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, 1998
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.)
209 Redwood Shores Parkway
Redwood City, California 94065
(Address of principal executive offices) (Zip Code)
(650) 628-1500
(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 February 9, 1999
--------------------- -----------------
$0.01 par value per share 61,180,007
ELECTRONIC ARTS INC. AND SUBSIDIARIES
INDEX
Part I - Financial Information Page
- ------------------------------ ----
Item 1. Condensed Consolidated Financial Statements
Condensed Consolidated Balance Sheets at
December 31, 1998 and March 31, 1998 3
Condensed Consolidated Statements of Operations for the Three
Months Ended December 31, 1998 and 1997 and the Nine Months
Ended December 31, 1998 and 1997 4
Condensed Consolidated Statements of Cash Flows for
the Nine Months Ended December 31, 1998 and 1997 5
Notes to Condensed Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 12
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
2
PART I - FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
ELECTRONIC ARTS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(Dollars in thousands)
(unaudited)
ASSETS
December 31, March 31,
1998 1998
--------- ---------
Current assets:
Cash, cash equivalents and short-term investments $ 201,236 $ 374,560
Marketable securities 2,644 3,721
Receivables, less allowances of $95,691 and $51,575, respectively 314,650 139,374
Inventories 30,249 19,626
Other current assets 67,318 52,530
--------- ---------
Total current assets 616,097 589,811
Property and equipment, net 169,227 105,095
Long-term investments 24,200 24,200
Investments in affiliates 25,559 20,541
Intangibles and other assets 101,407 6,034
--------- ---------
$ 936,490 $ 745,681
========= =========
LIABILITIES, MINORITY INTEREST AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 70,581 $ 56,233
Accrued liabilities 221,707 125,480
--------- ---------
Total current liabilities 292,288 181,713
Minority interest in consolidated joint venture 2,949 --
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 61,063,609 and 60,159,601, respectively 611 602
Paid-in capital 259,722 234,294
Retained earnings 381,498 330,540
Accumulated other comprehensive loss (578) (1,468)
--------- ---------
Total stockholders' equity 641,253 563,968
--------- ---------
$ 936,490 $ 745,681
========= =========
<FN>
See accompanying notes to condensed consolidated financial statements.
</FN>
3
ELECTRONIC ARTS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(unaudited)
Three Months Ended Nine Months Ended
December 31, December 31,
1998 1997 1998 1997
--------------------------------------------------------------
Net revenues $ 520,155 $ 391,245 $ 944,139 $ 704,785
Cost of goods sold 273,772 210,799 495,660 376,752
--------- --------- --------- ---------
Gross profit 246,383 180,446 448,479 328,033
--------- --------- --------- ---------
Operating expenses:
Marketing and sales 56,451 45,027 123,618 100,695
General and administrative 23,195 17,578 55,007 42,658
Research and development 61,819 45,358 146,410 109,292
Amortization of intangibles 2,479 -- 3,385 --
Charge for acquired in-process technology -- 1,500 44,115 1,500
Merger costs -- -- -- 10,792
--------- --------- --------- ---------
Total operating expenses 143,944 109,463 372,535 264,937
--------- --------- --------- ---------
Operating income 102,439 70,983 75,944 63,096
Interest and other income, net 3,942 16,558 10,507 22,250
--------- --------- --------- ---------
Income before provision for income taxes
and minority interest 106,381 87,541 86,451 85,346
Provision for income taxes 33,800 28,921 35,172 28,164
--------- --------- --------- ---------
Income before minority interest 72,581 58,620 51,279 57,182
Minority interest in consolidated
joint venture (50) -- (321) 28
--------- --------- --------- ---------
Net income $ 72,531 $ 58,620 $ 50,958 $ 57,210
========= ========= ========= =========
Net income per share:
Basic $ 1.19 $ 0.99 $ 0.84 $ 0.98
========= ========= ========= =========
Diluted $ 1.15 $ 0.96 $ 0.81 $ 0.94
========= ========= ========= =========
Number of shares used in computation:
Basic 60,936 58,961 60,621 58,615
========= ========= ========= =========
Diluted 63,229 61,134 63,210 60,571
========= ========= ========= =========
<FN>
See accompanying notes to condensed consolidated financial statements.
