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Executives

Tricia Gugler - Director, Investor Relations

John S. Riccitiello - Chief Executive Officer, Director

Eric F. Brown - Chief Financial Officer, Executive Vice President

John Pleasants - Chief Operating Officer and President - Global Publishing

Peter Moore - President, EA Sports Label

Analysts

Douglas Creutz - Cowen & Company

Leo Choy - Pacific Growth Equities

John Taylor - Arcadia

Brent Thill - Citigroup

Mike Hickey - Janco Partners

Mark Weinkes - Goldman Sachs

Daniel Ernst - Hudson Square Research

Anthony Gikas - Piper Jaffray

Eric Handler - Barclays Capital

Benjamin Schachter - UBS

Jess Lubert - Banc of America Securities

Colin Sebastian - Lazard Capital

Justin Post - Merrill Lynch

Jeetil Patel - Deutsche Bank

Arvind Bhatia - Stern Agee Leach

Electronic Arts Inc. (ERTS) F2Q09 Earnings Call October 30, 2008 5:00 PM ET

Operator

Good day, everyone and welcome to the Electronic Arts second quarter fiscal year 2009 earnings conference call. Today’s conference is being recorded. For opening remarks and introductions, I would like to turn the call over to your host, Miss Tricia Gugler, Senior Director of Investor Relations. Please go ahead.

Tricia Gugler

Great. Thank you. Welcome to our second quarter fiscal 2009 earnings call. Today on the call we have John Riccitiello, our Chief Executive Officer; Eric Brown, our Chief Financial Officer and John Pleasants, our Chief Operating Officer.

Before we begin, I’d like to remind you that you may find copies of our SEC filings, our earnings release and a replay of this webcast on our web site at investor.ea.com. Shortly after the call we will post a copy of our prepared remarks on our website. Throughout this call we will present both GAAP and non-GAAP financial measures. Non-GAAP measures exclude the following items: amortization of intangibles, stock-based compensation, acquired in-process technology, restructuring charges, losses on strategic investments, certain abandoned acquisition-related costs, and the impact of the change in deferred net revenue related to certain packaged goods and digital content.

In addition, starting with its fiscal 2009 results, the company began to apply a fixed, long-term projected tax rate of 28% to determine its non-GAAP results. Prior to fiscal 2009, the company’s non-GAAP financial results were determined by excluding the specific income tax effects associated with the non-GAAP items and the impact of certain one-time income tax adjustments.

Our earnings release provides a reconciliation of our GAAP to non-GAAP measures. 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.

Please see our earnings release and the supplemental information on our website for a detailed GAAP to non-GAAP reconciliation and our trailing twelve month segment shares and a summary of our financial guidance.

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 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 October 30, 2008 and disclaim any duty to update them.

Now I would like to turn the call over to John.

John S. Riccitiello

Thanks, Tricia. Let me update briefly on a few items on our agenda today. I am going to start with a review of Q2, talk about our back-half of the year, the economy, and an update on how things are working at EA. Eric will review our Q2 results in detail and provide our specific guidance for FY09. He will also discuss our cost reduction initiatives. John Pleasants will discuss key learnings from Q2, the current retail environment, our holiday slate and our progress in our digital direct-to-consumer businesses. Then I’ll wrap up with a few closing thoughts. After that, Eric, John and I will be happy to take your questions.

Q2 results -- we came in as expected on the top and bottom line. Our Sports franchises, especially Madden, performed well. SPORE and Warhammer Online met our high expectations. And I want to call out the teams behind Madden, Tiger, NHL, FIFA, SPORE, Dead Space and Warhammer for creating some incredibly innovative, high-quality titles.

Looking forward, we have an outstanding slate of great titles for the second half of our fiscal year and especially for the crucial holiday quarter. Despite this strength, we believe it is now prudent to lower our guidance for the balance of the fiscal year. As you know, we have moved Harry Potter to FY10 with the slip of the movie, which is particularly hard -- costing us $0.13 EPS -- as we have completed and expensed a solid game but won’t see revenues until next year. And in recent weeks, we have experienced sharply adverse foreign exchange. The recent spike up in the dollar compared to where it was when we provided guidance in May and July, if it holds, will reduce our earnings per share by approximately $0.12. Third, we are seeing continued weakness with catalog sales and are starting to see weakness at retail in October. These factors, balanced against our total set of puts and takes, have us reducing our range by $0.30 EPS both at the top and bottom end.

There are four areas I would like to address before turning the microphone over to Eric: first, the broad economic environment; second, EA’s recent operational performance; third, the flow through of top line revenue at EA to bottom line EPS; and fourth, the reduction in force we announced earlier today and other planned future cost reductions.

In addressing the economic environment, I’ll start by telling you what I believe most of you know -- the game industry has been very resilient in past recessions. History shows us that the technology driver of new consoles has outweighed the negative of a recession. And this time we have three strong and well differentiated consoles, each in growth mode. Having three strong players at one time is unprecedented.

And I am sure you know just how good a value games are to the consumer. A single $60 game can deliver 50 to 100 hours of play, a far better consumer value than a trip to the movies or a live music or sports event. We also note just how strong games sales have been thus far this year, up 30% in North America and we estimate 22% in Europe. Retailers, both in Europe and North America, have added space for the game industry. Still, we recognize these times are unprecedented and so far in October, there are indicators that consumers and retailers are being more cautious. We remain optimistic for our sector longer term but cautious in the short term.

Turning to EA’s operational performance, let me start with some of the negatives. We’ve experienced a few slips and kills. Recently, we killed Tiberium, a move we made for quality reasons. And Saboteur is moving to FY10. And, as I mentioned, we are also seeing continued weakness in our catalog sales.

On the positive side, we are seeing across-the-board improvements in innovation and quality of our games, whether on PC, consoles, mobile phones or in Sports or with our new IPs. Overall, our metacritic scores are up. This is translating to solid front line sales for both our sequel titles and new intellectual properties. On-time delivery of games is up in all four of our labels. And EA Partners continues to perform well in sales and in signing new profitable deals.

