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 September 30, 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 November 11,1998
--------------------- ----------------
$0.01 par value per share 60,967,520
<PAGE>
ELECTRONIC ARTS INC. AND SUBSIDIARIES
INDEX
Part I - Financial Information Page
- ------------------------------ ----
Item 1. Condensed Consolidated Financial Statements
Condensed Consolidated Balance Sheets at
September 30, 1998 and March 31, 1998 3
Condensed Consolidated Statements of Operations for
the Three Months Ended September 30, 1998 and 1997
and the Six Months Ended September 30, 1998 and 1997 4
Condensed Consolidated Statements of Cash Flows for
the Six Months Ended September 30, 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
<PAGE>
PART I - FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
<TABLE>
ELECTRONIC ARTS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(Dollars in thousands)
(unaudited)
<CAPTION>
ASSETS
September 30, March 31,
1998 1998
------------------------------
<S> <C> <C>
Current assets:
Cash and short-term investments $160,339 $374,560
Marketable securities 2,727 3,721
Receivables, less allowances of $56,543 and $51,575, respectively 202,250 139,374
Inventories 26,113 19,626
Other current assets 76,989 52,530
-------- --------
Total current assets 468,418 589,811
Property and equipment, net 157,747 105,095
Long-term investments 24,200 24,200
Investments in affiliates 27,607 20,541
Intangibles and other assets 101,349 6,034
-------- --------
$779,321 $745,681
======== ========
LIABILITIES, MINORITY INTEREST AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $78,108 $56,233
Accrued liabilities 134,889 125,480
-------- --------
Total current liabilities 212,997 181,713
Minority interest in consolidated joint venture 2,480 -
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 60,831,152 and 60,159,601, respectively 608 602
Paid-in capital 253,316 234,294
Retained earnings 308,967 330,540
Accumulated other comprehensive income (loss) 953 (1,468)
-------- --------
Total stockholders' equity 563,844 563,968
-------- --------
$779,321 $745,681
======== ========
<FN>
See accompanying notes to condensed consolidated financial statements.
</FN>
</TABLE>
3
<PAGE>
<TABLE>
ELECTRONIC ARTS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(unaudited)
<CAPTION>
Three Months Ended Six Months Ended
September 30, September 30,
1998 1997 1998 1997
-------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Net revenues $245,763 $189,828 $423,984 $313,540
Cost of goods sold 134,299 103,641 221,888 165,953
------- ------- ------- -------
Gross profit 111,464 86,187 202,096 147,587
------- ------- ------- -------
Operating expenses:
Marketing and sales 33,523 29,032 67,167 55,668
General and administrative 16,395 13,191 31,812 25,080
Research and development 48,349 36,252 84,591 63,934
Amortization of intangibles 906 - 906 -
Charge for acquired in-process technology 41,836 - 44,115 -
Merger costs - 10,792 - 10,792
------- ------- ------- -------
Total operating expenses 141,009 89,267 228,591 155,474
------- ------- ------- -------
Operating loss (29,545) (3,080) (26,495) (7,887)
Interest and other income, net 3,750 3,142 6,565 5,692
------- ------- ------- -------
Income (loss) before provision for income
taxes and minority interest (25,795) 62 (19,930) (2,195)
Provision (benefit) for income taxes (563) 21 1,372 (757)
------- ------- ------- -------
Income (loss) before minority interest (25,232) 41 (21,302) (1,438)
Minority interest in consolidated
joint venture (41) - (271) 28
------- ------- ------- -------
Net income (loss) (25,273) $ 41 $(21,573) $ (1,410)
======= ======= ======= =======
Net income (loss) per share:
Basic $ (0.42) $ 0.00 $ (0.36) $ (0.02)
======= ======= ======= =======
Diluted $ (0.42) $ 0.00 $ (0.36) $ (0.02)
======= ======= ======= =======
Number of shares used in computation:
Basic 60,642 58,528 60,471 58,427
======= ======= ======= =======
Diluted 60,642 60,636 60,471 58,427
======= ======= ======= =======
<FN>
See accompanying notes to condensed consolidated financial statements.
