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Electronic Arts Inc. (ERTS)

F4Q06 Earnings Conference Call

May 3, 2006, 5:00 p.m. EST

Executives

Tricia Gugler - Director of IR

Warren Jenson - EVP, CFO, Chief Administrative Officer

Larry Probst - Chairman, CEO

Frank Gibeau - EVP, General Manager of North American Publishing

Analysts

Mike Wallace - UBS

Evan Wilson - Pacific Crest

Chris Kwak - SIG

John Taylor - Arcadia

P.J. McNealy - American Technology

Mike Hickey - Janco Partners

Jeetil Patel - Deutsche Bank

Heath Terry - Credit Suisse

Edward Williams - Harris Nesbitt

Shawn Milne - Friedman Billings

Justin Post - Merrill Lynch

Presentation

Operator

Good day, everyone, and welcome to the Electronic Arts fourth quarter fiscal year 2006 earnings conference call. Today's call is being recorded. For opening remarks and introductions, I would like to turn the call over to Ms. Tricia Gugler, Director of Investor Relations. Please go ahead, ma'am.

Tricia Gugler

Welcome to our fourth quarter and fiscal 2006 earnings call. Today on the call, we have Larry Probst, Chairman and Chief Executive Officer; Warren Jenson, Chief Financial and Administrative Officer; and Frank Gibeau, Executive Vice President and General Manager of North American Publishing.

Before we begin, I would like to remind you that you may find copies of our SEC filings, our earnings release and a replay of the webcast on our website at investor.ea.com. Shortly after the call, we will post a copy of Warren's remarks on our website.

Throughout this call, we will present both GAAP and non-GAAP financial results. Non-GAAP results exclude charges and related income tax effects associated with acquired in-process technology, amortization of intangibles, employee stock-based compensation, restructuring charges and certain litigation expenses. In addition, the Company's non-GAAP results exclude the impact of certain one-time income tax adjustments.

Our earnings release provides a reconciliation of our non-GAAP to GAAP results. In addition, in anticipation of expensing stock options next quarter, we have expanded our non-GAAP disclosures to include a reconciliation of our GAAP to non-GAAP statement of operations. Information regarding our use of non-GAAP measures, along with a schedule demonstrating how we calculate ROIC, will also be included with a copy of Warren's remarks we post on our website.

These non-GAAP measures are not intended to be considered in isolation from, a substitute for, or superior to our GAAP results, and we encourage investors to consider all measures before making an investment decision.

All comparisons made in the course of this call are against the same period for the prior year, unless otherwise stated. We have included our trailing 12-month platform shares and our 2006 estimated market outlook in a supplemental schedule on our web site.

During the course of this call, we may make forward-looking statements regarding future events and the future financial performance of the Company. We caution you that actual events and results may differ materially. We refer you to our most recent Form 10-K and 10-Q for a discussion of risk factors that could cause our actual results to differ materially from those discussed today. We make these statements as of May 3, 2006, and disclaim any duty to update them.

And now, I would like to turn the call over to Warren.

Warren Jenson

Good afternoon, everyone. Fiscal 2006 was a year in which we held our own competitively, but at the same time we felt the impact of a challenging marketplace. There were, however, several highlights.

Overall, our titles performed well. We ended the year with 27 platinum hits, of which 12 were double platinum. We ended the year as the number one publisher in North America on Xbox 360 and were number two behind Microsoft in Europe. On the PSP, we were number one in both North America and in Europe. On the Nintendo DS, we are the number two publisher behind Nintendo.

We were also pleased with the launch of our first open-world game Godfather, which sold close to 2 million copies in the first week. Harry Potter and the Goblet of Fire sold more than 4.5 million copies, outperforming last year's Harry Potter and the Prisoner of Azkaban.

We continued to expand our revenue base from wholly-owned IP. This past year, roughly 41% of total revenue came from owned intellectual properties, up 4 points from last year. Need for Speed Most Wanted was our top-selling title for the year. We are also pleased with our newest IP, Black, which has sold approximately 1.5 million copies.

We now have six $1 billion lifetime franchises at retail, two more than last year. NBA Live and Harry Potter join Madden, Need for Speed, Sims and FIFA. Madden has now become our first franchise to exceed $2 billion.

Our sports business continues to thrive. Madden '06 unit sales were up over 10% year over year. FIFA '06 unit sales were up more than 20%. NBA Live continues to set the pace in pro basketball, with 69% revenue share for the fiscal year. NCAA football sold more than 2 million copies. Our two new sports titles, MVP NCAA Baseball and Arena Football, both had solid performances.

Again this year, our teams won several important awards for creative excellence. We took seven awards at E3 in 2005. At China Joy, EA won four PC awards. We received five awards from the Academy of Interactive Arts and Sciences. In Europe, EA won four top awards at Leipzig. This recognition summarizes what we are all about: creativity, innovation and leadership.

This year, we further strengthened our long-term position. We extended our exclusive relationship with FIFA for the next eight years and Tiger Woods for six years. We have likewise extended our Harry Potter license through 2011. We entered into a long-term exclusive arrangement to bring the Simpsons to next-gen consoles. We are now in preproduction with Steven Spielberg as part of our exclusive interactive relationship.

In mobility, with the acquisition of JAMDAT, we are a global leader on mobile phones and in a position to quickly expand this business. Our revenue from mobile platforms, which includes both handhelds and cellular phones, increased by $275 million in the year, reaching $393 million or 14% of revenue.

Online, we have developed and launched our digital distribution platform for PC games. To date, we have completed more than 750,000 transactions over the Web. We are also the leading third-party content provider on Xbox Live Marketplace, with 2.3 million downloads of digital content in less than five months.

