Tricia Gugler – VP of IR
John Riccitiello – CEO
Eric Brown – CFO and EVP
Jeetil Patel – Deutsche Bank
Edward Williams – BMO Capital Markets
Justin Post – Merrill Lynch
Ben Schachter – UBS
Brent Thill – Citigroup
Daniel Ernst – Hudson Square Research
Colin Sebastian – Lazard Capital Markets
Tony Gikas – Piper Jaffray
Mike Hickey – Janco Partners
John Taylor – Arcadia Investment
Heath Terry – FBR Capital Markets
Doug Creutz – Cowen & Company
Electronic Arts Inc. (ERTS) F3Q09 (Qtr End 12/31/08) Earnings Call Transcript February 3, 2009 5:00 PM ET
Good day, everyone, and welcome to Electronic Arts Third Quarter Fiscal Year 2009 Earnings Conference Call. Today’s call is being recorded. At this time, I would like to turn the call to Ms. Tricia Gugler, Vice President of Investor Relations. Please go ahead.
Welcome to our third quarter fiscal 2009 earnings call. Today on the call we have John Riccitiello, our Chief Executive Officer; and Eric Brown, our Chief Financial 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 web cast 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. 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 all 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 the supplemental information on our website for our trailing twelve month segment shares, our Q4 releases, 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-Q for a discussion of risk factors that could cause our actual results to differ materially from those discussed today. We make these statements as of February 3, 2009, and disclaim any duty to update them.
Now I would like to turn the call over to John.
Earlier today we announced our third quarter results came in below our expectations and that we have significantly reduced our financial outlook for fiscal year ‘09. On today's call, I will discuss our performance for fiscal year ’09, including our cost-cutting actions. I will outline the key conclusions we drew out from the year. I will then outline our outlook for the industry in 2009 and EA's plans and financial guidance for fiscal year ’10. Eric will review our holiday quarter results, discuss our cost-cutting initiatives in more detail, and provide a specific guidance for fiscal year ’09 and ’10. I will wrap up with a few closing thoughts and then we will open it up for Q&A.
We are disappointed with our holiday quarter and our FY09 performance. These results point to three conclusions, which are incorporated into our strategies going forward. First, we need to improve our approach to bringing key titles to market. Consumers have become more cautious and we need longer lead times on marketing and in some cases more productive investment of our publishing resources. In short, we need to start earlier and focus more.
Second, in this environment, we believe our operating expenses are too high and need to come down. Third, the Nintendo Wii is even more important than one year ago. It is a clear leader in this cycle. In calendar year ’08, we were the number three publisher in this platform in both North America and in Europe, but we need to move further up on the charts.
Now, I would like to cover our holiday quarter. First a few comments on the industry. Industry software sales in the holiday quarter were up 15% in North America and we estimate 10% in Europe. These holiday quarter results, while below industry growth rates recorded earlier in the year were solid. The Nintendo Wii delivered the strongest performance among the console players. We also saw continued strong growth in various subscription and micro-transaction businesses, showing the ongoing strength and potential of direct-to-consumer business model. This strong sector performance in the shadow of a very challenging macroeconomic environment is yet another solid data point suggesting our industry can fare well in tough times.
In Q3, EA significantly missed its numbers and revenue came in approximately $115 million below Street estimates. Although this is difficult to piece apart, the macro and the micro, a significant portion relates to our own performance. Clear and simple, our titles did not perform to our expectations. With the exception of FIFA, we did not deliver the blockbuster titles or chart position we expected. Competitively, EA had only one of the top five titles in North America and Europe versus typically two or more. We were depending on new IP in a year where consumers were even more cautious with their dollars. And one of our anchor titles, Need for Speed, did not deliver fully on our expectations.
From a macro standpoint, we saw certain retailers reduce inventories below historical and expected levels, particularly in North America. During the holiday quarter, we saw a significant discrepancy between our sell in and sell through. This is the consequence of key retailers bringing down inventory levels. This is a circumstance we do not expect to be repeated in the future. In addition, the strengthening of the US dollar negatively influenced our Q3 sales by approximately $55 million.
Adding to this, our expense base was geared for a business that assumed much more revenue, resulting in a significant shortfall in our profitability. And while we began cost-cutting aggressively in Q3, we could not get ahead of the revenue shortfall to achieve our target profitability in the quarter.
Before I move to the future let me spend a moment on some of the positives our team has accomplished so far this year. We did make some progress on some important initiatives that will create value for EA for years to come. First, new IP. We launched Dead Space, Spore, Warhammer Online, Mirror’s Edge, and a number of Hasbro games. And while we expect to benefit in the future from increased sales from these franchises, generally games with a two on them sell better and do sell with a lower R&D budget.
Second quality, overall we made significant strides in driving innovation and quality into our games. Our 2008 slate was better than our 2007 slate. We had 13 titles rated at 80 or above versus seven last year, a statistic we are particularly proud of. This is two to three times that of other third-party publishers.
Third, we expanded our kids and family business. We built our own IP with MySims and Boom Blox and in partnership with Hasbro, we added several key titles including, LITTLEST PET SHOP and NERF “N-Strike.”
And finally Digital direct, which includes online and wireless, was up 27% year-to-date to more than $300 million. Our successful POGO business hit an all-time high of 1.7 million paying subscribers. We successfully launched a new MMO, Warhammer Online, and added a number of titles in countries to our growing online – Asia online business. And EA Mobile has generated $141 million in revenue so far this year, up 29%.
With the holidays we had six of the top 20 iPhone games.
With that I would like to turn our attention to the future. In the past, we have highlighted two focus areas of our strategy, drive hits in our core business and grow our direct-to-consumer businesses. To these pillars, we add two more, manage expenses aggressively and increase focus on the Nintendo Wii platform.
First, drive hits on our core. We plan to match strong quality with strong marketing, particularly for our top 10 titles. Operationally, we expect to improve the way we go to market with our titles, starting earlier to create positive buzz and demand. Consistent with this strategy, we have made a decision to move titles including the Sims 3, Godfather 2, and Dragon Age for the PC from Q4 FY09 to FY10. These titles have high potential based on consumer research and early reviews from critics. In the case of Sims 3, we're moving this title to June 3 to give us additional time to build the worldwide marketing campaign a title like this deserves.
