FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
--------------------
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended December 31, 1997
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the Transition Period from ______ to_____
Commission File No. 0-17948
ELECTRONIC ARTS INC.
(Exact name of registrant as specified in its charter)
Delaware 94-2838567
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1450 Fashion Island Boulevard
San Mateo, California 94404
(Address of principal executive offices) (Zip Code)
(650) 571-7171
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
YES X NO _____
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
Outstanding at
Class of Common Stock January 24, 1998
--------------------- ----------------
$0.01 par value per share 59,242,893
ELECTRONIC ARTS INC. AND SUBSIDIARIES
INDEX
Part I - Financial Information Page
- ------------------------------ ----
Item 1. Consolidated Financial Statements
Consolidated Balance Sheets at
December 31, 1997 and March 31, 1997 3
Consolidated Statements of Income for
the Three Months Ended December 31, 1997 and 1996 4
and the Nine Months Ended December 31, 1997 and 1996
Consolidated Statements of Cash Flows for
the Nine Months Ended December 31, 1997 and 1996 5
Notes to Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 11
Part II - Other Information
Item 1. Legal Proceedings 29
Item 4. Submission of Matters to a Vote of Security Holders 29
Item 6. Exhibits and Reports on Form 8-K 29
Signatures 30
Exhibit Index 31
2
PART I - FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
ELECTRONIC ARTS INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands)
ASSETS
December 31, March 31,
1997 1997
----------------- -------------
(unaudited) (unaudited)
Current assets:
Cash and short-term investments $287,813 $268,141
Marketable securities 3,128 5,548
Receivables, less allowances of $68,935 and $43,268, respectively 273,257 103,244
Inventories 32,259 17,873
Prepaid royalties 14,378 10,311
Deferred income taxes 6,008 5,259
Other current assets 13,005 10,724
-------- --------
Total current assets 629,848 421,100
Property and equipment, net 93,101 89,762
Prepaid royalties 6,310 9,351
Long-term investments 27,311 34,478
Investments in affiliates 20,041 25,657
Other assets 4,166 3,693
-------- --------
$780,777 $584,041
======== ========
LIABILITIES, MINORITY INTEREST AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $95,491 $43,450
Accrued liabilities 160,705 92,787
-------- --------
Total current liabilities 256,196 136,237
Minority interest in consolidated joint venture - 28
Stockholders' equity:
Preferred stock, $0.01 par value. Authorized 1,000,000 shares - -
Common stock, $0.01 par value. Authorized 104,000,000 shares;
issued and outstanding 59,166,510 and 58,263,058, respectively 592 583
Paid-in capital 210,633 188,547
Retained earnings 315,188 257,978
Unrealized appreciation of investments 1,227 2,593
Translation adjustment (3,059) (1,925)
-------- --------
Total stockholders' equity 524,581 447,776
-------- --------
$780,777 $584,041
======== ========
See accompanying notes to consolidated financial statements.
3
ELECTRONIC ARTS INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share data)
(unaudited)
Three Months Ended Nine Months Ended
December 31, December 31,
1997 1996 1997 1996
-------------- ------------------- -------------- ----------------
Net revenues $391,245 $290,849 $704,785 $516,855
Cost of goods sold 210,799 142,655 376,752 253,142
------- ------- ------- -------
Gross profit 180,446 148,194 328,033 263,713
------- ------- ------- -------
Operating expenses:
Marketing and sales 45,027 38,886 100,695 79,377
General and administrative 17,578 13,614 42,658 37,028
Research and development 45,358 37,053 109,292 96,978
Charge for acquired in-process technology 1,500 - 1,500 -
Merger costs - - 10,792 -
------- ------ ------- ------
Total operating expenses 109,463 89,553 264,937 213,383
------- ------ ------- -------
Operating income 70,983 58,641 63,096 50,330
Interest and other income, net 16,558 1,343 22,250 10,147
------- ------ ------- -------
Income before provision for income taxes
and minority interest 87,541 59,984 85,346 60,477
Provision for income taxes 28,921 21,281 28,164 21,058
------- ------ ------- -------
Income before minority interest 58,620 38,703 57,182 39,419
Minority interest in consolidated
joint venture - - 28 1,291
------- ------- ------- -------
Net income $58,620 $38,703 $57,210 $40,710
======= ====== ======= =======
Net income per share - basic $0.99 $0.67 $0.98 $0.71
======= ====== ======= =======
Net income per share - diluted $0.96 $0.65 $0.94 $0.68
======= ====== ======= =======
Number of shares used in computation
- - basic 58,961 57,800 58,615 57,366
======= ====== ======= =======
Number of shares used in computation
- - diluted 61,134 59,989 60,571 59,445
======= ====== ======= =======
See accompanying notes to consolidated financial statements.
4
ELECTRONIC ARTS INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
(unaudited)
Nine Months
Ended December 31,
1997 1996
-------------- -------------
Operating activities:
Net income $ 57,210 $ 40,710
Adjustments to reconcile net income to net cash provided by
(used in) operating activities:
Minority interest in consolidated joint venture (28) (1,291)
Equity in net loss of affiliates 1,162 1,149
Gain on sale of affiliate (12,625) -
Depreciation and amortization 20,393 16,247
(Gain) loss on sale of fixed assets 480 (38)
Loss on disposition of assets related to merger 5,607 -
Gain on sale of marketable securities (3,757) (6,700)
Charge for acquired in-process technology 1,500 -
Change in assets and liabilities:
Receivables (170,013) (131,011)
Inventories (14,386) (4,341)
Prepaid royalties (1,026) 7,878
Other assets (1,760) (958)
Accounts payable 52,041 19,377
Accrued liabilities 64,110 69,349
Deferred income taxes 53 (169)
------------- ------------
Net cash provided by (used in) operating activities (1,039) 10,202
------------- ------------
Investing activities:
Proceeds from sales of furniture and equipment 25 152
Proceeds from sales of marketable securities 6,824 19,121
Purchase of marketable securities (2,762) -
Capital expenditures (25,358) (29,946)
Acquisition of minority interest in EA Japan (3,225) -
Investment in affiliates 17,079 (4,770)
Purchase of held to maturity securities (1,008) (18,521)
Proceeds from maturity of securities 6,240 17,253
Change in short-term investments, net (4,428) 335
Other 211 216
------------- ------------
Net cash used in investing activities (6,402) (16,160)
------------- ------------
Financing activities:
Proceeds from issuance of common stock 19,306 16,174
Tax benefit from exercise of stock options 2,789 7,437
------------- ------------
Net cash provided by financing activities 22,095 23,611
------------- ------------
Translation adjustment (1,134) 2,151
Minority interest on translation adjustment - 14
------------- ------------
Increase in cash and cash equivalents 13,520 19,818
Beginning cash and cash equivalents 141,996 125,730
------------- ------------
Ending cash and cash equivalents 155,516 145,548
Short-term investments 132,297 61,447
------------- ------------
Ending cash and short-term investments $287,813 $206,995
============= ============
5
ELECTRONIC ARTS INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)
(Dollars in thousands)
(unaudited)
Nine Months
Ended December 31,
1997 1996
---------------------
Supplemental cash flow information:
Cash paid during the year for income taxes $ 4,348 $ 2,099
======= ========
Non-cash investing activities:
Decline on unrealized appreciation of investments $(2,115) $(12,719)
======== ========
See accompanying notes to consolidated financial statements.