</FN>
4
ELECTRONIC ARTS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
(unaudited)
Nine Months
Ended December 31,
1998 1997
--------- ---------
Operating activities:
Net income $ 50,958 $ 57,210
Adjustments to reconcile net income to net cash provided by (used in)
operating activities:
Minority interest in consolidated joint venture 321 (28)
Equity in net loss of affiliates 110 1,162
Gain on sale of affiliate -- (12,625)
Depreciation and amortization 31,145 20,393
(Gain) loss on sale of fixed assets (3,871) 480
Loss on disposition of assets related to merger -- 5,607
Gain on sale of marketable securities (1,454) (3,757)
Provision for doubtful accounts 5,428 4,061
Charge for acquired in-process technology 44,115 1,500
Change in assets and liabilities, net of acquisitions:
Receivables (176,546) (174,074)
Inventories (6,591) (14,386)
Other assets (13,434) (2,786)
Accounts payable 8,322 52,041
Accrued liabilities 83,749 64,110
Deferred income taxes 478 53
--------- ---------
Net cash provided by (used in) operating activities 22,730 (1,039)
--------- ---------
Investing activities:
Proceeds from sale of furniture and equipment 8,234 25
Proceeds from sales of marketable securities 1,818 6,824
Purchase of marketable securities -- (2,762)
Capital expenditures (95,697) (25,358)
Investment in affiliates (5,128) 17,079
Purchase of held to maturity securities -- (1,008)
Proceeds from maturity of securities 17,271 6,451
Change in short-term investments, net 117,551 (4,428)
Acquisition of Westwood Studios, Inc. (122,688) --
Acquisition of other subsidiaries, net of cash acquired (11,805) (3,225)
--------- ---------
Net cash used in investing activities (90,444) (6,402)
--------- ---------
Financing activities:
Proceeds from sales of shares through employee stock
and other plans 21,374 19,306
Tax benefit from exercise of stock options 4,063 2,789
Proceeds from minority interest investment in consolidated
joint venture 2,109 --
--------- ---------
Net cash provided by financing activities 27,546 22,095
--------- ---------
Translation adjustment 1,666 (1,134)
--------- ---------
Increase (decrease) in cash and cash equivalents (38,502) 13,520
Beginning cash and cash equivalents 215,963 141,996
--------- ---------
Ending cash and cash equivalents 177,461 155,516
Short-term investments 23,775 132,297
--------- ---------
Ending cash, cash equivalents and short-term investments $ 201,236 $ 287,813
========= =========
5
ELECTRONIC ARTS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)
(Dollars in thousands)
(unaudited)
Nine Months
Ended December 31,
1998 1997
-------------------------
Supplemental cash flow information:
Cash paid during the year for income taxes $22,325 $ 4,348
======= =======
Non-cash investing activities:
Change in unrealized appreciation of investments $ (713) $(2,115)
======= =======
See accompanying notes to condensed consolidated
financial statements.
6
ELECTRONIC ARTS INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Basis of Presentation
The condensed 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
1999 presentation.
These condensed 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, 1998 as filed with the Securities and Exchange Commission
("Commission") on June 26, 1998 and other documents filed with the Commission.
Note 2. Inventories
Inventories are stated at the lower of cost or market. Inventories at
December 31, 1998 and March 31, 1998 consisted of (in thousands):
December 31, 1998 March 31, 1998
----------------- --------------
Finished goods $25,544 $17,234
Raw materials and work in process 4,705 2,392
------- -------
$30,249 $19,626
======= =======
Note 3. Accrued Liabilities
Accrued liabilities at December 31, 1998 and March 31, 1998 consisted of (in
thousands):
December 31, 1998 March 31, 1998
----------------- --------------
Accrued expenses $ 64,667 $ 25,872
Accrued royalties 63,693 36,830
Accrued compensation and benefits 42,072 29,318
Accrued income taxes 27,853 26,095
Deferred revenue 13,606 2,797
Warranty reserve 8,456 3,462
Deferred income taxes 1,360 1,106
-------- --------
$221,707 $125,480
======== ========
7
ELECTRONIC ARTS INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(continued)
Note 4. Operations by Geographic Areas
The Company operates in one industry segment. Information about the Company's
operations in North America, Europe, Asia Pacific and Japan for the three and
nine months ended December 31, 1998 and 1997 is presented below (in thousands).
North Asia
America Europe Pacific Japan Eliminations Total
-------- -------- -------- -------- -------- --------
Three months ended December 31, 1998
- ------------------------------------
Net revenues from unaffiliated customers $302,060 $195,856 $ 13,811 $ 8,428 $ -- $520,155
Intersegment net revenues 6,792 4,799 716 -- (12,307) --
-------- -------- -------- -------- -------- --------
Total net revenues $308,852 $200,655 $ 14,527 $ 8,428 $(12,307) $520,155
======== ======== ======== ======== ======== ========
Operating income $ 35,914 $ 63,415 $ 3,053 $ 57 $ -- $102,439
Identifiable assets $569,275 $326,544 $ 20,234 $ 20,437 $ -- $936,490
Nine months ended December 31, 1998
- -----------------------------------
Net revenues from unaffiliated customers $558,255 $328,382 $ 30,235 $ 27,267 $ -- $944,139
Intersegment net revenues 14,008 9,643 716 12 (24,379) --
-------- -------- -------- -------- -------- --------
Total net revenues $572,263 $338,025 $ 30,951 $ 27,279 $(24,379) $944,139
======== ======== ======== ======== ======== ========
Operating income $ 17,289 $ 52,372 $ 3,430 $ 2,853 $ -- $ 75,944
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
The increase in the operating income in Europe and decrease in the operating
income in North America for the three and nine months ended December 31, 1998 as
compared to the prior year periods was attributable to the allocation of certain
research and development expenses relative to a new worldwide cost sharing
agreement.
8
ELECTRONIC ARTS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
Note 5. Comprehensive Income
Other comprehensive income includes primarily foreign currency translation
adjustments and unrealized gains (losses) on investments. Total comprehensive
income for the three and nine months ended December 31, 1998 and 1997 was as
follows (in thousands):
Three Months Ended Nine Months Ended
December 31, December 31,
1998 1997 1998 1997
-----------------------------------------------------------
Net income $ 72,531 $ 58,620 $ 50,958 $ 57,210
-------- -------- -------- --------
Other comprehensive income (loss), net of tax
Unrealized depreciation of investments (27) (2,648) (257) (1,365)
Foreign currency translation adjustments (1,505) 46 1,147 (1,133)
-------- -------- -------- --------
Total other comprehensive income (loss) (1,532) (2,602) 890 (2,498)
-------- -------- -------- --------
Total comprehensive income $ 70,999 $ 56,018 $ 51,848 $ 54,712
======== ======== ======== ========
Note 6. Acquisitions
In July 1998, the Company acquired ABC Software AG and ABC Software GmbH
(collectively "ABC"), independent distributors of entertainment, edutainment and
application software in Switzerland and Austria, respectively, for approximately
$9,466,000 in cash (net of cash acquired of $5,099,000) and $570,000 in other
consideration. The transaction has been accounted for under the purchase method.