With Godfather 2, we are moving it to Q1 FY10, providing a better launch window and more time for longer lead marketing. For Dragon Age, we are moving the PC launch to Q3 FY10 to coincide with the console launch giving us the opportunity to make a bigger splash with its epic BioWare RPG title, and of course the BioWare team will continue to
polish this game for even greater quality.
Other potential hit titles are also getting a new approach. For example, we have completely reworked the development model for the Need for Speed franchise. We are moving this franchise to parallel development in separate studios allowing for a full two-year development cycle for each annual title. These are just a few examples of our commitment to improving our position in the global top five and top 10, which is where we see the strongest returns for EA's core business.
Second aggressively manage expenses, as you know, we have been working to reduce our cost base given the uncertain macro environment, changing industry trends and our recent performance. We are planning FY10 operating expenses at approximately $2.1 billion, which is a $500 million decrease from previously expected FY10 run rate. This is a substantial expense reduction and is the consequence of tough calls on headcount, SKU count, facilities, variable spend, and CapEx. Eric will discuss the cost reductions in more detail.
Third, capitalize on the progress we've made on the Wii. We have a spectacular slate for FY10, which will be supported by a Wii focused advertising campaign. We are starting FY10 strong with Tiger Woods PGA tour, EA Sports Active, EA Sports Tennis, Boom Blox 2, Harry Potter, and MySims Racing; all in Q1, and it gets better each quarter.
Fourth, drive our content direct-to-consumer. This is a strategic initiative that is very important for the long term. In FY09, we made $150 million online investment with limited associated revenue. In FY10, all significant online spending, except for the LucasArts BioWare Star Wars MMO, will be generating positive income. These investments are working. We expect over $500 million in direct-to-digital revenue in fiscal year ’10.
Now to our outlook for the industry and for EA. For the industry, we believe we are roughly midway through what is shaping up to be an extended console cycle. As you know, calendar year ’08 was a very strong year for the game business with software sales up over 20%. We entered calendar year ’09 with a 50% increase in the hardware installed base with more room to move on hardware pricing; and we expect to exit the year with a larger console-base as compared with the same point in the previous cycle.
We are entering calendar year ‘09 optimistic about the industry, but are tempering our optimism somewhat to reflect the continued global economic recession. For calendar year ’09, our projections assume no major up-tick in the broader economic environment and software sales growth in the mid-single digits for both North America and Europe. We’ve planned our expense base assuming conservative revenue growth, which we believe is prudent in these times.
On FY10 revenue, we are assuming no growth in segment shares despite the move of key titles like the Sims 3, Dragon Age PC, Godfather 2, and Harry Potter. We have planned our core titles conservatively even though we have a stronger slate and we plan to push our top 10 titles harder this year.
We also assume that our co-publishing and distribution book revenue will be down approximately $300 million in FY10. These assumptions result in a revenue projection of $4.3 billion in FY10 with 5% growth. Our expenses match this conservative Q1 revenue. Every expense category will be down with the exception of variable marketing.
We expect FY10 operating expenses to be roughly $2.1 billion, down significantly from our run rate. Net, this translates to roughly $1 in non-GAAP EPS in FY10, which is approximately a 10% non-GAAP operating loss margin. These targets are achievable and appropriate given the macro environment.
Now, I would like to turn the call over to Eric.
Thank you, John, and good afternoon, everyone.
For Q3, we delivered non-GAAP revenue of $1.74 billion, which was flat to last year and non-GAAP diluted EPS of $0.56 versus $0.90 a year ago. On a GAAP basis, revenue was $1.65 billion, up 10% year-over-year and the GAAP diluted loss per share was $2 versus a loss per share of $0.10 a year ago. This quarter our GAAP EPS includes one-time charges for goodwill impairment and a tax valuation allowance, which together comprise a $1.91 in GAAP EPS loss. I will touch on these in more detail shortly.
Key titles in the quarter were FIFA ‘09, our bestselling title with 7.8 million copies, up 4% year-to-date over last year's FIFA ’08. In Europe, we estimate it was the number one title across all platforms in the holiday quarter. Need for Speed Undercover sold 5.2 million copies, down 7% from last year's Need for Speed Prostreet. Sell-through was up in Europe year-over-year but down in North America. LITTLEST PET SHOP sold 2.8 million copies on the Wii and DS and PC, a great start for a new IP; and charted in the top 5 on the NDS in both North America and Europe in the holiday quarter. In addition, Dead Space, Mirror’s Edge, Madden NFL 09, and NBA Live 09 each sold over 1 million copies. Madden 09 was the number six title across all platforms in North America for calendar year ‘08.
From EA partners, Rock Band 2 in partnerships with MTV Harmonix sold 1.9 million copies, and Left 4 Dead, in partnership with Valve, sold 1.8 million copies. In our digital-to-direct businesses, we generated $116 million in revenue, up 28% year-over-year with strong performance across all units including POGO. Warhammer Online now has over 300,000 paying subscribers in North America and Europe. Wireless revenue was $50 million, up $11 million from a year ago on the strength of (inaudible). Digital download games and our micro-transaction revenue was $21 million, up 75% due to further expansion of our online distribution capabilities.
I would now like to spend some time discussing Q3 in more detail. Please note that all of the following references to third quarter results are non-GAAP, unless otherwise stated. Non-GAAP revenue was $1.74 billion flat year-over-year. At constant currency rates, revenue increased 4%. The growth was primarily driven by distribution our business, Star Wars [ph], and subscription revenue. Our core packaged goods business slowed considerably in December.
By geography, North America non-GAAP revenue was $910 million, up $49 million or 6%, primarily due to our distribution business. International non-GAAP revenue was $832 million, down $41 million or 5% driven by adverse FX. At constant currency rates, revenue was up 4% primarily due to FIFA 09.
Moving to the rest of the income statement, non-GAAP gross profit was $821 million, down $138 million or 14% year-over-year. Non-GAAP gross profit margin was 47.1% versus 55.3%. The decrease is primarily attributable to approximately six points related to a higher mix of distribution revenue and lower margins in our co-publishing business, and approximately two points related to an increase in price protection and returns reserves. At quarter-end, we had increased exposure in the retail channel that required additional reserves.
