Best Buy accounted for approximately 12.3% and 10.1%, respectively, of our gross receivable balance. 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 and our domestic receivables are not covered by insurance. As a result, we are subject to credit risks, particularly in the event that any of the receivables represent a limited number of retailers. If we are unable to collect our accounts receivable as they become due, it could adversely affect our liquidity and working capital position and we would be required to increase our provision for doubtful accounts.
Loan Facilities: 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 provided for borrowings of up to $40,000 through the expiration of the credit agreement on August 28, 2005. Available borrowings under the agreement are reduced by the amount of any outstanding standby letters of credit, which at July 31, 2005, was $1,560. At July 31, 2005, we had no borrowings under the credit agreement and were in compliance with all financial and other covenants.
On August 24, 2005, we entered into a new credit agreement with JPMorgan Chase Bank, N.A. (“JPMorgan”), and terminated our credit agreement with Bank of America, N.A. The JPMorgan credit agreement provides for borrowings of up to $50,000 through the expiration of the agreement on August 23, 2006. Advances under the credit agreement bear interest at a rate of 0.25% to 0.75% over the bank’s prime rate, or at the Eurodollar rate plus 1.25% to 1.75% depending our consolidated leverage ratio. We are required to pay a commitment fee to the bank equal to 0.25% of the unused loan balance and borrowings under the agreement are collateralized by certain of our assets. The credit agreement also contains financial and other covenants (including a consolidated asset coverage ratio) and limits or prohibits us from paying cash dividends, merging or consolidating with another corporation, selling or acquiring assets (other than in the ordinary course of business), creating liens and incurring additional indebtedness. Available borrowings under the agreement are reduced by the amount of any outstanding stand-by letters of credit.
In May 2005, our United Kingdom subsidiary renewed its credit facility agreement with Lloyds TSB Bank plc (“Lloyds”) under which Lloyds agreed to make available borrowings of up to approximately $23,000. 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 the Company. Available borrowings under the agreement are reduced by the amount of outstanding guarantees. The facility expires on March 31, 2006. We had no outstanding guarantees and no borrowings under this facility as of July 31, 2005.
Capital Expenditures: We expect to spend an additional $5,000 in connection with the continued improvement of our network infrastructure and software systems for our domestic and international operations. We also expect to make additional capital expenditures of approximately $1,000 for leasehold improvements and equipment in our new warehouse facilities in Cincinnati, Ohio,
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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)
(Dollars in thousands, except per share amounts)
$1,000 for leasehold improvements and equipment in our warehouse facilities in Toronto, Canada and a further $2,500 for leasehold improvements and equipment for several of our studios. As of the date of this report, we have no other material commitments for capital expenditures.
Treasury Stock: At July 31, 2005, common stock at an aggregate cost of $23,309 was held in treasury.
In January 2003, the 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. During the quarter ended July 31, 2005, we repurchased 520,341 shares of our common stock at an aggregate cost of $14,998. In August 2005, we repurchased 405,000 shares of our common stock at an aggregate cost of approximately $9,947.
Separately, in July 2005, we modified a stock compensation arrangement and accepted for return 412,500 shares of our common stock, held by three employees with a fair market value at the original issuance date of approximately $9,350, for cash bonuses payable in the future. At the date of modification, 366,667 shares were fully vested and $8,311 of compensation expense had been previously recognized. At July 31, 2005, the return of these vested shares and the related cost have been included as part of treasury stock. The remaining unvested shares were forfeited and the additional compensation expense of such future cash bonuses, expected to approximate $1,039, will be recognized ratably as expense through February 2006.
Legal and Accounting Expenses:We have incurred and may continue to incur significant legal, accounting and other professional fees and expenses in connection with pending regulatory and litigation 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 foreseeable future.