Club Pogo now has more than 1 million subscribers, and revenue is up more than 40% year over year. In China, we have chosen our online operator, and are about to launch our closed beta for Pogo. Online revenue is now closing in on $100 million. In March alone, people spent 3.6 billion minutes on our sites, making EA Online one of the largest online communities in North America. Taken together, these moves all serve to strengthen EA globally on consoles and the PC, in online and in mobility, the three pillars of interactive leadership.

For the next few minutes, I'll focus my remarks in two areas. First, I will review our Q4 financial results. Second, I will go over our outlook and financial guidance. And then, following my comments, Larry, Frank and I will open the call for your questions.

Q4 net revenue was $641 million, up 16%, driven primarily by Godfather, Black and by Fight Night Round 3 on the 360. We released 29 SKUs in the quarter, compared to 25 a year ago. We had five titles that went platinum: Godfather, Fight Night Round 3, Black, FIFA Street 2 and The Sims Open for Business. In addition, Need for Speed Most Wanted sold over 1 million copies in the quarter, and The Sims 2 over 900,000.

Console revenue was $360 million, up 14%. The increase was driven by the Xbox 360 and the PS2. While current-gen revenue was down 6%, Xbox 360 revenue more than offset the decline in Xbox.

PC revenue was $104 million, up 22%, primarily due to the strength of Lord of The Rings: Battle for Middle Earth II.

Mobility revenue more than doubled to $88 million, driven by increases in PSP and mobile phones and, to a lesser extent, the DS. During the quarter, we had four of the top ten PSP titles in both North America and in Europe. Cellular revenue totaled $15 million, due to the consolidation of JAMDAT in the back half of the quarter. We had four of the top five titles in North America on the cell phone, with Tetris at number one. In the UK for the month of March, on cell phones we had four of the top ten titles.

Copublishing and distribution revenue was $52 million, down $37 million year over year. We had no significant launches this quarter.

Internet, licensing and other revenue was $37 million, up $9 million, primarily due to higher license revenue.

Geographically, North America revenue was $340 million, up $52 million or 18%. The increase was driven by revenue related to Xbox 360, mobile platforms and the PC. Current-gen revenue was down 10%, due to double-digit declines in the Xbox and GameCube, partially offset by an increase in revenue on the PS2.

International revenue was $301 million, up $36 million or 14% year over year. Changes in foreign exchange rates negatively impacted our top line by $24 million. Europe revenue was $262 million, up $44 million or 20%, driven by the PSP and, to a lesser extent, the PS2 and Xbox 360.

Overall, current-generation console revenue was up 4%, due to the strength of our titles on the PS2. Asia revenue was down 17% year over year, driven by lower distribution revenue and a decline in current-gen.

Moving on to the rest of the income statement, gross profit in the quarter was $397 million, up 24%. Gross margin was 61.9% versus 57.9%. The increase was driven principally by lower price protection and sales return charges.

Operating expenses, marketing and sales; marketing and sales expense was $102 million, up $15 million over last year due to higher advertising associated with the launch of both Black and Godfather.

G&A was $54 million, down $12 million year over year. The decrease was driven primarily by lower employee-related litigation costs. On a run rate basis, G&A was roughly flat.

R&D was $188 million, up $27 million or 17%, driven by an increase in spending for next-generation titles and online content and functionality. R&D headcount was up 22% from approximately 4,200 to roughly 5,200 employees. Acquisitions accounted for 8 points of this increase.

GAAP diluted loss per share was $0.05 versus GAAP diluted earnings per share of $0.02 a year ago. Non-GAAP diluted earnings per share were 14 versus 9. The difference between GAAP and non-GAAP EPS is principally due to acquisition-related charges, the repatriation of $375 million in foreign earnings under the American Jobs Creation Act of 2004, and restructuring activities.

On a trailing 12-month basis, operating cash flow was $596 million versus $634 million for the comparable period. Our return on invested capital on a trailing 12 months was 21% versus 60% a year ago. Our GAAP diluted share count for the quarter was 304 million versus 322 million a year ago. On a non-GAAP basis, it was 312 million for the quarter. Had stock-based compensation expense been included in our results, GAAP diluted loss per share would have increased by roughly $0.05. As you know, we will begin expensing next quarter.

On to the balance sheet. Cash, short-term investments and marketables were $2.4 billion, down from a year ago, primarily related to the completion of our share repurchase program and the cash acquisition of JAMDAT. Gross accounts receivable were $431 million versus $458 million a year ago, a decrease of 6% due to the timing of our release schedule. Reserves against outstanding receivables totaled $232 million, up $70 million from last year. Reserve levels were 12% as a percentage of trailing six-month net revenue, up 4 points from last year. As a percentage of trailing nine-month net revenue, reserves were 9%, up 3 points.

Inventory was $61 million, flat to last year. No one title represents more than $7 million of net exposure. We recorded $707 million of intangibles related to our acquisition of JAMDAT. Of this amount, $212 million will be amortized to the P&L over two to 12 years.

Our outlook and guidance. Before we get into the numbers, we thought it would be helpful to update our thoughts on the transition, the year ahead and our priorities in investments.

First, let me talk about the transition. As we look ahead, we feel that what we are going after today is a lot more than a console transition. The interactive industry as we see it is really going through a global transformation. This transformation involves not only the consoles and PCs but everything online and everything mobile, too.

It is also opening new markets. It is all about connectivity and changing the way in which people play games. In this context, we want to outline our investment priorities for fiscal 2007. Each of these priorities is a critical element in our plan to sustain and extend our global leadership.