6
ELECTRONIC ARTS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. BASIS OF PRESENTATION
The consolidated financial statements are unaudited and reflect all adjustments
(consisting only of normal recurring accruals) that, in the opinion of
management, are necessary for a fair presentation of the results for the interim
period. The results of operations for the current interim period are not
necessarily indicative of results to be expected for the current year or any
other period. Certain amounts have been reclassified to conform to the fiscal
1998 presentation.
These consolidated financial statements should be read in conjunction with the
consolidated financial statements and notes thereto included in Electronic Arts
Inc. (the "Company") Annual Report on Form 10-K for the fiscal year ended March
31, 1997 as filed with the Securities and Exchange Commission ("Commission") on
June 23, 1997 and certain other information included in the Company's
Registration Statement on Form S-4 as filed with the Commission on June 25,
1997.
NOTE 2. PREPAID ROYALTIES
Prepaid royalties consist primarily of prepayments for manufacturing royalties,
original equipment manufacturer (OEM) fees and license fees paid to celebrities
and professional sports organizations for use of their trade name. Also included
in prepaid royalties are prepayments made to independent software developers
under development arrangements that have alternative future uses. Prepaid
royalties are expensed at the contractual royalty rate as cost of goods sold
based on actual net product sales. Management evaluates the future realization
of prepaid royalties quarterly and charges to income any amounts that management
deems unlikely to be realized through product sales. Royalty advances are
classified as current and non-current assets based upon estimated net product
sales within the year.
NOTE 3. INVENTORIES
Inventories are stated at the lower of cost or market. Inventories at December
31, 1997 and March 31, 1997 consisted of (in thousands):
December 31, 1997 March 31, 1997
----------------- --------------
Raw materials and work in process $ 7,153 $ 4,714
Finished goods 25,106 13,159
------- ------
$32,259 $17,873
======= =======
NOTE 4. ACCRUED LIABILITIES
Accrued liabilities at December 31, 1997 and March 31, 1997 consisted of (in
thousands):
December 31, 1997 March 31, 1997
----------------- --------------
Accrued royalties $ 57,890 $33,592
Accrued expenses 48,892 24,792
Accrued income taxes 21,922 12,611
Accrued compensation and benefits 27,259 19,750
Deferred income taxes 1,438 1,385
Deferred revenue 2,640 657
Accrued merger expenses 664 -
-------- -------
$160,705 $92,787
======== =======
7
ELECTRONIC ARTS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
NOTE 5. OPERATIONS BY GEOGRAPHIC AREAS
The Company operates in one industry segment. Information about the Company's
operations in North America, Europe, South Asia Pacific and Japan for the three
and nine months ended December 31, 1997 and 1996 is presented below (in
thousands).
North South Asia
America Europe Pacific Japan Eliminations Total
------- ------ ---------- ----- ------------ -----
Three months ended December 31, 1997
Net revenues from unaffiliated
customers $230,079 $140,778 $15,070 $5,318 $ - $391,245
Intersegment net revenues 25,127 2,187 141 109 (27,564) -
-------- -------- ------- ------ -------- --------
Total net revenues $255,206 $142,965 $15,211 $5,427 $(27,564) $391,245
======== ======== ======= ====== ========= ========
Operating income (loss) $45,206 $24,001 $3,379 $(1,603) $ - $70,983
Identifiable assets $541,576 $204,554 $24,036 $10,611 $ - $780,777
Nine months ended December 31,
1997
Net revenues from unaffiliated
customers $406,930 $247,979 $33,845 $16,031 $ - $704,785
Intersegment net revenues 42,251 7,586 486 109 (50,432) -
-------- -------- ------- ------ -------- --------
Total net revenues $449,181 $255,565 $34,331 $16,140 $(50,432) $704,785
======== ======== ======= ======= ========= ========
Operating income (loss) $ 29,689 $ 32,218 $ 7,124 $(5,935) $ - $ 63,096
Three months ended December
31, 1996
Net revenues from unaffiliated
customers $162,546 $104,985 $10,025 $13,293 $ - $290,849
Intersegment net revenues 28,185 2,797 - 56 (31,038) -
-------- -------- ------- ------ -------- --------
Total net revenues $190,731 $107,782 $10,025 $13,349 $(31,038) $290,849
======== ======== ======= ======= ========= ========
Operating income (loss) $ 34,970 $ 22,233 $ 2,687 $(1,249) $ - $ 58,641
Identifiable assets $443,522 $150,712 $14,288 $22,529 $ - $631,051
Nine months ended December 31,
1996
Net revenues from unaffiliated
customers $301,663 $169,903 $20,998 $24,291 $ - $516,855
Intersegment net revenues 42,952 5,046 - 67 (48,065) -
-------- -------- ------- ------ -------- --------
Total net revenues $344,615 $174,949 $20,998 $24,358 $(48,065) $516,855
======== ======== ======= ======= ========= ========
Operating income (loss) $24,744 $26,125 $4,892 $(5,431) $ - $50,330
8
ELECTRONIC ARTS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
NOTE 6. FOREIGN CURRENCY
The Company utilizes foreign currency forward exchange contracts to hedge
foreign currency market exposures of underlying assets, liabilities and other
obligations, primarily intercompany receivables that are denominated in foreign
currencies. The Company does not use forward exchange contracts for speculative
or trading purposes. The Company transacts business in various foreign
currencies, including European and Canadian currencies. At December 31, 1997 and
March 31, 1997, the Company had foreign exchange contracts, all having
maturities of 90 days or less, to purchase and sell approximately $17,520,000
and $27,549,000, respectively, in foreign currencies, primarily German
Deutschmarks, Swedish Krona, Netherlands Guilders and British Pounds. Gains and
losses on currency forward contracts that are designated and effective as hedges
of existing transactions are recognized in income in the same period as losses
and gains on the underlying transactions are recognized and generally offset.
The difference between the face value and market value of these contracts is not
significant. The counterparties to these contracts are substantial and credit
worthy multinational commercial banks. The risks of counterparty nonperformance
associated with these contracts are not considered to be material.
NOTE 7. ACQUISITION AND DIVESTITURE
In December 1997, the Company completed the sale of Creative Wonders, LLC, a 50%
joint venture company formed with the Walt Disney Company for $16,750,000 in
cash. The Company recognized a gain of $12,625,000, included in interest and
other income.
In December 1997, the Company acquired the remaining 35% ownership interest in
Electronic Arts Victor, Inc. ("EAV") from Victor Entertainment Industries, Inc.
("VEI") for approximately $3,225,000 in cash. As a result of the acquisition,
the joint venture has become a wholly-owned subsidiary of the Company and has
been renamed Electronic Arts, K.K. The acquisition was accounted for as a step
acquisition purchase and the excess purchase price over fair value of the net
tangible assets acquired was allocated to purchased in-process technology,
goodwill and other intangible assets. The Company incurred a charge to
operations of $1,500,000 for the acquired in-process technology as of the date
of the acquisition after concluding that the related technology had no
alternative future use after taking into consideration the potential for usage
of the software in different products and resale of the software.
