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Electronic Arts Inc. (ERTS)

Q1 2007 Earnings Conference Call

August 1, 2006 5:00 pm ET

Executives

Lawrence F. Probst - Chairman of the Board, Chief Executive Officer

Warren C. Jenson - Chief Financial Officer, Executive Vice President, Chief Administrative Officer

Frank D. Gibeau - Executive Vice President, General Manager, North America Publishing

Tricia Gugler - Director of Investor Relations

Analysts

Edward Williams - BMO Capital Markets

Lowell Singer - Cowen and Company

Michael Wallace - UBS

Chris Kwak - Susquehanna Financial Group / SIG

Justin Post - Merrill Lynch

John Taylor - Arcadia Investment Corporation

Evan Wilson - Pacific Crest Securities

Colin Sebastian - Lazard Frères & Co.

Tony Gikas - Piper Jaffray & Co.

Heath Terry - Credit Suisse First Boston

Elizabeth Osur - Citigroup

Arvind Bhatia - Sterne, Agee & Leach, Inc.

Glen Reid - Bear, Stearns & Co.

Presentation

Operator

Welcome to the Electronic Arts first quarter fiscal 2007 earnings conference call. Today’s call is being recorded. For opening remarks and introductions, I would like to turn the call over to Ms. Tricia Gugler, Director of Investor Relations. Please go ahead.

Tricia Gugler

Welcome to our first quarter fiscal 2007 earnings call. Today on the call we have Larry Probst, Chairman and Chief Executive Officer; Warren Jenson, Chief Financial and Administrative Officer; and Frank Gibeau, Executive Vice President and General Manager of North America Publishing.

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

Throughout this call, we will present both GAAP and non-GAAP financial measures. Non-GAAP measures exclude charges and related income tax effects associated with acquired and processed technology, amortization of intangibles, employee stock-based compensation, restructuring charges, and certain litigation expenses.

In addition, the company’s non-GAAP results exclude the impact of certain one-time income tax adjustments.

Our earnings release provides a reconciliation of our GAAP to non-GAAP measures. Information regarding our use of non-GAAP measures, along with a schedule demonstrating how we calculate return on invested capital, will also be included with a copy of Warren’s remarks we post on our website.

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

All comparisons made in the course of this call are against the same period for the prior year, unless otherwise stated.

We have included our trailing 12-month platform shares and our 2006 estimated market outlook in a supplemental schedule on our website.

During the course of this call, we may make forward-looking statements regarding future events and the future financial performance of the company. We caution you that actual events and results may differ materially. We refer you to our most recent Form 10-K for a discussion of risk factors that could cause our actual results to differ materially from those discussed today. We make these statements as of August 1, 2006 and disclaim any duty to update them.

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

Warren C. Jenson

Good afternoon, everyone. We would like to start off with a few highlights from the quarter. First quarter results exceeded our expectations. Revenue was $413 million -- up $48 million or 13 percent year-over-year. GAAP diluted loss per share was $0.26 versus $0.19 a year ago. Non-GAAP diluted loss per share was $0.12 -- an improvement of $0.06 versus a year ago.

These results were driven by the strong performance of several titles:

  • FIFA World Cup sold more than 2.8 million copies. It was the number one title in the UK for seven consecutive weeks and in Germany for six consecutive weeks. FIFA World Cup also had a strong showing in North America -- it was our biggest title for the quarter;
  • On cell phones, we completed our first global launch with FIFA World Cup. We released 2,000 SKUs with over 80 carriers in 33 countries;
  • Battlefield 2 Modern Combat on the 360 was also well received;
  • Sims 2 Family Fun Stuff sold over 700,000 copies;
  • NFL Head Coach had a solid debut, selling over 400,000 copies;
  • Life-to-date -- we are now the number one publisher in both North America and Europe on the 360; and
  • Our FIFA franchise has now generated over $2 billion at retail

In the quarter, Spore won three awards at E3 -- Best Original, Best PC and Best Simulation Game -- the most wins for any one game and the most for a third party publisher.

We have extended our exclusive relationship with the PGA TOUR and have also extended our NHL and NHL Players Association non-exclusive licenses. All licenses for our major sports games are now secured through at least 2009.

In Korea, we launched our first online game, FIFA Online, with our partner Neowiz. A few interesting data points:

  • FIFA Online was the first game to reach 100,000 thousand peak concurrent users in its first month;
  • On the day of July 15th alone, over 1 million people played the game; and
  • In just 60 days, we have registered over 3.5 million unique users.

Although still early, we are pleased with the strong consumer response. We are planning to begin monetizing FIFA Online with micro-transactions this week.

Finally, we are pleased to have recently closed the Mythic Entertainment acquisition. We are happy to welcome Mark Jacobs, Rob Denton and their team to EA.