The excess purchase price over the fair value of the net tangible assets
acquired of approximately $7,377,000 was allocated to goodwill and is being
amortized over 7 years.
In September 1998, the Company completed the acquisition of Westwood Studios,
Inc. and certain assets of the Irvine, California - based Virgin Studio
(collectively "Westwood") for approximately $122,688,000 in cash, including
transaction expenses. The preliminary allocation of the excess purchase price
over the net tangible liabilities assumed was $129,982,000 of which, based on
management's estimates prepared in conjunction with a third party valuation
consultant, $41,836,000 was allocated to purchased in-process research and
development and $88,146,000 was allocated to other intangible assets. Amounts
allocated to other intangibles include franchise trade names of $32,357,000,
existing technology of $6,510,000, workforces of $1,680,000 and other goodwill
of $47,599,000 and are being amortized over lives ranging from two to twelve
years. Purchased in-process research and development includes the value of
products in the development stage that are not considered to have reached
technological feasibility or to have alternative future use. Accordingly, this
non-recurring item was expensed in the Consolidated Statement of Operations upon
consummation of the acquisition. The non-recurring charge for in-process
research and development reduced basic earnings per share by approximately $0.59
in the fiscal second quarter of 1999. The results of operations of Westwood and
the estimated fair value of assets acquired and liabilities assumed are included
in the Company's financial statements from the date of acquisition.
9
ELECTRONIC ARTS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
In connection with the Westwood acquisition, the purchase price has been
allocated to the assets and liabilities assumed based upon the fair values on
the date of acquisition, as follows (in thousands):
Current assets $ 3,091
Property and equipment 3,257
In-process technology 41,836
Other intangible assets 88,146
Current liabilities (13,642)
---------
Total purchase price $ 122,688
=========
Note 7. Earnings Per Share
The following summarizes the computation of Basic Earnings Per Share ("EPS") and
Diluted EPS. 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 (in thousands, except per share amounts):
Three Months Ended Nine Months Ended
December 31, December 31,
1998 1997 1998 1997
------------- ------------- --------------- --------------
Net income $72,531 $58,620 $50,958 $57,210
Shares used to compute net income per share:
Weighted average common shares 60,936 58,961 60,621 58,615
Dilutive stock options 2,293 2,173 2,589 1,956
------- ------- ------- -------
Dilutive potential common shares 63,229 61,134 63,210 60,571
======= ======= ======= =======
Net income per share:
Basic $ 1.19 $ 0.99 $ 0.84 $ 0.98
Diluted $ 1.15 $ 0.96 $ 0.81 $ 0.94
Excluded from the above computation of weighted-average shares for diluted EPS
were options to purchase 2,228,208 and 391,693 shares of common stock during the
three and nine months ended December 31, 1998, respectively, and 409,106 and
1,367,334 shares during the three and nine months ended December 31, 1997,
respectively, as the options'exercise price were greater than the average market
price of the common shares.
10
ELECTRONIC ARTS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
Note 8. New Accounting Pronouncements
In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards No. 133 ("SFAS 133") "Accounting for
Derivative Instruments and Hedging Activities", which establishes accounting and
reporting standards for derivative instruments and hedging activities. SFAS 133
is effective for all fiscal quarters beginning after June 15, 1999. The Company
is determining the effect of SFAS 133 on its financial statements.
In March 1998, the American Institute of Certified Public Accountants issued
Statement of Position ("SOP 98-1"), Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use. SOP 98-1 requires that certain
costs related to the development or purchase of internal-use software be
capitalized and amortized over the estimated useful life of the software. SOP
98-1 is effective for financial statements issued for fiscal years beginning
after December 15, 1998. The Company does not expect the adoption of SOP 98-1 to
have a material impact on its results of operations.
In December 1998, AcSEC issued SOP 98-9, "Software Revenue Recognition, with
Respect to Certain Arrangements," which required recognition of revenue using
the "residual method" in a multiple element arrangement when fair value does not
exist for one or more of the undelivered elements in the arrangement. Under the
"residual method," the total fair value of the undelivered elements is deferred
and subsequently recognized in accordance with SOP 97-2.
The Company does not expect the adoption of SOP 98-9 will have a material impact
on its results of operations.
11
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 24 to 28, as well as in
the Company's Annual Report on Form 10-K for the fiscal year ended March 31,
1998 as filed with the Securities and Exchange Commission on June 26, 1998 and
other documents filed with the Commission. 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,
1998 1997 % change
--------------------------------------------------------------------------
Consolidated Net Revenues
Three Months Ended $520,155,000 $391,245,000 32.9%
Nine Months Ended $944,139,000 $704,785,000 34.0%
North America Net Revenues
Three Months Ended $302,060,000 $230,079,000 31.3%
as a percentage of net revenues 58.1% 58.8%
Nine Months Ended $558,255,000 $406,930,000 37.2%
as a percentage of net revenues 59.1% 57.7%
International Net Revenues
Three Months Ended $218,095,000 $161,166,000 35.3%
as a percentage of net revenues 41.9% 41.2%
Nine Months Ended $385,884,000 $297,855,000 29.6%
as a percentage of net revenues 40.9% 42.3%
The Company derives revenues primarily from shipments of entertainment software,
which includes EA Studio Compact Disk ("CD") products for dedicated
entertainment systems ("CD-video games"), EA Studio CD personal computer
products ("PC-CD"), EA Studio cartridge products and Affiliated Label ("AL")
products that are published by third parties and distributed by EA. The Company
also derives revenues from licensing of EA Studio products and AL products to
hardware companies ("OEMs") and online subscription revenues.