</FN>
</TABLE>
4
<PAGE>
<TABLE>
ELECTRONIC ARTS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
(unaudited)
<CAPTION>
Six Months
Ended September 30,
1998 1997
-------------- --------------
<S> <C> <C>
Operating activities:
Net loss $(21,573) $ (1,410)
Adjustments to reconcile net loss to net cash used in operating
activities:
Minority interest in consolidated joint venture 271 (28)
Equity in net (income) loss of affiliates (88) 953
Depreciation and amortization 15,720 13,818
Loss on sale of fixed assets 335 84
Loss on disposition of assets related to merger - 5,607
Gain on sale of marketable securities (1,454) (2,070)
Provision for doubtful accounts 1,966 1,104
Charge for acquired in-process technology 44,115 -
Change in assets and liabilities, net of acquisitions:
Receivables (60,684) (40,874)
Inventories (2,455) (2,426)
Other assets (19,967) (7,195)
Accounts payable 15,849 11,535
Accrued liabilities (2,783) (2,558)
Deferred income taxes 162 (417)
-------- --------
Net cash used in operating activities (30,586) (23,877)
-------- --------
Investing activities:
Proceeds from sales of marketable securities 1,818 3,091
Purchase of marketable securities - (2,762)
Capital expenditures (67,871) (16,646)
Investment in affiliates (6,978) 904
Purchase of held to maturity securities - (1,008)
Proceeds from maturity of securities 17,218 3,520
Change in short-term investments, net 105,150 28,431
Acquisition of Westwood Studios, Inc. (122,688) -
Acquisition of other subsidiaries, net of cash acquired (11,805) -
Other - 136
-------- --------
Net cash (used in) provided by investing activities (85,156) 15,666
-------- --------
Financing activities:
Proceeds from sales of shares through employee stock
plans and other plans 16,180 8,731
Tax benefit from exercise of stock options 2,848 1,027
Proceeds from minority interest investment in consolidated
joint venture 2,109 -
-------- --------
Net cash provided by financing activities 21,137 9,758
-------- --------
Translation adjustment 2,752 (1,180)
-------- --------
Increase (decrease) in cash and cash equivalents (91,853) 367
Beginning cash and cash equivalents 215,963 141,996
-------- --------
Ending cash and cash equivalents 124,110 142,363
Short-term investments 36,229 98,362
-------- --------
Ending cash and short-term investments $160,339 $240,725
======== ========
</TABLE>
5
<PAGE>
ELECTRONIC ARTS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)
(Dollars in thousands)
(unaudited)
Six Months
Ended September 30,
1998 1997
-----------------------
Supplemental cash flow information:
Cash paid during the year for income taxes $12,621 $1,232
======= ======
Non-cash investing activities:
Change in unrealized appreciation of investments $ (230) $1,906
======= ======
See accompanying notes to condensed consolidated financial statements.
6
<PAGE>
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.
Note 2. Inventories
Inventories are stated at the lower of cost or market. Inventories at September
30, 1998 and March 31, 1998 consisted of (in thousands):
September 30, 1998 March 31, 1998
------------------ --------------
Raw materials and work in process $ 5,007 $ 2,392
Finished goods 21,106 17,234
------- -------
$26,113 $19,626
======= =======
Note 3. Accrued Liabilities
Accrued liabilities at September 30, 1998 and March 31, 1998 consisted of (in
thousands):
September 30, 1998 March 31, 1998
------------------ --------------
Accrued expenses $47,449 $25,872
Accrued royalties 44,559 36,830
Accrued compensation and benefits 20,997 29,318
Accrued income taxes 9,376 26,095
Deferred revenue 6,369 2,797
Warranty reserve 5,065 3,462
Deferred income taxes 1,074 1,106
-------- --------
$134,889 $125,480
======== ========
7
<PAGE>
<TABLE>
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
six months ended September 30, 1998 and 1997 is presented below (in thousands).