For the next few minutes, I will focus my remarks in two areas. First I will review our Q1 financial results. Second, I will go over our outlook and financial guidance, and then following my comments, Larry, Frank and I will open the call to your questions.

Q1 performance -- net revenue was $413 million, up 13% driven by FIFA World Cup, Battlefield on the 360, and strong catalog. By platform, the revenue increase was driven by Xbox 360 and cellular phones, partially offset by declines in current gen. We released 16 SKUs in the quarter, same as a year ago.

Console revenue was $194 million, up 6%. The increase was driven by Xbox 360, which more than offset the decline in all current generation revenue. In North America and in Europe, we had three of the top-10 titles on the 360.

Mobility -- revenue was $85 million, up $33 million or 63%. On mobile phones, revenue was $33 million. We had four of the top-10 games in North America, with Tetris at number one. On handhelds, revenue was $52 million, flat year-over-year. We launched four handheld SKUs in the quarter versus six a year ago.

PC revenue was $66 million, down 11% primarily due to last year’s strength of Battlefield 2.

Co-Publishing and Distribution revenue was $42 million, up 40% driven by the success of Half Life 2.

Internet, licensing and other revenue was $26 million, flat to last year. Club Pogo now has 1.3 million subscribers, up 44 percent year-over-year.

Geographically, North America revenue was $209 million, up $25 million or 14%, driven by the Xbox 360 and cellular phones, partially offset by declines in current gen, PSP and PC.

PS2 related revenue was flat year-over-year.

International revenue was $204 million, up $23 million or 13%. Excluding a $10 million negative impact from foreign exchange, international revenue would have increased 18%.

Europe revenue was $169 million, up $25 million or 17%, driven by the Xbox 360, PSP and co-pub and distribution revenue, partially offset by declines in current gen consoles.

Asia revenue was down 5%, primarily due to foreign exchange.

Moving on to the rest of the income statement, gross profit in the quarter was $245 million, up 14%. Gross margin was 59.3% versus 58.6%, up 70 basis points. The increase was principally due to lower sales return charges and a shift in mix toward higher margin platforms. These improvements were partially offset by a higher mix of licensed titles and increased royalty rates.

Operating expense -- as you know, this quarter we adopted FAS-123R. In total, this increased our operating expenses by $37 million.

Marketing and Sales -- marketing and sales expense was $77 million, up 3% due to our adoption of FAS-123R. Excluding stock-based compensation, marketing and sales would have been down by 4% due to lower ad spending.

G&A was $59 million, up $8 million due to stock-based compensation. Excluding the impact of stock-based compensation, G&A would have been down 6%.

R&D was $216 million, up $33 million or 18% primarily due to the expensing of stock-based compensation and the addition of JAMDAT. Excluding stock-based compensation, R&D increased 7%. R&D headcount was approximately 5,200, roughly flat versus year-end, and up 15% from a year ago. JAMDAT accounted for eight points of this increase.

Our GAAP tax rate for the quarter was 18%. Let me remind everyone that in a loss quarter, a lower tax rate results in a greater net loss and an increased loss per share. As I mentioned in our last call, you can expect our rate this year to be volatile and potentially fluctuate dramatically quarter to quarter.

GAAP diluted loss per share was $0.26 versus $0.19 a year ago. Non-GAAP diluted loss per share was $0.12 versus $0.18. The $0.14 difference between GAAP and non-GAAP EPS is due to employee stock-based compensation, amortization of intangibles, and restructuring charges.

Our trailing 12 month operating cash flow was $589 million versus $669 million for the comparable period.

Our return on invested capital on a trailing 12-month basis was 17% versus 47% a year ago.

Now, on to the balance sheet.

Cash, short-term investments and marketable securities were $2.4 billion, down $35 million from year-end. Gross accounts receivable were $225 million versus $278 million a year ago, a decrease of 19% due to the timing of our release schedule.

Reserves against outstanding receivables totaled $184 million, up $73 million from last year. Reserve levels were 17% as a percentage of trailing six month net revenue, up five points. As a percentage of trailing nine month net revenue, reserves were 8%, up three points.

Inventory was $59 million, down $7 million from last year. Other than NCAA Football, no one title represented more than $5 million of net exposure.

Now, our outlook and guidance. Before getting into the numbers, we thought we would highlight a few things. First, while things can change very quickly, the current sales environment is healthy. NCAA sell-through is up over 10% year over year, and pre-orders for Madden are at record levels.

Second, we are very much looking forward to a great fall and holiday with all platforms hitting the store shelves. We are not far off from having all the pieces of the next-generation engine in place.

Third, we are very pleased with the excitement that is surrounding the Nintendo Wii and DS Lite. We see these platforms as real opportunities to grow our business. Accordingly, we have recently ramped up development for both the Wii and DS Lite.

Finally, we think the early success of FIFA Online in Korea is encouraging. These early learnings will be invaluable for the long term.