Contractual Obligations and Contingent Liabilities and Commitments
A summary of annual minimum contractual obligations and commitments as of July 31, 2005 is as follows:
| | | | | | | | | | | Distribution
Agreements | | | Total | |
Licensing and
Marketing
Agreements | Software
Development
Agreements |
| Fiscal Years Ending October 31, | Leases |
| |
|
| |
|
| |
|
| |
|
| |
|
| |
| Remainder of 2005 | $ | 15,448 | | $ | 22,843 | | $ | 7,188 | | $ | 2,910 | | $ | 48,389 | |
| 2006 | | 58,523 | | | 37,106 | | | 14,801 | | | 1,283 | | | 111,713 | |
| 2007 | | 54,053 | | | 10,845 | | | 13,004 | | | — | | | 77,902 | |
| 2008 | | 53,942 | | | — | | | 12,314 | | | — | | | 66,256 | |
| 2009 | | 55,075 | | | — | | | 12,037 | | | — | | | 67,112 | |
| Thereafter | | 157,083 | | | — | | | 37,441 | | | — | | | 194,524 | |
| |
|
| |
|
| |
|
| |
|
| |
|
| |
| | $ | 394,124 | | $ | 70,794 | | $ | 96,785 | | $ | 4,193 | | $ | 565,896 | |
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| |
Licensing and Marketing Agreements: Our license expense consists primarily of payments to licensors of intellectual properties under agreements which expire at various times through December 2012. As of July 31, 2005, we have minimum guaranteed licensing and marketing commitments of $394,124 outstanding under various licensing agreements of which $2,622 are recorded in our condensed consolidated balance sheet as the licensor does not have any significant performance obligation. Minimum guaranteed licensing and marketing commitments primarily reflect our agreements with major sports leagues and players’ associations.
Software Development Agreements:Our payments made to third-party developers include contractual advances and royalty payments under agreements which expire at various times through October 2007. Assuming performance by third-party developers, we have aggregate outstanding commitments of $70,794 under various software development agreements at July 31, 2005. We have also established an internal royalty program pursuant to which we pay royalties to certain of our development personnel based on product sales.
Lease Commitments:Our offices and warehouse facilities are occupied under non-cancelable operating leases expiring at various times from August 2005 to February 2015. We also lease certain furniture, equipment and automobiles under non-cancelable leases expiring through December 2008. Future minimum rental payments for fiscal 2005 are $7,188 and aggregate minimum rental payments through applicable lease expirations are $96,785.
Distribution Agreements:We periodically enter into distribution agreements to purchase various software games that require minimum guaranteed payments. These agreements, which expire between August 2005 and June 2006, require remaining aggregate minimum guaranteed payments of $4,193 at July 31, 2005.
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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)
(Dollars in thousands, except per share amounts)
Contingent Consideration:In connection with the acquisition of Mobius in March 2004, we agreed to make additional contingent payments of approximately $1,900 based on the delivery of products. In fiscal 2003, 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 for the first three years after acquisition. The Company does not anticipate making these contingent payments within the next twelve months.
In March 2005, we renegotiated a $6,000 contingent obligation due upon the delivery of the final PC version ofDuke Nukem Foreverthrough the payment of $4,250 and issuance of a promissory note in the principal amount of $500. The payment of the promissory note is contingent upon the commercial release of such product prior to December 31, 2006.
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 OperationsSales 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, 2005 and 2004, sales in international markets accounted for approximately 33.5% and 24.2%, 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.
Cautionary Statement and Risk FactorsSafe 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 our titles is characterized by short product life cycles. If our titles are delayed, we may experience quarterly revenue and profit shortfalls.
The market for our titles is characterized by short product life cycles and frequent introductions of new products. New products may not achieve significant market acceptance or generate sufficient sales to permit us to recover development, manufacturing and marketing costs associated with these products. The life cycle of a title generally involves a relatively high level of sales during the first few months after introduction followed by a rapid decline in sales. Because revenues associated with an initial product launch generally constitute a high percentage of the total revenues associated with the life of a product, any delay in the commercial release of one or more new products could result in significant quarterly revenue and profit shortfalls and cause our operating results to be materially different from expectations. In addition, if we release a limited number of new products during any period, the failure of one or more of such products to achieve market acceptance could seriously hurt our business.
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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)
(Dollars in thousands, except per share amounts)
A substantial portion of our revenues is derived from a limited number of titles, and we must continue to publish “hit” titles in order to succeed.