Now on to the question of how revenue flows thru to our margins -- if you look at our growth year-over-year, we expect to add over $1 billion in revenue this year, with overall operating margins increasing up to 300 basis points. There are three aspects of this performance that I would like to peel apart for you: our core business, our EAP business, and our investments in digital direct initiatives.

EA’s business, excluding co-publishing and distribution, is expected to grow from $3.3 billion in fiscal year ’08 to over $4 billion in fiscal year ’09. We are expecting at least 500 basis points of operating leverage year-over-year. We’re not yet where we want to be but we expect a doubling in operating margin year-over-year.

We expect to deliver this performance even while making significant up-front online investments. These investments include our spending on the Star Wars: The Old Republic MMO, developing seven of our franchises into mid-session games, the infrastructure to self-publish micro-transaction games in Asia, our Nucleus online registration and billing system and other platform technologies to build direct-to-consumer business models for our core packaged goods games. We think these investments are crucial to EA’s long term success because in the future we see slower growth in the basic packaged goods business and higher margins, greater growth and reduced cyclicality with these new direct-to-consumer businesses. We’re investing approximately $150 million in these activities. We believe this investment, while compressing near term results, sets us up for success longer term.

Our EAP business is growing very rapidly, increasing our co-pub and distribution revenue from approximately $700 million in FY08 to over $1 billion in FY09. Operating margins in this business, while solid, are less than our own business and this year are expected to be single digit.

The FY09 negative for the P&L is the result of the recent success we’ve had in signing new properties from some of the best developers in the world. Each of these new co-development deals involves some up-front investment, and in FY09 we’re running about $35 million ahead of FY08 on these investments with no associated revenue. This development is expensed now with significant returns expected in the future.

If we were to cut short our investments in EAP and digital direct, our operating profit would look much better today, with approximately 350 points of more operating margin. Although this would help for the short term, cutting these investments is not the right answer for the long term.

Now I’d like to turn to the cost actions we announced today. Given the uncertain economic environment and the ever present need to drive greater efficiencies, earlier today we announced that we are reducing headcount. We are taking costs out, both now and as we progress thru our FY10 planning. We’ve made the decision to eliminate positions totaling approximately 6% of our current workforce and will manage headcount additions aggressively going forward. And as we go through our FY10 planning process we will continue to focus on costs and efficiencies and eliminate marginal SKUs.

Now, I would like to turn the call over to Eric.

Eric F. Brown

Thank you, John and good afternoon everyone. For Q2, we delivered record non-GAAP revenue of $1.125 billion, our top and bottom line came in as we expected -- overall a solid quarter.

A few highlights -- as usual, Q2 was a big sports quarter. Madden NFL 09 was our best selling title in the quarter selling 4.5 million copies; while units were flat to last year, we did this on two fewer platforms. NCAA Football 09 sold 1.8 million copies, up 5% year-over-year. Tiger Woods PGA TOUR 09 sold 1.5 million copies and the Wii title is one of the highest rated recently released games. NHL 09 is our highest rated sports titles so far this cycle, with a metacritic rating of 89 on the Xbox 360 and PS3. Sell thru has been up over 85% year-over-year on these platforms. Overall our core sports titles delivered as expected in the quarter.

Before leaving sports, I would also like to mention FIFA 09, which is a Q3 title. It is off to its strongest start in history with the first three weeks of sell thru up an estimated 30% year-over-year.

Q2 was also about new IP. During the quarter, we launched 3 new games. SPORE is off to a great start selling nearly 2 million copies and is the number one PC title in North America and is number three in Europe year-to-date. Mercenaries 2 sold 1.9 million copies and Warhammer Online: Age of Reckoning had a strong debut selling 1.2 million copies.

In addition, through our EA Partners business, we shipped Rock Band 2 software exclusively for the Xbox 360. Combined with the original Rock Band, the franchise sold over 1.5 million copies in the quarter. Calendar year to date, Rock Band is the number one title across all platforms in North America.

And finally, during the quarter we recognized $110 million in digital direct-to-consumer revenue, up $27 million or 33% year-over year and 22% sequentially. This is the first time this revenue stream has hit the $100 million mark in a quarter. This growth was fueled by digital downloads, wireless, advertising and POGO subscriptions.

In the quarter, we had $16 million of sales through our EA Store and other third party sites, up $12 million from last year. SPORE alone generated $5 million. Since the launch of our new EA Store last September, we’ve had over one million downloads. We are now up and running in 31 countries.

Our wireless business also experienced strong growth, up $8 million year-over-year or 21%.

I would now like to spend some time discussing Q2 in more detail. Please note that all of the following references to second quarter results are non-GAAP, unless otherwise stated.

Q2 non-GAAP revenue was $1.126 billion, up 20% year-over-year. Foreign exchange positively impacted the top-line by 2%. As expected, our Q2 revenue was primarily driven by the launches of Madden NFL 09, SPORE, Mercenaries 2, NCAA Football 09, Tiger Woods PGA Tour 09, Warhammer Online and the continued sales of MTV Games and Harmonix Rock Band.

By geography -- North America non-GAAP revenue was $746 million, up $221 million or 42%, primarily due to growth in distribution and PC revenue. International non-GAAP revenue was $380 million, down $31 million – down $31 million – or 8% and down 12% at constant currency rates. The year-over-year decline traces to a comparison to Q208 which included approximately $120 million of FIFA. This year, FIFA 09 launched in Q309. Revenue in the quarter was driven by Rock Band, SPORE, Mercenaries 2 and Warhammer.

Moving to the rest of the income statement, non-GAAP gross profit was $573 million, up 4% year-over-year. Non-GAAP gross profit margin was 50.9% versus 58.7%, down 7.8 percentage points due to a higher mix of co-publishing and distribution revenue.

Operating Expenses -- before getting into the details, let me remind you that this year we are recording our bonus expense in a straight-line fashion instead of recognizing the expense in proportion to quarterly profitability as we have in the past. This impacts the quarterly phasing of our bonus expense. As we said on our last call, this change will negatively impact Q1, Q2 and Q409 and have a corresponding favorable impact on expenses in Q3. During the quarter, this resulted in an approximate $29 million overall increase to operating expenses year-over-year.