I will conclude my portion of today’s call with our market outlook and our financial guidance. 2006 market outlook -- essentially, our outlook for the industry remains the same. We expect overall software sales in North America and Europe for calendar 2006 to be flat to down 5%.

We are planning for the PS3 and Nintendo Wii to launch in the late fall.

In addition, we expect the overall mobile phone game segment to be up 25% to 30%.

Now, on to our financial guidance. I would like to once again highlight a few points.

First, there are many uncertainties. While we expect the PS3 and Nintendo Wii to launch successfully, there could easily be delays and shipment quantities could fall below our estimates. Should this happen, it would cause our numbers to drop materially. We have also yet to finalize our next-gen royalty agreements with both Sony and Nintendo.

Second, demand for existing platforms and software could fall off abruptly, even below our expectations.

Third, there is significant development risk, particularly given the challenges of transition. It is possible that a title could slip out of any given quarter or for the fiscal year.

Finally, it is important that you carefully review and assess the risk factors detailed in our SEC filings.

Now the numbers, for the quarter ending September 30, we expect:

  • Revenue to be between $635 million and $685 million;
  • GAAP diluted loss per share to be between $0.28 and $0.22; and
  • Non-GAAP diluted earnings per share to be roughly breakeven.

Overall, we expect our non-GAAP EPS to be roughly $0.25 better than our GAAP loss per share. The estimated break-down of these adjustments is as follows:

  • Stock-based compensation, approximately $0.10;
  • Amortization of intangible assets, roughly $0.04;
  • Restructuring charges, approximately $0.02 related to our European reorganization; and
  • Acquisition charges of roughly $0.09 associated with our acquisition of Mythic Entertainment and Digital Illusions

If you are projecting a loss in the second quarter, the appropriate share count would be approximately 308 million. If you are projecting positive earnings, the appropriate share count would be roughly 317 million.

In Q2, we expect to ship 43 SKUs compared to 37 a year ago. We have already shipped NCAA Football on four platforms and Lord of the Rings Battle for Middle Earth 2 on the Xbox 360. Lord of the Rings is a break-though product which for the first time successfully brings real-time strategy to consoles.

In addition, we expect to release:

  • Def Jam on the PSP;
  • FIFA 2007 on seven platforms ;
  • Godfather on two platforms;
  • Madden NFL 2007 on eight platforms ;
  • Madden NFL 2007 Hall of Fame Deluxe on two platforms;
  • NASCAR Thunder on three platforms;
  • NBA Live 2007 on five platforms;
  • NHL 2007 on five platforms;
  • The Sims 2 Glamour Life Stuff Expansion Pack; and
  • Tiger PGA TOUR 2007 on four platforms.

In the quarter, we also expect to offer downloadable game content on Xbox Live Marketplace. Some examples include a map pack for The Lord of the Rings Battle for Middle Earth 2 and we will also be releasing a steady stream of EA Sports content later in Q2.

On mobile phones, we plan to release seven games -- Tetris Mania, EVDO Tetris, Scrabble, SimCity, Madden NFL 2007, FIFA Street 2, and Def Jam Fight for New York.

Now, our full year guidance. For the full year, we expect:

  • Revenue to be between $2.8 billion and $3.0 billion;
  • GAAP diluted loss per share to be between a loss of $0.30 and breakeven; and
  • Non-GAAP diluted earnings per share to be between $0.35 and $0.65.

Overall, we expect our non-GAAP EPS to be roughly $0.65 better than our GAAP results. The estimated break-down of these adjustments is as follows:

  • Stock-based compensation, roughly $0.31;
  • Amortization of intangible assets, approximately $0.15;
  • Restructuring charges, roughly $0.05 related to our European reorganization; and
  • Acquisition charges of approximately $0.14 related to our acquisition of Mythic Entertainment and Digital Illusions.

Please note, we have tightened and slightly increased our top-line estimates. We have increased our estimated GAAP loss as a result of our recent acquisitions and because we have increased the number of SKUs under development, including more SKUs for the Nintendo Wii and DS Lite. Much of this spend is for fiscal 2008.

We continue to believe our non-GAAP EPS guidance is appropriate.

Finally, a few housekeeping items.

Looking ahead to the holidays, we now expect our Q3 revenue as a percentage of the total year to be roughly 40%.

If you are projecting a loss for the year, the appropriate share count would be approximately 310 million. If you are projecting positive earnings, the appropriate share count would be roughly 320 million.

We again ask you to keep in mind that with the introduction of next-generation platforms and the global expansion of online gaming –you will see more games delivered with significantly enhanced online game play. In some situations, this may delay the recognition of revenue. This of course will have no adverse impact on cash flows.

With that, we are pleased to open the call to your questions.

Question-and-Answer Session

Operator

Thank you, Mr. Jenson.

(Operator Instructions)

Your first question comes from Edward Williams with BMO Capital Markets.

