Take-Two Interactive Software, Inc. F2Q06 (Qtr ended Apr 30, 2006) Earnings Conference Call (TTWO)

Jun. 8.06 | About: Take-Two Interactive (TTWO)

Take-Two Interactive Software, Inc. (NASDAQ:TTWO)

F2Q06 Earnings Conference Call

June 8, 2006 4:30 p.m. EST

Executives

Paul Eibeler, Chief Executive Officer, President, Director

Karl Winters, Chief Financial Officer

Cindi Buckwalter, Executive Vice President

Analysts

Heath Terry - Credit Suisse First Boston

P.J. McNealy - American Technology Research

Edward Williams - Harris Nesbitt

Anthony Gikas - Piper Jaffray & Co.

Elizabeth Osur - Smith Barney Citigroup

John Taylor - Arcadia Investment Corporation

Daniel Ernst - Hudson Square Research, Inc.

Chris Kwak - SIG

Operator

Greetings, ladies and gentlemen, and welcome to the Take-Two Interactive Software second quarter fiscal 2006 financial results conference call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star, zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Ms. Cindi Buckwalter, Executive Vice President of Take-Two Interactive Software. Thank you, Ms. Buckwalter, you may begin.

Cindi Buckwalter

Thank you. Good afternoon, and thank you all for joining us today. Before we begin, I would first like to quickly review our safe harbor statement by reminding everyone that the statements made during this call that are not historical facts are considered forward-looking statements under federal securities laws.

These forward-looking statements are based on the beliefs of our management, as well as assumptions made by and information currently available to us at this time. Actual operating results may vary significantly from these forward-looking statements based on a variety of factors.

These important factors are described in our filings with the SEC, including our 10-Q for the first quarter ended January 31, 2006, which may be obtained from our website at www.take2games.com, or by contacting the SEC.

Today’s call will consist of a presentation by our management team, followed by a question-and-answer period.

With me today from Take-Two are Paul Eibeler, our President and CEO, and Karl Winters, our CFO.

At this time, I am pleased to introduce Paul Eibeler. Paul.

Paul Eibeler

Good afternoon, and thanks for joining us. I would like to first summarize a few highlights that we will be discussing today. We made strides in streamlining our global organization. Karl will provide more details shortly, but the reductions we have already made, including those during the current quarter, will result in over $28 million in annual savings. These actions, including closing some development studios, were difficult, but were necessary steps as we continue to manage our business through this tough console transition.

We are fortunate to have the industry’s best development talent, the cornerstone of our plans. From Rockstar’s Table Tennis to 2K’s BioShock, we showcased the innovation and quality of our product development teams at E3 last month. This continued focus on creating compelling content will enable Take-Two to grow and gain market share.

Finally, we are pleased to announce that the Federal Trade Commission inquiry is closed. There were no fines nor penalties. As always, we are committed to supporting the ESRB educate parents and consumers about the rating system.

Let me hand the call over to Karl.

Karl Winters

Thanks, Paul, and good afternoon. Before we review our operating results for the quarter, I would like to provide some insight into the cost-cutting and other initiatives we implemented in Q2 and Q3, and provide details regarding the financial impact on our results.

As we mentioned in our Q1 earnings call, the console transition has proven to be more difficult than we and others in the industry had expected, and as a result, we determined it was necessary to streamline our business so that we are better prepared for the opportunities we see ahead of us next year and beyond.

We took a hard look at our global operations across all functional areas, and closely examined our product release schedule for both current and next-gen platforms, including reevaluating sales expectations for our titles.

Based on that analysis, we made some very difficult decisions, including the decision to close three of our development studios -- Indie Built, Rockstar Vienna, and Frog City -- along with consolidating some of our smaller PC studios into our premier Firaxis Studio.

While these decisions were very difficult, since they involve lost jobs along with a short-term financial plus to the company, we believe they are the right long-term decisions given the current market conditions.

These are just our most visible cost-saving initiatives. There have been other expense reductions as well. We believe these actions will lead to over $28 million in annual savings going forward.

As mentioned in the press release today, the total charge in the second quarter from our asset write-offs and studio closings was approximately $26 million, of which $24 million are non-cash items. When I review the quarter’s results in a minute, I will provide details on how these charges impacted our income statement.

In addition to the second quarter charges, we expect to incur approximately $3 million of charges in Q3, when the balance of our planned initiatives are completed.

We are also in the process of relocating our international publishing headquarters to Geneva from the U.K. This move is not only a cost-savings measure, but it should also benefit us in several other ways. Switzerland provides a more central location to support our growth in Europe, it offers a favorable business environment, and it is in close geographic proximity to attractive emerging markets. We expect this relocation to result in approximately $3 million in charges in fiscal 2006, spread over the third and fourth quarters.

Now, moving on to our Q2 operating results. Net sales for the second quarter were $265 million compared to $222 million a year ago. Our net loss for the quarter was $50 million, or $0.71 per share, compared to a net loss of $8 million, or $0.12 per share in the second quarter of 2005.

Total revenue in the second quarter was up 19% compared to Q2 last year due to a 36% increase in our publishing business. Publishing revenue was led by the sales of The Elder Scrolls IV: Oblivion for X-Box 360 and PC, which together represented about 40% of publishing revenue. This was followed by Major League Baseball 2K6 on multiple platforms, which was approximately 14% of publishing revenue in the quarter.