<CAPTION>
North Asia
America Europe Pacific Japan Eliminations Total
------- ------ ------- ----- ------------ -----
<S> <C> <C> <C> <C> <C> <C>
Three months ended September 30, 1998
Net revenues from unaffiliated customers $187,081 $ 45,732 $ 8,061 $ 4,889 $ - $245,763
Intersegment net revenues 1,380 2,332 - (1) (3,711) -
-------- -------- -------- -------- -------- --------
Total net revenues $188,461 $ 48,064 $ 8,061 $ 4,888 $ (3,711) $245,763
======== ======== ======== ======== ======== ========
Operating income (loss) $ (8,441) $(21,306) $ 109 $ 93 $ - $(29,545)
Identifiable assets $529,742 $219,981 $ 13,438 $ 16,160 $ - $779,321
Six months ended September 30, 1998
Net revenues from unaffiliated customers $256,195 $132,526 $ 16,424 $ 18,839 $ - $423,984
Intersegment net revenues 7,216 4,844 - 12 (12,072) -
-------- -------- -------- -------- -------- --------
Total net revenues $263,411 $137,370 $ 16,424 $ 18,851 $(12,072) $423,984
======== ======== ======== ======== ======== ========
Operating income (loss) $(18,625) $(11,043) $ 377 $ 2,796 $ - $(26,495)
Three months ended September 30, 1997
Net revenues from unaffiliated customers $120,602 $ 54,520 $ 8,929 $ 5,777 $ - $189,828
Intersegment net revenues 9,146 2,970 - 1 (12,117) -
-------- -------- -------- -------- -------- --------
Total net revenues $129,748 $ 57,490 $ 8,929 $ 5,778 $(12,117) $189,828
======== ======== ======== ======== ======== ========
Operating income (loss) $ (3,900) $ 1,624 $ 1,303 $ (2,107) $ - $(3,080)
Identifiable assets $433,797 $142,742 $ 18,007 $ 10,684 $ - $605,230
Six months ended September 30, 1997
Net revenues from unaffiliated customers $176,851 $107,201 $ 18,775 $ 10,713 $ - $313,540
Intersegment net revenues 17,124 5,399 345 - (22,868) -
-------- -------- -------- -------- -------- --------
Total net revenues $193,975 $112,600 $ 19,120 $10,713 $(22,868) $313,540
======== ======== ======== ======== ======== ========
Operating income (loss) $(15,517) $ 8,217 $ 3,745 $ (4,332) $ - $ (7,887)
</TABLE>
The decreased in the operating loss in Europe for the three and six months ended
September 30, 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
<PAGE>
ELECTRONIC ARTS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
Note 5. Comprehensive Income
<TABLE>
SFAS 130 requires items of other comprehensive income be classified, net of
income taxes, by their nature in the financial statements. For the Company,
other comprehensive income includes primarily foreign currency translation
adjustments and unrealized gains on investments. Total comprehensive income for
the three and six months ended September 30, 1998 and 1997 was as follows (in
thousands):
<CAPTION>
Three Months Ended Six Months Ended
September 30, September 30,
1998 1997 1998 1997
------------------------------------------------
<S> <C> <C> <C> <C>
Net income (loss) $(25,273) $ 41 $(21,573) $(1,410)
--------- -------- --------- --------
Other comprehensive income (loss), net of tax
Unrealized appreciation (depreciation) of
investments (1,008) 312 (230) 1,283
Foreign currency translation adjustments 3,965 (2,662) 2,652 (1,179)
--------- -------- --------- --------
Total other comprehensive income (loss) 2,957 (2,350) 2,422 104
--------- -------- --------- --------
Total comprehensive loss $(22,316) $(2,309) $(19,151) $(1,306)
========= ======== ========= ========
</TABLE>
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 excess purchase price over of the net tangible
liabilities assumed was $129,982,000 of which, based on management's estimates
prepared in conjuction 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
<PAGE>
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
<TABLE>
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):
<CAPTION>
Three Months Ended Six Months Ended
September 30, September 30,
1998 1997 1998 1997
---------------------------------------------------------
<S> <C> <C> <C> <C>
Net income (loss) $(25,273) $ 41 $(21,573) $(1,410)
Shares used to compute net income
(loss) per share:
Weighted average common shares 60,642 58,528 60,471 58,427
Dilutive stock options - 2,108 - -
-------- ------ -------- -------
Dilutive potential common shares 60,642 60,636 60,471 58,427
======== ====== ======== =======
Net income (loss) per share:
Basic $ (0.42) $ 0.00 $ (0.36) $ (0.02)
Diluted $ (0.42) $ 0.00 $ (0.36) $ (0.02)
</TABLE>
Due to the net loss reported for the three and six months ended September 30,
1998 and the six months ended September 30, 1997, stock options have been
excluded from the Diluted EPS calculation. Had net income been reported in these
periods, dilutive potential common shares would have been 63,425,000 and
63,208,000 for the three and six months ended September 30, 1998, and 60,275,000
for the six months ended September 30, 1997.
10
<PAGE>
Note 8. New Accounting Pronouncement
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 operation.
11
<PAGE>
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
<TABLE>
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.