North America net revenues increased $71,981,000, or 31.3%, and $151,325,000, or
37.2%, for the three and nine months ended December 31, 1998, respectively,
compared to the same periods last year due to increased sales of PlayStation and
Nintendo 64 ("N64") titles as well as the distribution of Affiliated Label
titles. For the three and nine months ended December 31, 1998, PlayStation net
revenues for North America increased $32,750,000 and $69,778,000, respectively,
in comparison to the same periods last year due to more titles released in the
third fiscal quarter compared to the same period last year including Westwood
titles acquired in September 1998, the greater installed base of
12
PlayStation consoles and a larger market for PlayStation products. Total North
America N64 revenues increased $9,827,000 and $59,777,000 for the three and nine
month periods, respectively, as compared to the same periods last year due to
more titles released in the current year as well as a larger N64 market.
Affiliated Label revenues increased $40,262,000 and $39,623,000 for the three
and nine months ended December 31, 1998, respectively, primarily due to the
distribution of products published by Square EA and Accolade. Though North
America's net revenues are expected to continue to grow in fiscal 1999, the
Company may not maintain these growth rates.
International net revenues increased $56,929,000, or 35.3%, and $88,029,000, or
29.6%, for the three and nine months ended December 31, 1998, respectively,
compared to the same periods last year. The increase in international revenues
was primarily attributable to higher sales in Europe. Total net revenues in
Europe were $195,856,000 and $328,382,000 for the three and nine months ended
December 31, 1998, respectively, compared to $140,778,000 and $247,979,000 for
the same respective periods last year. European revenues increased due to a
larger PlayStation market as well as sales of PlayStation titles including FIFA
99, released in the third fiscal quarter and World Cup 98 released in the first
fiscal quarter.
Total net revenues in Japan were $8,428,000 and $27,267,000 for the three and
nine months ended December 31, 1998, respectively, compared to $5,318,000 and
$16,031,000 for the same respective periods last year. The increase in Japan was
due to strong sales of PlayStation titles including World Cup 98 and Theme
Aquarium, for the three months, and FIFA: Road to World Cup 98 for the nine
months ended December 31, 1998, respectively.
Total net revenues in the Asia Pacific region decreased by 8.4% to $13,811,000
and 10.7% to $30,235,000 for the three and nine months ended December 31, 1998
compared to the same periods last year due to the weakness in Asian currencies
and a decrease in Affiliated Label product sales.
EA Studio Net Revenues:
32-bit Video Game Product Net Revenues
December 31, December 31,
1998 1997 % change
-------------------------------------------------------------
Three Months Ended $ 222,364,000 $ 152,021,000 46.3%
as a percentage of net revenues 42.7% 38.9%
Nine Months Ended $ 416,835,000 $ 286,108,000 45.7%
as a percentage of net revenues 44.1% 40.6%
The Company released six 32-bit CD-video game products during the third quarter
of fiscal 1999 comprised solely of titles for the PlayStation, including FIFA 99
and Knockout Kings, compared to four PlayStation and three Saturn titles for the
same period last year. The increase in 32-bit sales for the three and nine
months ended December 31, 1998 compared to the prior year was attributable to
the greater installed base of PlayStation consoles, more titles released in the
third fiscal quarter as compared to the same period last year, the related
release of key titles for this platform during the quarter and strong catalog
sales partially offset by a decline in Saturn revenues.
13
For the three and nine months ended December 31, 1998, PlayStation sales were
$222,271,000 and $416,118,000, respectively, compared to $146,526,000 and
$271,188,000 in the comparable prior year periods. For the three and nine months
ended December 31, 1998, PlayStation sales grew 51.7% and 53.4%, respectively.
The Company expects revenues from PlayStation products to continue to grow in
fiscal 1999, but as revenues for these products increase, the Company does not
expect to maintain these growth rates.
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.
Personal Computer CD Product Net Revenues
December 31, December 31,
1998 1997 % change
-------------------------------------------------------------
Three Months Ended $ 104,964,000 $ 101,054,000 3.9%
as a percentage of net revenues 20.2% 25.8%
Nine Months Ended $ 186,473,000 $ 188,474,000 (1.1%)
as a percentage of net revenues 19.8% 26.7%
The Company released ten PC-CD titles in the third quarter of the current fiscal
year for the IBM personal computer and compatibles including FIFA 99, compared
to thirteen for the same period last year.
Sales of PC-CD products for the three months ended December 31, 1998 increased
3.9% compared to the prior year as increased sales in Europe, primarily due to
the releases of FIFA 99 and Populous - The Beginning, were partially offset by a
decrease in North America due to fewer product releases compared to the prior
year. The decrease in sales of PC-CD products for the nine months ended December
31, 1998 is primarily attributable to a decline in sales in North America, Asia
Pacific and Japan due to fewer product releases compared to the prior year
partially offset by an increase in sales in Europe due to sales of World Cup 98
and FIFA 99.