Other leading Q2 titles were Grand Theft Auto: Liberty City Stories for PSP, Top Spin 2 for X-Box 360, Grand Theft Auto: San Andreas and Midnight Club 3: Dub Edition Remix, both for PS2.

Our sports business was once again a strong contributor to revenue. Sports titles represented over 30% of our publishing revenue in the second quarter.

Jack of All Games’ second quarter revenue declined year over year, due primarily to reduced sales of current generation hardware and software, and a decrease in average selling prices as the industry transitions to next-gen platforms.

On a positive note, Jack’s hardware and accessory business picked up due to the introduction and increased availability of X-Box 360 hardware. Additionally, even with this significant contribution from hardware, which carries lower margins than software products, Jack achieved gross margins in the double-digits as a result of their continued focus on margin expansion.

Looking at our consolidated results, our total gross profit margin for the quarter was significantly impacted by our product mix, which was heavily weighted toward lower margin licensed titles in our publishing business.

Our internally owned, internally developed titles, which typically provide much higher margins, represented less than 20% of our publishing revenue in the quarter, while our sports business contributed over 30% of the quarter’s publishing revenue, and our licensed external products were 50%.

The bulk of our licensed product revenue came from The Elder Scrolls, which was co-published with Bethesda Softworks. As we said in prior earnings call, co-publishing gross margins can range anywhere from 20% to 40%, and in this case, tip toward the lower end of that range.

Major League Baseball 2K6 was also a big driver of revenue, and carries fairly high royalty costs. These two titles were the leading factors in our increased Q2 royalty expense compared to last year. In comparison, our publishing business in Q2 last year was led by Midnight Club 3: Dub Edition and Grand Theft Auto: San Andreas, both higher margin, internally owned and internally developed titles.

Also impacting gross margins in Q2 this year were approximately $18 million in write-offs of software development costs for several titles, resulting primarily from our reassessment of sales expectations. Our software development costs were also higher this year due to the larger number of internally developed titles that were released compared to Q2 last year.

In the second quarter, our product costs increased because of our higher volume of business, but decreased as a percentage of revenue due to our mix of publishing and distribution business. Our revenue split in the quarter was roughly 75% publishing and 25% distribution, compared to our publishing-distribution split of 66% versus 34% in Q2 last year.

Our operating expenses in the second quarter were approximately $95 million, up about $11 million from last year’s second quarter, primarily driven by nearly $8 million of charges related to our write-offs and cost-cutting initiatives. However, our selling and marketing expenses declined year over year, due primarily to a reduction in marketing and co-op expenses.

Additionally, our marketing expenses were higher last year as we heavily supported the launch of our 2K Sports and 2K Games publishing labels, which were established in fiscal 2005.

G&A expenses rose this year as a result of additional rent and new offices for the development studios we have acquired since last year’s second quarter, increases in IT expenses for system improvements, along with higher professional and legal fees.

R&D expenses increased due to the additional employees from studio acquisitions, as well as $2 million in severance and other costs related to the closure of our Indie Built and Frog City Studios during the quarter.

Depreciation and amortization expenses increased, primarily due to about $6 million in write-offs of intangibles and trademarks related to our cost-cutting initiatives. The increases in our operating expenses were partially offset by reduced incentive compensation this year due to the company’s performance.

At the end of Q2, we had about $141 million in cash, as compared to $107 million in cash at year-end. Net accounts receivable at the end of the second quarter were approximately $130 million, compared to $198 million at the end of Q4 and $127 million at this time last year.

Our DSO’s in Q2 were approximately 44 days compared to 58 days in the fourth quarter and 52 days in the second quarter last year.

Our accounts receivable reserves stood at about $88 million at the end of the quarter, representing approximately 40% of gross receivables. Our Q2 reserves were approximately 17% of trailing 6 months revenue, and about 11% of trailing 9 months revenue, higher than last year’s Q2 levels due to the mix of publishing product we sold this year.

Inventories at the end of the quarter were approximately $92 million, down significantly from $136 million at year-end, and $117 million at Q2 last year, due to our continued focus on managing Jack’s inventory levels.

Our software and development costs and licenses totaled about $106 million at the end of the quarter, compared to approximately $118 million at the end of year-end, at about the same level at this time last year.

We currently have over 45 titles in various stages of development on current and next-gen platforms. While we have talked in prior earnings calls about the number of SKU’s in development, which represent all the different platforms titles are being developed for, we think it is more meaningful to talk about titles than SKU’s.

While we are discussing the balance sheet, I want to give you a heads-up that beginning with our July 31st financial statements, you will see deferred revenue broken out on our balance sheet, relating to agreements for online content, in-game advertising, and licensing of our intellectual property. Most recently, we have received approximately $35 million of payments in our third quarter, and we expect to receive additional payments this year. To the extent we have not performed the obligations required under these agreements, we will report such payments as deferred revenue on our balance sheet.

Now a few comments about the future. We are assuming a continued cautious retail environment in 2006 due to the ongoing console transition. While we still do not have the visibility to provide detailed financial guidance, given the short-term uncertainty, we can provide some data points that should be helpful in updating your models.

First, to address the balance of 2006: as we said in the press release, we expect to return to profitability in Q4, driven primarily by our release schedule and also by the anticipated ramp up in consumer spending as we approach the holiday season.