The goodwill and other intangible assets of approximately $1,700,000 is being
amortized over 7 years. The results of operations reflect a minority interest
elimination through the date of the acquisition. No minority interest in EAV was
recorded for the losses generated in the three months ended December 31, 1997 as
VEI's interest in the net equity of EAV had fallen below zero.
9
NOTE 8. EARNINGS PER SHARE
In February 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No 128, "Earnings per Share" (SFAS 128). SFAS 128
requires dual presentation of basic earnings per share ("EPS") and diluted EPS
on the face of all statements of earnings for all entities with complex capital
structures. Basic EPS is computed as net earnings divided by the
weighted-average number of common shares outstanding for the period. Diluted EPS
reflects the potential dilution that could occur from common shares issuable
through stock-based compensation plans including stock options, restricted stock
awards, warrants and other convertible securities using the treasury stock
method. The following summarizes the computation of Basic EPS and Diluted EPS
(in thousands except for per share amounts):
Three Months Ended Nine Months Ended
December 31, December 31,
1997 1996 1997 1996
----------- ---------------- --------------- ---------------
Net Income $58,620 $38,703 $57,210 $40,710
Shares:
Weighted Average Common Shares 58,961 57,800 58,615 57,366
Dilutive Stock Options 2,173 2,189 1,956 2,079
-------- ------ ------ ------
Dilutive Potential Common Shares 61,134 59,989 60,571 59,445
======== ====== ====== ======
Earnings Per Share:
Basic $0.99 $0.67 $0.98 $0.71
Diluted $0.96 $0.65 $0.94 $0.68
10
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
This Quarterly Report on Form 10-Q and in particular Management's Discussion and
Analysis of Financial Condition and Results of Operations contains forward
looking statements regarding future events or the future financial performance
of the Company that involve certain risks and uncertainties discussed in
"Factors Affecting Future Performance" below at pages 23 to 28, as well as in
the Company's Annual Report on Form 10-K for the fiscal year ended March 31,
1997 as filed with the Securities and Exchange Commission on June 23, 1997 and
the Company's Registration Statement on Form S-4 filed with the Commission on
June 25, 1997. Actual events or the actual future results of the Company may
differ materially from any forward looking statement due to such risks and
uncertainties.
Net Revenues December 31, December 31,
1997 1996 % change
------------------- ------------------ -----------------
Consolidated Net Revenues
Three Months Ended $391,245,000 $290,849,000 34.5%
Nine Months Ended $704,785,000 $516,855,000 36.4%
North America Net Revenues
Three Months Ended $230,079,000 $162,546,000 41.5%
as a percentage of net revenues 58.8% 55.9%
Nine Months Ended $406,930,000 $301,663,000 34.9%
as a percentage of net revenues 57.7% 58.4%
International Net Revenues
Three Months Ended $161,166,000 $128,303,000 25.6%
as a percentage of net revenues 41.2% 44.1%
Nine Months Ended $297,855,000 $215,192,000 38.4%
as a percentage of net revenues 42.3% 41.6%
The Company derives revenues from shipments of EA Studio Compact Disk ("CD")
products for dedicated entertainment systems ("CD- video games"), EA Studio CD
personal computer products ("PC CD") (primarily entertainment software), EA
Studio cartridge products, licensing of EA Studio products, distribution of EA
Studio and Affiliated Label ("AL") products through hardware companies ("OEMs")
and shipments of AL products that are published by third parties.
11
North America net revenues increased $67,533,000, or 41.5%, and $105,267,000, or
34.9%, for the three and nine months ended December 31, 1997, respectively,
compared to the same periods last year primarily due to increased sales of Sony
PlayStation ("PlayStation") titles; a key release for the Nintendo 64 ("N64")
and increased Affiliated Label revenues resulting from the addition of Accolade
and key releases of new products from other affiliates. North America
PlayStation sales reflected the increase in installed base of these consoles and
the release of hit sports titles for this platform. Total North America
PlayStation revenue increased $48,126,000 or 108.9% and $88,225,000 or 98.5% for
the three and nine month periods, respectively.
N64 net revenues in North America were $38,790,000 and $39,426,000 for the three
and nine months ended December 31, 1997, respectively, and are primarily
comprised of sales of Madden 64 which was released in the quarter ended December
1997. There were no sales of N64 products in the comparable prior year periods.
Affiliated Label revenues increased $17,498,000, or 122.1%, and $34,027,000, or
121.0%, for the three and nine months ended December 31, 1997, respectively. For
the quarter ended December 1997, Affiliated Label sales increased primarily due
to the release of Test Drive 4 published by Accolade, Inc., an affiliate added
in the quarter ended March 1997. Accordingly, there were no revenues generated
by this affiliate in the prior year. In addition to increased sales of Accolade
products, year to date Affiliated Label sales in the North America increased due
to the release of The Lost World: Jurassic Park ("Jurassic Park") which was
co-published by the Company and Dreamworks Interactive and released in the
quarter ended September 1997.
The increase in North America net revenues was partially offset by a decrease in
net revenues from the sales of 16-bit cartridge products and, to a lesser
degree, from Sega Saturn ("Saturn") sales. 16-bit revenues decreased
$36,529,000, or 89.2%, and $50,336,000, or 85.0%, compared to the prior year
three and nine month periods due to the completed transition of 16-bit cartridge
platforms to 32-bit and 64-bit video games. Sales of Saturn titles decreased
$4,169,000 and $6,879,000 for the three and nine months ended December 31, 1997,
respectively, as this platform has not achieved the level of market acceptance
as compared to other next generation platforms. Though North America net
revenues are expected to continue to grow in fiscal 1998, they may not grow at
as high a rate as compared to this quarter.
International net revenues increased $32,863,000, or 25.6%, and $82,663,000, or
38.4%, for the three and nine months ended December 31, 1997 compared to the
same periods last year. The increase in international revenues for these
periods was primarily due to growth in European net revenues consisting of
higher sales of AL and PlayStation products, and to a lesser degree, N64 and PC
CD sales. Total net revenues in Europe were $140,778,000 for the three months
ended December 31, 1997 compared to $104,985,000 in the same period last year,
while revenues for the nine month period were $247,979,000 compared to
$169,903,000 in the same period last year.
European AL sales increased $20,989,000 for the three months and $40,794,000 for
the nine months ended December 31, 1997 compared to the prior year due to the
third quarter release of Croc - Legend of Gobbos ("Croc"), published by
Twentieth Century Fox Home Entertainment ("Fox"), Test Drive 4 published by
Accolade and continued distribution under an exclusive international agreement
with Fox and other affiliates. In addition, AL sales for the nine month period
increased due to the worldwide release of Jurassic Park, as noted above.
12
European PlayStation sales increased $18,501,000, or 60.2%, and $33,181,000, or
72.8%, for the three and nine months ended December 31, 1997, respectively,
reflecting the worldwide growth in installed base of this platform. European N64
sales were $8,306,000 and $10,269,000 for the three and nine month periods
ended December 1997 due to the release of FIFA: Road to the World Cup in the
third fiscal quarter. There were no sales of N64 products in Europe in the
comparable prior year periods.