Marketing and sales -- marketing and sales expense, excluding stock-based compensation, was $192 million, up $33 million primarily due to increased advertising to support our Q2 releases and higher personnel-related costs, including the bonus phasing. As a percentage of revenue marketing and sales was 17% of non-GAAP revenue, consistent with last year.

General and administrative -- G&A expense excluding stock-based compensation was $79 million, up $5 million. The increase was driven primarily by the bonus phasing.

Research and development -- R&D, excluding stock-based compensation, was $337 million, up $100 million. Of the $100 million, $29 million is related to the acquisition of VGH, $32 million in contracted services due to a greater number of projects under development and EAP advances, and $20 million related to bonus phasing.

R&D headcount ended the quarter at roughly 7,400, up 7% year-over-year adjusted for M&A.

Below the operating income line, other income and expense was $7 million, down $25 million from a year ago due to a decline in interest income and foreign exchange losses.

Income taxes -- on a GAAP basis, we recorded $81 million of tax benefit. On a non-GAAP basis, we recorded taxes at 28%.

GAAP diluted loss per share was $0.97 versus diluted loss per share of $0.62 a year ago. This quarter, our GAAP loss included $21 million of pre-tax acquisition-related charges associated with the abandonment of the Take-Two transaction.

Non-GAAP diluted loss per share was $0.06 versus diluted earnings per share of $0.27 a year ago.

Our trailing twelve month operating cash flow was $219 million versus $145 million for the prior period. We’re expecting to generate significant positive cash flows for the remainder of the year.

Turning to the balance sheet, cash and short term investments were $1.825 billion at quarter end, down $122 million from last quarter due to cash used in operations. With respect to our cash and our short term investment portfolio, we managed to navigate the downturn in the capital markets relatively well and for the quarter, we realized only a small net gain and incurred no impairment charges on the portfolio.

Marketable equity securities and other investments were $648 million, down $104 million from last quarter due to declines in the market value of our strategic investments.

During the quarter, we recognized a pre-tax loss of $34 million in the P&L related to our investment in Neowiz. At quarter end after the write down, we had a net unrealized gain of $438 million, comprised of a $441 million unrealized gain on Ubisoft and a $3 million unrealized loss on The9.

Gross accounts receivable were $715 million versus $609 million a year ago, an increase of 17% primarily due to the growth in non-GAAP revenue.

Reserves against outstanding receivables totaled $168 million, down $17 million from a year ago. Reserve levels were 10% of trailing six month non-GAAP revenue, down four points. As a percentage of trailing nine month non-GAAP revenue, reserves were 6%, down three points. The decrease year-over-year is related to A, a higher mix of our revenue coming from our distribution business for which we have less return risk, and lower channel exposure in Europe.

Inventory was $328 million, up $105 million sequentially. Only a small portion of this increase is for our own titles where we carry full inventory risk.

Ending deferred net revenue from packaged goods and digital content was $424 million, up $232 million sequentially primarily due to a build of deferred net revenue related to our Q2 releases.

Now to our outlook -- let’s start with the industry. We continue to expect software sales to grow 20% or more this year combined for North America and Europe. Keep in mind that year-over-year comparables will get more difficult in the holiday quarter given the robust growth experienced a year ago.

Now for our guidance -- before, I get into the numbers, I would like to provide some detail on our recently announced cost reduction plan. Beginning in our third fiscal quarter, we expect to reduce our worldwide staff by approximately 6% across the labels, publishing and corporate divisions. We expect to incur cash charges of approximately $10 million, the majority of which will be incurred in our fiscal third quarter. We expect this action to result in annual operating cost savings of approximately $50 million.

As part of this cost reduction initiative, we expect to reduce hiring and continue to expand in lower cost locations. At the end of FY09, we expect to have fewer employees in high cost locations versus the end of last year. Also, as we enter our planning process for FY10, we expect to carefully scrutinize all operating expense budgets and optimize the company SKU plan.

Now for the GAAP guidance -- for the full year, we expect: GAAP revenue to be between $4.9 billion and $5.15 billion; GAAP EPS to be between a diluted loss per share of $0.21 to diluted earnings per share of $0.07; GAAP gross margin to be between 54% and 55%; diluted share count to be approximately 325 million shares.

We expect to end the year with roughly $500 million in deferred net revenue related to online-enabled packaged goods.

Now our non-GAAP guidance -- as John indicated, we are lowering our full year EPS guidance by $0.30 on both the top and bottom end of the range for various items including: the shift of Harry Potter, which is $0.13 of EPS; foreign exchange impact, which is $0.12 of EPS; catalog weakness and other factors. including the slip of Saboteur.

For the full year, we now expect: non-GAAP revenue to be between $5.0 billion and $5.3 billion; non-GAAP EPS to be between $1.00 and $1.40 per share; non-GAAP gross margin to be between 55.5% and 56.5%; diluted share count to be approximately 325 million shares.

Please see our press release for the difference between our expected GAAP and non-GAAP guidance.

Let me provide some additional detail. FX assumptions -- foreign exchange rates have been volatile in the last few weeks and for purposes of guidance, we are taking into account current spot rates. To the extent the U.S. dollar continues to strengthen against the Euro and GBP, we may have downside EPS exposure.

On Non-GAAP expenses -- R&D; given our headcount reduction, more focus on headcount additions through the back half of the year and the weaker Canadian dollar, we now expect non-GAAP R&D will increase roughly 25% to 27% year-over-year. Core R&D expenses are expected to grow at a high single digit percentage year-over-year.

We expect sales and marketing to be flat as a percentage of revenue versus last year, and we expect G&A to be down 1 to 1.5 points as a percentage of revenue versus last year.

On non-GAAP operating margins, we expect a non-GAAP operating margin of 8.5% to 11.25% for FY09, or an increase of 50 to 325 basis points from fiscal ‘08.

Below the operating income line, we expect that non-GAAP other income and expense will be roughly $35 million this year, down from our last estimate and down significantly from last year as a result of steep declines in interest rates and foreign exchange losses.