For fiscal 2007, we expect to be profitable for the year, although we anticipate the normal seasonality of the business to lead to significant variability in our quarterly results. Additionally, to provide some more color around our expectations for our three key publishing labels, next year we would expect the relative breakdown of our publishing revenue to be roughly about 50% from Rockstar, and the remaining 50% from 2K Sports, 2K Games, and Global Star.

I would also like to provide some more details about our sports business, both the present and future, to demonstrate why we are excited about this business and why we have committed significant capital to it, both from a development and marketing standpoint.

We have invested about $60 million in development studio acquisitions, $40 million in software development since acquiring the studios, and another $80 million in licenses and IP for products delivered to date.

We have assembled 9 top-quality development teams with about 300 people working on our sports titles. We have already made some major traction in the category, with close to $100 million in sports business in just the first 6 months of fiscal 2006, compared to about $65 million for all of fiscal 2005.

We have secured long-term license agreements with the NBA, NHL, NCAA, and an exclusive third-party deal with Major League Baseball. Our NBA X-Box 360 title has been selling well against the competing product at comparable retail pricing, so we are clearly executing on the strategy that we outlined to you when we entered the sports business.

The next critical step in leveraging our sports investment is capturing the opportunity of next-gen, which we always said was our sweet spot in sports, when we expect to leverage the benefits of both premium software pricing and increased hardware penetration.

To give you an idea of the leverage provided by higher software pricing and higher unit sales, let me walk through a few numbers from NPB for our U.S. sales. In fiscal 2005, if you exclude the NFL title which we no longer offer, in the U.S. alone we sold just under 3 million units of sports titles at an average retail price of about $20. Year-to-date in fiscal 2006, we sold close to 2 million units at an average retail price of about $35, as estimated by NPB. Based on our current model, and expected release schedule, we expect to sell more than 5 million units of sports titles in the U.S. in 2007, at an average retail price of $45.

Assuming these levels of sales in the U.S., and additional international sales, our sports business should become profitable and a much more meaningful business for us next year.

In addition to higher pricing and greater hardware penetration, we expect to see increasing levels of in-game advertising in our sports titles. We already have advertising in several of our sports games, and given the attractive demographics of sports video game players and the amount of time they spend playing video games, we expect advertising within our sports titles to increase significantly.

Online game play should also become a valuable revenue source for us, as we believe sports fans are very interested in subscription services and other downloadable content to keep their stats up to date and game play experience fresh.

So while the sports business is a long-term commitment for Take-Two, it is one we think is clearly well worth the effort.

For our overall business, we see multiple drivers for operating margin expansion longer term. The cost-cutting initiatives announced today, with anticipated annual savings of over $28 million, will have a positive impact on our margins going forward.

As the install base of new hardware platforms ramps up in 2007, we will realize higher unit sales for our next-gen titles, which should translate into a faster recoupment of our development costs.

We expect to continue to see higher average retail pricing on new releases for the next-gen hardware platforms. In addition to higher software pricing, we are beginning to see incremental revenue from in-game advertising, as well as licensing our IP for mobile platforms and other products.

With a continued consumer adoption of online game play as the next-gen platforms roll out, we will also begin to capture high margin sales from micro transactions and subscription revenue, and as we announced at E3, from the delivery of episodic content for our games.

Lastly, the recent opening of our 2K office in Shanghai provides the opportunity to both reduce development costs for our titles and generate incremental revenue streams for the sale of localized content in international markets. Taking these factors together, we believe we can show meaningful improvement in our operating margins in 2007 and 2008.

At this point, I will turn the call back to Paul.

Paul Eibeler

Thanks, Karl. FTC -- I want to revisit the news announced by the Federal Trade Commission today. As you can imagine, we are pleased that the FTC has concluded its very thorough investigation and that the matter has been resolved. We recognize the importance of the FTC investigation and the necessity of maintaining public confidence in the ESRB rating system, and helping the ESRB educate parents and consumers about the rating system.

We look forward to putting this behind us and focusing on what we do best -- creating interactive entertainment.

Our outlook for the industry is unchanged. Beyond the short-term challenges and uncertainty, we continue to have great confidence in our long-term prospects for ’07 and beyond. We are driven by the exciting technological capabilities of the next-gen systems, the growing installed base of hardware with the increase in online adoption rates, the consumer appetite for compelling content and most importantly, the talent of our product development organization.

Our job now is to prepare for the next wave of growth by continuing to manage through the transition and focus on three strategic priorities. First, continuing to support our high-quality, diverse product line-up for ’06. Second, improving the efficiency of our operations and leveraging our strength as a top-tier publisher, and third, maintaining our investment in strong development resources.

Content -- the Take-Two story is, and always will be, about exciting quality product. We are continuing to create an increasingly diverse line-up based on strong established brands and compelling new titles. Our product strength was evident in the quarter. Elder Scrolls IV: Oblivion and Major League Baseball 2K6 were among the top ten titles for April in the NPB rankings. Grand Theft Auto: San Andreas was the top title for February according to NPB, with sales spurred by the Greatest Hits pricing. Rockstar’s other Greatest Hits title for the quarter was Midnight Club 3: Dub Edition Remix.

Also during the quarter, 2K released 24: The Game for PS2, and Top Spin 2 for X-Box 360, Gameboy, and DS. We finished the quarter as the number two publisher in the U.S. for April, and had over a 30% increase in both dollars and units compared to April ’05.