European PC CD sales increased $5,467,000, or 16.5%, and $15,526,000, or 27.9%,
for the three and nine months ended December 31, 1997, respectively, primarily
due to growth of this platform in Europe and as a result of strong sales of
Dungeon Keeper, which was released in the first fiscal quarter of 1998. Overall
European sales were offset by a decrease in 16-bit revenues of $13,191,000 and
$16,502,000, for the three and nine months ended December 31, 1997,
respectively, attributable to the transition to 32-bit and 64-bit video games.
Sales in the South Asia Pacific region increased by 50.3% to $15,070,000 for the
three months ended December 31, 1997 compared to $10,025,000 in the prior year
while revenues for the nine month period were $33,845,000 compared to
$20,998,000 in the prior year. The increase is attributable to increased sales
of Affiliated Label, PC CD and PlayStation titles resulting from both the
increase in installed base of these platforms and the growth in sales offices
throughout the region, including China, Singapore, New Zealand and Hong Kong.
Revenues from the sale of Affiliated Label titles for the three month period
increased $2,561,000 to $5,048,000 as a result of key releases from certain
affiliates and continued distribution of Fox titles, as noted above. AL revenues
for the nine months ended December 31, 1997 were $11,624,000 compared to
$3,983,000 in the prior year. For the three and nine months ended December 31,
1997, PC CD net revenues increased $1,325,000 and $2,684,000, respectively,
while PlayStation net revenues increased $1,361,000 and $2,885,000,
respectively.
Net revenues in Japan for the third fiscal quarter of 1998 were $5,318,000
compared to $13,293,000 for the corresponding period in the prior year while
year to date revenues were $16,031,000 versus $24,291,000 for the comparable
period last year. The decrease in revenues was due primarily to the lack of
locally developed titles in this market, primarily for the PlayStation, and the
significant decline in sales of Saturn products, which represented 29% of third
quarter sales last year, offset by additional sales of PC CD titles. In the
quarter ended December 31, 1997, the Company released no original titles for the
PlayStation compared to one in the comparable prior year period.
13
EA STUDIO NET REVENUES:
- ----------------------
32-BIT VIDEO GAME PRODUCT NET REVENUES
December 31, December 31,
1997 1996 % change
----------------- ------------------- -------------
Three Months Ended $152,021,000 $96,352,000 57.8%
as a percentage of net revenues 38.9% 33.1%
Nine Months Ended $286,108,000 $179,250,000 59.6%
as a percentage of net revenues 40.6% 34.7%
The Company released seven 32-bit CD-video game products during the third
quarter of fiscal 1998 comprised of four for the PlayStation, including NBA Live
98, FIFA: Road To The World Cup 98 and MotoRacer, and three for the Saturn,
including NASCAR 98. The increase in sales for the three and nine months ended
December 31, 1997 compared to the prior year periods is attributable to the
greater installed base of PlayStation consoles and the related release of key
titles for this platform during the quarter offset by a decline in Saturn
revenues.
For the three months ended December 31, 1997, the majority of the 32-bit
videogame revenue increase was attributable to PlayStation sales which were
$146,526,000, compared to $82,502,000 for the three months ended December 31,
1996. For the nine months ended December 31, 1997 and 1996, PlayStation revenues
were $271,188,000 and $152,934,000, respectively. The Company expects revenues
from PlayStation products to continue to grow in fiscal 1998, but as revenues
for these products increase, the Company does not expect to maintain these
growth rates.
Net revenue from the sale of other 32-bit products, primarily from sales of
products for the Saturn, were $5,495,000 for the quarter ended December 31, 1997
compared to $13,850,000 for the same period in the prior year. For the nine
months ended December 31, 1997 and 1996 other 32-bit revenues were $14,920,000
and $26,316,000, respectively. As the installed base of Saturn consoles has not
achieved the growth rates of PlayStation consoles, the Company's revenues from
sales of Saturn products have declined and are expected to decline further in
future years. The Company plans fewer releases of Saturn products in fiscal 1998
than fiscal 1997 and currently plans to release one Saturn product after the
quarter ending December 31, 1997.
Under the terms of a licensing agreement entered into with Sony Computer
Entertainment of America in July 1994 (the "Sony Agreement"), as amended, the
Company is authorized to develop and distribute CD-based software products
compatible with the PlayStation. Pursuant to the Sony Agreement, the Company
engages Sony to supply PlayStation CDs for distribution by the Company.
Accordingly, the Company has limited ability to control its supply of
PlayStation CD products or the timing of their delivery. See Hardware Companies,
below.
14
Under the terms of a licensing agreement entered into with Sega Enterprises,
Ltd. in January 1995 (the "Sega Saturn Agreement"), the Company is authorized to
develop and distribute CD-based software products compatible with the Sega
Saturn. Pursuant to the Sega Saturn Agreement, the Company engages various third
party manufacturers approved by Sega to supply its Saturn CDs for distribution.
Accordingly, the Company has limited ability to control its supply of Saturn CD
products or the timing of their delivery. See Hardware Companies, below.
PERSONAL COMPUTER CD PRODUCT NET REVENUES
December 31, December 31,
1997 1996 % change
------------------ ------------------- -------------
Three Months Ended $101,054,000 $90,374,000 11.8%
as a percentage of net revenues 25.8% 31.1%
Nine Months Ended $188,474,000 $166,481,000 13.2%
as a percentage of net revenues 26.7% 32.2%
The Company released thirteen PC CD titles in the third quarter of the current
fiscal year for the IBM personal computer and compatibles including Wing
Commander Prophecy and Nuclear Strike, compared to thirteen for the same period
last year. The increase in sales of PC CD products for the nine months ended
December 31, 1997 is attributable to growth in the PC CD market worldwide and
expansion of the Company's direct worldwide distribution. Year to date PC CD
sales also increased due to the worldwide release of Dungeon Keeper during the
first quarter. The growth in PC CD sales for the three and nine month periods
ended December 31, 1997 was partially offset by a decline in titles published
by Maxis. Maxis revenues for the three and nine months ended December 31, 1997,
decreased $10,285,000, or 59.7%, and $11,409,000, or 42.1%, respectively. Though
PC CD revenues are expected to continue to grow in fiscal 1998, they may not
grow at as high a rate as in prior periods.
64-BIT VIDEO GAME PRODUCT NET REVENUES
December 31, December 31,
1997 1996 % change
------------------ ------------------- -------------
Three Months Ended $47,514,000 $ - N/M
as a percent of net revenues 12.1% N/A
Nine Months Ended $50,547,000 $ - N/M
as a percent of net revenues 7.2% N/A
The Company released two N64 titles, Madden 64 and FIFA: Road to the World Cup
98, in the quarter ended December 31, 1997. The Company had its initial release
of a title for the N64 in the quarter ended March 31, 1997 and accordingly there
were no revenues from the sales of N64 titles in the comparable three and nine
month periods. In March 1997, the Company signed a licensing agreement with
Nintendo to develop, publish and market certain sports products for the N64. Due
to the development time necessary for these products, the Company does not
anticipate shipping any additional products for the N64 in the fiscal year
ending March 31, 1998.