Edward Williams - BMO Capital Markets

Just a quick question, if you will, on the PlayStation 3 relative to the Xbox 360. Can you characterize where you are at this stage, Larry, in terms of the development for that system? How long will it take to really harness the power and leverage it with the releases?

Frank D. Gibeau

Right now in terms of development with PS3 versus our 360 launch titles, we are seeing some very strong breakthroughs from the multiprocessor environment on the PS3 that will enable us to do some really unique things for that platform.

But in this timeframe that we are looking at going forward with this Christmas, it is going to be difficult to harness the full power of the PS3 on first generation software versus what will be second generation 360 games, so while there might be some differences between the games, they are going to be more alike than different, is our opinion at this time.

As those machines develop over time, there is a lot of horsepower inside the PS3 that we will be able to unlock over years two, three and four that we are very excited about.

Edward Williams - BMO Capital Markets

Can you just comment a little bit about the development efficiencies in next gen products, where you are on the learning curve with the 360?

Lawrence F. Probst

Just to give you sort of a brief summary, I would say we are slightly ahead of where we were on the 360 at the same time last year.

Operator

The next question is from Lowell Singer with Cowen.

Lowell Singer - Cowen and Company

Thank you. I was wondering if you could talk a little bit about your assessment of the hardware environment. I mean, it is clear that you are making a more aggressive push, both on handheld and consoles with Nintendo platforms. Do you see evolving as a share shift from Sony and Microsoft to Nintendo? Or do you think Nintendo's expected success over the next couple of years is all incremental to what you had originally forecasted? Thank you.

Frank D. Gibeau

We believe the momentum behind the Microsoft 360 and the Nintendo systems is very strong right now, and will probably have a market expansion effect. The PS3 is clearly the market leader, or the PlayStation technology is clearly the market leader worldwide, but strong competition from Microsoft and Nintendo we believe will expand the market.

The DS right now is a very hot platform at retail. It has a very strong lineup of software and the sell-through in June was extremely strong. We believe that momentum will carry that platform forward to very high levels.

The PSP is doing well in the international markets as well as in North America and for the first time, we really have a competitive handheld market, which again is having a positive overall effect on the market.

Operator

Moving on to Mike Wallace with UBS.

Michael Wallace - UBS

Just a couple of things -- how many launch titles do you think you are going to have for the PlayStation 3 and for the Wii? What is your best guess at the units that are actually delivered this Christmas on both?

Lawrence F. Probst

We expect to have four or five launch titles on the PS3. We have specifically talked about Madden, Need for Speed and Tiger. We suspect there will be one or two more.

By launch period -- I am describing that as from the day they ship the hardware to the end of the calendar year -- the number on the Wii platform is probably two, but we expect to ship five in our fiscal year on the Wii platform.

With regard to quantities on the hardware, we cannot give you an answer this point. I am sure you have read what Sony has said publicly. Nintendo has not made any public statements.

If history is the guide, I suspect Sony will be challenged to hit the 6 million number they talked about in their fiscal year. We hope they do, but history has shown that hardware companies typically come up a little short against their initial forecasts.

Michael Wallace - UBS

I assume that you are doing what we are doing, which is assuming that Sony comes up short. As far as Nintendo, you think they are in the ballpark of the number Sony put out there, or maybe a little better?

Lawrence F. Probst

Well, Sony is talking about 6 million units in their fiscal year on a global basis. I do not think Nintendo has said anything along those lines.

As I said a few moments ago, we would expect they will be challenged to hit that 6 million unit number. That is a number they talk about in terms of manufacturing, not sell through. We will have to wait and see what Nintendo says about their specific quantities by market.

Michael Wallace - UBS

The Wii, I assume Madden is one. What would the other one be, if you said two?

Lawrence F. Probst

Need for Speed.

Michael Wallace - UBS

Then just one more thing -- do you think, I mean, a lot of speculation that the PSP is going to get cut, which they probably need to do. What about the PS2? Some rumblings that maybe they take the price down this Christmas to $99 -- do you think there is a shot that one or two of those things happen?

Lawrence F. Probst

I would be surprised to see a downward price adjustment on the PS2.

Michael Wallace - UBS

PSP, maybe?

Lawrence F. Probst

Possibly. You will have to ask Sony.

Operator

You have a question from Chris Kwak of SIG.

Chris Kwak - Susquehanna Financial Group / SIG

You commented about the royalty structure, that you still need to negotiate with Sony and Wii. Can you give us a sense for what we should be thinking about that, in terms of whether it is going to be roughly the same percentage, or is it going to be fluctuating pretty wildly depending on the vendor there?

Secondly, when you look at Nintendo Wii and the DS Light, and your commitment there, clearly it is a greater commitment. Can you put that in perspective? Maybe the size or range of that commitment, number of heads, things of that nature? Thank you.