64-bit Video Game Product Net Revenues
December 31, December 31,
1998 1997 % change
---------------------------------------------------------------
Three Months Ended $ 57,168,000 $ 47,514,000 20.3%
as a percent of net revenues 11.0% 12.1%
Nine Months Ended $ 121,702,000 $ 50,547,000 140.8%
as a percent of net revenues 12.9% 7.2%
The Company released four N64 titles in the third quarter of the current fiscal
year compared to two releases in the comparable prior year period. For the three
and nine months ended December 31, 1998, the increase in N64 revenues was
primarily due to more title releases for this platform compared to the same
periods last year and a larger
14
N64 market. Sales of N64 products are expected to continue to grow in fiscal
1999, but as revenues for these products increase, the Company does not expect
to maintain these growth rates.
Under the terms of the N64 Agreement, the Company engages Nintendo to
manufacture its N64 cartridges for distribution by the Company. Accordingly, the
Company has little ability to control its supply of N64 cartridges or the timing
of their delivery.
In connection with the Company's purchases of N64 cartridges for distribution in
North America, Nintendo requires the Company to provide 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 of N64
cartridges. Because of these and other factors, the carrying of an inventory of
cartridges entails significant capital and risk. See Hardware Companies, below.
Affiliated Label Net Revenues
December 31, December 31,
1998 1997 % change
-------------------------------------------------------------
Three Months Ended $ 128,209,000 $ 79,027,000 62.2%
as a percentage of net revenues 24.6% 20.2%
Nine Months Ended $ 199,688,000 $ 150,923,000 32.3%
as a percentage of net revenues 21.2% 21.4%
The increase in Affiliated Label net revenues for the three and nine months
ended December 31, 1998 was primarily due to distribution of products published
by Square EA and Accolade in North America, and the acquisition of ABC Software.
Cost of Goods Sold
December 31, December 31,
1998 1997 % change
-------------------------------------------------------------
Three Months Ended $ 273,772,000 $ 210,799,000 29.9%
as a percentage of net revenues 52.6% 53.9%
Nine Months Ended $ 495,660,000 $ 376,752,000 31.6%
as a percentage of net revenues 52.5% 53.5%
The decrease in cost of goods sold as a percentage of net revenues for the three
and nine months ended December 31, 1998 compared to the same periods last year
was due to lower professional and celebrity royalties, as a percent of net
revenues, partially offset by higher manufaturing royalties and product costs
associated with increased PlayStation and N64 sales.
15
Marketing and Sales
December 31, December 31,
1998 1997 % change
-------------------------------------------------------------
Three Months Ended $ 56,451,000 $ 45,027,000 25.4%
as a percentage of net revenues 10.9% 11.5%
Nine Months Ended $ 123,618,000 $ 100,695,000 22.8%
as a percentage of net revenues 13.1% 14.3%
The increase in marketing and sales expenses for the three and nine months ended
December 31, 1998 was primarily attributable to increased television and print
advertising to support new releases and increased cooperative advertising
associated with higher revenues in North America and Europe 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. Increases were partially offset by savings
attributable to the acquisition of Maxis, Inc. in July, 1997.
General and Administrative
December 31, December 31,
1998 1997 % change
-------------------------------------------------------------
Three Months Ended $ 23,195,000 $ 17,578,000 32.0%
as a percentage of net revenues 4.5% 4.5%
Nine Months Ended $ 55,007,000 $ 42,658,000 28.9%
as a percentage of net revenues 5.8% 6.1%
The increase in general and administrative expenses for the three and nine
months ended December 31, 1998 was due primarily to an increase in headcount and
occupancy costs to support the increase in growth in North America and Europe
operations, including additional offices opened in Europe, including
Switzerland and Austria, compared to the same periods last year.
Research and Development
December 31, December 31,
1998 1997 % change
-------------------------------------------------------------
Three Months Ended $ 61,819,000 $ 45,358,000 36.3%
As a percentage of net revenues 11.9% 11.6%
Nine Months Ended $ 146,410,000 $ 109,292,000 34.0%
As a percentage of net revenues 15.5% 15.5%
The increase in research and development expenses for the three and nine months
ended December 31, 1998 was due to additional headcount related expenses
attributable to the acquisition of Westwood Studios Inc. and certain assets of
the Irvine, California-based Virgin Studio (collectively "Westwood") in
September 1998 and Tiburon Entertainment, Inc. in April 1998, higher development
costs per title, as products are including more content and are more complex and
time consuming to develop, and an increase in development for Ultima Online.
16
Charge for Acquired In-Process Technology
December 31, December 31,
1998 1997 % change
--------------------------------------------------------
Three Months Ended $ -- $ 1,500,000 N/M
as a percentage of net revenues N/A 0.4%
Nine Months Ended $44,115,000 $ 1,500,000 N/M
as a percentage of net revenues 4.7% 0.2%
In connection with the purchase of Westwood in September 1998, the Company
allocated $41,836,000 of the $122,688,000 purchase price to in-process research
and development projects. This preliminary allocation represents the estimated
fair value based on risk-adjusted cash flows related to the incomplete research
and development projects. At the date of acquisition, this amount was expensed
as a non-recurring charge as the in-process technology had not yet reached
technological feasibility and had no alternative future uses. Westwood had three
major PC-CD projects in progress at the time of the acquisition including two in
the best-selling franchise Command and Conquer and one in the critically
acclaimed Lands of Lore series. As of the acquisition date, costs to complete
the Westwood projects acquired were expected to be approximately $9.1 million,
$10.6 million and $1.0 million in fiscal 1999, 2000 and 2001, respectively. The
Company believes there has been no significant changes to these estimates as of
December 31, 1998. The Company currently expects to complete the development of
these projects at various dates through fiscal 2001 and to publish the products
upon completion.