Our priorities. Number 1, next-gen platforms. Next-gen leadership will continue to be objective one for EA. We expect to dramatically expand our next-gen SKU count in the year ahead, supporting the Xbox 360, PS3 and the Nintendo Wii. While not console-specific, we are also planning to support Microsoft's sister rollout in a meaningful way.

Number 2, online. In online, we expect to launch Pogo in China, in Europe and on Xbox Live Arcade. We expect to significantly enhance our PC digital distribution platform, as well as EA Nation. On our key games, we expect to build more downloadable content with an eye toward micro transactions, and finally, develop and launch two advanced casual games in Asia.

Third, mobility. In cell phones, our objective is to leverage the JAMDAT acquisition to take advantage of our EA content portfolio and quickly expand our presence globally. In handhelds, we expect to continue to actively support both the PSP and the NDS.

Fourth, wholly-owned intellectual properties. We're slightly over 40% of revenue today. Our objective is to build on this base. You'll see some of our work at E3.

And finally, fifth, globalization. We are obviously busy in China and the rest of Asia, but we are also busy in Eastern Europe, too. By the end of fiscal 2007, we expect to have more than 300 active production and deployment personnel in China, India and in Eastern Europe.

It is on the basis of these five priorities that we have built our fiscal 2007 operating plan. So what does this mean for R&D spending in fiscal 2007? Last year, R&D was $758 million or roughly $760 million. Of this amount, approximately $600 million was spent in our worldwide studios on technology, console and PC products. $100 million was spent on mobile platforms, which includes cell phones and handhelds. Approximately $60 million was spent in online, which includes console online, Pogo, EA Nation and our digital distribution platform.

Looking ahead to fiscal 2007, we expect our spending in our core studio to increase by 5% to 10% as we continue to transition to next-gen SKUs and away from current-gen, and mobility to increase by 55% to 60%; and in online, to increase by 80% to 90% year over year.

As a result of the scope of our priorities, we now expect our fiscal 2007 R&D to increase by 15% to 20% year over year, excluding the impact of stock-based compensation. We recognize this range is higher than what we said three months ago, and a clear hit to our short-term profitability.

That said, we think we have appropriately prioritized the spend. We think we have made the right decisions, and are making a smart long-term move. This investment is core to our global leadership on next-gen consoles, in online and in mobile platforms.

I will conclude my portion of today's call with our market outlook and our financial guidance. 2006 market outlook; essentially, our outlook for the industry remains the same. We expect overall software sales in North America and in Europe for calendar 2006 to be flat to down 5%. We are planning for the PS3 and Nintendo Wii to launch in the late fall. In addition, we expect the overall mobile phone game segment to be up 25% to 30%.

Now, the numbers. Before jumping into the numbers and into the specifics, I would like to cover off a few things that are relative to our guidance. Number 1, once again, this is a year with many uncertainties. While we expect the PS3 and Nintendo Wii to launch successfully, there could easily be delays and shipment quantities could fall below our estimates. Should this happen, it would cause our numbers to drop materially. Likewise, while it looks like Microsoft is successfully ramping production, any significant Xbox 360 interruptions would negatively impact our performance.

Two, we continue to expect the PSP to do well. A significant shortfall in expected sell-through would also hurt us.

Third, our development risk is high. While we feel we are in great shape on the Wii and the PS3, we, like the rest of industry, still have not built a game. Many unknowns exist.

And finally, we have a lot going on. With greater complexity comes higher risk.

We have tried to take these factors into account in the breadth of our full-year guidance, but at this early date, we can't be sure that we have adequately captured the uncertainties. We also ask that you review the risk factors identified in our SEC filings.

Now, the numbers. For the quarter ending June 30, we expect revenue to be between $300 million and $340 million, GAAP diluted loss per share to be between $0.42 and $0.36, non-GAAP diluted loss per share to be between $0.28 and $0.22. Overall, we expect our non-GAAP earnings to be roughly $0.14 higher than our GAAP EPS.

The estimated breakdown of these adjustments is as follows: stock-based comp, $0.09; amortization of intangibles, $0.03; restructuring charges, $0.02, related to our European reorganization.

In Q1, we expect to ship 16 SKUs, consistent with a year ago. Our Q1 releases include FIFA World Cup 2006 on eight platforms. As you know, this title has already shipped and we're pleased to say it's off to a great start. It was the best-selling title in Germany in the first week, post-launch. Battlefield 2: Modern Combat on Xbox 360; a Battlefield 2 booster pack for digital download; Battlefield Deluxe on the PC; James Bond 007: From Russia With Love on the PSP; NFL Head Coach on three platforms; and The Sims 2 Family Fun Stuff expansion pack.

Please note that Superman will not ship in Q1. Instead, we are planning on a fall release, concurrent with the release of the movie on DVD. On mobile phones, we plan to release eight games.

Now, our full-year guidance. For the full year, we expect revenue to be between $2.7 billion and $2.95 billion; GAAP diluted earnings per share to be between a loss of $0.15 and earnings of $0.15; non-GAAP diluted earnings per share to be between $0.35 and $0.65. Overall, we expect our non-GAAP earnings to be roughly $0.50 higher than our GAAP EPS.

The estimated breakdown of these adjustments is as follows: stock-based compensation, $0.30; amortization of intangible assets, $0.15; and restructuring charges, $0.05, related to our European reorganization. Please note this estimate does not include any charges associated with the potential closing of our DICE acquisition.

In total, we plan to release between 30 and 35 titles, including Need for Speed; Medal of Honor: Airborne, which we are now planning to release in Q4; Battlefield 2142; Command & Conquer: Tiberian Wars; ARMY OF TWO, an exciting new IP from our Montreal studio; Sims expansion packs and a version of The Sims for the laptop and a new Def Jam title.