Lawrence F. Probst

With respect to the third party business model with both Sony and Nintendo, we do not have details and we are hoping to have some in the next few weeks.

Frank D. Gibeau

In terms of relative investment on the Wii in the DS, we are moving resources against those platforms to increase SKU count. I am not sure headcount is the right metric to look there in terms of level of commitment, because the systems are different to develop for and it could be external versus internal mix development.

We are definitely going after those platforms as a greater percentage of our mix in terms of development.

Chris Kwak - Susquehanna Financial Group / SIG

Is it reasonable to assume you could have the same number of SKUs maybe 12 months from now on the Wii versus the PS3, for example? Or is that being too aggressive?

Lawrence F. Probst

That is too aggressive. It is unlikely we would have the same number of SKUs. We have not talked about how many. We have not finalized our SKU plan, but I would say it could be something like roughly half of what we have on PS3.

Operator

The next question is from Justin Post with Merrill Lynch.

Justin Post - Merrill Lynch

Thank you. A quick financial question -- it looks like the ratio of receivable reserves to receivables is really high. Did you ship any reorders in June?

Second question, the expense levels with R&D, clearly an issue of the street, how that is ramping this cycle versus their last cycle. Do you expect to see some expense synergies as you are able to port maybe a little later in this cycle than you did in the last cycle?

Warren C. Jenson

Let me go ahead and I will take that question. On the reserves, I do not think that ratio of reserves to receivable is really relevant, because, for example, the receivables went down, largely having to do with when we shipped the product, so you end up with smaller receivable.

The absolute amount of the reserve really has to do with that which you have reserved in the channel, so it is kind of comparing apples to oranges, but it is just the way the GAAP accounting works.

I think the better methodology is that which we talk about, which is looking back on a trailing six and trailing nine-month revenue basis. The net is as we have gone through and analyzed the channel, we think where we are is exactly where we should be.

On the expense side, we are trying to do several things.

One, we are investing across the board in what we think the opportunities of the next gen will be. That is going to be in getting ready for the next gen platforms, in getting ready for online globally. I think what we are doing in Korea with FIFA Online is a good example of that in online.

Then finally, doing things that we need to win in the mobile marketplace globally.

As we look ahead to the R&D line, right now, I would say we are at a point where all eyes have to be focused on delivering the product against these product launches. Then from there, it is all about looking at ways to deliver great entertainment and see that which we can do to generate productivity in order to scale that line.

I think you can assume, one, we will make the necessary long-term investments to win, but at the same time, I know there is nobody in our organization anywhere, including the studio, or for that matter in any of the other functions that really is not focused on building scalable solutions so that we can scale that expense base as we move forward.

Justin Post - Merrill Lynch

Thank you. One follow-up just on the receivables, did you have an abnormally low amount of shipments in June relative to last year? Thank you.

Warren C. Jenson

I would not say in June, no, there is no -- it really has to do with when you created the reserve and when the programs have been applied. So for example, in Europe, many of the reserves that have been established, those programs may not have been applied yet.

The only thing I would tell you is that the only thing I would focus on relative to the charges in the quarter was that we did have smaller charges this year as opposed to last year, and that ended up helping gross margin.

Operator

This question is from John Taylor with Arcadia.

John Taylor - Arcadia Investment Corporation

I have a couple of quick questions. One, the change in format for E3, I am wondering how you guys are thinking about that as potential cost savings for next year, given you do not need to throw a ton of resources, a spiffy product just for the show and having all of the bodies down there and so on, so that is the first question.

I wonder if you can quantify what your direct-to-consumer business was, all the direct digital download, what that piece was, and help us understand how you are thinking about it. In relation to that, talk about how we ought to think about how you are going to monetize FIFA and POGO in China, and that sort of stuff. Thank you.

Warren C. Jenson

With regard to the adjustment that was made to E3, we fully support the decision that was made by the ESA board. We think it makes good business sense. We see that as the appropriate evolution of the E3 event.

In terms of cost savings, it will save us multiple millions next year.

John Taylor - Arcadia Investment Corporation

Is there a potential offset in dues and so on, so that it is not just a straight savings? Are there any offsets?

Warren C. Jenson

Well, obviously E3 was a primary revenue driver for the ESA, and without that event happening as it has in the past, there are going to be some dues assessments to all of the companies in the industry association that are different than what they have been historically, but net net, it is still a big win financially.

John Taylor - Arcadia Investment Corporation

Does this maybe have double-digits?

Warren C. Jenson

Double-digit what?

John Taylor - Arcadia Investment Corporation

You know, millions.

Warren C. Jenson

What is a double-digit million?

John Taylor - Arcadia Investment Corporation

$10 million or more?

Warren C. Jenson

I think for some of the larger companies in the industry, that is a possibility.

John Taylor - Arcadia Investment Corporation

Then, can you talk about that direct digital, how you are thinking about that for this year, maybe some specifics on the monetization of FIFA, etc.?