The nature of the efforts required to develop the acquired in-process technology
into commercially viable products principally relate to the completion of all
planning, designing and testing activities necessary to establish that the
product can be produced to meet its design requirements including functions,
features and technical performance requirements. Though the Company currently
expects that the acquired in process technology will be successfully developed,
there can be no assurance that commercial or technical viability of these
products will be achieved. Furthermore, future developments in the entertainment
software industry, changes in computer or videogame console technology, changes
in other product offerings or other developments may cause the Company to alter
or abandon these plans.
The value assigned to purchased in-process technology was determined by
estimating the completion percentage of research and development efforts at the
acquisition date, forecasting risk adjusted revenues considering the completion
percentage, estimating the resulting net cash flows from the projects and
discounting the net cash flows to their present values. The completion
percentages were estimated based on cost incurred to date, importance of the
completed development tasks and the elapsed portion of the total project time.
The revenue projection used to value the in-process research and development is
based on unit sales forecasts for worldwide sales territories and adjusted to
consider only the revenue related to development achievements completed at the
acquisition date. Net cash flow estimates include cost of goods sold and sales,
marketing and general and administrative expenses and taxes forecasted based on
historical operating characteristics. In addition, net cash flow estimates were
adjusted to allow for fair return on working capital and fixed assets, charges
for franchise and technology leverage and return on other intangibles.
Appropriate risk adjusted discount rates ranging from 20% to 22.5% were used to
discount the net cash flows back to their present value.
17
The remaining identified intangibles will be amortized on a straight-line basis
over over two to twelve years based on expected useful lives of franchise
tradenames, existing products and technologies, retention of workforce, and
other intangible assets. The Company expects to finalize its cash flow estimates
by March, 1999. If these projects are not successfully developed, the Company
may not realize the value assigned to the in-process research and development
projects. In addition, the value of other acquired intangible assets may also
become impaired.
Additionally, for the nine months ended December 31, 1998, the charge for
in-process research and development also included write-offs associated with the
acquisition of two software development companies in the first quarter of fiscal
1999.
For the three and nine months ended December 31, 1997, the Company incurred a
charge of $1,500,000 for acquired in-process technology in connection with the
acquisition of the remaining 35% minority ownership interest in Electronic Arts
Victor, Inc. in December 1997. This charge was made after the Company concluded
that the in-process technology had no alternative future use after taking into
consideration the potential usage of the software in different products and
resale of the software.
Amortization of Intangibles
December 31, December 31,
1998 1997 % change
----------------------------------------------------
Three Months Ended $ 2,479,000 $ -- N/M
as a percentage of net revenues 0.5% N/A
Nine Months Ended $ 3,385,000 $ -- N/M
as a percentage of net revenues 0.4% N/A
Amortization of intangibles results from the acquisitions of Westwood and ABC
Software in the second quarter of fiscal 1999.
Interest and Other Income, Net
December 31, December 31,
1998 1997 % change
--------------------------------------------------------------
Three Months Ended $ 3,942,000 $ 16,558,000 (76.2%)
as a percentage of net revenues 0.8% 4.2%
Nine Months Ended $ 10,507,000 $ 22,250,000 (52.8%)
as a percentage of net revenues 1.1% 3.2%
For the three and nine months ended December 31, 1998, the decrease in interest
and other income, net, was primarily attributable to the sale of the Company's
50% ownership interest in Creative Wonders LLC in December 1997. The sale
resulted in a gain of $12,625,000 in the prior fiscal year.
18
Income Taxes
December 31, December 31,
1998 1997 % change
-----------------------------------------------------------------
Three Months Ended $ 33,800,000 $ 28,921,000 16.9%
Effective tax rate 31.8% 33.0%
Nine Months Ended $ 35,172,000 $ 28,164,000 24.9%
effective tax rate 40.7% 33.0%
The Company's effective tax rate for the nine months ended December 31, 1998 was
negatively affected as there was no tax benefit recorded for a portion of the
charges related to the acquired in-process technology. Excluding the effect of
these charges, the effective tax rate for the three and nine months ended
December 31, 1998 would have been 32.0% as compared to a 33.0% tax rate in the
corresponding prior year periods. The lower rate of 32.0% results primarily from
reinstatement of the federal research and experimental credit.
Minority Interest in Consolidated Joint Venture
December 31, December 31,
1998 1997 % change
-----------------------------------------------------
Three Months Ended $ (50,000) $ -- N/M
as a percentage of net revenues 0.0% N/A
Nine Months Ended $ (321,000) $28,000 N/M
as a percentage of net revenues 0.0% 0.0%
In the first quarter of fiscal 1999, the Company formed EA Square KK which is
seventy percent owned by the Company and thirty percent owned by Square Co. Ltd.
("Square"), a third party video game console software publisher in Japan.
Minority interest for the three and nine months ended December 31, 1998
represents Square's 30% interest in the net income of EA Square KK.
For the three and nine months ended December 31, 1997, the minority interest
represented the 35% interest in Electronic Arts Victor ("EAV") owned by Victor
Entertainment Industries, Inc. ("VEI"). The Company acquired the remaining 35%
minority ownership interest in EAV held by VEI in December 1997.