Separately, we have agreed with MGM and Danjac to end our James Bond license. We no longer feel this partnership fits with our respective corporate strategies. We want to thank MGM and Danjac; they have been great partners.

In addition, in EA Sports, we plan to launch Madden NFL, FIFA, NBA Live, Tiger PGA Tour, NCAA Football, MVP NCAA Baseball. This year, you will also see further integration of ESPN content into our titles. In mobile phones, we plan to release 25 to 30 games.

Further, we expect our revenue for the rest of the year to land in roughly the following percentages: 20% to 25% in Q2, 40% to 45% in Q3 and 20% to 25% of the total in Q4. We expect our second-quarter EPS to be roughly breakeven on a non-GAAP basis.

We expect gross margin to come down year over year as a result of lower current-generation pricing and higher content royalty rates. Some of this pressure will likely be offset by a mix shift toward higher-margin platforms, including the PS3.

On the expense side, excluding stock-based compensation, we expect R&D to increase by 15% to 20% for the year. Approximately 6 points of this increase is a result of consolidating JAMDAT for the full year. Both G&A and marketing and sales should remain relatively flat year over year as a percentage of revenue.

On share count, we expect our fully-diluted share count at year end to be about 320 million shares. Finally, we ask that you keep in mind that with the introduction of next-gen platforms and the global expansion of online gaming, we will see more games delivered with significantly enhanced online game play. In some situations, this may increase deferred revenue. This, of course, will have no adverse impact on cash flows.

We look forward to seeing everyone at E3 next week. With that, we will open the call to your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Mike Wallace, UBS.

Mike Wallace - UBS

A couple of questions. Let me just start looking longer-term. If you look at where the earnings are now, and looking at where they peaked in '04 and look at where the margins peaked in '04, my question is, how do you get back up there? Is R&D spending going to maintain a much higher pace?

Assuming gross margins at best are flat with where they were this past cycle, R&D is a lot higher. How are you going to get the margins back to where they were in fiscal '04? Or at this point, do you think that that is something that's not going to happen over the next couple years?

Warren Jenson

What I will tell you is I will go through the factors and what we are focused on. Above the line, we are clearly focused on building great entertainment for next-gen products, and we are really pleased with what we see. We think there's some, hopefully, great things to come.

The second thing on the content side is we are really focused on building new forms or new revenue streams from fundamentally online-based content and also mobile. So some of those revenue streams carry with them much higher margins.

Secondly, we're also focused, as I mentioned in our priorities, in building wholly-owned intellectual property. I think, if there's one thing that we can do to help the cause for increased margins in the next cycle, it is to build our base of wholly-owned intellectual property. As you know, we're up 4 points this year to 40%. Obviously, we hope to expand that.

I think the other thing that we will look to is to see how the market expands in the next cycle, when thinking about top line revenues.

Mike Wallace - UBS

So, in order to pick it up and get back up there, it would have to come through market share gains and maybe a little on the gross margin, if the mix changes?

Warren Jenson

Here is what I will do, is I will go through the factors, and then what will happen will be dependent upon those mix of factors and how they play out. On the expense side, I would tell you that every organization in the Company is focused on scalability. We know that as we move into '08 and beyond, we are going to look to scale this organization, as we expect revenues to grow more significantly. So the combination of those factors will be determinative in where we get to, margin-wise.

Mike Wallace - UBS

Let me just follow up then on the revenue guidance for this year. It looks like, I don't know, flattish to down 10% or so. In past transitions, the Company has picked up market share. If you are adding $100 million plus from the JAMDAT deal, does that mean that you're going to lose some share? Are you doing less PC titles? What is behind the revenue guidance for this year?

Warren Jenson

I will give a macro view of that, and then maybe Frank or Larry wants to jump in on the market side of things. What we tried to do when we went through our guidance, just as I said, Mike, was to take everything into account we could in setting a range. The reality is we are in a very uncertain year, for all the reasons that I mentioned, whether it's actual shipment dates, launch quantities, development risk; you name it, it exists today.

So, as we debated back and forth, this is the appropriate range. Yes, we will have more revenue from mobile, and we certainly expect to be highly competitive in the marketplace. But, that said, that's the right range.

Mike Wallace - UBS

Okay, just two more quick ones. Spore, is that not this fiscal year? And you mentioned the PS3 is a higher-margin platform. Is the royalty rate $1 lower than it was?

Larry Probst

Spore is not in this fiscal year, and we don't have any details on the business model on the PlayStation 3 yet.

Mike Wallace - UBS

The assumption is the economics will be a little bit better?

Larry Probst

I don't think we can make any assumptions, because we don't have any details.

Mike Wallace - UBS

Thanks.

Operator

Our next question comes from Evan Wilson, Pacific Crest.

Evan Wilson - Pacific Crest

Thanks for taking the question. First, I was hoping you comment on a little more detail in terms of JAMDAT, what you expect for not just the wireless industry as a whole, but some of the slowness we have heard of, not as it relates to your business but as the industry is it churning a little bit more than we expected? So just comment there.

I was just hoping you could also go back a little for me as well, and talk about how in the last transition you guys experienced one down year of EPS during the transition. Now this is three consecutive down years. If you could just point to the main differences between what is going on now, what happened then, considering the strength in your balance sheet and market position now?

Warren Jenson

I'll take the first part, on mobile. We're very pleased with what we're seeing in the integration that we have had with JAMDAT. I think we're off to a great start, working very well together and already starting to get the EA content integrated into the JAMDAT system of development and deployment.