15
Under the terms of its licensing agreement with Nintendo, the Company engages
Nintendo to manufacture its N64 cartridges for distribution. Accordingly, the
Company has little ability to control its supply of cartridges or the timing of
their delivery. A shortage of microchips or other factors outside the control of
the Company could impair the Company's ability to obtain an adequate supply of
cartridges. In connection with the Company's purchases of N64 cartridges for
distribution in North America, Nintendo requires that the Company provide it
irrevocable letters of credit prior to Nintendo's acceptance of purchase orders
from the Company for purchases of these cartridges. For purchases of N64
cartridges for distribution in Japan and Europe, Nintendo requires the Company
to make cash deposits. Furthermore, Nintendo maintains a policy of not accepting
returns. Because of these and other factors, the carrying of an inventory of
cartridges entails significant investment and risk. See Hardware Companies,
below.
LICENSE/OEM NET REVENUES
December 31, December 31,
1997 1996 % change
----------------- ------------------- -------------
Three Months Ended $3,466,000 $8,897,000 (61.0%)
as a percentage of net revenues 0.9% 3.1%
Nine Months Ended $11,320,000 $20,102,000 (43.7%)
as a percentage of net revenues 1.6% 3.9%
The decrease in license/OEM net revenues for the three and nine months ended
December 31, 1997 compared to the same period last year was primarily a result
of a decrease in the licensing of Maxis products in Europe and Japan and of EA
products in Europe.
16-BIT VIDEO GAME PRODUCT NET REVENUES December 31, December 31,
1997 1996 % change
----------------- ------------------- -------------
Three Months Ended $6,368,000 $56,769,000 (88.8%)
as a percentage of net revenues 1.6% 19.5%
Nine Months Ended $13,959,000 $81,703,000 (82.9%)
as a percentage of net revenues 2.0% 15.8%
The Company released no new 16-bit video games for the Sega Genesis ("Genesis")
or the Super Nintendo Entertainment System ("SNES") during the three and nine
months ended December 31, 1997. 16-bit revenues for the quarter ended December
31, 1997 were primarily attributable to the sales of the Company's 16-bit
products published under a licensing arrangement with a third party. As the
16-bit video game market has made the transition to next generation 32-bit and
64-bit systems, the Company does not expect to release any new 16-bit titles in
fiscal 1998 and revenues from the sales of 16-bit products in fiscal 1998 are
not expected to be significant.
16
AFFILIATED LABEL NET REVENUES
December 31, December 31,
1997 1996 % change
----------------- ------------------- -------------
Three Months Ended $79,027,000 $38,337,000 106.1%
as a percentage of net revenues 20.2% 13.2%
Nine Months Ended $150,923,000 $68,943,000 118.9%
as a percentage of net revenues 21.4% 13.3%
The increase in Affiliated Label net revenues for the three and nine months
ended December 31, 1997 compared to the prior year periods was due to higher
sales of Affiliated Label products in Europe, North America and South Asia
Pacific. The increase for the quarter ended December 31, 1997 is due primarily
to the release of Test Drive 4 published by Accolade, which was added as a
worldwide affiliate in the quarter ended March 1997, and Croc published by Fox
and distributed outside of North America. The increase for the nine months ended
December 31, 1997 is due to the release of Croc, the addition of Accolade, Inc.
as noted above, the continued distribution under an exclusive international
agreement with Fox, and the release of Jurassic Park in the second fiscal
quarter.
COST OF GOODS SOLD
December 31, December 31,
1997 1996 % change
----------------- -------------------- --------------
Three Months Ended $210,799,000 $142,655,000 47.8%
as a percentage of net revenues 53.9% 49.0%
Nine Months Ended $376,752,000 $253,142,000 48.8%
as a percentage of net revenues 53.5% 49.0%
The increase in costs of goods sold as a percentage of net revenues for the
three and nine months ended December 31, 1997 compared to the same periods last
year was primarily due to increased sales of lower margin affiliated label and
N64 titles, the decrease in PC CD sales as a proportion of total net revenues
and higher professional, celebrity and manufacturing royalties on CD-video and
PC CD game titles.
17
MARKETING AND SALES
December 31, December 31,
1997 1996 % change
------------------ ------------------- --------------
Three Months Ended $45,027,000 $38,886,000 15.8%
as a percentage of net revenues 11.5% 13.4%
Nine Months Ended $100,695,000 $79,377,000 26.9%
as a percentage of net revenues 14.3% 15.4%
The increase in marketing and sales expenses for the three and nine months ended
December 31, 1997 was primarily attributable to increased television and print
advertising worldwide to support new releases and increased cooperative
advertising associated with higher revenues as compared to the prior year
periods. Marketing and sales expenses also increased due to additional headcount
related to the continued expansion of the Company's worldwide distribution
business and increased trade show expenses. Increases were partially offset by
savings attributable to the integration of Maxis in July, 1997.
GENERAL AND ADMINISTRATIVE
December 31, December 31,
1997 1996 % change
------------------ ------------------- --------------
Three Months Ended $17,578,000 $13,614,000 29.1%
as a percentage of net revenues 4.5% 4.7%
Nine Months Ended $42,658,000 $37,028,000 15.2%
as a percentage of net revenues 6.1% 7.2%
The increase in general and administrative expenses for the three months ended
December 31, 1997 was due primarily to an increase in payroll and occupancy
costs due to the opening of additional international offices and additional
depreciation related to the installation of new management information systems
worldwide partially offset by savings attributable to the integration of Maxis
in the second quarter of fiscal 1998. The increase for the nine months ended
December 31, 1997 was due to the factors noted above offset by lower bad debt
expenses related to additional bad debt reserves taken in the prior year.
RESEARCH AND DEVELOPMENT
December 31, December 31,
1997 1996 % change
------------------ ------------------- --------------
Three Months Ended $45,358,000 $37,053,000 22.4%
as a percentage of net revenues 11.6% 12.7%
Nine Months Ended $109,292,000 $96,978,000 12.7%
as a percentage of net revenues 15.5% 18.8%
The increase in research and development expenses for the three and nine months
ended December 31, 1997 was due to additional headcount related expenses
attributable to increased in-house development capacity, higher development
costs per title and additional depreciation of computer equipment.
18
CHARGE FOR ACQUIRED IN-PROCESS TECHNOLOGY
December 31, December 31,
1997 1996 % change
------------------ ------------------- --------------
Three Months Ended $1,500,000 $ - N/M
as a percentage of net revenues 0.4% N/A
Nine Months Ended $1,500,000 $ - N/M
as a percentage of net revenues 0.2% N/A
In connection with the acquisition of the remaining 35% minority ownership
interest in Electronic Arts Victor, Inc. in December 1997, the Company incurred
a charge of $1,500,000 for acquired in-process technology. This charge was made
after the Company concluded that the in-process technology had no alternative
future use after taking into consideration the potential for usage of the
software in different products and resale of the software.