Actual events or the actual future results of the Company may differ materially
from any forward looking statement due to such risks and uncertainties.
<CAPTION>
Net Revenues September 30, September 30,
1998 1997 % change
------------------- ------------------ -----------------
<S> <C> <C> <C>
Consolidated Net Revenues
Three Months Ended $245,763,000 $189,828,000 29.5%
Six Months Ended $423,984,000 $313,540,000 35.2%
North America Net Revenues
Three Months Ended $187,081,000 $120,602,000 55.1%
as a percentage of net revenues 76.1% 63.5%
Six Months Ended $256,195,000 $176,851,000 44.9%
as a percentage of net revenues 60.4% 56.4%
International Net Revenues
Three Months Ended $ 58,682,000 $ 69,226,000 (15.2%)
as a percentage of net revenues 23.9% 36.5%
Six Months Ended $167,789,000 $136,689,000 22.8%
as a percentage of net revenues 39.6% 43.6%
</TABLE>
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 $66,479,000, or 55.1%, and $79,344,000, or
44.9%, for the three and six months ended September 30, 1998, respectively,
compared to the same periods last year. This increase was due to strong sales of
Nintendo 64 ("N64") and PlayStation titles including Madden NFL 99 and NASCAR 99
for both platforms which were both released in the second fiscal quarter. Total
North America N64 revenues increased $44,388,000 and $49,951,000 for the three
and six month periods, respectively, as compared to the same periods last year
due to the release of two titles for this platform in the second fiscal quarter
and one in the first fiscal quarter versus no releases in the
12
<PAGE>
same periods last year. For the three and six months ended September 30, 1998,
PlayStation net revenues for North America increased $21,112,000 and
$37,029,000, respectively, in comparison to the same periods last year. Though
North America's net revenues are expected to continue to grow in fiscal 1999,
the Company does not expect to maintain these growth rates.
International net revenues decreased $10,544,000, or 15.2% for the three months
ended September 30, 1998 compared to the same period last year. The decrease in
international revenues was primarily attributable to lower sales in Europe as a
result of the timing of available new product releases applicable to that
marketplace. Total net revenues in Europe were $45,732,000 for the three months
ended September 30, 1998 compared to $54,520,000 for the same period last year.
For the six months ended September 30, 1998, international net revenues
increased $31,100,000, or 22.8%, compared to the same period last year. The
increase in international revenues was attributable to a growth in sales in
Europe and Japan primarily attributable to the success of World Cup 98 in Europe
and FIFA: Road to World Cup 98 in Japan, respectively, which released in the
quarter ended June 30, 1998. Total net revenues in Europe were $132,526,000 for
the six months ended September 30, 1998 compared to $107,201,000 for the same
period last year. For the six months ended September 30, 1998, Japan sales
increased by 75.9% to $18,839,000 compared to $10,713,000 for the same period
last year.
International sales were also affected by a decline in net revenue in Japan and
the Asia Pacific regions due to weaknesses of local currencies compared to the
prior year. Though sales in local currencies increased from the prior year, net
revenues in the Asia Pacific region decreased by 9.7% to $8,061,000 for the
three months ended September 30, 1998 compared to $8,929,000 for the same period
last year. For the six months ended September 30, 1998, net revenues in Asia
Pacific decreased 12.5% to $16,424,000 compared to $18,775,000 for the same
period last year. Sales in Japan for the three months ended September 30, 1998
decreased by 15.4% to $4,889,000 primarily due to exchange rate comparisons. For
the six months ended September 30, 1998, the exchange rate comparisons were
offset by the success of FIFA: Road to World Cup 98, as noted above.
<TABLE>
EA Studio Net Revenues:
<CAPTION>
32-bit Video Game Product Net Revenues
September 30, September 30,
1998 1997 % change
------------------- ------------------- -------------
<S> <C> <C> <C>
Three Months Ended $ 98,228,000 $ 90,857,000 8.1%
as a percentage of net revenues 40.0% 47.9%
Six Months Ended $194,472,000 $134,087,000 45.0%
as a percentage of net revenues 45.9% 42.8%
</TABLE>
The Company released seven 32-bit CD-video game products during the second
quarter of fiscal 1999 comprised solely of titles for the PlayStation, including
Madden NFL 99, NASCAR 99, NCAA Football 99, NHL 99 and Moto-Racer 2, compared to
eight PlayStation and two Saturn games for the same period last year. The
increase in 32-bit sales for the three and six months ended September 30, 1998
compared to the prior year was attributable to the greater installed base of
PlayStation consoles, the related release of
13
<PAGE>
key titles for this platform during the quarter and strong catalog sales
partially offset by a decline in Saturn revenues.