Income taxes -- we expect our non-GAAP tax rate for FY09 to be 28%. You can also use this 28% rate to model the quarters. On a GAAP basis, we expect $35 million to $70 million of tax expense. Please note that our GAAP tax rate can be particularly volatile at lower levels of pretax income as a relatively small change can produce a big swing in our annual effective tax rate.

A few things you need to keep in mind for the quarters. Given the change in mix of our revenue, we expect our non-GAAP gross profit margin to be in the mid 50s for Q3 and low 60s for Q4.

On bonus phasing, we expect to incur $35 million to $40 million in bonus expense in each quarter, given the straight line accounting. Relative to last year, this will result in less bonus expense in Q309 versus Q308. Last year, the bulk of the full year bonus expense was booked in Q308.

Now our Q3 title slate -- we have 21 titles and 56 SKUs slated for Q3 versus 10 titles and 38 SKUs a year ago. Please see the supplemental deck on our website for the complete listing.

We made the decision to launch Lord of the Rings Conquest in a better ship window, January 09.

From EA Partners, we expect to ship 13 SKUs, including Left 4 Dead and Rock Band Track Packs.

From EA Mobile, we plan to release 12 games, including Need for Speed, FIFA and Trivial Pursuit.

That concludes our guidance and outlook commentary.

I would now like to turn the call over to John Pleasants, our Chief Operating Officer.

John Pleasants

Thank you, Eric and good afternoon, everybody. I would like to cover a few topics. First, go a bit deeper on Q2 and discuss some of our learnings and observations. Second, discuss what we are seeing at retail and key titles we have for the upcoming holiday quarter. And third, wrap up with what we are doing in our digital direct-to-consumer businesses.

As John and Eric indicated, Q2 came in as expected but we wanted to share a few observations.

First in sports -- we raised a question on the July earnings call as to whether quality and innovation would trump soft pre-orders. We now have the answer -- it does. Every one of our sports simulation titles was up in quality this year and our sales trend has turned positive.

Second, SPORE met our initial expectations as a packaged goods PC product and we are pleased to report it’s the most successful North American new IP launch on PC, beating both The Sims and World of Warcraft. So we’re off to a great start. What is also interesting is the strong user engagement we are seeing -- over 40 million creations have been shared online, and on YouTube 150,000 videos have been uploaded and viewed over 30 million times. That makes us very confident that we can build SPORE into a platform for years to come. We have two expansion packs coming over the next six months with much more on the way.

Third, we are also making progress with non-traditional forms of marketing. This is an important initiative for us as we look to drive efficiencies in our cost of customer acquisition. We continue to experiment with viral and online marketing and are thrilled with the response from our Tiger Woods and Mercenaries campaigns, in particular. If you haven’t already done so, you should check out the Tiger Woods walk on water YouTube video, which has received over 2.3 million viewings so far.

Now let me shift to the retail environment and our holiday slate. As you know well, the overall retail environment is tough -- foot traffic is soft, consumer spending is down and total retail forecasts for the holiday are down. However, in our category retailers are betting on the video game sector this holiday. Major retailers are continuing to add space to the sector; particularly Walmart and Best Buy in North America and Asda and Tesco in Europe. Specialty retailers continue to add hundreds of stores. Although these are positive indicators, the overall economic environment is leading retailers to be more conservative with their open-to-buys and general inventory management. Based on what we have seen in October, retailers are being cautious, particularly in North America.

In addition, we are seeing weakness in catalog particularly in games with limited online connectivity. This is something we are addressing directly with post launch content such as on NBA Live, where the game is refreshed daily. You’ll see more of this in our upcoming launches.

For EA, we’ve got an incredibly strong slate of titles that we believe positions us well this holiday. We’ve got tent pole games -- Need for Speed Undercover, FIFA, NBA Live and My Sims. We’ve got new innovative IP, including critically acclaimed Mirror’s Edge and Dead Space. We’ve got our casual line up, including Littlest Pet Shop and Nerf-n-Strike from Hasbro. We’re thrilled to be expanding into this important genre and finally, we’ve got a broad slate of Nintendo games. We’ve released 10 SKUs and have 30 coming, including Nerf-n-Strike, Skate it and MySims Kingdom.

Now let me switch gears and talk about a key long term strategic initiative for EA, our digital direct-to-consumer businesses. We are back in the MMO business with the launch of Warhammer Online. Currently, 800,000 people are playing online worldwide. In North America, we have 250,000 subscribers in less than two weeks and are seeing conversions of over 70%. Although it is still early days, we like what we are seeing. In addition, we announced we have Star Wars: The Old Republic MMO under development in EA’s BioWare studio in partnership with Lucas Arts.

We are making good progress in Asia with our mid-session games. Today we have nine instances of our FIFA and NBA Street franchises in closed beta in various countries across Asia and we expect to be generating revenue on all of them by year-end. That compares to just one game last year.

We are starting to make progress on premium downloadable content. Burnout Paradise was our first full download game on the PlayStation Network, with over 20,000 downloads in a three week period. In Tiger Woods PGA TOUR 09, consumers have purchased 90,000 pieces of content in just over five weeks, driving micro-transaction revenue up 5x that of last year.

On the PC side, we just launched the Sims 2 store and so far, we have generated $14.50 per paying user in micro-transactions. Although the dollars are all relatively small, the growth is significant.

Our wireless business is also delivering, with revenue up 25% for the first six months. This business is on track to generate over $185 million in revenue this year, consistent with our previous guidance.

With that, I’ll turn it back to John.

John S. Riccitiello

Thanks, John. Before we take your questions I want to emphasize a few thoughts. First, reducing our guidance is a big deal and we take it seriously. We’re proactively making cost adjustments now and will continue to do so as we plan the next fiscal year. Second, we are in a fast growing industry driven by innovation and technology. Third, we are making significant progress on the business and have the right long term strategy and are driving towards our FY11 targets.

In summary, while we are very bullish longer term, we are more cautious in the short term. With that, we would be happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) We’ll take our first question from Doug Creutz with Cowen & Company.

Douglas Creutz - Cowen & Company

Thanks. If I could drill down on the guidance a little bit, you mention currency issues, presumably depress revenue, you’ve got some title push-backs which depress revenue, but you are leaving your non-GAAP revenue guidance I believe unchanged for the year. So presumably there is something offsetting that which is doing better than you expected and I guess could you just explain how that all fits together? Thanks.