Grand Theft Auto and certain of our other titles are “hit” products and have historically accounted for a substantial portion of our revenues. For the nine months ended July 31, 2005, our ten best selling titles accounted for approximately 54.7% of our revenues, withGrand Theft Auto: San Andreas for the PlayStation 2 accounting for 33.4% of our revenues;Midnight Club 3: DUB Edition for the PlayStation 2 accounting for 5.6% of our revenues;Grand Theft Auto: San Andreas for Xbox accounting for 4.5% of our revenues,Midnight Club 3: DUB Editionfor Xbox accounting for 2.9% of our revenues; and Grand Theft Auto: San Andreasfor PC accounting for 2.6% of our revenues. For the years ended October 31, 2004 and 2003, our ten best selling titles accounted for approximately 46.3% and 50.6%, respectively, of our revenues, withGrand Theft Auto products accounting for approximately 20.9% and 33.6%, respectively, of such revenues for these periods. If we fail to continue to develop and sell new commercially successful “hit” titles, our revenues and profits may decrease substantially and we may incur losses.
Rapidly changing technology and hardware cycles could adversely affect our operations and our ability to forecast our operating results.
The interactive entertainment industry is cyclical and is associated with rapidly changing technology. We expect that Microsoft, Sony and Nintendo will introduce next generation hardware platforms into the marketplace in late 2005 and 2006. As a result, we anticipate that as these newer and more advanced hardware platforms achieve market acceptance, consumer demand for software for older platforms will decline. During the transition to next generation platforms, we expect to continue to devote significant development resources on products designed for current generation platforms, including Sony’s PlayStation 2 and Microsoft’s Xbox. Consumers may elect to defer purchases of game software for these platforms until newer platforms become available. If consumer demand for these platforms declines generally or as a result of a next generation platform transition or if we are required to reduce prices for our current generation titles sooner than anticipated, we may experience lower than expected sales or losses from products designed for older platforms.
During the transition to next generation platforms, we also expect to devote significant development resources on products designed for next generation hardware platforms, initially for the Xbox 360TM video game and entertainment system from Microsoft. Our ultimate success will depend on our ability to accurately predict which platforms will achieve widespread consumer acceptance. The time, resources and costs associated with the development of next generation software have increased substantially, which increases our risk of loss in the event that new platforms do not achieve commercial success. It is difficult to anticipate hardware development cycles, and we have made and will continue to make both internal and external software development commitments and product investment decisions well in advance of the introduction of new hardware platforms, resulting in cash outflows without corresponding revenues. If new hardware platforms are delayed or do not achieve consumer acceptance, we may be unable to recover our investments and our business could be seriously hurt. Furthermore, during this transition, our operating results may become more volatile and difficult to predict, which could cause wide fluctuations in our stock price.
A number of software publishers who compete with us have developed and commercialized or are currently developing online games for use by consumers over the Internet. Future increased consumer acceptance and increases in the availability of online games or technological advances in online game software or the Internet could result in a decline in platform-based software and negatively impact sales of our products. Direct sales of software by major publishers over the Internet would materially adversely affect our distribution business.
Our efforts to diversify our product offerings and expand into the market for sports and other licensed titles may not be successful.Our significant investments in licenses for sports titles may not result in profitable operations.
We have recently diversified our product offerings by capitalizing on significant growth opportunities in the market for sports and other licensed action and strategy titles. Our success in this market will depend in part on our ability to attract licensors with popular properties and to enter into favorable arrangements with these licensors, including licensors representing the major sports leagues and players’ associations. Competition for sports and other licensed properties is intense. If we are unable to continue to obtain and maintain licenses to popular properties, our revenue and profitability with respect to these products could decline dramatically. Competition for licenses has also increased advances and royalties payable to licensors, which currently represent substantial financial commitments on our behalf. We may be unable to enter into favorable license agreements, for financial or other reasons, and despite our efforts to diversify our product offerings, we may be unable to achieve increased levels of revenues or profitability.
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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)
(Dollars in thousands, except per share amounts)
Our business is dependent on our ability to enter into favorable publishing arrangements with third parties.
Our success depends on our ability to continually 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, which could result in material delays and significantly increase our costs to bring particular products to market. Software development costs, promotion and marketing expenses and royalties payable to software developers have increased significantly in recent years and reduce 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 agreements with third-party developers, the agreements may be terminated or modified in ways that may be burdensome to us. Failure to commercialize products that require significant investments could result in corresponding charges to earnings.
The interactive entertainment software industry is highly competitive both for our publishing and distribution operations.