Operating expenses. Before getting into the details, let me point out a couple of factors that affect a number of line items in our Q3 P&L. First only a small portion of our cost reduction program was implemented in time to affect our Q3 results. And second, for bonus, we recorded a credit of $12 million this quarter versus an expense of $80 million last year.
Marketing and sales, non-GAAP marketing and sales expense was $245 million, up $37 million. Excluding the impact of bonus, marketing and sales was up $51 million primarily due to more advertising spend for larger slate of titles in Q3 versus Q3 last year.
General and administrative, non-GAAP G&A expense was $71 million, down $13 million. Excluding the impact of bonus, G&A was roughly flat year-over-year. Facility and personnel related costs were offset by increases in bad debt expense in contracted services.
Research and development, non-GAAP R&D was $271 million, down $29 million. Excluding the impact of bonus in each year, R&D was up $32 million year-over-year primarily due to our VGH acquisition.
Restructuring charge, during the quarter we recorded $18 million of restructuring expense, $13 million from the plan that we announced on December 19.
Below the operating income line, non-GAAP other income and expense was $14 million, down $18 million from a year ago due to a decline in interest income and increased foreign exchange losses.
Income taxes, on a GAAP basis, we recorded a provision of $324 million, which included a $244 valuation allowance charge that we are required to record against deferred tax assets that are deemed currently unrealizable for accounting purposes. This determination is based on historical GAAP losses, which includes the revenue deferrals. In addition, the Q3 tax provision includes the reversal of deferred tax benefits recorded in the first six months of the year. We will be able to realize these assets when we return to GAAP profitability. On a non-GAAP basis, we recorded taxes at 28%.
GAAP diluted loss per share was $2 versus a diluted loss per share of $0.10 a year ago. Please see our GAAP to non-GAAP reconciliation in our earnings release. This quarter, our GAAP EPS also includes one-time charges for goodwill impairment and a tax valuation allowance of approximately $1.91 in GAAP EPS loss.
Non-GAAP diluted earnings per share were $0.56 versus diluted earnings per share of $0.90 a year ago.
Our trailing twelve month operating cash flow was $82 million versus $267 million for the prior period. Even though we lowered our outlook, we expect to be slightly cash flow positive for the year.
Turning to the balance sheet, cash and short term investments were approximately $2.0 billion at year end – or at quarter end, up $134 million from last quarter due to cash generated from operations.
Marketable equity securities and other investments were $302 million, down $338 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 $27 million in the P&L related to our investment in The9. At quarter end, after the write down, we had a net unrealized gain of $128 million, comprised of a $132 million unrealized gain on Ubisoft and a $4 million unrealized loss on Neowiz.
Gross accounts receivable were $1.1 billion relatively flat to last year and consistent with our revenue.
Reserves against outstanding receivables totaled $303 million, up $44 million from a year ago. During the quarter, our sales reserve rate was 16% of revenue versus 11% a year ago. The increase year-over-year is related to higher price protection and returned reserves recorded in the quarter as a result of greater inventory in the channel.
Inventory was $295 million, up $117 million from a year ago. Excluding our EA partner inventory, for which EA has limited exposure, inventory was up $55 million primarily due to a broader slate of titles. No single EA title represented more than $15 million in net exposure.
Goodwill was $808 million after the impairment charge. During the quarter, we recorded a $368 million non-cash charge for goodwill impairment related to our wireless business. Although we took a charge, this highly profitable business is meeting our expectations in FY09 and we expect continued strong growth in the years ahead.
Ending deferred net revenue from packaged goods and digital content was $512 million, down $83 million from a year ago primarily due to revenue mix.
Now to our outlook, before we get into our guidance, I would like to provide more detail on our cost reduction plan. We started this work back in October as we discussed in our Q2 call. The focus on rationalizing our SKU plan and scrutinizing all operating and capital budgets for FY10. As John indicated earlier, we went into our FY10 planning process with the goal of matching operating expenses with a more conservative projection of revenue. We moved up the timing of our internal budget processes so that we could adjust our SKU plan, allowing us to take our costs sooner rather than later.
We now expect total non-GAAP operating expenses of approximately $2.1 billion in fiscal 10, down $500 million from our prior expectations for FY10. This is down $300 million from the $2.4 billion run rate we had at the time of our Q2 earnings call in October. We also expect to benefit from savings in FY09, ending the year with operating expenses of approximately $2.25 billion.
We made reductions in five different areas. Let me discuss each briefly. First our product portfolio, we increased the hurdle rate for new titles. This resulted in a 30% reduction in the number of SKUs we plan to launch in FY10 versus our previous plans. Excluding our EA partner business, we expect to publish approximately 50 titles and 125 SKUs in FY10. The 125 SKUs compares with 145 in fiscal ‘09. Had we not shifted certain titles from FY09 to FY 10, the delta would have been even greater.
Second, personnel costs. We are reducing headcount by 1,100 people or 11% of our workforce. This includes headcount at all levels; staff, managers, directors, and VPs and above, and across all functions and geographies. Most of the reductions are in high cost locations. We expect three quarters of the reduction to be completed by fiscal year end. We are also eliminating myriad increases in fiscal ‘10. And finally, we continue to take advantage of low-cost locations. At the end of FY09, we expect to have 19% of our employees in low-cost locations versus 13% a year ago. Third, facilities. We expect to close 12 facilities, up from the 9 we communicated on December 19.
Fourth area, other variable spend. We reviewed all operating budgets, including contracted services and T&E, resulting in significant cuts for fiscal ‘10. We plan for every expense category to be down year over year, with the exception of direct advertising spend. And finally capital spending, we expect to reduce our estimated FY09 CapEx spend of about $110 million by approximately 40% in fiscal 2010. Net, these actions will yield $0.5 billion of savings from our previously expected FY10 run rate. For the restructuring component, which includes facilities closures and severance, we expect to incur a total charge of $65 million to $75 million over the next 12 months, and the reconciliation between GAAP and non-GAAP.
Now for our guidance, please refer to our press release for our revenue EPS guidance for both fiscal ‘09 and fiscal ‘10 and a reconciliation of our GAAP to non-GAAP financial measures. Our revised fiscal ‘09 revenue outlook is $900 million below the low end of our previous guidance. The difference is attributable to, number one, approximately $500 million shortfall as a result of weaker than expected sales due to macro economic and EA specific issues.