Eric F. Brown

Thanks for the question. We are leaving the top end of the range unchanged at $5.0 billion to $5.3 billion and what we have is a mix change. We are doing better than we expected last quarter in terms of our distribution business. The discrete previously announced title slip of Harry Potter is a high margin title. That is pushed out into fiscal ’10, so all in there are puts and takes on the revenue line.

Specifically in regard to the change in the EPS, we called out Harry Potter, as previously announced. That’s $0.13. Foreign exchange is $0.12 with all of our profitability ahead of us in the back half of the fiscal year, and so those would be the primary drivers on the reduction of the guidance for EPS.

John S. Riccitiello

A little color on the top line is Rock Band in particular is doing better. FIFA looks like it is doing better. Dead Space has got off to a strong start, and sports is performing well. On the offset, you’ve got catalog, Saboteur, and a few other items, so hence the lack of change in the top line guidance.

Operator

We’ll go next to [Leo Choy] with Pacific Growth Equities.

Leo Choy - Pacific Growth Equities

Thanks for taking my questions. I’ve just got a question on sports -- last year you guys mentioned a slower start for the sports label and with some of the numbers coming out for Madden, I was wondering if that puts you back on track in terms of your target.

John S. Riccitiello

I believe you are referring to last year or last call, actually, where we had suggested that we had very weak pre-orders on our key titles. And as John Pleasants had mentioned during his commentary, the question that we had raised or Peter Moore had raised during the last call was something we were very concerned about at the time, which is we had low pre-orders, we had the expectation for higher quality and innovation, and we were unsure which was going to be the more important factor in determining how many units we would sell or how many dollars of revenue we would generate. And as we mentioned, the revenues have come in as expected, with each of our sequel titles collectively adding up to year-over-year growth, in line with our expectations. So by and by, I think we learned that quality wins.

Operator

(Operator Instructions) We will move next to John Taylor with Arcadia Investments.

John Taylor - Arcadia

You’ve got a pretty big range in terms of the operating margin for the year and I wonder, other than revenue operating leverage, I wonder what factors you might call out in terms of operating cost lines or specific products that might account for that variability. And I’m going to sneak in a second one, if you can -- could you give us an update on the high/low percentages, high/low cost locations? Thanks.

Eric F. Brown

One of the factors we considered in setting the guidance range at the top and the bottom end is of course product mix. We’ve talked about it before. We’re heading into peak season. We still have the bulk of revenue and more than 100% of our EPS in front of us, and so that in and of itself can be, will be the most important swing factor in terms of how our bottom line plays out.

We are bringing in the cost line items and OpEx, either fairly consistent with what we discussed last time. G&A is the same, marketing and sales up a point, and expectations for R&D actually down a little bit, so we feel we have a pretty good handle on OpEx, so this boils down to product mix.

John S. Riccitiello

I think contributing to the wide spread really is early reports in North America suggesting retail was quite slow -- a little better in Europe, but it makes it a little hard to see through so keeping the range wide is frankly a better judgment at this point, given lack of visibility over how the consumer is going to react between now and the holidays.

Your headcount question, we’re expecting to finish the year with approximately 19% of our headcount in low cost locations versus 13% at the beginning of the year. And one other point that I would identify here is we expect year over year to finish this fiscal year with fewer actual heads in high cost locations than we started the year, something that at least as far back as my memory goes, which is mid-90s, that’s not happened. So it’s a strong shift, consequence of our moves into low cost locations and it’s happening in a year when we are generating more than $1 billion in top line growth. So it’s the right things to be doing for our business.

Operator

We’ll go next to Brent Thill with Citi.

Brent Thill - Citigroup

John, just on operating margins, your goal for fiscal ’11 to get to 25%, should we now assume that’s going to be way more back-end loaded based on the actions that you are taking today?

And I guess just as a follow-up on the margins, is there anything near-term you can really turn to really amp the margins up here?

John S. Riccitiello

Well, I’m going to start by telling you that we are not giving updated guidance for FY11, that our focus at the present time is on the balance of FY09, executing well through a significant cost reduction, making sure that we set up FY10 by being tougher on heads and projects and SKUs, so that we can get our operating margins where we want them to be.

In terms of understanding the complexion of FY11, I would point you back to a few of the comments that I made. This year we are carrying $150 million net investment in online and then incremental to just even last year, $35 million in EAP. Those types of things are investments today in profits tomorrow, so they reverse themselves out and then some.

So one of the reasons I think you are seeing, if you are asking what is discontinuous or what would signal a shift, it’s getting through the investment period of creating the right online set of business models for us, and that certainly is planned to take place prior to the start of FY11 in a big way and continue from there.

Operator

We’ll go next to Mike Hickey with Janco Partners.

Mike Hickey - Janco Partners

Given the considerable, at least it looks like considerable we are seeing from the consumer, what gives you guys confidence that you will be able to hold pricing into the holiday? I mean, [I assume] if you bring out a calculator, you can definitely justify the value proposition but $60, much less $200, is still a fairly large purchase.

John S. Riccitiello

Well look, I think our industry historically -- I’ve been through this before in prior cycles. What determines the sustainability of retail pricing on front-line games has a great deal more to do with associated hardware pricing. So by and large, you saw front-line pricing hold on the PlayStation 2 until we were down below $149 for the hardware. What that was about is you are bringing a different consumer in the marketplace, you know, expanding breadth, if you will, you’re getting to a mass market and it takes lower pricing to incent that consumer to buy the software that goes with it. They initially would wait and buy catalog but breaking price was a profitable decision to make once we got down into those low price points on the PS2.

As you can see, frontline pricing on all three consoles is well above that level right now, so we are seeing compression, we are seeing weaker catalog, we are seeing some faster moves to breaks, but we are not seeing anything to suggest that there is a broad-based need to move frontline pricing down.

In fact, one of the things you could argue, if you look at the data, is we are getting more of our sales in the first month than we have ever seen on new title introductions. Of course, that means there is less catalog but it also means that the consumer is quite willing to be in this line day one and buy the titles they want, and they are relatively price in-elastic at that point.