Frank D. Gibeau

I will get to FIFA in a second, but conceptually what we are doing is creating a digital distribution channel for our PC products that includes both full product as well as mission packs, and basically what we call paid downloadable content. That will be available on multiple platforms, not only the PC but also through the Xbox Live service.

We are looking at a variety of strategies there, and looking at that business as an opportunity to further monetize our gains in new ways that were not available in the last generation, so that direct-to-consumer link is important to us from a standpoint of not only the distribution of goods that we sell but also customer service and eventually being able to serve dynamically advertising into those games. Building that link and that online connection will help us monetize the gains in new ways.

With regard to POGO in China, that is still in closed beta. Also, with regard to FIFA in Korea, the monetization strategies are going to start to get executed in the next couple of weeks, and those are going to be primarily micro-transaction based. When we start to get that data in, we will have a much better sense of what the total opportunity will be.

Warren C. Jenson

I would just add, if you look at the absolute dollars recognized in the quarter, it is probably somewhere around $4 million or $5 million.

John Taylor - Arcadia Investment Corporation

As you are thinking about the potential for this year, you made an interesting comment that maybe it moves into a deferred revenue account as opposed to being recognized. Can you give us any sense of, are we thinking 50-50 in terms of cash flow division between those two accounts, or how should we think about that?

Warren C. Jenson

It is really going to be dependent upon the product, because the way the accounting really works is you have to determine two things. You have to determine the value of the online service that you are providing, and have evidence of that value, and then determine a useful life.

It could be that the entire product or revenue value of the product is deferred over a period of six months, it could be over a period of three months, it could be that a portion of it is. So it is really going to be dependent upon the product and dependent upon the nature of the service.

Operator

We have a question from Evan Wilson with Pacific Crest Securities.

Evan Wilson - Pacific Crest Securities

Thanks for taking the questions, I have three. I will just throw them all out there.

First, how are you thinking about FIFA this year in fiscal Q2? You obviously sold a lot of FIFA into the channel in the last particular quarter.

Also, I would like to get a little detail on gross margins for fiscal Q2, so we can back into quantifying your increasing royalty costs there.

Then also, could you give us a little direction on the amount of revenue you guys expect to see over the next two fiscal years from all the Asia stuff you are doing, Tales Runner in Korea, the Pogo beta in Shanghai, as well as Warhammer Online. Thank you.

Lawrence F. Probst

With regard to FIFA, we are feeling really good about that product. If you add the number of units we sold on World Cup and FIFA, it will probably be our second best-selling franchise this year, after Need for Speed. So we have high expectations for FIFA on the coattails of the success we that we have had with the World Cup.

Frank D. Gibeau

With the launch coming up in Q2, we obviously are managing the channel inventory on World Cup and FIFA '06 to get us into position for FIFA '07, to be set for a great launch over Christmas.

Warren C. Jenson

I will hop on to the other two questions, but one thing I would also add on FIFA is clearly we are building momentum in North America in soccer. I think if you look at World Cup 2006 as an example, the momentum continues to build there, which is absolutely a positive.

As I look at gross margin, looking into Q2, I would expect it today to be down year over year, give or take roughly 300 basis points.

Looking at the monetization of our activities in Asia, I think it is too early to make a prediction. Again, I think the early signs coming out of the beta in Korea are very positive now. Our next test is to see how the monetization works. We are going to have to go through that with Pogo, hopefully in the coming months to make the same calls.

Our commitment is we do believe in the market. We do believe in the successes that we have had and will look for ways to take several of our other products and repeat what we have been able to do, at least so far, in a very short period of time, on FIFA.

The opportunity is there. I think it is too early to quantify the results.

Evan Wilson - Pacific Crest Securities

It sounds like you think that FIFA shipments can be flat this fiscal Q2 over last fiscal Q2, at least?

Warren C. Jenson

I am not making any predictions today in terms of unit volume for the quarter, although I would expect you could say at least flat, maybe up from there.

Lawrence F. Probst

Yes, we expect it to be slightly up.

Operator

Next question is from Colin Sebastian with Lazard Capital Markets.

Colin Sebastian - Lazard Frères & Co.

Of the titles you mentioned for Q2, are there any you would care to mention that are on the cusp? That is first of all.

Secondly, recent sales trends, have they given you any insight into the $60 price point for next-gen products? Related to that, what are your assumptions for Wii software pricing?

Lawrence F. Probst

We think the SKU plan for Q2 is in good shape.

With regard to pricing on the Wii, all of the companies in the industry are going to have to make a decision about that. The only thing I heard is the CEO of Nintendo saying that he could not imagine any of their titles being sold beyond $49.95, so again, everybody is going to have to make their own decision about pricing on that platform.

Colin Sebastian - Lazard Frères & Co.

Following up on the question about micro transactions, or digital downloads, is there anything you can tell us about the online capabilities of the PS3, or at least your PS3 titles that are planned for there? Thank you.