For the three and six months ended September 30, 1998, PlayStation sales were
$97,891,000 and $193,848,000, respectively, compared to $85,645,000 and
$124,662,000 in the comprable prior year periods. For the three and six months
ended September 30, 1998 PlayStation sales grew 14.3% and 55.5%, 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 the rates achieved in fiscal 1998 again in fiscal 1999.
Net revenues from the sale of other 32-bit products, primarily from sales of
products for Saturn, were $337,000 for the quarter ended September 30, 1998
compared to $5,212,000 for the same period in the prior year. For the six months
ended September 30, 1998 and 1997 other 32-bit revenues were $624,000 and
$9,425,000, respectively.
<TABLE>
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.
<CAPTION>
Personal Computer CD Product Net Revenues
September 30, September 30,
1998 1997 % change
------------------- ------------------- -------------
<S> <C> <C> <C>
Three Months Ended $42,299,000 $42,320,000 0.0%
as a percentage of net revenues 17.2% 22.3%
Six Months Ended $81,509,000 $87,420,000 (6.8%)
as a percentage of net revenues 19.2% 27.9%
</TABLE>
The Company released nine PC-CD titles in the second quarter of the current
fiscal year for the IBM personal computer and compatibles including Need for
Speed III: Hot Pursuit, compared to five for the same period last year.
Sales of PC-CD products for the three months ended September 30, 1998 were flat
compared to the prior year as increased North America sales were offset by
decreases in the international territories. The decrease in sales of PC-CD
products for the six months ended September 30, 1998 is primarily attributable
to a decline in sales of Maxis titles for this period.
14
<PAGE>
<TABLE>
64-bit Video Game Product Net Revenues
<CAPTION>
September 30, September 30,
1998 1997 % change
------------------- ------------------- -------------
<S> <C> <C>
Three Months Ended $43,586,000 $ 700,000 N/M
as a percent of net revenues 17.7% 0.4%
Six Months Ended $64,533,000 $3,033,000 N/M
as a percent of net revenues 15.2% 1.0%
</TABLE>
The Company released two N64 titles in the second quarter of the current fiscal
year compared to no new releases in the prior year. For the three months ended
September 30, 1998 the increase in N64 revenues was due to the release of Madden
NFL 99 and NASCAR 99. For the six months ended September 30, 1998, net sales
increased due to the successful first quarter release of World Cup 98 primarily
in Europe. Sales of N64 products are expected to grow in fiscal 1999, but as
revenues for these products increase, they may not grow at the current rate.
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
cartidges. Because of these and other factors, the carrying of an inventory of
cartridges entails significant capital and risk. See Hardware Companies, below.
<TABLE>
Affiliated Label Net Revenues
<CAPTION>
September 30, September 30,
1998 1997 % change
------------------- ------------------- -------------
<S> <C> <C> <C>
Three Months Ended $56,665,000 $45,854,000 23.6%
as a percentage of net revenues 23.1% 24.2%
Six Months Ended $71,479,000 $71,896,000 (0.6%)
as a percentage of net revenues 16.9% 22.9%
</TABLE>
The increase in Affiliated Label net revenues for the three months ended
September 30, 1998 was primarily due to sales of Parasite Eve published by
Square EA which was released in the second fiscal quarter of 1999 and the
acquisition of ABC, an independent software distributor of primarily Affiliated
Label products in Switzerland and Austria, in July 1998. This increase was
partially offset by a decline in sales of Jurassic Park which released in the
comparable prior year quarter. Additionally, the increase in AL sales for the
three and six months ended September 30, 1998 was offset as the prior year
periods included sales of products from Creative Wonders, an affiliate which was
sold in the third fiscal quarter of 1998.