Operator

We’ll go next to Mark Weinkes with Goldman Sachs.

Mark Weinkes - Goldman Sachs

Thank you. Just wondering, what do you think the $1.00 to $1.40 in EPS targets translates to in terms of free cash flow per share? And then just a clarification -- when you say retail slower in early October, are you referencing EA retail, videogame retail overall, or just in general retail?

Eric F. Brown

I’ll take the first half of the question. We are not providing specific operating or free cash flow guidance for the full year but we do expect to turn significantly operating and free cash flow positive in the second half of this year. We also expect to significantly grow cash flow year over year, FY09 compared to FY08.

John Pleasants

On the retail side, the comments that I was making were about retail overall as a category. And as it relates to our specific sector, we have seen just in even recent weeks a bit of a constriction of people’s appetite to be as aggressive with things like open-to-buys. So it’s just a -- it’s sort of a pre-positioning that makes us a little nervous in terms of how they are looking at the holiday.

Operator

(Operator Instructions) We will move next to Daniel Ernst with Hudson Square.

Daniel Ernst - Hudson Square Research

Good evening. Thanks for taking my call. My question is on Warhammer -- could you just clarify the stat you made on the 70% conversion? Does that refer to [the thousand] versus people who have bought the game so far? And then can you talk about what that conversion looks like at the end of the 30-day initial trial that you get with the game?

And then related to that, can you talk a little bit about the profitability of the title, given the start-up costs and having to maintain the servers and where you see that tracking, where do you have to take this in terms of sub count before this thing starts to contribute operating margins at least in line with corporate overall? Thanks.

John S. Riccitiello

The way we measure this, and we may [follow with more detail], is the consumer gets 30 days on a game from the day they initially install the title and register. And so when we are talking about 70%, what we are talking about is we are just shy of two weeks from the first tranche of consumers hitting the 30-day point. And for those consumers, 70% that have made the, you know, come to their 30-day point and made the decision to continue their subscription of the title. Seventy-percent is a very high statistic. We would not expect it to sustain itself but then again, it’s not surprising that the first buyers of a title are sort of the most loyal to the intellectual property and you would get a higher conversion rate to full subscription. You can expect that to drip down some from here.

In terms of our servers, we manage them ourselves in North America. We work with a partner in Europe. That’s been previously announced. We have not managed our rollout in Asia yet. That’s the next step. We are also not at the point of conversion in Europe. So there is more in front of us than behind us.

The things that we need to manage and pay a lot of attention to as we look forward is driving unit volumes up as we push more aggressively across Europe, Asia, continued sales in North America in terms of putting the top of the funnel, and then maintaining both the conversion rate and managing attrition to drive this business to be -- you know, get to a major milestone like 300,000 or 400,000 ongoing subscribers, and from there up to whatever level we can achieve. So far, it’s meeting and exceeding our expectations.

Operator

We’ll go next to Tony Gikas with Piper Jaffray.

Anthony Gikas - Piper Jaffray

A couple of quick ones, real quick -- how about the -- could you just talk about key changes to execution at retail over the holidays, given the change in the macro environment, in terms of like ad spending, any bundling, co-op spend, et cetera? And then Eric, could you please repeat the gross margin guidance by quarter?

John S. Riccitiello

We are very focused on retail execution right now. You know, again I say somewhat pridefully that I think it’s probably one of the strongest organizations we have at EA, our publishing organization, particularly in our western markets, where most of this activity is going on. We have been very carefully managing discounts and bundling right now. There’s been a lot of that activity going on and you can rest assured that we will sort of manage that carefully.

Eric F. Brown

In regard to your question on guidance, to recap what we had, for the third quarter, we’re expecting non-GAAP gross profit margins to be in the mid-50s, and for the fourth quarter we’re expecting non-GAAP gross profit margins to be in the low-60s.

John S. Riccitiello

The last thing I would say, Tony, too, was just we put a particular focus on our marketing mix over the course of the year on retail. I think that this year we are significantly up on our retail spend versus other media outlets that we focus on and in particular on actual infrastructure, primarily led by our sports franchises. We’ve put a lot of new units into Best Buy and we are spending a lot more than we have in the past on things like circulars and in-retail advertising. So we’ve got a lot of merchandising, a lot of POP, and a lot of foot space out there, if you will, so again it’s something that we feel pretty strongly about this coming holiday.

Operator

We’ll go next to Eric Handler with Barclays Capital.

Eric Handler - Barclays Capital

Just a clarification on FX -- you talked about a $0.12 impact to the bottom line but you didn’t really mention FX as a top line impact. Am I missing something there or was -- can you just clarify that issue?

Eric F. Brown

That’s correct. We quantified FX impact for EPS only for the full year. The revenue range, again we made the comment that mix is kind of an important component of that outcome. Overall we are expecting some depression of revenue as a result of the FX changes, but we feel that we can maintain the overall comp line range.

John S. Riccitiello

Just a little detail inside of that -- so we obviously have puts and takes in our guidance going forward. The Salvator slip is a take, FIFA upside is a put, and the [offsetting] Rock Band upside. One of the downsides is FX, which is approximately $150 million of our top line but we had enough on the positive side to offset that. Unfortunately, too much of that is low margin business, hence the shift in guidance in the bottom line.

Eric Handler - Barclays Capital

Okay, so it’s -- a lot of what we are seeing then is really the EA Partners business that’s the distribution?

John S. Riccitiello

Yeah, we have a sharp increase there.

Eric Handler - Barclays Capital

Okay. Thanks.

Operator

We’ll go next to Benjamin Schachter with UBS.

Benjamin Schachter - UBS

You mentioned you had a lot of confidence in Rock Band 2 and it’s off to a good start, but given everything that is going on with retail, what really gives you the confidence to bank on this going forward, particularly with the price points? And then John, also you mentioned that seven franchises are slated to become mid-session games. Could you just give us a high level view of how you view margins for more of these online and subscription pack products, particularly through the consoles and how they are going to work with the first parties? Thanks.