What we saw at E3 strengthens our optimism for the long term. We are pleased that Sony and Nintendo have announced November ship dates for PlayStation 3 and Wii. For PS3, we have a number of projects on the way, and expect to have several titles available in the launch period. Nintendo’s Wii should provide additional opportunities for our sports and mass-market family titles.

The X-Box 360 has shown the strong consumer demand in both their appetite for next-gen content and acceptance of higher price points for these products. We believe the next-gen technology plays to our strengths as game developers, as we continue to make compelling and ground-breaking products.

The investments we have made during this cycle in building our strong product development resources of over 1,100 people ensure our ability to create compelling content. We are pleased with the improvements we have been able to make in both game play and graphics, as our developers have become more confident with the 360.

Rockstar’s Table Tennis is an excellent example of this. Released worldwide last week and shown at E3, this title has created a lot of buzz, receiving Team X-Box and Gamespot nods as the best sports game of E3.

Our next generation line-up continues to grow. The announcement of Rockstar’s Grand Theft Auto IV, which will launch simultaneously on PlayStation 3 and X-Box 360 in October ’07, was the most anticipated news event at E3.

Additionally, we announced a Rockstar/Microsoft strategic alliance, where Rockstar will provide exclusive downloadable episodic content for X-Box Live. This is a new area of opportunity for us, with the potential to drive incremental sales and extend the product life cycle. Downloadable episodic content is one of several ways we will maximize the value of our key brands to create additional revenue streams.

Also at E3, Rockstar announced Grand Theft Auto: Vice City Stories for PSP, shipping on October 17th ’06, further extending the Grand Theft Auto brand -- an all-new story set in Vice City. This game promises to be an exciting hardware driver for the holiday season.

As announced yesterday, Grand Theft Auto: Liberty City Stories, the best-selling PSP title, is now available in North America on PS2. The game will be on the European retail shelves on June 23rd.

2K also showed a strong and diverse range of titles. BioShock was named Game of the Show by IGN, Gamespot, and others. The title received more than 14 awards and multiple nominations.

The Darkness, based on the popular comic book series, also created lots of buzz for its great storyline and game play, receiving numerous critical mentions and nominations.

Da Vinci Code premiered at E3 and was available worldwide on PS2, X-Box, and PC, in coordination with the blockbuster Columbia Pictures film on May 19th .

2K and Microsoft demonstrated the multi-player function of Prey live on the floor at each booth. The game received high praise, with MTV highlighting Prey as the multi-player game of choice. Prey is coming to PC and X-Box 360 next month.

The 2K PC line-up is built around five properties:

  1. Sid Meier's Civilization IV: Warlords, the first expansion for this critically acclaimed title;
  2. Sid Meier's Railroads;
  3. Civ City Rome;
  4. Stronghold Legends; and
  5. Dungeon Siege II: Broken World Expansion Pack, and the PSP title, Dungeon Siege: Throne of Agony.

Sid Meier has taken an active role in helping manage our premiere 2K development studios. His experience and intuitive knowledge of the industry are true assets for the entire organization.

Licensed product from 2K included The Family Guy from Fox, The Darkness, based on the successful comic book series and developed by critically acclaimed Starbreeze developer, as well as Ghost Rider, a popular Marvel comic book franchise that will be released in coordination with a feature film starring Nicholas Cage scheduled for February.

We provided a first look at part of our broad sports line-up: NHL 2K7, NBA 2K7, and College Hoops 2K7. We demonstrated the features of MLB 2K6 on X-Box 360. 2K Sports E3 titles were nominated for more than eight awards, and NBA 2K7 was both IGN’s and Game Daily’s best sports games, with BET calling it the hottest game around.

I am pleased to say that we recently signed a multi-year, non-exclusive licenses with the NHL and NHLPA. We now have a sports line-up built around solid, long-term licenses with the four major leagues.

Operating efficiency -- we have taken decisive steps to streamline operations, making our internal development studio resources more productive.

Investing in development resources -- while we pursue cost efficiencies, we believe it is also important to strike a balance between the need to manage expenses and to invest in creative resources to capture the opportunities of the next cycle.

Along these lines, we established 2K Shanghai, both as a development studio and a centre for sales and marketing. This presence will allow us to tap into the growing China game market and provide access to that country’s development talent. The first title from 2K Shanghai, due out this summer, will be the localized Chinese version of Sid Meier's Civilization IV for PC.

As a result, we continue to have one of the most diverse and talented development organizations in the industry, with over 1,100 employees in seven countries. By comparison, we entered the cycle in 2000 with approximately 100 people in product development. Since that time, we have added studios like Angel, now Rockstar San Diego, Moebius, now Rockstar Leeds, Visual Concepts, KUSH Games, Irrational, and Firaxis.

Looking to the future, we are increasingly confident in our prospects in ’07 and beyond. Here are a few of the factors that we believe will contribute to stronger results:

  • We expect to see operating margin expansion in both ’07 and ’08 as we benefit from a stronger mix of internal, wholly-owned IP, higher price points, and additional revenue streams like episodic content and in-game advertising;
  • We expect our investment in the sports portfolio to begin showing profitability in the fiscal ’07 timeframe as we capture sales at premium pricing; and
  • We are excited about our entire product line-up for ’07. We plan a strong slate to take advantage of the greater installed based of next-gen systems, including Grand Theft Auto IV, BioShock, The Darkness, the complete Sports 2K line-up. In addition to traditional sports titles, including games based on the league licenses, you will see sports products from the internal development teams that have created great boxing and tennis titles.