OPERATING INCOME
December 31, December 31,
1997 1996 % change
------------------ ------------------- --------------
Three Months Ended $70,983,000 $58,641,000 21.0%
as a percentage of net revenues 18.1% 20.2%
Nine Months Ended $63,096,000 $50,330,000 25.4%
as a percentage of net revenues 9.0% 9.7%
Operating income was higher for the three and nine months ended December 31,
1997 compared to the same periods last year due to increased revenue and related
gross profit margins partially offset by increased operating expenses including
the charge for acquired in-process technology as discussed in Note 7, above.
The increase for the nine months ended December 31, 1997 was partially offset by
merger costs related to the acquisition of Maxis.
INTEREST AND OTHER INCOME, NET
December 31 December 31,
1997 1996 % change
----------------- ------------------- --------------
Three Months Ended $16,558,000 $1,343,000 N/M
as a percentage of net revenues 4.2% 0.5%
Nine Months Ended $22,250,000 $10,147,000 119.3%
as a percentage of net revenues 3.2% 2.0%
Interest and other income, net, increased for the three and nine months ended
December 31, 1997 compared to the same periods last year primarily due to higher
interest income attributable to higher cash balances as compared to the prior
year periods and the sale of the Company's 50% ownership interest in Creative
Wonders LLC as discussed in Note 7 in December 1997. The sale resulted in a
gain of $12,625,000.
19
INCOME TAXES
December 31, December 31,
1997 1996 % change
----------------- ------------------- --------------
Three Months Ended $28,921,000 $21,281,000 35.9%
effective tax rate 33.0% 35.5%
Nine Months Ended $28,164,000 $21,058,000 33.7%
effective tax rate 33.0% 34.8%
The Company's effective tax rate for the three and nine months ended December
31, 1997 was lower than the comparable prior year periods as a result of the
higher proportion of international income subject to a lower foreign effective
tax rate as compared to prior comparable periods and the reinstatement of the
federal research and development tax credit in fiscal 1998.
MINORITY INTEREST IN CONSOLIDATED JOINT VENTURE
December 31, December 31,
1997 1996 % change
------------------ ------------------- --------------
Three Months Ended $ - $ - 0.0%
as a percentage of net revenues N/A N/A
Nine Months Ended $28,000 $1,291,000 (97.8%)
as a percentage of net revenues 0.0% 0.3%
As discussed in Note 7, the Company acquired the remaining 35% minority
ownership interest in EAV held by VEI in December 1997. Prior to the
acquisition, EAV was sixty-five percent owned by the Company and thirty-five
percent owned by VEI, (formerly Victor Musical Industries, Inc.) a wholly owned
subsidiary of Victor Company of Japan, Limited. No minority interest in EAV was
recorded for the losses generated in the three months ended December 31, 1997 as
VEI's interest in the net equity of EAV prior to the acquisition had fallen
below zero. Minority interest for the nine months ended December 31, 1997
reflects only a portion of reported losses for EAV as the net equity of EAV fell
below zero in the first quarter of fiscal 1998.
20
NET INCOME
December 31, December 31,
1997 1996 % change
----------------- ------------------- --------------
Three Months Ended $58,620,000 $38,703,000 51.5%
as a percentage of net revenues 15.0% 13.3%
Nine Months Ended $57,210,000 $40,710,000 40.5%
as a percentage of net revenues 8.1% 7.9%
The increase in net income for the three months ended December 31, 1997, before
the gain on sale of Creative Wonders, LLC and charge for acquired in-process
technology discussed above, as compared to the prior year period was primarily
related to higher revenues, gross profits, offset by higher operating expenses.
Net income for the nine months ended December 31, 1997 increased due to the
growth in revenues and gross margins offset by higher operating expenses. The
impact of the gain on sale of Creative Wonders, LLC of $12,625,000, before
income taxes, was offset by the charge for acquired in-process technology and
merger costs of $10,792,000, before income taxes, incurred in the second quarter
of fiscal 1998.
21
LIQUIDITY AND CAPITAL RESOURCES
As of December 31, 1997, the Company's working capital was $373,652,000 compared
to $284,863,000 at March 31, 1997. Cash and short term investments increased by
approximately $19,672,000 during the nine months ended December 31, 1997 as the
Company used $1,039,000 of cash in operations and $25,358,000 in capital
expenditures offset by proceeds from the Company's employee stock programs,
proceeds from the sale of Creative Wonders, LLC and from sales of securities.
Reserves for bad debts and sales returns increased from $43,268,000 at March 31,
1997 to $68,935,000 at December 31, 1997. Reserves have been charged for returns
of product and price protection credits issued for products sold in prior
periods. Management believes these reserves are adequate based on historical
experience and its current estimate of potential returns and allowances.
Inventory levels at December 31, 1997 increased compared to March 31, 1997 due
mainly to increases of AL inventories in Europe to support the growth of the
business related to the opening of multiple new distribution facilities in
Europe to support the Company's direct distribution effort.
In connection with the Company's purchases of Sony products to be distributed in
Japan, Sony of Japan requires cash deposits totaling one-third of purchase
orders. Additionally, Nintendo of Japan requires cash deposits on all orders of
N64 cartridge products in Japan. In lieu of letters of credit, EA Japan utilizes
a line of credit to fund these deposits for purchases of Sony and Nintendo
products in Japan and for other operating requirements. At December 31, 1997, EA
Japan had approximately $3,800,000 outstanding on this line.
The Company's principal source of liquidity is $287,813,000 in cash and
short-term investments. Management believes the existing cash, cash equivalents,
short-term investments, marketable securities and cash generated from operations
will be sufficient to meet cash and investment requirements for the foreseeable
future.
22
FACTORS AFFECTING FUTURE PERFORMANCE
Future operating results of the Company depend upon many factors and are subject
to various risks and uncertainties. Some of those important risks and
uncertainties which may cause the Company's operating results to vary or which
may materially and adversely affect the Company's operating results are as
follows:
THE INDUSTRY AND COMPETITION. The interactive software business has historically
been a volatile and highly dynamic industry affected by changing technology,
limited hardware platform life cycles, hit products, competition, component
supplies, seasonality, consumer spending and other economic trends. The business
is also intensely competitive. A variety of companies offer products that
compete directly with one or more of the Company's products. These direct
competitors vary in size from very small companies to companies with financial,
managerial and technical resources comparable to or greater than those of the
Company. Typically, the Company's chief competitor on dedicated game platforms
is the hardware manufacturer/licensor itself, to which the Company must pay
royalties, and in the case of Sony and Nintendo, manufacturing charges. For
example, Sony has aggressively launched sports product lines that directly
compete with the Company's sports products on the PlayStation. In addition,
competition for creative talent has intensified, and the attraction and
retention of key personnel by the Company is increasingly difficult.
PRODUCTS. Interactive entertainment software products typically have life spans
of only 3 to 12 months. In addition, the market is crowded with a large number
of titles competing for limited shelf space at retail. The Company's future
success will depend in large part on its ability to develop and introduce new
competitive products on a timely basis and to get those products distributed
widely at retail. To compete successfully, new products must adapt to new
hardware platforms and emerging industry standards, provide additional
functionality and be successfully distributed in numerous changing worldwide
markets. If the Company were unable, due to resource constraints or
technological or other reasons, to successfully develop and distribute such
products in a timely manner, this inability would have a material adverse effect
on its operating results and financial condition.