John S. Riccitiello

I’ll take the second piece while John focuses on the first -- on the MSGs, these are actually businesses with very, very different economic models in our packaged goods business and when you look at it as a system basis using FIFA online in Korea, you will see that we generate more absolute revenue than we did with our prior packaged goods business on the micro-transaction model. But in this case, we split that revenue with a local partner, Neowiz. On a consolidated basis, it’s both a higher absolute margin once it gets to scale and it is a higher revenue in that one marketplace.

One of the reasons we are doing as many tests as we are, John had mentioned the nine instances with both NBA Street and FIFA rolling across Asia, is to give us enough data to be able to answer your question definitively. And at this point in time, what we have is models to show how aggressive or how successful these can be, with principal titles like the one we’ve announced, Battlefield Heroes, which is going global late in our fiscal year.

The simple answer to your question is we intend to run them directly in most markets, hence we’ll capture all the revenue. If the revenue is substantial, this business is margin accretive to Electronic Arts but it starts with a fixed cost of establishing servers, customer supports, and all of the intelligence behind it. So again, the principal issue is how much consumer uptake there is.

Our model show this being a more attractive business for us by a fairly wide margin. We now need to deliver on those visions and it is really early. We really have got only substantive experience for one title in one country. We note though that our competitors in Asia that have been doing this model more broadly and for longer periods of time have and often do generate pretax margins north of 50%. So of course, they are running at scale. Our goal is to do the same.

John Pleasants

On the Rock Band 2 question, so quite a few things that give us confidence there -- the first and most important obviously is just the quality of the product. Rock Band 2 is a 93 metacritic product. I think there’s only been two products launched the entire year that have a score above that, that being GTA and Mario Super Smash Brothers, so those products speak for themselves. So we have an absolutely fantastic product is the first starting point.

The second thing is Rock Band 2 is an unbundled product, so you don’t have to buy the big box at the same high ASP that you did for Rock Band 1. So in an unbundled presentation, there’s a lot more flexibility for consumers just to buy whatever component they want. They do not need to therefore buy all of the hardware as they did the first time. And that price point we think again, given this economy, is going to be particularly attractive.

Third, it’s launching obviously in this Q3 holiday season. We think it’s going to be a fantastic gifting item in a category that continues to boom, which is the family and music category and social categories. And then finally long-term, MTV has done a fantastic job in their business development and obviously the signing and announcing of the Beatles is fantastic for this franchise long-term. So we see nothing but bright lights for Rock Band 2.

Operator

We’ll go next to Jess Lubert from Banc of America Securities.

Jess Lubert - Banc of America Securities

Good afternoon. Wii related revenue is down more than $20 million year over year, despite strong sales of this console. Can you walk us through what you need to do better to gain share in the Wii, and perhaps offer what insights you can into the breakdown of retail trends amongst hardcore versus casual gamers?

John S. Riccitiello

So the principal issue on our Wii revenues, and I don’t have a sub-total in front of me right now, [I’ll pop out and have] somebody try to bring it to me, but the real easy gap for us is last year our number one Wii title was Harry Potter and this year it’s not because we don’t have Harry Potter, and that’s a big year-over-year miss. Of course, we have it next year.

The biggest issue for us in driving our Wii business is really starting now. Downstairs there’s a line in our lobby for our own store to by the Nerf N-Strike product, which is going to be very strong on the Wii. And so we are really just moving into our strength and frankly, given the nature of this particular consumer, it would not surprise me to see relatively weak sales through the next couple of weeks until we get right in front of the Thanksgiving holiday where the gift consumer goes into the store and picks up titles like a second look at titles we released earlier this year, like Boom Blox, you know, what we’ve got coming now and through the holidays with our titles like Hasbro and Monopoly and Family Game Night, et cetera. And then also pick up titles, you know, that extra title for Dad, like Tiger on the Wii, which is a fantastic piece of software.

So I think on Wii, year over year, big issue -- Harry Potter, no Harry Potter. The fall is coming really starting today and what we are going to be looking at very carefully is what happens in the week running up to Thanksgiving and the first two weeks after, because that’s where this consumer usually shows up.

Eric F. Brown

I would also note that last year in Q2, we had a FIFA Wii SKU and this year we are launching FIFA in Q3, so that’s a change in terms of the year-over-year SKU plan comp.

Operator

We’ll go next to Colin Sebastian with Lazard Capital.

Colin Sebastian - Lazard Capital

Thanks for taking my question. John, I don’t want to beat a dead horse, but back to your comment on retailers lowering their open-to-buy -- is that across the board? And then, would you characterize this as a reaction to slower sell-through or are they preparing for the possibility? And still related to that then, what gives you the confidence in reaffirming the 20% industry growth forecast?

John S. Riccitiello

What it primarily is is that when you sort of get underneath the covers of that a little bit, what retailers have seen is that first of all, the foot traffic is down and secondly in our category, the things that are really moving are the big titles and they are getting a lot of movement on discount product. So when things are all the way down into the value consumer. It’s the sort of middle tier product of what obviously as we all know there’s a lot of product in the marketplace from all the different publishers, it’s that middle tier product that has slowed down. So what they are doing is they are focusing more on the bigger front line titles. They are being a lot more cautious with catalog ordering in particular and especially in that kind of mid-zone, so that does affect I think all publishers, not just EA, obviously, but it’s something that we are seeing, we are feeling, and we are working through and obviously trying to optimize results for.

The second question again was -- ?

John Pleasants

-- answer for you -- 20% industry growth. It takes roughly 8% for the last three months of the year for us to finish at 20% even. That seems like a reasonable estimate based on what we are seeing so far. You know, we are seeing a bit of a split with Europe doing a little bit better than North America and one of the things that [inaudible] -- I can point to one good reason why Europe overall as a sector is outperforming North America; it’s FIFA. So one of the things that sort of tells you there’s a pulse in the industry is when titles are what drive movement and right now Europe is outperforming North America in one of the most important titles in that marketplace is the main reason for it, and it’s nice that we are the beneficiaries of that.

Operator

We’ll go next to Justin Post with Merrill Lynch.

Justin Post - Merrill Lynch

John, when you think about the hit titles or the top titles you had in the quarter, are these sequel-able? Do you find any issues? And did you guys have to take any extra reserve for these titles? I know you gave us a shift in numbers as you went through the month of October. How’s your reserve situation?