Frank D. Gibeau

There have not been any formal announcements from Sony on what their online plans or capabilities will be, so it is difficult for us to comment on that at this time. You will have to ask Sony.

We do know that from the experience with the Xbox 360 with the online connection on the console is something that customers love, and that will be a key leverage point from this point forward. We think Sony understands that but we have not heard anything formal yet in terms of those announcements.

Warren C. Jenson

I think one thing you can count on though is that we have in development actively alternatives to monetize the online environment, whether it is the creation of digital content, whether it is downloadable capacity, expansion packs -- however that model ends up working out, hopefully we will be prepared.

Operator

The next question is from Tony Gikas with Piper Jaffray.

Tony Gikas - Piper Jaffray & Co.

A couple of quick questions for you. I know it is early, but if hardware launches go off with your expectations, not Sony or Nintendo, what type of a growth rate should we be looking at for the industry in calendar 2007? Is it a double-digit number? If so, is it mid-teens or approaching 20%?

Second question, I am sorry if I missed this -- did you indicate what the level of revenues were from micro-transactions during the quarter? Do you get any more visibility on that revenue model? If so, could you maybe describe that a little bit more for us?

Third part, level of in-game advertising in your long-term outlook.

Warren C. Jenson

I will take a piece of that, and then Frank can jump in.

Looking ahead to calendar '07, I think we obviously all want to see how the launches go, but I would say sitting here today, this early, we would easily see double-digit growth in the marketplace for calendar 2007 sitting here -- again, we are a long way from that, but from all that we can tell, we would easily see that.

I would not be any more specific than that, other than to say we foresee a very healthy market looking into the next calendar year.

We did mention that in terms of digital downloads and things like that, it was, call it $4 million or $5 million in the quarter, and would expect to see that build over time.

Frank, if you would like to add to that.

Frank D. Gibeau

With regard to your question about dynamic in-game advertising, we believe that will grow very fast with the next generation of connected consoles, which is really the key driver for how big that market is.

I am sure you are aware of all the different market estimates out there. They are all over the map in terms of how big this opportunity is. We believe that it can be significant for us.

We have a substantial amount of inventory inside our games that is fairly easy to monetize, given the types of games that we are making, with racing and sports and so on. We are looking at it as significant, but it is really going to come down to looking at the GAAP market growth rates and looking at the connected units within that.

Tony Gikas - Piper Jaffray & Co.

Could those two revenue streams, the micro-transactions and in-game advertising, say three years out, be mid- or high-single digits as a percent of total sales?

Lawrence F. Probst

I would say it is a possibility.

Warren C. Jenson

It is hard to make that call, but sure.

Operator

The next question is from Heath Terry with Credit Suisse.

Heath Terry - Credit Suisse First Boston

Thank you. Can you give us an idea, the 10% increase that you are seeing in NCAA, is that unit or revenue that you are referencing there?

Lawrence F. Probst

That is unit, and so the revenue will be higher because we have higher price points attached to the Xbox 360 this year.

Heath Terry - Credit Suisse First Boston

Can you give us an idea of what kind of mix you are seeing so far between Xbox 360 and the previous generation?

Frank D. Gibeau

360 is trailing the PS2 by a little bit. The percentage of business that is moving to the 360 is within line with what we expect, but the PS2 is still the number one platform.

Heath Terry - Credit Suisse First Boston

Thank you. You said just by a little bit -- is that much of a surprise, given the fact that there is such a huge difference in the installed base?

Frank D. Gibeau

It was not surprising to us. It was basically what we forecasted, based on pre-orders and looking at the market data. There is a lot of activity in that 360 base, where your power users of sport products have moved on to the 360.

In the first two weeks of sell-through, it was not that surprising at how high 360 was. It will obviously as we get into the holiday period smooth out a little bit more where that base will start to take over more.

Heath Terry - Credit Suisse First Boston

When you see that combined with the higher attach rates that you are seeing with 360, to what degree do you feel like, or is that giving you more confidence that the $60 price point is going to be sustainable longer term? How long do you think this higher attach rate, or this attach rate growth that we are seeing in next generation is going to be sustainable?

Frank D. Gibeau

It is interesting. I think they are at a four-and-a-half tie ratio through year-to-date on the 360, which is higher than it has been historically at this time period.

The $60 price point we are not getting a lot of resistance to. We are launching good quality products that have high depth with connected game play that frankly customers are feeling is a good value for $60. So we are not seeing any weakness in the $60 price point.

The tie ratio, there is a good slate of 360 games coming between now and Christmas, so that tie ratio should be solid.

It is interesting that even on the DS, we are seeing higher than historical tie ratios. We are not sure quite yet what is driving that, but the tie ratios are much better than expected at this time of year.