Secondly, approximately $300 million related to the shift in titles to fiscal ‘10, and third, approximately $100 million due to the strengthening of the US dollar. In addition, we expect GAAP and non-GAAP gross profit margins of approximately 50%. We expect GAAP operating expenses of approximately $2.95 billion and non-GAAP operating expenses of approximately $2.25 billion. On taxes, on a GAAP basis, we expect tax expense of approximately $250 million to $275 million, and expect to record non-GAAP taxes at 28%. For fiscal 2010, we expect GAAP operating expenses of approximately $2.4 billion and non-GAAP of approximately $2.1 billion. We expect GAAP gross profit margin to be approximately 57% to 59% and non-GAAP gross profit margins of approximately 58% to 59%.
On a non-GAAP basis, we expect all of our expense line items to be down in absolute dollars, and down as a percentage of revenue. This is also true assuming we pay a full bonus in FY10 versus a much lower bonus funding assumption in fiscal ‘09. We expect R&D to be approximately 27% of revenue. We expect sales and marketing to be approximately 15% of revenue, and we expect G&A to be approximately 6% of revenue. $1 non-GAAP EPS translates to a non-GAAP operating margin of approximately 10%. We expect that non-GAAP other income and expense will be roughly $25 million, down significantly from last year as a result of steep declines in interest rates. Taxes, on a GAAP basis, we expect tax expense of approximately $40 million to $60 million, and expect to record non-GAAP taxes at 28%.
Foreign exchange assumptions, FX rates have been volatile this year, and we expect that to continue. For purposes of guidance, we are using current spot rates. To the extent the US dollar continues to strengthen against the euro and the British pound, we will have downside revenue and EPS exposure. To the extent the Canadian dollar strengthens against the US dollar, we also had downside EPS exposure.
That concludes our guidance and outlook commentary. With that, I’ll turn it back to John.
Before we take your questions, I want to close with a few thoughts. First, we are optimistic for the industry in the year ahead. Second, we have hit the reset button on our cost structure. We have not lowered our ambitions, we have knocked our cost structure to a more conservative revenue projections. We have made the hard calls, now it’s all about execution. And finally, we have been and will continue to be focused on game quality and innovation. Our FY10 slate is very promising.
Let me tell you about some of the titles I’m particularly excited about this year. In Q1, EA Sports will drive our Wii initiative with the debut of the new tennis franchise from EA Sports Active, a new fitness product. Also from EA Sports is the return of our acclaimed Fight Night franchise. At the end of Q1, Harry Potter And The Half Blood Prince is releasing in conjunction with the motion picture from Warner Brothers. The main event is the launch of Sims 3 on June 3, a brand new experience with a host of online features. I’d urge you to check out the new Sims website.
In Q2, we will launch Need for Speed Shift. This is the first title under our new approach to development. Our Nintendo title Need For Speed Nitro will follow in Q3. In July and August, we delivered the one-two punch [ph] of NCAA Football and Madden NFL. In Q3, we will launch Dragon Age, an epic new IP from BioWare. We are introducing Brutal Legend, a heavy-metal action fantasy starring Jack Black, and NBA Live, a franchise that has made a big rebound with critics and consumers will be back with a leap forward with the Dynamic DNA online feature.
In Q4, Battlefield
Bad Company will be back on consoles from our Dice Studio in Stockholm. BioWare will release Mass Effect II on multiple platforms and the Redwood Shores game that gave us Dead Space will launch a brand new intellectual property based on Dante’s Inferno. In addition, our partners at MTV Harmonix have announced a new music title based on the Beatles to be released in our FY10.
With that, we would be happy to take your questions.
Operator, we would like to open the call to questions.
Thank you. (Operator instructions) And the first question comes from Jeetil Patel with Deutsche Bank.
Jeetil Patel – Deutsche Bank
Hi, guys. You have got 14% fewer SKUs coming out in fiscal ‘10 versus fiscal ‘09, I guess can you walk us through from the down 14% in the SKUs to the plus – flat to plus five – call it plus 5% on the revenue side? I guess what are you implying in terms of productivity versus change in FX et cetera, and then also just your pricing assumptions for the industry as a whole?
So, there is a lot pieces to your question there. I’ll do my level best to wrap them up in one answer. First off, your point-to-point comparisons on SKUs I think is a tad misleading because it incorporates the move of some SKUs relatively right from the end of fiscal ‘09 to the beginning of fiscal ’10. So actually think your low teens estimate understates the shift in SKUs and the reduction in our investment in new R&D.
The second observation I would make is in terms of mapping that to revenue growth, I'll start at the strategic level and point out that we are very purposely reducing the number of SKUs, in particular our secondary and tertiary SKUs and/or titles that are too close to the breakeven point to justify being developed and launched. So we believe we are making a move to enhance our ability to focus, create bigger hits in the marketplace, and all things being equal, generate at least as much, if not more revenue.
Now things frankly are not all equal and I think you need to take this question apart carefully. If I were to do this from a modeling perspective from the outside and looking at Electronic Arts, I would probably start with the observation that we have highlighted today in the call that our distribution revenue is down approximately $300 million year over year. I think that's a very important starting point, and that's a lower margin business, and one of the reasons our gross margins were up so sharply is the reduction in that as a percentage of our revenue.
From there, there is half a dozen different ways you might want to cut it, but if you were to cut it like we did, you would look at it by label. And if you started with sports, you would see that our business is up approximately $100 million dollars year over year. Just over 100% of that are new titles we are launching in the year like Fight Night and EA Sports Active. We have actually developed a plan with our key sequel titles being down slightly.
In terms of our games label, that is actually down approximately $100 million year over year. That is a function – actually $200 million year over year – that is a function of the EAP reduction, cost distribution reduction, being primarily concentrated in our games label. And then if you take a look at the slate of titles that we have got, basically Dragon Age and some of the titles we have mentioned on the call mapping against a slightly lesser slate in the prior year, we believe that is approximately $100 million dollars net up.
The third piece is the Sims/Play label, which we have up net $300 million year over year. And the easiest way to think about that is everything is roughly the same, except we have added Sims 3 and two movie titles, one Harry Potter, and one we have yet to announce, which is a net cleanup of about $300 million. So that pretty much ties out to our $4.3 billion growth rate for that revenue estimate for the fiscal year.