15
<PAGE>
<TABLE>
Cost of Goods Sold
<CAPTION>
September 30, September 30,
1998 1997 % change
------------------- -------------------- --------------
<S> <C> <C> <C>
Three Months Ended $134,299,000 $103,641,000 29.6%
as a percentage of net revenues 54.6% 54.6%
Six Months Ended $221,888,000 $165,953,000 33.7%
as a percentage of net revenues 52.3% 52.9%
</TABLE>
Cost of goods sold as a percentage of net revenues for the three months ended
September 30, 1998 was comparable to the same period last year due to an
increase in sales of N64 products, offset by a decrease in sales of PC-CD
products. For the six months ended September 30, 1998, cost of goods sold as a
percentage of revenues decreased due to an increase in sales of PlayStation
products, offset by a decrease in sales of higher margin PC-CD products and an
increase in lower margin N64 product sales
<TABLE>
Marketing and Sales
<CAPTION>
September 30, September 30,
1998 1997 % change
------------------- ------------------- --------------
<S> <C> <C> <C>
Three Months Ended $33,523,000 $29,032,000 15.5%
as a percentage of net revenues 13.6% 15.3%
Six Months Ended $67,167,000 $55,668,000 20.7%
as a percentage of net revenues 15.8% 17.8%
</TABLE>
The increase in marketing and sales expenses for the three and six months ended
September 30, 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.
<TABLE>
General and Administrative
<CAPTION>
September 30, September 30,
1998 1997 % change
------------------- ------------------- --------------
<S> <C> <C> <C>
Three Months Ended $16,395,000 $13,191,000 24.3%
as a percentage of net revenues 6.7% 6.9%
Six Months Ended $31,812,000 $25,080,000 26.8%
as a percentage of net revenues 7.5% 8.0%
</TABLE>
The increase in general and administrative expenses for the three and six months
ended September 30, 1998 was due primarily to an increase in headcount and
occupancy costs to support the increase in growth in Europe and North America
operations.
16
<PAGE>
<TABLE>
Research and Development
<CAPTION>
September 30, September 30,
1998 1997 % change
------------------- ------------------- --------------
<S> <C> <C> <C>
Three Months Ended $48,349,000 $36,252,000 33.4%
as a percentage of net revenues 19.7% 19.1%
Six Months Ended $84,591,000 $63,934,000 32.3%
as a percentage of net revenues 20.0% 20.4%
</TABLE>
The increase in research and development expenses for the three and six months
ended September 30, 1998 was due to additional headcount related expenses
attributable to the acquisition of Westwood Studios Inc. and certain assets of
the Irvine, California - based Vigin Studio (collectively "Westwood") in
September 1998 and Tiburon Entertainment, Inc. in April 1998, higher development
costs per title and an increase in support for Ultima Online.
<TABLE>
Charge for Acquired In-Process Technology
<CAPTION>
September 30, September 30,
1998 1997 % change
------------------- ------------------- --------------
<S> <C> <C> <C>
Three Months Ended $41,836,000 $- N/M
as a percentage of net revenues 17.0% N/A
Six Months Ended $44,115,000 $- N/M
as a percentage of net revenues 10.4% N/A
</TABLE>
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 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. Costs to complete these projects, as well as
several other projects acquired, are expected to be approximately $9.1 million,
$10.6 million and $1.0 million in fiscal 1999, 2000 and 2001, respectively. 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.
17
<PAGE>
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. An
appropriate risk adjusted discount rate was used to discount the net cash flows
back to their present value. The remaining identified intangibles will be
amortized on a straight-line basis over two to twelve years based on expected
useful lives of franchise tradenames, existing products and technologies,
retention of workforce, and other intangible assets. 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.
For the six months ended September 30, 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.
<TABLE>
Amortization of Intangibles
<CAPTION>
September 30, September 30,
1998 1997 % change
------------------- ------------------- --------------
<S> <C> <C> <C>
Three Months Ended $906,000 $- N/M
as a percentage of net revenues 0.4% N/A
Six Months Ended $906,000 $- N/M
as a percentage of net revenues 0.2% N/A
</TABLE>
Amortization of intangibles results from the acquisitions of Westwood and ABC in
the second quarter of fiscal 1999.
<TABLE>
Interest and Other Income, Net
<CAPTION>
September 30 September 30,
1998 1997 % change
------------------- ------------------- --------------
<S> <C> <C> <C>
Three Months Ended $3,750,000 $3,142,000 19.4%
as a percentage of net revenues 1.5% 1.7%
Six Months Ended $6,565,000 $5,692,000 15.3%
as a percentage of net revenues 1.5% 1.8%
</TABLE>
For the three and six months ended September 30, 1998, the increase in interest
and other income, net, was primarily attributable to the equity in the net loss
of Creative Wonders, an
18
<PAGE>
affiliate company sold in December 1997, compared to the equity in the net
income of Square Electronic Arts, LLC in the comparable current year periods.