Heath Terry - Credit Suisse First Boston

Just one last question -- when you look out at the online attach rates that are being talked about for micro-transactions -- and I realize we are still in the very early stages of this -- to what degree do you think you are going to be able to migrate those same kinds of transactions into your games? How many games do you think will ultimately support micro-transactions?

Should we expect the attach rate we are seeing on some of these now also holds up as we start to see a proliferation of available content, downloadable content out there?

Frank D. Gibeau

I think there are a couple things to consider.

First, from a technical standpoint, all of our games that are connected will have micro-transaction capabilities -- whether or not we have content for a given franchise available and positioned for that, that remains to be seen.

I can tell you that in the case of EA Sports, and a lot of our major franchises on the entertainment side, we are planning to have downloadable content available for those connected users.

One of the things you have to look at on the 360 is when they stay it is 60% connected, some of those are silver users versus gold users, so some of the folks are using it for browsing and not necessarily commerce yet.

The percentage is growing on the gold level, which is really great news. If they can hold at 60%, that will be amazing. We think it will come down a little bit as they get further into the cycle, but the percentage of gold versus silver will go up, so that will probably offset.

Warren C. Jenson

One thing I would add to that, Heath, when you get a micro-transaction-based world, big games are going to win. So if you are a small game, there will be limited capability and limited life. If it is a game that has legs and a big following, particularly on the online side, those are going to be the ones that are going to do decent numbers.

Operator

(Operator Instructions)

The next question is from Elizabeth Osur with Citigroup.

Elizabeth Osur - Citigroup

Most of my questions have been asked, but I guess just two quick ones. Warren, with regard to your R&D guidance and some of the detail that you have given on the last call, can we assume that an increase in resources being put towards DS Light and Wii would increase your R&D estimates for the year?

Warren C. Jenson

Yes, you should.

Elizabeth Osur - Citigroup

Will there be increases in any of the other areas versus your prior expectation, either on mobile or online?

Warren C. Jenson

No, I would say that also in reference to G&A and marketing and sales, and they still continue to hold in line with their historical percentages of revenue.

Elizabeth Osur - Citigroup

The content that you have downloadable on Xbox Live marketplace now, I assume that the majority of that content is free and not paid. If that is true, can you talk about when the balance might switch, such that more of the content might be paid content?

Frank D. Gibeau

The balance is shifting now to paid. Our most recent release was a booster pack for Lord of the Rings: Battle for Middle-earth II. It was Aragorn's Journey, which was three maps. It was roughly 700 Microsoft points. That was our most recent release.

When we look at the relative mix of paid versus free, it is going to start to head more towards the pay.

Warren C. Jenson

Operator, we will take two more questions.

Operator

Thank you. The next question comes from Arvind Bhatia with Sterne, Agee.

Arvind Bhatia - Sterne, Agee & Leach, Inc.

First question was a catalog for the quarter, what the percentage was. Then, second on Madden, can you quantify the pre-orders? Just those two housekeeping questions.

Warren C. Jenson

Catalog for the quarter was 61%, and that is up from last year, last year was 50% for the same period, so a very strong catalog coming out of Q4 last year.

Frank D. Gibeau

With regard to the Madden pre-orders, we do not publicly release those quantities, but they are several hundred thousand, and they are up over the last year. We are feeling very good about the momentum.

Arvind Bhatia - Sterne, Agee & Leach, Inc.

Last question on the development costs for Nintendo Wii, obviously people expect that to be much lower than the other two consoles. Is there a way for you to help us understand what the delta is? Is it 25% less than the other two consoles? Some metric that helps us conceptualize the difference in cost.

Lawrence F. Probst

It is really too early to give you anything specific because we have not finished the Nintendo Wii product, so I think on the next call, we can give you better information because we will be close to -- in fact, we will have finished some titles and then we can give you some metrics. It is too early.

Warren C. Jenson

Last question, Operator.

Operator

The last question comes from Glen Reid with Bear, Stearns.

Glen Reid - Bear, Stearns & Co.

A lot of my questions were answered. Maybe broadly speaking, and historically you guys have been, this whole sector has been pretty insulated from any sort of consumer weakness. I am curious to get your thoughts, as a lot of those concerns are kind of flowing through different sectors of the market, how you think about the videogame sector and your company in particular in the face of potential consumer weakness or economic softness. Thank you.

Lawrence F. Probst

I will give you some thoughts and the other two guys can chime in. Based on our conversations with retailers, they seem pretty bullish about this category in the back-half of this year, given the expected launch of the PlayStation 3, the Nintendo Wii, the building momentum on the handheld platforms, the Xbox 360 continues to sell well, so their outlook is pretty positive, and we would agree with that.

Warren C. Jenson

Very good. Thank you, and thanks, everyone, for joining us.

Operator

That concludes today's conference. Thank you for your participation.

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Source: Electronic Arts Q1 2007 Earnings Conference Call Transcript (ERTS)
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