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. These competitors have 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 game publishers such as Electronic Arts, Activision, THQ, Midway Games and Atari and international publishers, such as SEGA, Vivendi, Ubi Soft, 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 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. Competition 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 our competitors.
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 to maintain current levels of sales of our titles. Competitors with more extensive lines and popular titles may 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 account for a significant portion of our sales. The loss of a principal customer could seriously hurt our business.
A substantial portion of our product sales are made to a limited number of customers, two of which have recently announced plans to merge. Sales to our five largest customers accounted for approximately 41.0% and 35.6% of our revenues, respectively, for the nine months ended July 31, 2005 and 2004. Sales to our five largest customers accounted for approximately 38.9% of our revenues for the year ended October 31, 2004. For the year ended October 31, 2004, sales of our products to Wal-Mart accounted for 10.4% of our revenues. Our sales are made primarily pursuant to purchase orders without long-term agreements or other commitments, and 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 materially adversely affect our operating results. Bankruptcies or consolidations of certain large retail customers could seriously hurt our business.
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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
Item 2. 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 by our customers and price concessions granted to our customers may adversely affect our operating results.
We are exposed to the risk of product returns and price concessions 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, we sometimes accept product returns from our distribution customers for stock balancing and negotiate accommodations to customers which include credits and returns, when demand for specific products falls below expectations. We accept returns and grant price concessions in connection with our publishing arrangements and revenue is recognized after deducting estimated reserves for returns and price concessions. While we believe that we can reliably estimate future returns and price concessions, if return rates and price concessions for our published titles exceed our reserves, our revenues could decline.
Failure to collect our accounts receivables on a timely basis will negatively impact our cash flow.
Our sales are typically made on credit. 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. Although we continually assess the creditworthiness of our customers, which are principally large, national retailers, if we are unable to collect our accounts receivable as they become due, it could adversely affect our financial condition and cash flow.
Rating systems for interactive entertainment software, potential legislation, consumer opposition and litigation could negatively impact sales of our “M” rated products.
The Entertainment Software Rating Board (“ESRB”) requires game publishers to provide consumers with information relating to graphic violence, profanity or sexually explicit material contained in software titles, and imposes significant penalties for noncompliance. Certain countries have also established similar rating systems as prerequisites for product sales in those countries. In some instances, we may be required to modify our products to comply with the requirements of foreign rating systems, which could delay the release of our products. Sales of certain of our titles have been prohibited in certain countries. Our software titles receive a rating of “E” (age 6 and older), “E10+” (age 10 and older), “T” (age 13 and over) or “M” (age 17 and over). Many of our titles have received an “M” rating. We believe that we comply with 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, motion picture and music containing violence or sexually explicit material. The Federal Trade Commission has issued reports to Congress with respect to the marketing of such material to under-17 audiences. In July 2005, we were notified that the staff of the Federal Trade Commission’s Division of Advertising Practices is conducting an inquiry into advertising claims made forGrand Theft Auto: San Andreas following the re-rating of the title by the ESRB from an “M” rating to an “AO” rating, which caused us to establish an approximate $33.0 million reserve for anticipated product returns primarily related to our North American inventory ofGrand Theft Auto: San Andreas. Consumer advocacy groups have 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 “M” rated video games to under-17 audiences) 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, national and local political and regulatory bodies) were to target our “M” rated titles, or if retailers decline to sell our “M” rated products or products containing graphic violence or sexually explicit material generally, 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. Additionally, although lawsuits seeking damages for injuries allegedly suffered by third parties as a result of video games have been unsuccessful in the courts, claims of this kind have been asserted against us from time to time. See “Legal Proceedings.”
We cannot publish our console titles without the approval of hardware licensors who are also our competitors.
We are required to obtain a license from Sony, Microsoft and Nintendo, who are also our competitors, to develop and publish titles for their respective hardware platforms. Our existing 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 net sales from titles for these hardware platforms, may be limited. If any licensor chooses not to renew or extend our license agreement at the end of its current term, or if the licensor were to terminate our license for
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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)
(Dollars in thousands, except per share amounts)
any reason, we would be unable to publish additional titles for that licensor’s platform. Termination of any such agreements could seriously hurt our business and prospects.