19
Net Income
December 31, December 31,
1998 1997 % change
--------------------------------------------------------------
Three Months Ended $ 72,531,000 $ 58,620,000 23.7%
as a percentage of net revenues 13.9% 15.0%
Nine Months Ended $ 50,958,000 $ 57,210,000 (10.9%)
as a percentage of net revenues 5.4% 8.1%
Net income for the three and nine months ended December 31, 1998, as compared to
the prior year periods, increased, excluding one-time charges, due to higher
revenues and gross profits, offset by higher operating expenses. For the three
months ended December 31, 1997, net income included a one-time gain on sale of
Creative Wonders, LLC in the amount of $8,459,000, net of taxes. For the nine
months ended December 31, 1998, net income included one-time charges for
acquired in-process technology of $37,506,000, net of taxes.
20
Liquidity and Capital Resources
As of December 31, 1998, the Company's working capital was $323,809,000 compared
to $408,098,000 at March 31, 1998. Cash, cash equivalents and short-term
investments decreased by approximately $173,324,000 during the nine months ended
December 31, 1998 as the Company used $95,697,000 in capital expenditures,
primarily related to new campus facilities in Canada and Europe, and
$134,493,000 in the acquisition of new subsidiaries offset by proceeds from the
Company's employee stock programs and generated $22,730,000 in cash from
operations.
The Company's principal source of liquidity is $201,236,000 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.
Year 2000 Readiness Disclosure
Background of Year 2000 Issues
Many currently installed computer systems and software products are
unable to distinguish between twentieth century dates and twenty-first century
dates because such systems may have been developed using two digits rather than
four to determine the applicable year. For example, computer programs that have
date-sensitive software may recognize a date using "00" as the year 1900 rather
than the year 2000. This error could result in system failures or
miscalculations causing disruptions of operations, including, among other
things, a temporary inability to process transactions, send invoices or engage
in similar normal business activities. As a result, many companies' software and
computer systems may need to be upgraded or replaced to comply with such "Year
2000" requirements.
State of Readiness
The Company's business is dependent on the operation of numerous
systems that could potentially be impacted by Year 2000 related problems. Those
systems include, among others: hardware and software systems used by the Company
to deliver products to its customers communications networks such as the
Internet and private intranets, which the Company depends on to receive orders
from products to its customers; the internal systems of the Company's customers
and suppliers; products sold to customers; the hardware and software systems
used internally by the Company in the management of its business; and
non-information technology systems and services used by the Company in the
management of its business, such as power, telephone systems and building
systems.
Based on an analysis of the systems potentially impacted by conducting
business in the twenty-first century, the Company is applying a phased approach
to making such systems, and accordingly, the Company's operations, ready for the
year 2000. Beyond awareness of the issues and scope of systems involved, the
phases of activities in progress include: an assessment of specific underlying
computer systems, programs and hardware; renovation replacement or redeployment
of Year 2000 non-compliant technology; validation and testing of technologically
compliant Year 2000 solutions; and implementation of the Year 2000 compliant
systems.
As a third party providing software products, the Company is dependent
on the hardware and software products used to deliver such products and
services. If such products are inoperable due to Year 2000 issues, the Company's
business, financial condition and results of results operations could be
adversely affected. An inventory of the Company's internal business
21
systems has been completed and planned software and hardware upgrades to ensure
Year 2000 compliance are in process. The upgrades to these systems are expected
to be completed by June, 1999.
Costs
To date the Company has not incurred significant costs directly related
to Year 2000 issues, even in cases where non-compliant information technology
systems were redeployed or replaced.
The Company believes that future expenditures to upgrade internal
systems and applications will not have a material adverse effect on its
business, financial condition and results of operations and are primarily
included within the Company's ongoing system development plan. In addition,
while the potential costs of redeploying personnel and of any delays in
implementing other projects is not known, the costs are anticipated to be
immaterial.
Risks of the Year 2000 Issues
The Company's financial information systems include an integrated suite
of business applications developed and supported by Oracle Corporation. These
applications systems are in place and currently support daily operations in the
United States. In Europe, the Company is in the process of upgrading or
replacing these application systems and expects to substantially complete this
process by April, 1999. Based on representations made by Oracle Corporation and
upon limited tests by the Company, the Company believes these systems to be Year
2000 compliant.
The Company believes its software products are Year 2000 compliant;
however, success of the Company's Year 2000 compliance efforts may depend on the
success of its customers dealing with their Year 2000 issues. Customer
difficulties with Year 2000 issues might require the Company to devote
additional resources to resolve underlying problems. Failures of the Company's
and/or third parties' computer systems could have a material adverse impact on
the Company's ability to conduct business. For example, a significant percentage
of purchase orders received from the Company's customers are computer generated
and electronically transmitted. In addition, the Year 2000 could affect the
ability of consumers to use the PC based products sold by the Company. If the
computer systems on which the consumers use the Company's products are not Year
2000 compliant, such noncompliance could affect the consumers ability to use
such products.
Contingency Plans
The Company continues to assess certain of its Year 2000 exposure areas
in order to determine what additional steps beyond those identified by the
Company's internal review in the United States are advisable. The Company is
currently developing a contingency plan for handling Year 2000 problems that are
not detected and corrected prior to their occurrence. The Company expects this
plan will be completed by June 30, 1999. The Company believes that the systems,
which represent the principal exposures, have been identified, and to the extent
necessary, are in the process of being modified to become Year 2000 compliant.
Additionally, the Company will be conducting tests of its principal business
systems to verify that those systems are Year 2000 compliant. Any failure of the
Company to address any unforeseen Year 2000 issue could adversely affect the
Company's business, financial condition and results of operations.