The second thing and it's not really a market, and I'll come to that. But we've also really expanded our production base, as JAMDAT is truly a global publisher and a global developer. And I think that's very helpful.

What I will tell you is we anticipate solid growth this year. As I said on the last call, we would expect our combined revenues to easily pass through $130 billion next year. I think one thing to keep in mind, which many of you already know, is that this business is not launch-driven. The things that will accelerate revenue growth are handsets and the introduction of new handsets. So you'll have to get used to some different dynamics that will affect the ebb and flow of the revenue streams.

Larry Probst

With regard to your question about what is different, I would say the following things. Fundamentally, it's just a more complex and more complicated market environment these days. In addition to navigating the console transition from current-generation to next-generation, we have to be paying attention to the PC platform and online play, casual games, the handheld business, the mobile opportunity, the business that's developing in Asia. So there just are a lot more moving parts. It's more complicated, it's more challenging and we have to get in position for all those things going forward.

Operator

Our next question comes from Chris Kwak, SIG.

Chris Kwak - SIG

Just in terms of the hiring that you did, in terms of getting the head count from 4,200 to 5,200 on the R&D side, you said 8 points came from acquisitions. Where was the other significant portion of that from?

Warren Jenson

In terms of where the hiring was done? The bulk of the hiring took place in our studios, and I would say broadly, across the board, in all of them, perhaps with a little bit of a heavier focus in Montreal, for example, and to some extent in Vancouver.

Chris Kwak - SIG

And just as a clarification, when you said the higher margin, did you say PS3 or PSP?

Warren Jenson

I did say PS3 in my remarks. So to Larry's point, I want to clarify. We do not yet have our business terms worked out with Sony. What we do know is that we have launched, at least our pricing on the Xbox 360 titles has been at $59 and, we think, well-received in the marketplace. Now, what we don't know is what pricing will be on those titles in the future. We will be market competitive. But that said, our titles have been very well-accepted on the Xbox.

Chris Kwak - SIG

Is that higher margin assumption or expectation on the PS3, is that much different than what you have seen on the Xbox 360?

Warren Jenson

No.

Chris Kwak - SIG

Lastly, on Superman and Medal of Honor, it sounds like both of them are delayed, one to coincide with the DVD release, the other one in Q4. Can you just walk us through the thinking behind that or what is causing that?

Frank Gibeau

With regards to Superman, really what the gating objective was to deliver a great game experience. The ambitious nature of the open-world design proved to be fairly challenging, with regard to hitting the launch window for the film. We wanted to look at a long-term opportunity here with Superman, so as a result we moved the product release to the fall to coincide with the DVD at holiday.

Actually, from a publishing standpoint, the DVD release at holiday is a nice combination. There are more vehicles for us to market and promote the game, and we're going to get a better game this fall than we would have with the movie release. So that was a basic story on Superman.

With regards to Medal of Honor: Airborne, that is going to be a critical franchise for us in the next cycle. That's a franchise that we want to grow over the next five years, over the next set of technologies. It's a very ambitious design, and again, we are prioritizing game quality higher than making that date.

Operator

Our next question comes from John Taylor - Arcadia.

John Taylor - Arcadia

I've got a couple of housekeeping questions and a couple of bigger ones. The tax charge related to the American Jobs Creation Act, could you give us that? Was there anything concentrated in license revenue in the fourth quarter that really boosted that? Those are the housekeeping.

The bigger questions are, what percent of revenue did you guys did last year direct with consumer, via subscription or -- actually, I want to make it broader than that. Maybe include advertising, the direct digital download stuff in one form or another. What do you think that number might look like percentage-wise, say, in a couple of fiscal years, maybe fiscal '08 kind of thing? That's a bigger question.

Larry, maybe for you, with all the stuff that's coming online since the PC has been the dominant online platform and definitely is in Asia, is the stage set for a comeback of the PC as a gaming platform?

Larry Probst

I think the PC platform has continued to represent a meaningful part of our business, specifically anywhere from 20% to 25% of our annual revenue. We've got some very important intellectual properties that live on that platform, like The Sims, SimCity, Spore. So we're going to continue to be active on that platform.

I think Microsoft probably has some aggressive plans in mind in conjunction with the launch of Vista later on next year. So yes, we think the PC is going to continue to be an important platform, and it clearly is the most important platform in most of the markets in Asia, outside of Japan.

John Taylor - Arcadia

So, let me just follow up on that. So, with the online piece really driving growth and packaged goods sales dropping off, is there an opportunity that the PC can actually take share back, do you think, from console usage in terms of the amount of time eyeballs are spent there, or money is spent on that platform?

Larry Probst

If you think about it on a global basis, I think the answer is probably yes.

John Taylor - Arcadia

Do you think there's much chance it can recover in the Western markets?

Larry Probst

In the foreseeable future, over the next two or three years, I don't see a huge shift away from consoles back towards the PC. But again, if you look at the opportunity on a global basis, the PC is going to continue to be significant, as long as that's what's driving the business in the key Asian territories.

Warren Jenson

I'll answer your other couple of questions. On the Homeland Investment Act, it was $18 million or roughly $0.05 to $0.06 a share. The second question dealt with how much in direct digital distribution-related revenue, and I probably want to go through and measure how we are thinking about Pogo as an example from a subscription basis.

If you talk about just pure digital downloads, the number is relatively small and about $10 million. And that is cash, $2 million of which we deferred, but in total, $10 million in cash. The good news is, I think, on that front we're just getting started. We clearly are making investments in the digital downloader. People love it, and I think you'll see expanded use of it as we go forward.