DEVELOPMENT. Product development schedules, particularly for new hardware
platforms and high-end multimedia PCs are difficult to predict because they
involve creative processes, use of new development tools for new platforms and
the learning process, research and experimentation associated with development
for new technologies. New CD-ROM product releases are frequently including more
content and are more complex, time-consuming and costly to develop and,
accordingly, cause additional development and scheduling risk. For example,
Dungeon Keeper for PC CD, originally scheduled to ship in the quarter ended June
1996, shipped in the quarter ended June 1997. In addition Populous 3 for PC CD
and PlayStation were scheduled for shipment in the fiscal year ended March 31,
1998 are now expected to ship in the fiscal year ending March 31, 1999. Also,
SimCity 3000, the follow on product to SimCity 2000, was scheduled to ship in
October 1997 at the time of the merger with Maxis. Due to additional development
delays, it is anticipated that this product will ship during the first half of
the fiscal year ending March 31, 1999. Additionally, development risks for
CD-ROM products can cause particular difficulties in predicting quarterly
results because brief manufacturing lead times allow finalizing products and
projected release dates late in a quarter. Manufacturing lead times during the
year for CD-based products have been as brief as
23
one to three weeks; cartridge products more typically have had a six to
twelve week lead time for manufacture. The Company's revenues and earnings are
dependent on its ability to meet its product release schedule and its failure to
meet those schedules could result in revenues and earnings which fall short of
analysts' expectations for any individual quarter and the fiscal year.
PLATFORM CHANGES. A large portion of the Company's revenues are derived from the
sale of products designed to be played on proprietary video game platforms such
as the PlayStation and the N64. The interdependent nature of the Company's
business and that of its hardware licensors brings significant risks to the
Company's business. The success of the Company's products is significantly
affected by market acceptance of the new video game hardware systems and the
life span of older hardware platforms, and the Company's ability to accurately
predict these factors with respect to each platform. In many cases, the Company
will have expended a large amount of development and marketing resources on
products designed for new video game systems (such as the new 32-bit systems)
that have not yet achieved large installed bases or will have continued product
development for older hardware platforms that may have shorter life cycles than
the Company expected. Conversely, if the Company does not choose to develop for
a platform that achieves significant market acceptance, or discontinues
development for a platform that has a longer life cycle than expected, the
Company's revenue growth may be adversely affected. For example, the Company
signed an agreement with Nintendo to develop and publish a line of EA SPORTS
products for the N64 in March of 1997, nearly seven months after introduction of
that platform in North America. Due to long development times associated with
this platform, the Company will not ship more than two N64 products under this
agreement in significant quantities during the fiscal year ending March 31,
1998.
The Company believes that investment in products for the 32-bit market,
including both PCCD and CD-video game platforms (particularly the PlayStation)
has been strategically important in positioning the Company for the now
completed transition to 32-bit machines. The Company continues to believe that
such investment is important and will continue its aggressive development
activities for 32-bit platforms. Although the PlayStation has achieved
significant market acceptance in all geographic territories, there can be no
assurance that its growth will continue at the present rates, particularly with
the introduction of the N64 by Nintendo. The market acceptance of the N64,
particularly in North America and Europe, may adversely affect the growth rate
of the 32-bit CD-platforms. While the Company has a broad range of products
available and under development for the PlayStation and for PCCD, the Company
will not ship more than two products for the N64 in any significant quantities
until calendar year 1998, as noted above.
HARDWARE COMPANIES. The Company's contracts with hardware licensors, which are
also some of the Company's chief competitors, often grant significant control to
the licensor over the manufacturing of the Company's products. This fact could,
in certain circumstances, leave the Company unable to get its products
manufactured and shipped to customers. In most events, control of the
manufacturing process by hardware companies increases both the manufacturing
lead times and the expense to the Company as compared to the lead times and
costs that the Company can achieve independently. For example, the Company, in
prior years, experienced delays in the manufacturing of PlayStation products
which caused delays in shipping those products. The results of future periods
may be affected by similar delays. Finally, the Company's contracts with
24
its hardware licensors often require the Company to take significant risks in
holding or prepaying for its inventory of products. In particular, the Company's
agreement with Nintendo for N64 products requires prepayment of costly
cartridge-based inventory, minimum orders and no rights of return.
REVENUE AND EXPENSES. A substantial majority of the revenue of the Company in
any quarter typically results from orders received in that quarter and products
introduced in that quarter. The Company's expenses are based, in part, on
development of products to be released in the future. Certain overhead and
product development expenses do not vary directly in relation to revenues. This
trend is increasing as the Company increases the proportion of products
developed internally. As a result, the Company's quarterly results of operations
are difficult to predict, and small delays in product deliveries may cause
quarterly revenues, operating results and net income to fall significantly below
anticipated levels. The Company typically receives orders shortly before
shipments, making backlog an unreliable indicator of quarterly results. A
shortfall in shipments at the end of any particular quarter may cause the
results of that quarter to fall significantly short of anticipated levels.
FILM AND VIDEOTAPE. The Company produces film and videotape to include in
certain products pursuant to agreements between certain of the Company's
subsidiaries with SAG, AFTRA and Equity. However, the costs of video production
are significantly higher than for software production, and for products which
include a substantial amount of video such as certain interactive movies, the
costs of producing the video component is significantly higher than the cost of
developing the software component. Accordingly, more units of such products must
be sold to recoup the development and production costs. There can be no
assurance that these products which include significant film or videotape
components will be commercially successful enough to recoup development costs.
In addition, the Company's agreements with SAG and AFTRA expire during the
current calendar year, and there can be no assurance that the Company will be
able to renegotiate favorable terms.
GROSS MARGINS. Gross margins as a percent of net revenues for the three and nine
months ended December 31, 1997 decreased compared to the comparable prior year
periods. The decrease was mainly due to increases in the mix of lower margin
Affiliated Label revenues due to the expansion of distribution worldwide and
releases of major titles by key affiliates, increased sales of N64 products and
the lower proportion of revenues associated with sales of higher margin PC CD
products to total revenues.
The mix in sales of the Company's products have a significant effect on gross
margins as a percentage of net revenues. If the proportion of PC CD net revenues
increase in relation to AL revenues, margins may increase. Conversely, if AL
revenues as a proportion of total revenues increase, overall margins may
continue to decrease. In addition, as the Company begins to ship N64 products in
significant quantities, margins may decline due to the higher cost of goods
associated with this cartridge-based platform. Further, gross margins continue
to be affected by increases in professional and celebrity royalties. Also, while
the costs of development of new products for 32- and 64-bit systems have
increased, overall cost of goods are not declining. For products on platforms
for which the Company is required to purchase its goods from the hardware
companies, the Company is unable to achieve cost reductions through
manufacturing efficiencies, and in addition have to pay manufacturing royalties
to hardware companies. Additionally, higher distribution expenses for operations
in Europe and North America continue to put
25
pressure on margins and retailers also continue to require significant price
protection for products. With an increasing number of titles available for
advanced platforms, such requirements for price protection may increase. The
Company also anticipates that retail and wholesale prices for interactive
entertainment products may decrease and gross margins may be further adversely
affected.