John Pleasants

When you are thinking about principal titles in terms of hits and whether they are sequel-able, I presume you are thinking about titles like Dead Space or Mirror’s Edge, which are actually Q3 titles as opposed to Q2, and/or SPORE. John’s answered the question on SPORE -- we feel very much that there is a franchise there. We’ve got expansion packs coming new business models coming, so yes, it’s a franchise.

Now titles like Dead Space and Mirror’s Edge, I think you can absolutely expect those titles to come back in one way, shape, or form but they are not likely to be annual sequels. Warhammer Online is a subscription game, another important IP for us. That’s going to be monthly, and Mercenaries 2, there will be a Mercenaries 3 and if I can have anything to do with it, there will be a Mercenaries 10.

In terms of reserves, Eric, any update?

Eric F. Brown

We’ve taken a close look at, you know, we’ve talked a bit about the catalog trend versus front-line title. We’ve assessed that carefully. We believe we are appropriately reserved.

Operator

We’ll go next to Jeetil Patel with Deutsche Bank.

Jeetil Patel - Deutsche Bank

Great, a couple of questions -- if I just take the midpoint of your guidance for this year, which is about a little over $500 million in profit and about $5.15 billion in revenue, and I then compare it against fiscal ’11, which is $6 billion and $1.5 billion in profit, that implies revenues grow $850 million and profits grow almost $1 billion, so I’m just trying to figure out how to reconcile that in terms of cost reduction as you look at the next several years. I am just trying to look at kind of the progression as you look forward in the next couple of years around what you stated already.

And then second, just on retail, I guess has there been any change or are you just more concerned at this point in terms of the open to buys, or is it too early to tell where this is all going to shake out in terms of I guess initial orders and what is going to play out on release dates and what have you?

Eric F. Brown

Kind of three different questions there -- I’ll try to take them in order. You asked about the $6 billion in revenue target. To clarify, when we talked about FY11, we talked about $6 billion plus in revenue and a lot of people have backed into a fixed 25% percentage in terms of the overall outcome. We were very clear in stating that $6 billion plus in revenue -- the percentage isn't necessarily what one should focus on.

In terms of the progression to get to those targets, we touched upon a little bit of this today. Because we expense R&D and external developer advances, we have kind of discontinuous events that cross from one fiscal period to the next, and so we could spend 18 months or more developing a game or an MMO, have pure, dilutive, R&D OpEx in the P&L, and then when we ship the product or when we turn the MMO on live and start generating subscription revenue, it comes at a significantly higher margin.

In the case where in our EAP business, where we are undertaking development with outside parties, we have pure expense for a period of time and then we ship a game and have all margin associated with that particular distribution business. And so we did note that, for example, we’ve stepped up investment in EAP advances. We quantified that earlier. That’s part of this, and we are also making significant operating expense investment in FY09 for online for ratable subscription based titles, such as MSGs in Asia and other regions.

And finally your third question about what can one expect in terms of the open-to-buy behavior, what we are seeing is more caution, smaller order sizes but greater frequency. And you look at that and it’s not unreasonable to think that there may be some kind of working capital management or optimization occurring in retailers as well, so that may be part of the pattern that we are seeing here.

John S. Riccitiello

To build on Eric’s point on retail, I want to be clear -- we’re not saying the sky is falling. In fact, I’m not going to give you the specifics we have from individual retailers, those are disclosed to us confidentially, but I’ve already mentioned FIFA is doing exceptionally well across Europe. We’ve had strong opens for new titles like Warhammer and Dead Space and others, and front line is holding up almost as if there isn't an economic turndown. And in a lot of ways, that should almost surprise us. We pointed you specifically to areas of weakness, catalog, and more specifically in North America to a less robust performance than Europe, at least so far.

There’s a lot of reasons to believe the sector will hold up better than most, if not almost all others as we move through a recession. What we are bringing to the table is caution, a recognition that catalog is weaker, and a commitment to managing our costs, both because it’s the right thing to do for business efficiency and it’s the right thing to do with a specter of a significant recession over our shoulder.

So we are coming at this I think with a balanced view and we think it’s appropriate for us to take these types of cost actions, especially given the broader economic environment.

I think we’ve probably got time for one more question.

Operator

Thank you. We’ll take our final question today from Arvind Bhatia with Stern Agee Leach.

Arvind Bhatia - Stern Agee Leach

Thank you. My question is can you tell us what catalog sales were during the quarter? And then sports, if you can tell us at this point what you are expecting that to be this year in percentage terms, up or down, and kind of the performance of sports on the Wii console?

Eric F. Brown

I’ll take the first half of that question. Catalog sales as a percent of overall revenue Q2 FY09 actuals were 17%, and that compares to 19% in Q2 last fiscal year.

John S. Riccitiello

In terms of our sports business and on the Wii, we generally don’t disclose quarterly numbers by label. I would offer -- you had also asked about the Wii. I would tell you that there’s two things for us to look at there. Overall, sports is meeting expectations in revenue right now. That’s a very good thing given where we were in terms of certainty or lack thereof a quarter ago.

In terms of the Wii in particular, we’ve seen some of the highest metacritic scores on the entirety of the Wii platform being turned in by EA Sports, particularly with titles like Tiger and NHL, really strong scores.

So the question becomes when does the consumer show up and how many of them show up in that crowd. We’ve got enough to believe that we are going to get a significant bump from prior year. I don’t know if it feels like it crosses through to the critical mass but the experience, the entertainment value and the quality is there to justify it.

But this is a consumer that shows up in November and December. It’s not a consumer that shows up on launch day. So we’ve got the products, we’ve got the programs, we’ve got the [inaudible] as John mentioned them, and we just need to close the bargain with the consumer over the course of the next four to five weeks.

Tricia Gugler

Okay. Thanks, everyone for joining us today. We look forward to updating you on our progress.

Operator

That does conclude today’s program. We thank you for attending and have a great day.

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Source: Electronic Arts F2Q09 (Qtr End 9/30/08) Earnings Call Transcript
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