On the license revenue side, going back through my thoughts in the closing review, I don't know of anything really in particular that stands out. But I'll go back through, and if there is anything, I would be happy to let you know.

John Taylor - Arcadia

Let me just follow up on the direct to consumer piece. I guess what I'm looking for here is, can you measure for us the amount of business you are doing directly? That you're generating through non-retail channels, as opposed to through retail channels with intermediaries that have some of those higher margins, and maybe how big that number might look after a couple years.

Frank Gibeau

Again, the numbers that Warren gave you are where we are at right now. In fact, it has proven to be quite an effective channel for us, not only to deliver content in the form of booster packs and micro transactions, but also to market it in a form against some of our retail games. As that grows in the next two years, we think that it can be significant. But at this time, it would be too difficult to handicap it as a percentage.

Operator

Our next question comes from P.J. McNealy, American Technology.

P.J. McNealy - American Technology

Good afternoon. A couple questions on pricing assumptions for fiscal year '07. Are you assuming that $39.99 holds up at retail for current-gen software? Are you assuming $499 for the PS3 for hardware price points? Just one related question to the PS3. Should we expect any online revenues through the PS3 in this fiscal year, and any thoughts on what their online structure looks like?

Larry Probst

I will take the question on PlayStation 3 hardware pricing. The answer is that Sony is going to have to provide that information; we're not going to speculate about that. They may or may not announce that at E3. We're just going to have to wait until next week and see what their strategy is.

Frank Gibeau

With regards to retail software pricing, we really let the market determine that, and we approach it on a SKU-by-SKU basis. Part of our short-term strategy, however, is going to be to leverage the recent hardware price moves from Sony on the PS2 and the PSP; leveraging Xbox 360's hardware availability as that increases, as the year goes on; and then, finally, prepare the channel for Q2 and Q3 from an inventory standpoint.

P.J. McNealy - American Technology

With online revenues from the PlayStation 3, should we expect anything in the fiscal year?

Warren Jenson

I would not. I think it is way, way too early. Secondly, I know I have said this before, a lot of these trends are very positive for the long term, but are going to be smaller dollars in the near term. So I would not expect anything material in this fiscal year.

Operator

Our next question comes from Mike Hickey, Janco Partners.

Mike Hickey - Janco Partners

Looking at your fiscal '07 overall R&D, the upper end of your range here looks like kind of what we're expecting for fiscal '08. Thinking about fiscal '08, should we see any sort of sequential pullback in R&D spend?

The second question is on your mobile side. As you broke out your R&D spend, it looks like that business is probably not profitable for you in fiscal '07. Could you clarify that, and do you expect it to be profitable in fiscal '08?

Larry Probst

I'll take the question on R&D spending. Obviously, it's pretty early in the game to be speculating about fiscal '08. But I would say that it would be our goal to reduce R&D spending as a percentage of revenue in fiscal '08.

Mike Hickey - Janco Partners

But you would see a sequential growth to that number? I don't understand.

Larry Probst

Too early to speculate.

Mike Hickey - Janco Partners

On the mobile side, can you clarify profitability for '07, at least?

Warren Jenson

So remember that the numbers I gave you include what we call mobility, which are things related to the trend toward mobility, which would be both handheld and cell phones. The combination of that business next year is clearly profitable.

Mike Hickey - Janco Partners

But for just the mobile cell phone side? Can you comment on that?

Warren Jenson

The mobile cell phone side, on a non-GAAP basis, clearly, we would expect to make money.

Operator

Our next question comes from Jeetil Patel, Deutsche Bank.

Jeetil Patel - Deutsche Bank

First of all, as you look at this upcoming fiscal year, can you just give us a sense of if you back out the JAMDAT contribution, it looks like you're down 5% to 10%. Just give us a sense of, in aggregate, what you're thinking in terms of average pricing moving down versus the volume trend in the business? Just to get a better handle of consumption in the industry.

Second, it looks like you're investing ahead of the curve in terms of future opportunities on different platforms. Globally, as you look out over the next cycle, there's going to be plenty of different opportunities out there. Do you think that, as you think about the marketplace, are you looking at a CAGR of 15%, 20%, 25%? Can you give us a sense of how you think about the growth playing out over a multi-year standpoint as you look forward beyond fiscal '07?

Warren Jenson

I'll try to go through several of those questions that you've asked. In terms of the long-term growth rate, we're not going to speculate. What I can tell you is that we know there is an exploding online market that today is not really even being measured. We have said next year that we think global cell phone or mobile phone growth would be in the 25% to 35% range. We feel pretty good about that. And we also know that as we go forward, with better technology, the trend is just going to increase. We think all of those things are positive.

I think, relative to long-term growth rates, this business with online, with mobility, is going to benefit from the ever-increasing presence of Web-based technology. So I think, while I won't speculate as to a rate, I think that we will clearly be a beneficiary of those trends. The other part of your question?

Jeetil Patel - Deutsche Bank

This year, fiscal '07, if you look at the decline in revenue modestly in terms of your guidance, how much do you think is related to just simplistically pricing trends in the industry as you are competitive, as pricing comes down on the hardware side and you're pricing your products more aggressively versus the unit volume on a year-on-year basis? And then a quick follow-up to that.

Frank Gibeau

In the transition years, the consumption is going to have some pressures on it. And clearly, current-gen pricing is declining. That is somewhat offset, obviously, by next-generation pricing being higher than last cycle. So for us individually, as a Company, we anticipate that consumption is going to be slightly down, but that is pretty typical in a transition.

Jeetil Patel - Deutsche Bank

The overall debt cost for next cycle or this upcoming cycle is much higher. Can you just give us a sense of whether you think the financial returns are different, similar? And maybe what the variables are to getting comparable returns in this cycle relative to the previous cycle, in terms of the margins in the business?