MARKETING AND DISTRIBUTION. Both the video game and PC businesses have become
increasingly "hits" driven. Additional marketing and advertising funds are
required to drive and support "hit" products, particularly television
advertising. There can be no assurance that the Company will continue to produce
"hit" titles, or that advertising for any product will increase sales
sufficiently to recoup those advertising expenses.
The Company has stock-balancing programs for its personal computer products
that, under certain circumstances and up to a specified amount, allow for the
exchange of personal computer products by resellers. The Company also typically
provides for price protection for its personal computer and video game system
products that, under certain conditions, allows the reseller a price reduction
from the Company for unsold products. The Company maintains a policy of
exchanging products or giving credits, but does not give cash refunds. Moreover,
the risk of product returns may increase as new hardware platforms become more
popular or market factors force the Company to make changes in its distribution
system. The Company monitors and manages the volume of its sales to retailers
and distributors and their inventories as substantial overstocking in the
distribution channel can result in high returns or the requirement for
substantial price protection in subsequent periods. The Company believes that it
provides adequate reserves for returns and price protection which are based on
estimated future returns of products, taking into account promotional
activities, the timing of new product introductions, distributor and retailer
inventories of the Company's products and other factors, and that its current
reserves will be sufficient to meet return and price protection requirements for
current in-channel inventory. However, there can be no assurance that actual
returns or price protection will not exceed the Company's reserves. See Revenue
and Expenses, above.
The distribution channels through which consumer software products are sold have
been characterized by change, including consolidations and financial
difficulties of certain distributors and retailers and the emergence of new
retailers such as general mass merchandisers. The development of remote and
electronic delivery systems will create further changes. The bankruptcy or other
business difficulties of a distributor or retailer could render the Company's
accounts receivable from such entity uncollectible, which could have an adverse
effect on the operating results and financial condition of the Company. In the
quarter ended September 1996, the Company recorded $2,300,000 in bad debt
expenses related to potentially uncollectible receivables from a customer who
filed for bankruptcy. In addition, an increasing number of companies are
competing for access to these channels. The Company's arrangements with its
distributors and retailers may be terminated by either party at any time without
cause. Distributors and retailers often carry products that compete with those
of the Company. Retailers of the Company's products typically have a limited
amount of shelf space and promotional resources for which there is intense
competition. There can be no assurance that distributors and retailers will
continue to purchase the Company's products or provide the Company's products
with adequate levels of shelf space and promotional support.
26
EMPLOYEES. Competition for employees in the interactive software business is
intense and increasing as competition in the industry increases. In the last
fiscal year, recruiting of the Company's employees generally, and its executive
officers in particular, has been intense. Large software and media companies
frequently offer significantly larger cash compensation than does the Company,
placing pressure on the Company's base salary and cash bonus compensation. Small
start-up companies such as those proliferating in the online business areas
offer significant potential equity gains which are difficult for more mature
companies like the Company to match without significant stockholder dilution.
While executive turnover has decreased in fiscal 1998 as compared to prior
years, virtually all of the executives continue to experience intense recruiting
pressure. There can be no assurance that the Company will be able to continue to
attract and retain enough qualified employees in the future.
FOREIGN SALES AND CURRENCY FLUCTUATIONS. For the nine months ended December 31,
1997 and for the fiscal year ended March 31, 1997, international net revenues
comprised 42% and 45% of total consolidated net revenues, respectively. The
Company expects foreign sales to continue to account for a significant and
growing portion of the Company's revenues. Such sales are subject to unexpected
regulatory requirements, tariffs and other barriers. Additionally, foreign sales
are primarily made in local currencies which may fluctuate. As a result of
current economic conditions in Asia, the Company is subject to additional
foreign currency risk. Though the Company does not currently derive a
significant portion of revenues and operating profits from sales in Asia and
other developing countries, the Company's foreign currency exposure may increase
as the Company's operations in these countries grow and if current economic
trends in Asia continue. There can be no assurance that these or other factors
will not have an adverse effect on the Company's future operating results.
INVESTMENTS IN AFFILIATES AND MARKETABLE SECURITIES. The Company has a number of
equity investments in affiliates, including small developers, such as Firaxis;
other publishers, such as Accolade, Inc. and Stormfront; and new ventures such
as Mpath Interactive. Additionally, the Company has an equity investment in the
3DO Company. These companies are generally small and without significant
financial resources. Financial difficulties for any of these companies could
cause a reduction in the value of the Company's investment. For example, in
fiscal 1996 the Company wrote off its investment in SportsLab in its entirety.
FLUCTUATIONS IN STOCK PRICE. Due to analysts' expectations of continued growth
and other factors, any shortfall in earnings could have an immediate and
significant adverse effect on the trading price of the Company's Common Stock in
any given period. As a result of the factors discussed in this quarterly report
and other factors that may arise in the future, the market price of the
Company's Common Stock historically has been, and may continue to be subject to
significant fluctuations over a short period of time. These fluctuations may be
due to factors specific to the Company, to changes in analysts' earnings
estimates, or to factors affecting the computer, software, entertainment, media
or electronics industries or the securities markets in general. For example,
during the most recently completed fiscal year, the price per share of the
Company's common stock ranged from $24.75 to $39.13 and in the first nine months
of the current fiscal year ranged from $20.13 to $39.56.
27
SEASONALITY. The Company's business is highly seasonal. The Company typically
experiences its highest revenues and profits in the calendar year-end holiday
season and a seasonal low in revenues and profits in the quarter ending in June.
Because of the foregoing factors, as well as other factors affecting the
Company's operating results and financial condition, past financial performance
should not be considered a reliable indicator of future performance, and
investors should not use historical trends to anticipate results or trends in
future periods.
28
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company is subject to pending claims. Management, after
review and consultation with counsel, considers that any
liability from the disposition of such lawsuits in the
aggregate would not have a material adverse effect upon the
consolidated financial position or results of operations of
the Company.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits - The following exhibits are filed as part of this
report:
10.39 Employment Agreement by and between the Registrant and
John Riccitiello dated August 29, 1997.
10.40 Lease Agreement by and between Registrant and John
Riccitiello dated August 29, 1997.
(b) Reports on Form 8-K: None
29
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.
ELECTRONIC ARTS INC.
(Registrant)
/s/E. STANTON MCKEE
-------------------
DATED: E. STANTON MCKEE
February 13, 1998 Executive Vice President and
Chief Financial and Administrative Officer
(Duly authorized officer)
30
ELECTRONIC ARTS INC. AND SUBSIDIARIES
FORM 10-Q QUARTERLY REPORT
FOR THE QUARTERLY PERIOD ENDED DECEMBER 31, 1997
EXHIBIT INDEX
EXHIBIT
NUMBER EXHIBIT TITLE PAGE
- ------ ------------- ----
10.39 Employment Agreement by and between 32
the Registrant and John Riccitiello
dated August 29, 1997.
10.40 Lease Agreement by and between 34
Registrant and John Riccitiello
dated August 29, 1997.
27 Financial Data Schedule 44
31