22
Euro Conversion
On January 1, 1999, eleven of the fifteen member countries of the European Union
established fixed conversion rates between their existing currencies (the
"legacy currency") and the one common legal currency known as the "Euro". From
January 1, 1999 through June 30, 2002 the countries will be able to use their
legacy currencies or the Euro to transact business. By July 1, 2002, at the
latest, the conversion to the Euro will be complete at which time the legacy
currencies will no longer be legal tender. The conversion to the Euro will
eliminate currency exchange rate risk between the member countries.
The Company does not anticipate any material impact from the Euro conversion on
its financial information systems which currently accommodate multiple
currencies. Computer software changes necessary to comply with the Year 2000
issue are generally compliant to the Euro conversion issue. Due to numerous
uncertainties, the Company cannot reasonably estimate the effect that the Euro
conversion issue will have on its pricing or market strategies, and the impact,
if any, it will have on its financial condition and results of operations.
23
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 packaged goods market is crowded with a
large number of titles competing for limited retail shelf space. 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, in the packaged goods market, 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 content and 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. CD-ROM products frequently include more content and are
more complex, time-consuming and costly to develop and, accordingly, cause
additional development and scheduling risk than earlier generation products. For
example, SimCity 3000, the follow on product to SimCity 2000, was expected to
ship in fiscal 1998, at the time of the merger with Maxis. Due to additional
development delays, this product did not ship until the fourth fiscal quarter of
1999. Also, Tiberian Sun, which was expected to ship in fiscal 1999 at the time
of the acquisition of Westwood Studios, will not be released until fiscal 2000
due to development delays. 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. The Company's revenues and earnings are dependent on its
ability to meet its product release schedule. 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
24
span of older hardware platforms, and the Company's ability to accurately
predict these factors with respect to each platform. In some cases, the Company
will have expended a large amount of development and marketing resources on
products designed for new video game 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, Sega has released its next
generation console platform, Dreamcast, in Japan in December 1998, and it is
expected to be released in North America in late calendar 1999. The market
acceptance of this platform may affect the revenue growth on other platforms for
which the Company currently develops.
Multiplayer Online Gaming. While the Company does not currently derive
significant revenues from online games, the Company believes that multiplayer
online gaming will become a more significant factor in the Company's business
and in the interactive gaming business generally in the future. Online gaming,
and particularly multiplayer online gaming such as the Company's Ultima Online
product, has at least four general areas of risk not currently associated with
most packaged good sales. First, the speed and reliability of the internet and
the performance of the players' internet service provider are not controlled by
the Company but impact game performance. Second, in "massively multiplayer"
games such as Ultima Online, unanticipated player conduct significantly affects
the performance of the game, and social issues raised by players' conduct
frequently determine player satisfaction. The Company's ability to effectively
proctor such games is uncertain. Third, the current business model is as yet
experimental and maybe unsustainable; whether revenues will continue to be
sufficient to maintain the significant support, service and product enhancement
demands of online users is uncertain. The Company has little experience in
pricing strategies for online games or in predicting usage patterns of its
customers. Finally, the legal standards that may apply to online products are
uncertain; though the action against the Company alleging defects in Ultima
Online was dismissed, regulation of the internet and the content it carries is
regularly proposed by various legislators, and piracy of online games is
difficult to prosecute under existing intellectual property laws. The viability
of this segment, generally, and the Company's ability to compete in the segment
will depend significantly on these and other factors outside the Company's
control.
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 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 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
25
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.
Gross Margins. Though gross margins for the Company's products as a whole
increased for the nine months ended December 31, 1998, the Company expects that
margins may fluctuate in any particular period and may decline for several
reasons. First, the mix in sales of the Company's products has a significant
effect on gross margins. As the Company releases more N64 products, which carry
significantly lower margins due to high cost of goods, overall gross margins may
decline. Similarly, if the proportion of AL revenues increases in relation to
other revenues, margins may also decline. Further, gross margins continue to be
affected by increases in professional and celebrity license fees and royalties.
Also, while the costs of development of new products for 32-bit and 64-bit
systems have increased, overall costs of goods are not declining significantly.
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, pays
manufacturing royalties to hardware companies. Additionally, retailers 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 expenditures for
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
addition, an increasing number of companies are competing for access to these
channels. The Company's arrangements with its
26
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.
Employees. Competition for employees in the interactive software business
continues to be 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 decreased in fiscal 1998 and for the nine months ended
December 31, 1998 as compared to prior periods, many key 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,
1998 and the fiscal year ended March 31, 1998, international net revenues
comprised 41% and 43% of total consolidated net revenues, respectively. The
Company expects foreign sales to continue to account for a significant 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. The Company has a number of equity investments in
affiliates, including small developers, such as Firaxis; other publishers, such
as Accolade, Inc., The 3DO Company and NovaLogic, Inc.; and new ventures such as
Mpath Interactive. Additionally, the Company has a minority investment in Square
Electronic Arts, LLC, a joint venture between the Company and Square Co., Ltd.
These companies are generally small and may not have significant financial
resources. Financial difficulties for any of these companies could cause a
reduction in the value of the Company's investment.
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 fiscal year ended March 31, 1998 the price per share of the Company's
common stock ranged from $20.13 to $46.94 and from $33.88 to $56.00 during the
nine months ended December 31, 1998.
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 during the quarters ending
June and September.
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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.
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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: None
(b) Reports on Form 8-K: None
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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.
ELECTRONIC ARTS INC.
(Registrant)
/s/E. STANTON MCKEE
-------------------
DATED: E. STANTON MCKEE
February 12, 1998 Executive Vice President and
Chief Financial and Administrative Officer
(Principal Accounting Officer)
30