In summary, we are highly focused on the future, continuing to develop compelling content and building our diverse product line, streamlining operations to manage through the transition, and investing in the innovations that will drive improved margins in ’07 and beyond.

Again, thanks for your time today. Operator, we will now open up the call to questions.

Question-and-Answer Session

Operator

Thank you.

(Operator Instructions)

Our first question comes from Mr. Heath Terry of Credit Suisse. Please proceed with your question.

Heath Terry - Credit Suisse First Boston

Great, thank you. Karl, could you give us a little bit more detail on the decision to break out deferred revenue? How much of that is directly tied to the Microsoft deal in terms of you providing online content to that versus being tied to the in-game advertising deals that you have put together?

Karl Winters

We are excited to be in a variety agreements that really cover the online content, the in-game advertising, the licensing of IP -- we think this has shown a material trend for us for the future. We have chatted about this at E3. We have chatted about it in the recent past and we think we are at a point where it is becoming meaningful and significant in terms of revenue capabilities for this company and really leveraging that IP in a variety of new ways, and we talked about the sports titles included there-in.

I think in respect to some of the confidentiality and competitive nature of the business, we are not going to break out details player by player, but there are a number of players involved in those revenue streams, and you can imagine from sports and the other pieces of IP that we have, that people would find that interesting.

I am afraid we cannot give you much more color than that.

Heath Terry - Credit Suisse First Boston

Is there an anticipated life of that $35 million in deferred revenue that you can’t talk about?

Karl Winters

I think other than to say that we will appropriately match it in the future when we have provided services for the agreements represented by that number. We certainly are talking about fiscal ’07 and things like that in terms of timeframes.

Heath Terry - Credit Suisse First Boston

Okay. Paul, the $18 million charge for writing off products and development, can you talk about how many products that represents? Are there any of those that you all put a name to before?

One change that I think we are noticing in the product line-up is previously you talked about an unnamed Rockstar sequel coming out for the current generation this year. Was that one of the titles that was written off, or has that simply been pushed to fiscal ’07?

Karl Winters

I think the titles that we are talking about in terms of write-offs were about a half a dozen, and then Paul, with regard to the release schedule for the future.

Paul Eibeler

Going back to the cost-savings, the cuts that we made were part of a long process. It was very difficult because of the growth path that we have been on. We continue to be extremely prudent, and we are examining every cost and every expense as we go through this transition. Period.

In terms of the Rockstar line-up, we traditionally play that line-up fairly close to the vest. As we have evaluated the market place, we have made some decisions and are in the process of making decisions with some products, of whether they belong on existing gen or whether we can use those assets and move them to next-gen. We are real pleased with the Table Tennis. We clearly identified the Vice City Stories for the back half of the year and identified Bully, and additional products from Rockstar. We will give more color as we go through the year.

Heath Terry - Credit Suisse First Boston

That one title though, specifically, the one that on previous calls you had talked about coming out this year, was that one moved or was that one…?

Paul Eibeler

That one was planned for existing gen, and we will have to follow-up with you depending on what happens in the near future, with the market place and some things we are doing in product development.

Heath Terry - Credit Suisse First Boston

Okay, but it is definitely off the table for this year?

Paul Eibeler

Correct.

Heath Terry - Credit Suisse First Boston

Okay. Thank you.

Operator

Thank you. Our next question comes from the line of Mr. P.J. McNealy with American Technology Research. Please proceed with your question.

P.J. McNealy - American Technology Research

Good afternoon. I think there is a little bit of frustration over the lack of guidance. I mean, the EPS for this quarter, for example, was not anywhere near where you guys came in. When you look out and can see that fiscal year ’07, that you can have some profitability in the sports line, and fiscal year ‘08’s titles, why not give guidance for the coming quarter and for the fiscal year and set expectations at this point?

Karl Winters

P.J., as you know, we have not been providing guidance in the recent past. We are trying to provide meaningful data points or mileposts for the future. The analysts estimates are obviously a product of everyone’s individual research, and there is a pretty big range of estimates out there, even for the current quarter that we just concluded.

The results last quarter included over $26 million worth of charges for our right-sizing the portfolio and addressing the strategic interest that we want to pursue for the business at hand. We continue to really try to work to improve the financial performance. We do have that optimism for the future, and when we feel comfortable that we understand the install base and the hardware launches and consumer behavior at a tighter level, we will get back into that in a more meaningful way.

Paul Eibeler

We do share your frustration, but there are a lot of uncertain factors, or uncertainty in the market place right now. We are very excited. We just shipped Liberty City Stories, which got some very, very good reviews and ratings for a game that was the No. 1 title on the PSP and we moved it to the console. We think it is going to be a big seller, but we do not have the confidence right now to actually put a number out there for you, so we are taking a small break from the guidance, and as we get into some more normalized business factors and conditions, we will make that decision to go back and give guidance.

[multiple speakers]

…an October year that presents an additional problem in terms of the guidance that is different from some of our competitors.