If you ask about FX, you could call FX and underlying industry growth a tie out. Of course, we did these things with much more detail than I am describing now, and that is essentially what happened for us. In terms of assumptions on industry pricing, I would make a couple of comments. The first of them is a close study of the industry performance in Q3 yields some I think fairly important conclusions. Perhaps, most important is that quality sells, and sells at a premium.
As you can see, if you study the NPD charts or their equivalent for Europe, you will see that the top 20 charts are denominated in titles with very high ASPs, suggesting the fact that the consumer chooses quality over price, despite the fact that there was a glut of inventory in the channel with some rabid discounting at the bottom end of the chain. So the consumer, even in a tough economic environment, chooses quality over price, and they always have in our sector.
Secondly, for reasons that I'm certain you understand, we're not in a position to give particular guidance or information of our pricing later in the year. That is a conversation between us and our customers, and something that needs to stay there, given the current environment, and frankly a good business environment.
And the next question will come from Edward Williams with BMO Capital Markets.
Edward Williams – BMO Capital Markets
John, just a follow up on Jeetil’s question a little bit, if you look at the unit assumptions on some of the key franchises, key annual franchises, Madden, NBA, Sims [ph], Need for Speed, et cetera, am I correct to assume that you are assuming those franchises, at least on a dollar basis, are going to go down a little bit? And then as we look at things like the Sims that have non-annual launches, how are you looking at that products performing in FY10 versus their prior launches?
So, in the case of everything you have mentioned in your list of sequels, you are correct. We have been slightly down. That's our base scenario. Of course, that is not what we are setting out to achieve, but we believe that’s a prudent forecast in today's environment. In terms of the rest of our slate, some of which we have great references for like Sims 3 and others, where we really need to look longer back in history at our competition, like a Dragon Age, to see how that might perform in the marketplace with some competitors out in the past year being more close to that in its performance.
And in general, we have used I’d say more conservative than not reference point. So I'm not going to give you particular unit volumes on the call for any of our titles. But we haven’t anything sort of pops into the top five, or that anything has got any sort of extraordinary revenue outcomes associated with it. We're hopeful that that will happen in the year, but that has not been our experience in the last 12 months, and we have chosen to take a realistic perspective on what is going to happen and what we can count on.
And the next question will come from Justin Post of Merrill Lynch.
Justin Post – Merrill Lynch
Thank you. John, can you talk about where you are on the margins for each of your labels and how much you think you can get improvement next year, and how do you measure your investment, because you are investing for 2010, 2011 and 2012, are you going to try to balance that versus delivering on the dollar next year?
When you ask about margins, there is really two margins you are probably thinking about. One is our gross profit percentage and the other is our operating margins pre overhead. And I'm not going to give you the specific numbers on them, but trust we’d venture a very diligent planning process, and we're very close to all of those numbers.
I would start by telling you that the gross profit percentages in all three businesses are very healthy. The Sims/Play label is very strong driven by a heady mix of TC associated with the Sims 3 launch. The Sports label is strong and robust, particularly as we move into more owned or near owned intellectual property, such as EA Sports Active. And the games label has always had strong gross profit margins as a consequence of being heavily dominated by owned intellectual properties.
So, gross profit in all three businesses look healthy in the coming year. The primary driver in terms of differentiating these businesses on an operating margin basis is R&D investment. And what you can see for both the sports label and Sims/ – we're calling in Play now, the Sims/Casual, these have R&D numbers below 20%. They are very strong businesses. R&D is tight and aligned with where they should be for businesses of this scale. We're very pleased with the return on investment on R&D that we have had and expect to achieve in the coming year.
We continue to see and I'm not going to give the specific numbers on this, higher R&D as a percentage for our games label. It is by far our largest unit, and if I were looking at that, I would make a couple of observations as to the why. One is we look very carefully at our investment per title, and overall, and both saw sharp improvement year over year. We feel very good about the productivity efficiency that's been driven into the games label by its leadership team, strong aggressive moves.
A large part of our year-over-year expense reduction, headcount reduction has come from a disciplined plan developed by Frank Gibeau and their team on the games label. I would also point out to you that the primary driver of R&D as a percent of revenue was in fact revenue. And one of the challenges we have had is this is a part of our business that for so many years has relied on the annual success of franchises like Medal of Honor and Need for Speed. And as we mentioned on the call, Need for Speed is slightly down. And year over year, we are now absent Medal of Honor franchise, both in FY09 and FY10.
What you see happening in the year is the rise of key franchises like Need for Speed through a new development plan; Battlefield, through some very aggressive development and smart moves; Dragon Age, which we believe has the potential to be an apex multi sequel title for us, as does Mass Effect and others within the portfolio. So right now, I would tell you that gross profits in the game play book is strong. And as a percentage of revenue where we’d like it to be, R&D relatively high, but that is a function of where we are in the turnaround of that business from a series of years where some of our properties flip-flopped. And I could not feel stronger about the title plan in (inaudible) being just the anecdote to that problem, and it is a case where I look for upside if there is upside in our plan. Hope that answered your question.
Moving on to Ben Schachter with UBS.
Ben Schachter – UBS
Given the change in the macro and some more things at the company, can you talk about how you are looking at acquisitions differently today than you were in the past? Then also if you have any thoughts on PS3 development and where you're thinking on that platform? Thanks.
This is Eric. I will take the first part of that question. Regards to M&A, our position today is very similar to what we discussed in the last call. We are taking a very measured view, not looking at large-scale M&A. You would look to us to do a couple small deals in the foreseeable future in the next couple of quarters. We are very focused on the operational aspects of our business. We will just go forward on our planning process, we have slimmed down by becoming more concentrated, and we will spend more time, at least in the short term there. So our position today is pretty much what we had on the call with you late last year.
So on PS3 development, actually I would tell you that the way we look at development is really in three buckets, if I just exclude mobile and Pogo for a minute. We think it is online games like what we're doing with our BioWare-Lucas or Lucas-BioWare partnership around the Star Wars property, and what we're doing with Warhammer, and what we are doing with some of our MSGs.