We expect that each of Microsoft, Sony and Nintendo will introduce next generation platforms into the marketplace in late 2005 and 2006. In order to publish products for a new platform, we will be required to enter into a license agreement in advance of a platform’s commercial introduction, which gives the platform licensor the opportunity to set our fee structure. Certain platform licensors have retained the right to change fee structures for online game play, and each licensor’s ability to set royalty rates makes it difficult for us to forecast our costs. Increased costs could negatively impact our operating margins. We may be unable to enter into license agreements for next generation platforms on satisfactory terms or at all. Failure to enter into any such agreement could also 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 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 or other publishers’ 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 net sales will decline and we could 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 calendar quarter (our fourth and first fiscal quarters), due primarily to increased demand for games during the holiday buying season. Our failure or inability to introduce products on a timely basis to meet seasonal fluctuations in demand could adversely affect our business and operating results. The uncertainties associated with software development, 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 and the price of our stock could decline significantly.
Our business is subject to risks generally associated with the entertainment industry, and we may fail to properly assess consumer tastes and preferences.
Our business is subject to all of the risks generally associated with the entertainment industry and, accordingly, our future operating results will depend on numerous factors beyond our control, including the popularity, price and timing of new hardware platforms being released; economic, political and military conditions that adversely affect discretionary consumer spending; changes in consumer demographics; the availability and popularity of other forms of entertainment; and critical reviews and public tastes and preferences, which may 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 certain game genres 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 platform licensors and produce finished products is unpredictable. During this period, consumer appeal for a particular title may decrease, causing product sales to fall short of expectations.
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. Our software is susceptible to piracy and 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. Well organized piracy operations have also proliferated in recent years as a result of the ability to download pirated copies of our software over the Internet. Although we attempt to incorporate protective measures into our software, piracy of our products could negatively impact our future profitability.
With advances in technology, game content and software graphics are expected to become more realistic. As a result, we believe that interactive entertainment software will increasingly become the subject of claims that such software infringes the intellectual property rights of others. From time to time, we receive notices from third parties or are named in lawsuits by third parties alleging
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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)
(Dollars in thousands, except per share amounts)
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 subject to product development risks which could result in delays and additional costs, and we must adapt to changes in software technologies.
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 ranges from twelve to twenty-four months and is expected to increase in connection with the development of next generation software. 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 and at budgeted costs.
Additionally, in order to stay competitive, our internal development studios must anticipate and adapt to rapid technological changes affecting software development. Any inability to respond to technological advances and implement new technologies could render our products obsolete or less marketable.
Our software is susceptible to errors, which can harm our financial results and reputation.
The technological advancements of new hardware platforms results in the development of 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 may continue to be narrow in the future. Accordingly, slight variations in operating costs and expenses could result in losses in our distribution business from period to period.
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 changes to our cost structure without 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 profit.
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 important to our success. In most cases, we have no guaranteed price or delivery agreements with suppliers. In certain product categories, limited price concessions or return rights offered by publishers 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. Further, manufacturers or publishers 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.
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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)
(Dollars in thousands, except per share amounts)
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 characterized by the introduction of new and enhanced generations of products and evolving industry standards. These changes may cause inventory to decline substantially in value over time or to become obsolete. We are exposed to inventory risk in our distribution business to the extent that supplier price concessions are not available to us on all products or quantities. In addition, suppliers may become insolvent and unable to fulfill price concession obligations.
We are subject to risks and uncertainties of international trade, including fluctuations in the values of local foreign currencies against the dollar.
Sales in international markets, primarily in the United Kingdom and other countries in Europe, have accounted for a significant portion of our net sales. Sales in international markets accounted for approximately 33.5% and 24.2%, respectively, of our revenues for the nine months ended July 31, 2005 and July 31, 2004. Sales in international markets accounted for approximately 27.5% of our revenues for fiscal 2004. 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, which could fluctuate against the dollar. While we may use forward exchange contracts to a limited extent to seek to mitigate foreign currency risk, our results of operations could be adversely affected by unfavorable foreign currency fluctuations.
The market price for our common stock may be highly volatile as a result of, among other things, factors affecting the industry.
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 a recently adopted standard that accounts for stock options as compensation expense. Additionally, recently enacted legislation focused on corporate governance, auditing and internal accounting controls imposes compliance burdens on us, and will require us to continue to devote substantial financial, technical and personnel resources to address various compliance issues and audit requirements.