P.J. McNealy - American Technology Research

Are you concerned with the market conditions with high-brow units in the second half of the year with the X-Box 360?

Paul Eibeler

We feel long term the market conditions are great, but short-term, just availability, ship dates, launch quantities, presents some real issues for us in terms of giving short-term guidance.

P.J. McNealy - American Technology Research

Thank you.

Operator

Thank you. Our next question comes from the line of Edward Williams with Harris Nesbitt. Please proceed with your question.

Edward Williams - Harris Nesbitt

Good afternoon. Karl, can you just give us some color on the $28 million savings. Where exactly will we see it on the income statement? Also, if you could just talk about the 2K sports product in ’07, just to make sure I am clear with this, the $45 number that you gave out, that is retail price that you are looking for, on average?

Karl Winters

Yes, answering the last one first, the $45 was the average retail price that we would expect based on the mix of product. Paul alluded to some additional expansion in our sports area, more titles to come, including those as well.

With regard to the breakdown of the charge, again, it was approximately $18 million run into the gross margins, and $8 million running through the operating expenses, with approximately $6 million of that running through depreciation/amortization, and $2 million through G&A.

Edward Williams - Harris Nesbitt

I was actually looking more for the savings. Where will we see it?

Karl Winters

Oh, the savings, I’m sorry. The savings would show up -- it would principally show up in the G&A and the R&D, into the extent that we are no longer building products there, obviously. We do not have the payroll to run, so you are going to see it really through the operating expense lines.

Edward Williams - Harris Nesbitt

Along the lines with the R&D, what do you have right now in Shanghai as far as headcount is concerned? Looking at headcount in general, is the 1,100 a number that we are likely to see constant through the end of the current fiscal year, or is that a number that could fluctuate some more?

Karl Winters

It might trend upward just a bit from the 1,100. We currently have about 20 or 30 people on the ground in Shanghai, and we have plans to expand that somewhat modestly, but this is really sort of our initial entry into that part of the world, and we are going to be prudent about how we approach that. We believe we have the right balance of internal resources and external relationships to really run the portfolio for the near-term here.

Edward Williams - Harris Nesbitt

What are your plans as far as the Nintendo Wii? Paul, you alluded to how you could take some of your sports properties, or some of your more family-oriented games towards it. What level of sport do you think Take-Two can provide for Wii? How significant can the Nintendo console really be for you in fiscal ’07, or are we going to have to look out to the later, or beyond?

Paul Eibeler

The positive for us is that we have not been a big player in the Nintendo platform, and the reception that this platform received at the E3 show is one that makes us take a real strong look at it. As we grow our sports business, there are opportunities with our sports games to extend them to the Wii system, particularly if you look at baseball, where we have an exclusive arrangement, as well as some of the other sports games, which would play extremely well on the Wii product, the non-licensed league ones.

Some of the 2K products will have an opportunity on the Wii. It is really probably a late ’07 and ’08 opportunity for us, but it presents an additional revenue stream that we did not have before.

Edward Williams - Harris Nesbitt

Final question is looking at inventory levels in general, you indicated that Jack’s had gone down, but what was Jack’s in the quarter, and where should we see inventory as the year progresses?

Karl Winters

The inventory split, distribution versus publishing, was about 50-50, so right around the $45 million range.

Edward Williams - Harris Nesbitt

Where should that number be as we look toward the end of the year?

Karl Winters

We would expect to maintain it, although we would grow it somewhat in anticipation of the holiday season, given our October 31st year-end. That normally is a balanced working capital position that we can maintain.

Paul Eibeler

In terms of the inventory for the distribution business, that presents a real opportunity for us because that inventory is all quality product. We are selling that and turning that in the market place, but there have been opportunity buys that we can take advantage of for the Jack business. We are running that business very cautiously and really watching all the expenses and really focusing on valuated services to the retail market place.

Edward Williams - Harris Nesbitt

Thank you.

Operator

Thank you. Our next question comes from the line of Mr. Tony Gikas with Piper Jaffray. Please proceed with your question.

Anthony Gikas - Piper Jaffray & Co.

Thank you. Just as it relates to the charges in the quarter, what was the change in the headcount of the production staff? Could you identify what the cash flows were during the quarter? Sorry, I missed that, if you mentioned it. Were there any changes to management that we should be aware of, relative to the restructure?

Karl Winters

We’ll take it in the order you laid out, Tony. It was about 200 people. We were marginally cash flow positive for the quarter. We have not announced any executive or senior level changes in management.

Anthony Gikas - Piper Jaffray & Co.

Could you just give us a quick update on how sales of The Da Vinci Code have been in the last few weeks?

Paul Eibeler

We shipped it to make the launch of the movie. We have product in full distribution, and it is a little bit early to tell, but we are a little bit cautious right now.

Anthony Gikas - Piper Jaffray & Co.

Okay, thank you.

Operator

Thank you. Our next question comes from the line of Elizabeth Osur with Citigroup. Please proceed with your question.

Elizabeth Osur - Smith Barney Citigroup

Thank you. Just a couple questions. Karl, you mentioned other opportunities in the sports business, like advertising and online transactions. Are those critical to your getting profitable in the sports business in fiscal 2007?

Karl Winters

I do not think they are critical. We tried to portray the picture for sports that we are confident that given the number of units we have been able to ship to date and the units that we would foresee in the future for profitable performance, gives us the ability to make such a statement.