<TABLE>
Income Taxes
<CAPTION>
September 30, September 30,
1998 1997 % change
------------------- ------------------- --------------
<S> <C> <C> <C>
Three Months Ended ($563,000) $ 21,000 N/M
effective tax rate 2.2% 34.5%
Six Months Ended $1,372,000 ($757,000) N/M
effective tax rate (6.9%) 34.5%
</TABLE>
The Company's effective tax rate for the three and six months ended September
30, 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 six months
ended September 30, 1998 would have been 33.0% as compared to a 34.5% tax rate
in the corresponding prior year periods. The lower rate of 33.0% results
primarily from having a higher estimated proportion of international income
subject to a lower foreign effective tax rate for the fiscal year.
<TABLE>
Minority Interest in Consolidated Joint Venture
<CAPTION>
September 30, September 30,
1998 1997 % change
------------------- ------------------- --------------
<S> <C> <C> <C>
Three Months Ended ($41,000) $- N/M
as a percentage of net revenues 0.0% N/A
Six Months Ended ($271,000) $28,000 N/M
as a percentage of net revenues (0.1%) 0.0%
</TABLE>
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. The
minority interest for the three and six months ended September 30, 1998
represents Square's 30% interest in the net income of EA Square KK.
For the three and six months ended September 30, 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. No minority
interest in EAV was recorded for the losses generated in the three months ended
September 30, 1997 as VEI's interest in the net equity of EAV had fallen below
zero.
19
<PAGE>
<TABLE>
Net Income (Loss)
<CAPTION>
September 30, September 30,
1998 1997 % change
------------------- ------------------- --------------
<S> <C> <C> <C>
Three Months Ended ($25,273,000) $ 41,000 N/M
as a percentage of net revenues (10.3%) 0.0%
Six Months Ended ($21,573,000) ($1,410,000) N/M
as a percentage of net revenues (5.1%) (0.4%)
</TABLE>
The decrease in net income for the three and six months ended September 30, 1998
as compared to the prior year period was primarily related to the charges for
acquired in-process technology as well as higher product development costs
associated with the acquisition of new studios partially offset by higher
revenues and gross profits. For the three and six months ended September 30,
1997, net income was reduced by merger costs in the amount of $10,792,000
associated with the acquisition of Maxis, Inc.
20
<PAGE>
Liquidity and Capital Resources
As of September 30, 1998, the Company's working capital was $255,421,000
compared to $408,098,000 at March 31, 1998. Cash and short-term investments
decreased by approximately $214,221,000 during the six months ended September
30, 1998 as the Company used $30,586,000 of cash in operations and $67,871,000
in capital expenditures, $134,493,000 in the acquisition of new subsidiaries
offset by proceeds from the Company's employee stock programs.
Reserves for bad debts and sales returns increased from $51,575,000 at March 31,
1998 to $56,543,000 at September 30, 1998. 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.
The Company's principal source of liquidity is $160,339,000 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.
21
<PAGE>
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 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 currently support daily operations in the United States and
Europe. 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 does
not presently have a contingency plan for handling Year 2000 problems that are
not detected and corrected prior to their occurrence. 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
<PAGE>
Euro Conversion
On January 1, 1999, eleven of the fifteen member countries of the European Union
are scheduled to establish 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 result of operations.
23
<PAGE>
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, 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 expected to ship in fiscal 1998, at the time of the merger with Maxis.
Due to additional development delays, it is anticipated that this product may
not ship until the fourth fiscal quarter of 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. 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
<PAGE>
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 announced that it will
introduce 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; the Company has recently been sued in an action alleging defects in
Ultima Online, 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 significantly below anticipated levels. The
Company typically receives orders shortly before
25
<PAGE>
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 six months ended September 30, 1998, the Company expects that
margins may be comparable to or decline from fiscal 1998 levels 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 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
26
<PAGE>
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 six months ended
September 30, 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 six months ended September 30,
1998 and the fiscal year ended March 31, 1998, international net revenues
comprised 40% 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 $38.13 to $55.56 during the
six months ended September 30, 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.
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
27
<PAGE>
indicator of future performance, and investors should not use historical trends
to anticipate results or trends in future periods.
28
<PAGE>
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
29
<PAGE>
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
November 13, 1998 Executive Vice President and
Chief Financial and Administrative Officer
(Principal Accounting Officer)
30
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