Warren Jenson

Here are the variables. Variable one is price. Variable two will be our ability to generate follow-on revenues, which will clearly be available in online. And I would say the principal beneficiaries of the micro transaction are going to be the big games, the ones that really have an established community around them and people keep playing them. We're fortunate that we have a lot of those games in our stable.

The third thing, which we don't know right now, because we have not built a game for the PlayStation 3, we have not yet been able to work to port the PlayStation 3 game to an Xbox 360 game or an Xbox 360 game to a PlayStation 3 game, we will work to try to scale the development cost. But again, that is something that it's way too early to speculate on, given the fact that we haven't really gone through it.

Larry Probst

The other component to that equation is the percentage of our business that is represented by wholly-owned intellectual property. As Warren mentioned earlier, that's around 40% now. We have a big focus going on within the Company to drive that number higher, and you're going to see us continue to expand our wholly-owned intellectual property portfolio.

Operator

Our next question comes from Heath Terry - Credit Suisse.

Heath Terry - Credit Suisse

I was wondering if you could just give us an idea, realizing it's only been a couple of weeks, what you're seeing on the initial price cut on PlayStation 2, what kind of an impact it's having on hardware sales and on your software business? As well, to the extent that you can comment on it, the improvement in 360 volumes and any impact that you might be seeing from the value price point or value pack on PlayStation portable?

Frank Gibeau

Sure. What we are hearing from retailers is about a 20% to 30% lift in the PS2 business, post price reduction. That has been sustained; that wasn't just a one-off. So we are feeling pretty good about that. We are seeing that impact in our catalog and in our new releases on PlayStation 2, so there is good news there.

With regards to the PSP, the new price point at $199, we believe, is opening up and addressing a new market that the $249, more expansive SKU was not getting to. But they are working in conjunction to stabilize and grow PSP sales.

With regard to Xbox 360, there is good flow on inventory. We actually believe that in May and June, retailers will actually be building inventory positions for the first time in the cycle on that hardware. The good news is the tie ratios on the 360 are around 4, which is a really solid number for us, and as the hardware improves, May or June we expect to be a good time for the 360.

Heath Terry - Credit Suisse

How do you interpret that strong tie ratio on 360? Does that give you any more confidence about the $60 price point on next-generation software being sustainable for maybe longer than you were thinking about initially?

Frank Gibeau

The market feedback on that price point is good, so far. The quality of the games and the quality of that hardware with the Xbox Live service, from a customer standpoint, they are seeing that value proposition as fair and in their interest.

Heath Terry - Credit Suisse

With this focus on growing your internally developed or your wholly-owned IP, can you talk to us about the differences in those margins and the business currently? How much more profitable are your wholly-owned IP titles versus the titles that you're licensing? And do you expect that to change as you put more of a focus on that?

Warren Jenson

I think there are a couple of interesting things. One is that this isn't true across the board. But by and large, the biggest hits in this industry have been games that have been developed, original IPs, I think that's one side of it, is that if you get the right concept, specifically built for video games, it can really win. The second aspect is the margin, and you can expect easy 10 to 20 basis points of improved margin.

Larry Probst

What I would add to that, Heath, is that there is increasing competition for significant licensed property, and those costs are going up. At a strategic level, we've taken a look at that. We're going to be very, very selective about what we license and what we don't license, and we are going to spend a lot more time trying to develop property that we own.

Operator

Our next question comes from Edward Williams, Harris Nesbitt.

Edward Williams - Harris Nesbitt

First, on the development side, I think you indicated that you are at 5,200 right now. Where is that headed by the end of the year? And then, as a follow-up to that, Larry, what steps are you taking to reduce the cost of developing a game as the next generation of consoles really builds out?

Larry Probst

Well, we're doing all the things that you would imagine. We're trying to share technology across all of our studios. We're looking for which components of the development process we can move to lower-cost locations. That's going to be an ongoing process as we go through this transition period.

The PlayStation 3 is a challenging platform to develop for it. It's going to be more expensive than the PlayStation 2, and we are going to try to make that as efficient a process as possible.

Edward Williams - Harris Nesbitt

At this point, are you outsourcing much of the development? Or if we look back on the PS2 and Xbox, how much of the development is outsourced? And how much do you think that will change in the next generation?

Larry Probst

Well, we're currently outsourcing more than we have previously, and we will continue to look for those opportunities in the future.

Edward Williams - Harris Nesbitt

If you look at the new areas, the mobility and the online categories, when do you expect to generate significant returns off of those, significant increases in development expenses?

Warren Jenson

I would say we're already benefiting from both of those. Clearly, on the handheld side, which is more of an established business. But one of the things we did on the development side, as I think we've mentioned, is to build, we call it fusion, which is more of a centralized capacity to build for the handhelds. These guys have done a great job in very effectively and efficiently building games for the handhelds. We expect to expand that and continue with it.

Mobile, we are just getting started, really, with the acquisition of JAMDAT. And I think, if things continue to go the way they look they will, we would expect to be generating returns very shortly.

Edward Williams - Harris Nesbitt

Just as a quick follow-up to that, if we look at the $130 million or so in revenue that you expect out of the mobile phone side of mobility, how much of that do you think will come from territories outside of North America in fiscal 2007?

Warren Jenson

Where we intend to expand first is, one, we will do a lot in Europe this year and then continue to expand in Asia. But the primary focus will be Europe. I could be off here a little bit, but the number is around $25 million to $35 million.