Those added revenue streams can only advance the ball further -- no pun intended.

Elizabeth Osur - Smith Barney Citigroup

I know you are not looking to give guidance for future years, but is it possible for you to give us some sense of the number of titles that might come out in this year and the next two years?

Karl Winters

I think I would prefer that we defer that for perhaps the next call. We usually do more of an update into, since our fiscal year touches two holiday seasons at the same time in the September time frame, but we wanted to try to address the market place as best we could see it today.

Elizabeth Osur - Smith Barney Citigroup

Final question, on the charge in the second quarter with regard to where that was allocated in the different cost of sales lines. Could you provide a little more detail there?

Karl Winters

The charge really ran through the software development costs.

Elizabeth Osur - Smith Barney Citigroup

All of it?

Karl Winters

Yes.

Elizabeth Osur - Smith Barney Citigroup

Okay, thank you very much.

Operator

Thank you. Our next question comes from the line of Mr. John Taylor with Arcadia Investment Corporation. Please proceed with your question.

John Taylor - Arcadia Investment Corporation

Hello. I have a couple of questions too. You are going to put some deferred revenue on the balance sheet, awaiting your fulfillment of certain things. I am wondering, how should we think about the margin contribution as that starts to come into revenue as you book that? Do you expect there to be much variability over time? Maybe talk around some of those issues. I have a couple after that. Thank you.

Paul Eibeler

For all the different people on your other call, we would be disappointed if you did not have at least four or five questions.

Karl Winters

We’ll take a few more after this one. Obviously, depending on whether we are talking about online content, which implies development costs and monies to be spent, versus the placement of in-game advertising or just the sheer licensing of IP, you will get the different margin assumptions.

I think it is fair to note that all would be expected to be very high margin opportunities, and therefore we would not foresee unusual variability that in one period, it would suddenly dip to a low-end of the publishing margin returns versus the high-end in the next quarter. They are going to be specifically related to the shipment of individual games or delivery of content in the future as we approach each unique piece of IP.

I do not know that I can break that down for you neatly in terms of this group is in that percentage, or you know, but as you can imagine, there is not a lot to be done with certain segments of that by way of added cost.

John Taylor - Arcadia Investment Corporation

Can we assume that if you were to work some of that off on a sports product, because there is some participation from the leagues, there is the contribution from that particular segment would be less than what you might be able to get out of one of your own IP’s?

Karl Winters

I think to the extent that you certainly have the possibility for sharing in certain arrangements, and you should expect that.

John Taylor - Arcadia Investment Corporation

Okay. Second question is, you are moving international to Geneva and closing a couple of studios and so on. Are there any other kind of big strategic things that have yet to be addressed, or is that pretty much the heavy lifting that you are going to be doing this time around to get positioned for the next cycle?

Paul Eibeler

That is the majority of the heavy lifting right now.

Karl Winters

We are mindful of the current burn rates and where we are putting our investments, but we really have taken a good hard look recently and we will still be opportunistic if anything strikes us as such.

John Taylor - Arcadia Investment Corporation

Okay, and the studios that you closed, were there any titles in particular that those studios were famous for?

Karl Winters

There were about a half-dozen pieces of IP that we had in various stages of development. Some are more significant, perhaps, than others, but for the ones that we think have unique value by way of franchise association, we certainly reserve the right to bring them into the market place with alternative development resources, whether internal or external. If we have more color on that in the future, we will let you know.

John Taylor - Arcadia Investment Corporation

Last question, you gave us the split between Jack and publishing on inventory. Could you give us the same thing on receivables, please?

Karl Winters

The receivables tipped a little heavier towards Jack. Its business ramps up a little bit more in the second half of the second quarter with the spring break holiday, Easter season. The publishing business was shift a little bit more evenly throughout the quarter.

John Taylor - Arcadia Investment Corporation

Okay, so there is a higher waiting?

Karl Winters

There is a higher waiting of receivables towards distribution than publishing.

Paul Eibeler

It is really just a timing issue of what they ship versus what publishing ships.

John Taylor - Arcadia Investment Corporation

Okay, thank you very much.

Operator

Thank you. Our next question comes from the line of Mr. Daniel Ernst of Hudson Square Research. Please proceed with your question.

Daniel Ernst - Hudson Square Research, Inc.

Good afternoon, thanks for taking the call. Two questions, if I might. Looking at margins, if I back out the charge there, margins is at 13%, still markedly lower than where you have been historically. Can you talk about what else happened in the quarter? I realize there was certainly the large percentage of co-published games, which as you said was in turn towards the bottom end of your range in the 20% to 40% margin, but still that is well above the normalized margin we’re calculating here of 13%. Maybe talk a little bit about what else happened in the quarter than what your expectations are in the near-term, without giving guidance, on the bottom line. At least give us some sense of where you think margins are turning in the near-term, then I have a follow-up. Thank you.

Karl Winters

Daniel, it is a reasonable question. We tried to provide a few points in the prepared comments. Really what occurred during the quarter, if you start with the various segments of the publishing business, about 20% of our publishing business came from a wholly-owned internally developed IP. Having said that, that 20% was really catalogue sales from products released in holiday ’05 or earlier. While that is still a nice margin business, it is not as robust as launch quantities on big titles that we might be bringing out, for instance, in the holiday season, or with our premiere pieces of IP franchises. So margin is somewhat compressed within that segment.

The sports business, I think as you observed, and others have observed, does not behave at the same level, given the licenses and the royalties that are involved there. So for instance, during the quarter, we had $82 million worth of royalties, against $200 million or thereabouts of publishing business. That is a significant percentage, and the sports business will carry much lower gross margins as a result.

Finally, of the 50% or thereabouts remaining, of we’ll call it licensed or externally developed product, about 80% of that number came to us by way of Oblivion, which we said on the call tipped well towards the low-end of the 20% to 40% range of gross margins.

When you add all that up, we are somewhat absent this quarter of our higher margin opportunities with our bigger, wholly-owned properties. At this point in the cycle, that is probably appropriate, and we certainly believe that for holiday ’06 and getting into ’07 as we get more next-gen materials and return to premium pricing and an install base that we can really sell too at a profitable level, that margin will expand. Even in the near-term, we have such titles as Liberty City Stories on PlayStation 2. Limited development resources had to be expended to bring that product into the market place. We have such things as Bully, Table Tennis -- these products carry much higher margins and will behave accordingly.

Daniel Ernst - Hudson Square Research, Inc.

Agreed, but if you look ahead to what you have lined up that has already come out in this quarter, what you have for the current quarter, based on where you are, internal versus external, what do you think margins should shake out in the current quarter?

Karl Winters

We think margins will increase from the current quarter given the mix of product that we expect to have and the nature of it.

Daniel Ernst - Hudson Square Research, Inc.

Second question, if you look at your strategy for diversification and looking at the sports and that is more easily defined in terms of market and what the expectations are relative to your competition. As you do new things like move titles, The Da Vinci Code, and you have a meta-critic rating there in the 50’s, what are you doing in terms of quality control in order to ensure that as you diversify, you are putting out those tier 1 titles that you are known for on the Rockstar side. Is there something you can do strategically to alter that path, rather than spin your wheels on developing titles that do not have that attraction to the market place, really, because maybe in part because the quality is not what you are known for?

Paul Eibeler

I think you have to break the business components down a little bit. When you look at our sports business, our sports games have always been highly rated and we have made significant improvements in any of the games that were not highly rated. We believe the Visual Concepts and KUSH and those studios are a great asset and make great products.

The Da Vinci Code, when you look at a licensed product, the key to that is making a good product that ships timely with the event, and the event in this case was the movie release. We still think we put a pretty good product out in the market place for that, but you are going to get a different type of review from that gaming editor who likes different types of products.

I think Civilization, I think Elder Scrolls, Prey, BioShock -- those products and the quality of those products are really evident in our commitment to delivering compelling content.

I think you should reexamine the whole picture and break it out. We do have some games like Family Guy from Fox, which is a different type of audience, and we believe we will put out a very good product, but that product might not get reviewed the same way as BioShock gets reviewed.

Our Rockstar guys have always put out tremendous, meta-critic, high-ranking type of games and they will continue to do that. One thing we have done with the Rockstar development is give them all the resources during this cycle to continue that and to actually put out a stronger flow of product as we move into next-gen.

Also, Sid Meier. His association with not just Civilization but with our 2K games area -- he is one of the industry greats. He is a real strong asset for us to make compelling content.

Cindi Buckwalter

Operator, at this point, we will take one more question.

Operator

Thank you. Our final question comes from the line of Mr. Chris Kwak with SIG. Please proceed with your question.

Chris Kwak - SIG

Can you hear me okay? Just a couple of questions. On the deferred revenue, if we could just revisit that and just ask, is it going to be broken out into long-term, or is everything short-term in terms of the deferred revenue? Should we assume that the cash is going to be collected up-front?

Karl Winters

If we have the deferred revenue on the books, it is fair to assume we have the cash in hand. In terms of the timing of the realizability of the deferred revenues, we will address that appropriately with our disclosures and on the face of the balance sheet as necessary.

Chris Kwak - SIG

Okay. Turning to LCS on the PS2, we haven’t really -- can you guys just help us think about what you are expecting or what you think is a reasonable expectation for that, relative to what is on the PSP, for example?

Paul Eibeler

We are very excited about the launch extending the brand, especially at this point in the cycle. We are pleased with some of the great reviews that we received on the product, although it is a smaller product than traditionally we have put out on the console business.

We have a fairly large launch quantity. Retailers are excited about it, but it has only been out there a day or to in the market. We think it will have a very long life, especially at the significant value pricing that it is at throughout the fall period.

We are just a little bit cautious given the uncertainty in the market place, but I certainly -- the response I heard from retail is that it is one of the must-have products and will be a great incremental sale to anyone shopping for video games for existing generation.

Chris Kwak - SIG

Just a follow-up on that, can you give us any guidance or a sense for is this near-herculean waters in terms of margins? Is it similar to the margin structure that you have either on the PSP or the PS2 and the prior iterations? Thank you.

Karl Winters

It is more similar than not. At that price point, it is somewhat compressed, but it is certainly on the healthy end of the publishing margin.

Chris Kwak - SIG

Great, thank you.

Cindi Buckwalter

Great. Thank you all for joining us today. We look forward to speaking with you next quarter. Good-bye.

Operator

Thank you, ladies and gentlemen. This concludes today’s teleconference. You may disconnect your lines at this time.

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