We are dependent on our management and key personnel for our success. If we fail to retain qualified creative and marketing personnel, our business could be seriously harmed.
We rely on our management and other key personnel for the successful operation of our business. We are dependent upon the expertise and skills of certain of our Rockstar employees responsible for content creation and product development and marketing. Although we have employment agreements with each of these creative, development and marketing personnel, and we have granted them incentives in the form of an internal royalty program based on sales of Rockstar published products, we may be unable to continue to retain these personnel at current compensation levels, or at all. Future changes to compensation arrangements could result in increased expenses and have a negative impact on our operating results. Failure to continue to attract and retain qualified management, creative, development and marketing personnel could materially adversely affect our business and prospects.
Our expansion and acquisitions may strain our operations, and we may not have sufficient financial resources to continue to expand our operations at previous levels.
We have expanded through internal growth and acquisitions, which has placed and may continue to place a significant strain on our management, administrative, operational, financial and other resources. We have expanded our publishing operations, significantly increased our advances to licensors and developers and manufacturing expenditures and enlarged our work force. To successfully manage this growth, we must continue to implement and improve our operating systems as well as hire, train and manage a substantial and increasing number of management, technical, marketing, administrative and other personnel. We may be unable to effectively manage these rapidly expanding operations which are geographically dispersed.
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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)
(Dollars in thousands, except per share amounts)
We have acquired rights to various properties and businesses, and we intend to continue to pursue opportunities by making selective acquisitions consistent with our business strategy. We may be unable to successfully integrate new personnel, property or businesses into our operations. If we are unable to successfully integrate personnel, properties or businesses into our operations, we may incur significant charges.
Our publishing and distribution activities require significant cash resources. We may be required to seek debt or equity financing to fund the cost of continued expansion. The issuance of equity securities would result in dilution to the interests of our stockholders.
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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
(Dollars in thousands, except per share amounts)
Item 3. Quantitative and Qualitative Disclosures About Market RiskWe 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, 2005, 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, 2005, our foreign currency translation adjustment loss was $7,415. Foreign exchange transaction gain for the nine months ended July 31, 2005 was $693. A hypothetical 10% change in applicable currency exchange rates at July 31, 2005 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 period covered by this report, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective at the reasonable assurance level for recording, processing, summarizing and reporting the information we are required to disclose in our reports filed under the Securities Exchange Act of 1934. There were no changes in our internal control over financial reporting during the fiscal quarter ended July 31, 2005 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
(Dollars in thousands, except per share amounts)
PART II – OTHER INFORMATION
Item 1. Legal Proceedings
In July 2005, the Company was notified that the staff of the Federal Trade Commission’s (“FTC”) Division of Advertising Practices is conducting an inquiry into advertising claims made forGrand Theft Auto: San Andreasfollowing the re-rating of the title by the Entertainment Software Rating Board (“ESRB”) from a Mature 17+ (“M”) rating to an Adults Only 18+ (“AO”) rating. The Company is cooperating with the FTC inquiry and believes that it acted in accordance with all applicable laws and regulations. The Company has also received requests for documents and information relating toGrand Theft Auto: San Andreas from the Attorneys General of the States of North Carolina and Connecticut.
In July 2005, the Company received three purported class action complaints against the Company and its subsidiary, Rockstar Games, Inc. (“Rockstar”), which were filed in the United States District Court for the Southern District of New York and one such complaint which was filed in the United States District Court, Eastern District of Pennsylvania. The plaintiffs, alleged purchasers of the Company’sGrand Theft Auto: San Andreas game, allege that the Company and Rockstar engaged in consumer deception, false advertising and common law fraud and were unjustly enriched as a result of the alleged failure of the Company and Rockstar to disclose thatGrand Theft Auto: San Andreas contained “hidden” content, which resulted in the game receiving an M rating from the ESRB rather than an AO rating. The complaints seek unspecified damages, declarations of various violations of law and litigation costs. The Company believes the complaints are without merit and intends to vigorously defend and seek dismissals of these actions.