Edward Williams - Harris Nesbitt

Larry, just going back to you for a moment, if we look at the next-gen cycle, how do you think the console sell-through will play out differently, if at all, on a percentage basis, on a geographic basis? So do you think Europe will take a greater share of the global market, or will we see the hardware companies be able to get the household penetration of the consoles extended beyond where they have been in the last couple cycles?

Larry Probst

Well, I think that there is an opportunity to increase the penetration level. Certainly, in some of the Western European countries like Germany, as an example, I think they are at 12% or 13% penetration rates, currently. So clearly, there's an opportunity there.

I think what is going to be interesting is to see what Microsoft and Sony and Nintendo do in some of the emerging markets around the world, in Eastern Europe, in Latin and South America and in some of the Asian territories, where there really hasn't been much of an effort in the past.

So when we think about cycle-to-cycle growth, I think that's going to be driven to some degree by markets that were unaddressed in previous cycles.

Edward Williams - Harris Nesbitt

Thank you very much.

Operator

Our next question comes from Shawn Milne, Friedman Billings.

Shawn Milne - Friedman Billings

Warren, just a housekeeping question. The tax rate was higher than I expected in the quarter. What is your tax rate guidance for fiscal '07?

Warren Jenson

I'm glad you brought that up, Shawn. A couple of things, let me preface this with. One of the things that -- and I'm sure many of you are aware of this, that in the current environment you have to expect our tax rate is going to fluctuate more. And that is going to be true for EA; it's true for every company in corporate America. It is just going to fluctuate more.

The second thing is it can be up, as it was this quarter, and for the year, based on our ultimate mix for us between foreign earnings and US-based earnings. So mix can have an immediate impact on our tax rate. And then, oftentimes, there are just miscellaneous one-time adjustments that happen on a regular basis.

Going forward, looking to next year, recognizing our GAAP guidance fluctuates around a loss and into a slight level of profitability, what I want to tell you is that minute adjustments in a tax item can have significant impact on rate.

So what we would tell you to do for this coming year is I'd use a GAAP rate of 40%. Now, what you will see is, as you back out the non-GAAP items, you'll see that rate come down. But at the same time recognize there will be big levels of fluctuation, particularly where you have loss quarters. And this is a year where you're going to feel that. Longer term, you could continue to expect our tax rate to trend between 27% to 29%.

Shawn Milne - Friedman Billings

Right. Going into the call, I was looking for 28%. The delta on 28% to 40% is a full $0.20 next year. Is that fair?

Warren Jenson

Well, you have to, again, look at this on a non-GAAP and a GAAP basis.

Shawn Milne - Friedman Billings

I'm looking on non-GAAP.

Warren Jenson

So the non-GAAP number in our tax rate could come down significantly from the 40%. Again, what we will do is we go through and tax effect each of those numbers in calculating what the rate would be. Then again, remember that you have got some loss quarters where you're going to benefit from the operating loss, and then there will also be income quarters.

So in absolute math, the spread between a 28% rate and 40% rate has an impact. But then you also have to look at what is the profit before tax, and you'll end up seeing that it's small; it has a relatively small absolute impact.

Shawn Milne - Friedman Billings

I need to go back to the '07 guidance again. The R&D number you put out there was modestly higher than, I would say, consensus expectations but not off the charts. The other expenses seemed well controlled in the current quarter.

So it then comes down to the revenue guidance of $2.7 billion at the low end seems incredibly low. If you take out JAMDAT, that would be modeling your core business down 14%.

What are we missing here, given that Microsoft is talking about higher Xbox 360 production, higher price points are sticking? What am I missing here? Is there a couple games that you have dramatically reduced expectations for? Is there an FX headwind that you're now modeling? It just seems like too much of a haircut here.

Warren Jenson

What we tried to do, and I can't say a lot more than I mentioned during the more formal part of the call; this is a period of heightened uncertainty, a period where there could easily be slips in production. We also have a lot going on with inside EA. And we tried to sit down and weigh those risks as best we could and say, okay, what is the range of our performance? And that is what we felt was appropriate.

Larry Probst

We also have to take into consideration the potential uncertainty around the launch of the new platforms from Sony and Nintendo. If history teaches us anything, it's that the best laid plans sometimes don't turn out to be reality.

Operator

Our next question comes from Justin Post, Merrill Lynch.

Justin Post - Merrill Lynch

I appreciate the R&D breakdown. On the $600 million for consoles, as the last cycle progressed, that grew. And then, did that really level off or start going the other way as the cycle progressed? And then I have one follow-up.

Warren Jenson

It pretty much leveled off for a few years and then increased. I think, in general, in the last cycle, you saw the cost line in total continue to increase, although the market expanded at a faster rate, which expanded our margins. That's what happened last time.

Justin Post - Merrill Lynch

Can you give us any help with the SKU or title count for next year versus the last year? Obviously, it feels like there could be some upside to your revenue numbers if everything works right. Can you just help us compare the SKU and title count year over year?

Larry Probst

The SKU count is roughly similar. I think it was about 131 in fiscal '06, and it's a number that's sort of high 120's in fiscal '07. So it's roughly the same.

Justin Post - Merrill Lynch

Is there any other major license out of IP that you are not going to be doing, like Bond, anything similar to that, that is going to slip out of the year?

Larry Probst

Not that we know of at this point in time.

Operator

Gentlemen, I will turn it back over to you for any closing remarks.

Warren Jenson

Thanks, everyone, and we look forward to seeing you at E3.

Operator

That does conclude today's conference. We do thank you for your participation.

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Source: Electronic Arts Inc. F4Q06 (Qtr ended Mar 31, 2006) Earnings Conference Call Transcript (ERTS)
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