A second bucket is what we are doing with Nintendo Wii, which is a major focus for us in the coming year. And the third category is Xbox 360 and PS3. The reason we put that into one bucket is the lion’s share of titles developed for these platforms are common. Of course, we work with each of the first party platforms on unique titles and might take advantage of the particular features of that platform, and we're very proud to have great marketing partnerships around key exclusive titles, both in the PS3 and the Xbox 360. But in general, think of us as having those three buckets, PS3, Xbox 360, bucked one; bucket two is the Wii; and bucket three is online.
And in terms of title count, I mean in emphasis, we have roughly an even balance between PS3/Xbox 360 being one bucket in terms of number of titles, just over 20, and just over 20 on Nintendo Wii. So in terms of our console, you might argue that we are evenly balanced between the – against, if you will, the installed base. Nintendo is the leader, they are getting half our emphasis in terms of title count.
And this question comes from Brent Thill with Citi.
Brent Thill – Citigroup
Thanks. John, just on the international business, it seems to be really lagging the growth you are seeing in North America, what is causing this dislocation, and what do you think helps turning around?
I actually think what you're probably seeing more than almost anything in our international business is really two factors that sort of make it look at a little bit different. One is a very substantial shift in FX, which on a back translation basis, causes our international businesses to look small, relatively small in growth rate. During the year, the dollars was dropping and the euro was rising, was precisely the opposite, and we looked like – our international business was generating outsized performance.
The second factor is the primary beneficiary of our Rock Band business has been North America. It was a gigantic revenue contributor to the business in North America in the tail end of our fiscal 2008 and all of fiscal 2009. Normalizing for these two, and looking at them, say, for example market share performance, they are very, very similar.
And this question comes from Daniel Ernst with Hudson Square Research.
Daniel Ernst – Hudson Square Research
Yes. Thanks, good evening. Thanks for taking the call. On your Nintendo Wii strategy, to date you have done a couple of things to get at – one being the Boom Blox new IP, and the other being taking franchises that you are doing well with and making them, I guess Wii centric with your all play feature, and also assume with FaceBreaker, you added K.O. Party in it. It sounds like you are kind of doing the same thing for the coming fiscal year, with Need For Speed having a different version, I think Nitro is its name, for the Wii. Can you talk about how you think you’re going to be doing it differently this coming fiscal year such that you are more successful relative to what you have done so far? Thanks.
So basically you live, you learn, you adjust and improve. And so this year's title slate is a significant improvement from last year because we learned what didn't work last year, which we are not sequelling, and we are emphasizing hard those things that do perform. In situations within our EA Sports portfolio, we had outsized strength in titles like Tiger and FIFA. We are sort of bringing those back in new and enhanced ways. In titles where we had lesser performance, we're adjusting to learn from those experiences.
But I actually would highlight a couple of things to more directly answer your question as opposed to staying up at the theory level. One is, we're going strong, right out of the box, with EA Sports. EA Sports Active is taking advantage of the world's fascination with fitness, the strength of the Wii Fit platform, with a spectacular title in my judgment at least that's coming out in our first quarter. In fact I'm heading up to Vancouver tonight, the development city of our EA Sports Active business.
If you go to the web, you can learn a little bit more about it. Peter Moore has been vocal on it with a number of press announcements. He is the President of our sports label. It looks like a very strong entry to me, and frankly a brand new category for Electronic Arts.
The second thing that is coming out in the quarter is we are launching our tennis SKU, our tennis title, and initially we only, and following it up with other franchises. This takes a spectacular advantage of the unique controller, I probably don't have to go too far to explain why that controller in your hands sort of feels more like a tennis racket than other controllers might.
In addition to that, we're taking up a big step forward with us Sims label. The MySims franchise is very successful on this platform, on the Wii platform. We are bringing three titles together, and we are aggressively marketing them. They have been among the most successful IP on the platform. We're going to market them aggressively, really as a range, and this is a premium range. We are really the only player in sort of the premium range ideas against the Nintendo platform have been Nintendo themselves. We are coming at this with a very strong entry, one of our best development teams, feels really, really good.
The third thing we're doing, we’ve had great success with last year, we are doubling down, we are basically getting 12 months business instead of six with our Hasbro business. Our Hasbro business has got a strong entry there. The fourth thing we're doing, and I would really like to put sort of a fine point on that is we are bringing core intellectual properties and franchise in categories we think have legs on the Wii platform. A good example of this is Dead Space. We are bringing a Wii title to market this year, and it is absolutely going to be the quality and fear factor that you’ve got on the PS3/ Xbox 360 and PC SKU this past year.
So I can go on a little bit more with other titles to reference and points to make, but I would tell you that we are also increasing our commitment to marketing, exclusively with marketing dollars, focused on the titles for this platform, marketed more as a range than individual titles.
So I think we have learned how to build better quality products for this platform. We have learned how to develop products that appeal more to the specific consumers, and bring consumers to this platform with our own intellectual properties, that really lived on other platforms that of course is a lot of cross ownership and will generate incremental sales for the Wii. And we're going to top that up with a stronger marketing campaign. So in a way I suppose it feels like we took two good steps forward last year. We got three more this year.
And the next question comes from Colin Sebastian with Lazard Capital Markets.
Colin Sebastian – Lazard Capital Markets
Thanks, good afternoon. First of all, in terms of the product portfolio, there were a number of your core franchises that you didn't talk about for the next fiscal year, so I'm curious. First of all, is there any franchises that didn't make the cut? And then secondly, are you implementing any new technology in the development process to improve game quality or save on costs or are you happy with the tools you have at your disposal? Thanks.
So, yes, there were titles. I don't think you would think of them as core titles that didn't make the cut. We’ve clearly made some moves on titles like Playground and Bogie and others. But one of the things that we’ve elected to do on this call is to not dwell a lot on what we are discontinuing. We’d thought we’d rather say this is more about the numbers. There's a lot of personal emotion that gets wrapped up in individual games. We’ve just been through in the process of managing our way through 12 facility closures and 1,100 person lay off. Basically, just for purposes of sensitivity, we think it is better to keep it at that level.
In terms of tools, we have actually made some good progress. One of the things we have done is, we have consolidated around the core engines. For example, on the games label, we're using core engine attack [ph] and spreading it across a number of titles in our Redwood Shores Studio. We are doing something very similar with our Dice Studio with an engine we titled Frostbite. We have propagated effectively a technology that you first saw in our NBA Street franchise, that’s now used in a number of our games titles, sports titles, which is how individuals NPCs and player characters are animated.
At this point in time, the lion's share of our titles, in fact, well north of 80% of our titles have some level of common code that can be considered core. So one of the reasons we’re able to put together such a strong slate for FY10, while reducing expenses is because we're taking advantage of some of these things.
I would add, the other thing that we're doing in terms of tools is a technology that we use to create builds, push builds, automate testing and enable distributed development in QA, both in-house and offshore. This is all working better. The net result of that is we're expecting to move these processes to lower cost locations versus we are today looking to the end of FY09.
And the next question comes from Tony Gikas with Piper Jaffray.
Tony Gikas – Piper Jaffray
Hi, good afternoon guys. You have given guidance on fiscal ‘10 relatively early and I'm wondering what gives you such confidence with the consumer and the environment that we are in, in sector sales that you are willing to give guidance this far out? And in the latter part of the cycle, do you feel like sales are easier to predict, or do industry sales become a little more variable?
Well, first off, I almost have to reframe your question a little bit to answer it accurately. Given our business circumstances, what we saw in Q3 and our expectations going forward, and what we have learned in calendar ‘08, we specifically pulled forward our full planning cycle up a quarter. So it is not about visibility, it is about completing the process, and we’ve completed the process a quarter earlier, put us in a position to guide a quarter earlier.
One of the key reasons we did this is that we learned that one of the things that we weren’t doing as effectively as we might is the long lead marketing planning. Essentially, some of the most important decisions on our launch plans for our key titles was being held in favor of the planning process that needed to be locked down in sort of the February-March timeframe. We did this because we wanted to get the, if you will, our budgets locked so we can in fact get into marketing execution 90 or 120 days earlier. A key learning, we restructured our entire planning process around it.
In terms of where we are in the cycle, you’d referenced that we are at the tail end of the cycle. I would actually suggest that that's probably not correct, or at least that I have a different take. I mean if you’ve listened to the commentary from both Sony and Microsoft in recent weeks at CES and other venues, their comments is they expect an extended cycle as do we. So we think it's more the middle of the cycle than it is the end of the cycle.
And in terms of predictability, I would tell you that how we managed to develop our revenue forecast is based on sort of nothing blowing out past sort of reasonable base judgment expectations. And when you are using that as the base model for how you forecast, it is frankly a little bit more predictable. So we’ve introduced predictability into our forecasting by taking a slightly different approach.
The other thing to add on to that is that looking at FY10 versus FY09, we talked about the revised deal of the distribution business. We are expecting that to be down, but we also have titles that we’ve moved from or used to be in FY09 into FY10. We touched on those, Sims 3, Harry Potter. These are net year-over-year pick-ups. So we've got kind of confidence and visibility on those – on those revenue streams. And also for fiscal ’10, we are going to get a full year of Warhammer subscription revenue. We talked about the fact that we are already at 300,000 subs. That is a very ratable and more predictable business, and so that is new for FY10 compared to fiscal ‘09. Next question please.
Certainly. The next question comes from Mike Hickey with Janco Partners.
Mike Hickey – Janco Partners
Hi guys. Thanks for taking my questions. I was curious if you can note a little bit on your fiscal ‘10 sales expectations, if you could identify what you think are going to be your top five titles ex EA Sports and EA Partners? And then I have a follow-up please.
Ex-EA Sports and EA Partners?
Mike Hickey – Janco Partners
Sorry, I have never taken – I’d never do a top five without Madden or FIFA in it. But top five without Madden or FIFA, it is almost a trick question, but you know clearly Dragon Age is there, Sims 3 is there, Need for Speed SHIFT is there, Bad Company is there, and probably Harry Potter Half Blood Prince will be next in the list. That would get us to 5. One of the nice things about some of those Dragon Age PC, Harry Potter Half Blood Prince, and the Sims 3 are fairly easy for us to forecast and feel confident in given the state of development that these are in. Next question.
Certainly. The next question comes from John Taylor with Arcadia Investment.
John Taylor – Arcadia Investment
Hi, I have got a couple as well here. So it looks like you are on track to do a little over 400 for the fiscal year in direct-to-consumer, and you are kind of forecasting a 500 number. So, I'm wondering, kind of how you are thinking about that growth rate as you go into fiscal ‘11 and forward, are we likely to see that accelerate, if so by how much? Kind of wondering maybe when out there, we might see a billion dollars kind of potential for that. So that this kind of the first one. The second one is, you talked a lot about cost management and it is – you know, given the market, given all the variables, it is awful hard to forecast unit sales, really what consumers are going to do. So you guys can control costs. I am wondering if with the mix shift to Nintendo and everything else that’s going on, what the implied breakeven unit delta might be? You don't need to tell us kind of what the average is, but I want to know how much it has come down by as you're thinking about that. And third is really easy, what are you assuming your Wii market share is likely to be in fiscal ‘10? Thanks.
I will take the first and the third and I will give Eric the breakeven question, I didn't quite track. So, in terms of – sorry about that JT. So in terms of the direct-to-digital, one of the things I would point out to you is that the mid-20s growth rate that you projected for our direct digital business based on what we have told you and putting the pieces together is very close to our own expectations. But I would tell you that I generally don't think of it as a composite other than preparing for earnings calls. Really what it is, it is Pogo, it is Mobile, it is MMOs, it is a series of MSGs, it is ultimately a new MMO that we are going to be launching in joint partnership with LucasArts. And so it is a series of businesses that feel like they have gotten good tailwinds that are growing, Pogo and Mobile in particular. It is secondarily a series of things that are really discontinuous that are adding to our business. Good examples of discontinuous, especially late last summer, the launch of Warhammer, the revenue stream where it was only a cost stream. When we launch our next MMO it will be, we believe, a much larger revenue stream where it has been only a cost stream. And we talked about Battlefield Heroes, our Need for Speed online, the number of launches we got in Asia, which we really don't have time to get into on the call today. But these are discontinuous activities that generate big steps forward in revenue. Because I don't – I am not here to tell you that I've got a prognostication of when it’s a billion dollars. But I would tell you that a major contributor to that will be our BioWare, LucasArts joint venture MMO. That will have an awful lot to do with that last step to $1 billion. Eric, do you want to take the breakeven point?
Yes. I won't give a kind of a quantitative change on the breakeven point for Wii SKUs, but I would offer the following three observations. One, as you look to FY10, we are to be getting the benefit of some learning curve. So FY’ 09 was the first year of all play mode in sports. So we have the benefit of that behind us and we intend to do better when we iterate in terms of the efficiency. Secondly, we are developing expertise in certain of our own studio locations in terms of Wii development. So again, we are advancing the learning curve there. And the third point is that, I touched upon this earlier, we are expanding our generic, proven [ph] library so that we can for, for example, QA and final a product, a Wii-specific product more efficiently than we would using more manual processes. So we feel that these three things are going to make us more efficient in terms of overall Wii output.
John Taylor – Arcadia Investment
So in terms of Wii market shares, let me tell you that overall what we guided to on the call is about 5% revenue growth and hence no market share growth. Of course, our goal internally would be to gain at least a market share point in the year. So let me give you a first hand observation how to look to that and maybe the easiest way to look to that is that on our distribution business, we lose about $300 million and then we have taken three titles and moved them into the next year, which adds about $300 million. So what does that tell me if you are up 5% in a 5% industry you are flat. So our internal models in aggregate don't show market share growth in terms of our guidance for FY10. Having said that, we do have high hopes to see growth on the Wii, given our titles slate in the year, which is stronger than last year. And, you know, to be honest with you, I don't think we will be satisfied if we didn't pick up something there. And of course that is important given that some of the legacy platforms like the PS2, where we have enjoyed strong share over time are in decline. So, we wanted to see market share growth there. I'm not giving you specific numbers. I know I'm not answering your question directly but I didn't want to make sure you've got an understanding what is required for our $4.3 billion is really the new IPs that we moved out of ‘09 and ‘10 offsetting the decline in distribution towards the whole shift.
And the next question will come from Heath Terry with FBR Capital Markets.
Heath Terry – FBR Capital Markets
Great, thanks. Just on the three titles that were shifted, are those shifts purely marketing related or should we also think that there was a development component to this? And then when you look at the Wii platform strategically, is there a structural difference, either because of the customer base or the gameplay format or Nintendo’s development skill that causes you to plan for EA’s ability to gain share on that platform to be limited, or can you ultimately with the right strategy get to an equal share with your other platforms.
So, I'll take the second question first in terms of Wii. The – on the Wii, I would say it is structurally different in a number of ways relative to the PS3 and Xbox 360. One is the prevailing premium price. It is $10 a unit less than it is for Xbox 360 and PS3 games. Secondly, development is typically a third to a fourth as much for a Wii game then it is for a PS3 or an Xbox 360 game, and that is really a function of the capacity of the hardware and the fact that it is not a high-definition gaming box. So we are not producing, you know, the number of – the amount of art for high-definition games. Third, there are differences in terms of the way the consumer proceeds with the brands. I think there is little doubt that Nintendo has an enviable position in terms of, sort of brand reputation relative to its own platform with its consumer base. And that is one of the reasons in the coming year, we have decided to make such a strong emphasis on quality. You will see we are taking great advantage of their new hardware addition with motion sensor, and that – what that is going to give us is the kind of gameplay we think will rival Nintendo on their own platform, and we are bringing marketing together in such a way that we think we can get noticed in ways that no other third party will. In terms of the three shifts, I would tell you that we were in a position, should we have wanted to or needed to, to ship all three titles in Q4 of FY09. So, they were ready to go at one level or another, but I will also tell you that in each of the three cases, holding the title does allow the team to push it a little harder for polish. And I would like to give you the perspective on each of the three in terms of what was the fundamental motivation to the move. In terms of Sims 3, frankly we see this as being one of the more important launches in our company, its history, and certainly in the coming fiscal year. When we looked at what we have done in terms of all the marketing preparation, what we have learned from the Q3 results in North America and Europe, we felt we could do better to build a marketing campaign worthy of a title of this high-quality. So this was really about investing more time and effort to be even more innovative on marketing. In the case of Godfather 2, to be honest with you, we looked at the title, title feels very solid. It appealed to its audience well and it was likely to ship as we had originally planned it. We were very cluttered, price reduced excess inventory channel both in North America and Europe in a heavy competitive environment. We didn't think we would get its best shot for success in Q4. And Dragon Age, frankly, this is going to sound almost upside down but sometimes too much quality can make you reassess your options. So with Dragon Age, this is truly an epic game both in scale, quality, and innovation. And we felt that we could mount a better campaign consolidating Dragon Age PC with console later in the year. And yes, that will allow them to polish it even more. So each of them had their own story.
Operator, we will take one more question.
And that question will come from Doug Creutz with Cowen & Company.
Doug Creutz – Cowen & Company
Thanks. You guys talked about how you are going to lengthen your time to market for the advertising campaign. I think clearly that means more dollars. What has changed to make you think that’s the appropriate strategy and why do you get confidence that spending more on advertising is going to yield better revenue for your games? Thanks.
Just for clarity sake, we did not tell you that we are spending more necessarily. We said we will spend it differently. And what gives us confidence in this is frankly some work that we did within our marketing teams that basically took apart our marketing campaigns, one by one, month by month, sometimes week by week, program by program compared with the competition, where our spending lived relative to release-launch and post-launch windows, the types of vehicles that will use to create buzz and demand in each of those windows, how were they spaced out over time in terms of launch windows on the Christmas holiday, and came to conclude that we were under spending in the pre-launch month in demand generation and that had an impact in terms of buzz and demand for the product at presale levels and before. And that we were spiking a little bit too much right on top of the launch, and so those were some of the conclusions. We made other deeper conclusions associated with revenue mix, our promotions work, et cetera. We went to school on ourselves and came back with a different answer than the one we fielded in the marketplace for 2008, and felt we had a better opportunity if we did it differently. Not wanting to essentially ignore our own learning, we took a look at our Q4 slate and felt that it was too late to do what our learnings from Q3 ’08 and prior to that had taught us, and so we adjusted our Q4 end launches to reflect our current learning.
Okay, thanks everyone for joining us today.
And that does conclude today's conference. We do thank you for your participation today.
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