In February 2005, the personal representatives of the Estates of Arnold Strickland and Ace Mealer brought an action in the Circuit Court of Fayette County, Alabama against the Company, Sony, Wal-Mart, GameStop and Devin Moore alleging under Alabama manufacturers liability and wrongful death statutes that the Company’s video games designed, manufactured, marketed and/or supplied to Mr. Moore resulted in “copycat violence” that caused the death of Messrs. Strickland and Mealer. The suit seeks damages (including punitive damages) against all of the defendants in excess of $600,000. The Company believes that the claims are without merit and that the action is similar to lawsuits brought and uniformly dismissed by courts in other jurisdictions. The Company intends to vigorously defend and seek a dismissal of this action.
The Company is involved in routine litigation in the ordinary course of its 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. Unregistered Sales of Equity Securities and Use of Proceeds
In January 2003, the Board of Directors authorized a stock repurchase program under which the Company may repurchase up to $25,000 of its common stock from time to time in the open market or in privately negotiated transactions. During the quarter ended July 31, 2005, the Company repurchased 520,341 shares of its common stock at an aggregate cost of approximately $14,998. As of July 31, 2005, $10,002 may be used to purchase additional shares of the Company’s common stock under this program. Detail of the repurchases is provided in the table below.
| Month of Purchase | | | Total number of
shares purchased/
returned | | | Average price
paid per share | | | Total number of
shares repurchased
as part of the
publicly announced
program | | | Total amount
purchased as part
of the publicly announced
program | | | Maximum dollar
value of shares that
may yet be purchased
under the program | |
| | |
|
| |
|
| |
|
| |
|
| |
|
| |
| May 2005 | | | — | | $ | — | | | — | | $ | — | | $ | 25,000 | |
| June 2005 | | | 520,341 | | | 28.82 | | | 520,341 | | | 14,998 | | | 10,002 | |
| July 2005 | | | 412,500 | (1) | | 22.67 | (1) | | — | | | — | | | 10,002 | |
| | |
|
| |
|
| |
|
| |
|
| |
|
| |
| Total/Average | | | 932,841 | | $ | 26.10 | | | 520,341 | | $ | 14,998 | | $ | 10,002 | |
| | |
|
| |
|
| |
|
| |
|
| |
|
| |
| | |
| (1) | In July 2005, the Company accepted for return 412,500 shares of its common stock held by three employees with a fair market value at the original issuance date of approximately $9,350. |
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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
(Dollars in thousands, except per share amounts)
Item 4. Submission of Matters to a Vote of Security Holders
The Company held its Annual Meeting on June 16, 2005. At the meeting, Paul Eibeler, Oliver R. Grace, Jr, Robert Flug, Mark Lewis, Todd Emmel, Steve Tisch and Barbara Kaczynski were elected as directors. Mr. Eibeler received 57,882,471 votes for, and zero votes against. Mr. Grace received 55,420,241 votes for, and zero votes against. Mr. Flug received 55,420,177 votes for, and zero votes against. Mr. Lewis received 56,137,315 votes for, and zero votes against. Mr. Emmel received 56,918,907 votes for, and zero votes against. Mr. Tisch received 56,136,880 votes for, and zero votes against. Ms. Kaczynski received 57,346,944 votes for, and zero votes against.
In addition, the stockholders approved an amendment to the Company’s 2002 Stock Option Plan to increase the number of shares of the Company’s common stock reserved for issuance under the Option Plan by 2,000,000 shares with 42,174,825 votes for and 13,591,306 votes against and an amendment to the Company’s Incentive Stock Plan to increase the number of shares of the Company’s common stock reserved for issuance under the Incentive Plan by 1,000,000 shares with 42,855,526 votes for and 12,881,224 votes against.
Item 6. Exhibits
| | Exhibits: |
| | | | | |
| | 10.1 | | | Take-Two Interactive Software, Inc., Incentive Stock Plan, as amended. |
| | | | | |
| | 10.2 | | | 2002 Stock Option Plan of Take-Two Interactive Software, Inc., as amended. |
| | | | | |
| | 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. |
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SIGNATURES
Pursuant to the requirements of 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 8, 2005 | By: | /s/ Paul Eibeler |
| | |
|
| | | Paul Eibeler
Chief Executive Officer and President
(Principal Executive Officer) |
| Date: September 8, 2005 | By: | /s/ Karl H. Winters |
| | |
|
| | | Karl H. Winters
Chief Financial Officer
(Principal Financial Officer) |
| | | |
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QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF