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Activision, Inc. (NASDAQ:ATVI)

Q1 2007 Earnings Conference Call

August 3, 2006 4:30 pm ET

Executives

Kristen Southey - Vice President of IR

Bobby Kotick - Chairman and CEO

Thomas Tippl - CFO

Mike Griffith - President and CEO of Activision Publishing

Analysts

Tony Gikas - Piper Jaffray

Jeetil Patel - Deutsche Bank

Doug Kriss - Cowen & Co.

Elizabeth Osur - Citigroup

Heath Terry - Credit Suisse

Edward Williams - BMO Capital Markets

Ralph Schackart - William Blair

John McPeake - Prudential

John Taylor - Arcadia

Colin Sebastian - Lazard Capital

Robert Haley - Gabelli & Co.

Presentation

Operator

Good day everyone, and welcome to Activision’s first quarter fiscal 2007 earnings conference. (Operator Instructions) At this time for opening remarks and introductions, I would like it turn the call offer to the Vice President of Investor Relations, Kristen Southey. Please, go ahead, Kristen.

Kristen Southey

Good afternoon, and thank you for join us today for Activision's Q1 fiscal '07 conference call. As always, I will start today's call with a review of Safe Harbor disclosure, followed by comments by Bobby Kotick, Chairman and CEO; Thomas Tippl, Chief Financial Officer; and Mike Griffith, President and CEO of Activision Publishing.

With regard to our Safe Harbor disclosure, I would like to remind everyone that the statements made during this call that are not historical facts are forward-looking statements. These forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties.

The Company cautions that a number of important factors could cause Activision's actual future results to differ materially from those expressed in any such forward-looking statements. Such factors include, without limitation: sales of the Company's titles during fiscal year 2007; consumer spending trends; the seasonal and cyclical nature of the interactive game market; the Company's ability to predict consumer preferences among completing hardware platforms, including next-generation hardware; software pricing; product returns and price protection; product delays; retail acceptance of our products; delays in hardware launches; industry competition; rapid changes in technology and industry standards; protection of proprietary rights; litigation and the informal SEC inquiry; maintenance and relationship with key personnel, vendors and third-party developers; international, economic, and political conditions; and integration of recently-acquired subsidiaries and identification of suitable future acquisition opportunities.

These important factors and other factors that potentially could affect the Company's financial results are described in our filings with the SEC, including the Company's most recent annual report on Form 10-K.

The Company may change its intentions, belief or expectation at any time and without notice, based upon any changes in such factors in the Company's assumptions or otherwise. The Company undertakes no obligation to release publicly any revisions to any forward-looking statement to reflect events or circumstances after the date hereof, or reflect the occurrence of anticipated events.

Additionally, with regard to the recently received letter of informal inquiry from the SEC regarding our stock option processes or related legal matters, we refer you to our 8-K filings.

Finally, unless otherwise noted, all financial commentary will be made excluding the impact of equity-based compensation. Please refer to our earnings release for a full reconciliation.

I would like introduce Bobby Kotick, our Chairman and CEO.

Bobby Kotick

Thank you, Kristen. For the first quarter, Activision delivered better than expected results, and our balance sheet and financial position remains strong. The quarter highlights include shipment of over 2 million units of DreamWorks products, driven by the strong launch of Over the Hedge. Our partnership with DreamWorks has now yielded four successful titles that have shipped in excess of 15 million units. DreamWorks is unique as a licensor in its understanding of the importance a video game can have in creating value in movie-based intellectual properties.

Quarter highlights also include the sales of X-men: The Official Game, which exceeded the million-unit mark, bringing our life to date total for the X-men franchise to 9 million units. Call of Duty 2 remains the best-selling next-generation console title since the launch of the Xbox 360; and in June, Guitar Hero, our newest wholly-owned intellectual property ranked as the No. 4 best-selling game overall, according to NPD, delivering its highest monthly sell-through since its launch last November.

We're on the verge of what is likely to be the most exciting time in our industry's history. The launches of the Sony PlayStation 3, the Nintendo Wii, and second-generation Xbox 360 titles are quickly approaching. The reported marketing commitments that first parties are making for the launch of the consoles are the largest marketing expenditures in the history of the video game industry. This should build enthusiasm and awareness, and hopefully result in strong consumer demand for new hardware and software.

These next-generation consoles offer something for every consumer. Whether it's the strong online environment 360 Marketplace provides, the incredibly high production values of the PS 3, or the unique ways its players can interact with objects on the screen with Nintendo's innovative controller, these systems will enable entirely new experiences for broader audiences. The Nintendo DS and Sony PSP provide opportunities for us to sell to an entirely new handheld consumer, which should add to the overall market growth.

In addition, new sources of margin expansion are starting to materialize. Commercially viable digital downloads of game add-ons is becoming more feasible. First parties are increasingly validating the opportunities for in-game advertising, and new rich media wireless devices should all contribute to profit growth over time.

To take advantage of these future opportunities we remain focused on expanding our balanced franchise portfolio, strengthening our next-generation development leadership, expanding our distribution reach, and furthering our initiatives to reduce development expense through organizational efficiencies.

Our competitive advantage is derived from our ability to access intellectual property rights, successfully create new franchises, leverage our own proprietary development resources, and extend our broad distribution capabilities, all of which should lead to continued margin expansion and higher returns on invested capital for the future.

While the future is exciting, realizing our growth and profit goals are not without significant risk. Development costs are higher, business models may change, consumers may find the Internet provides new forms of entertainment which may reduce consumer enthusiasm for video games generally, and competition for talented employees remains fierce, especially of the caliber we've been so success at recruiting and retaining.

While increasing production costs and volatility of transitioning to new hardware remains a challenge and a risk, there is much to be excited about as the installed base of next-generation hardware grows. We're committed to finding new ways to reduce rising development cost, including outsourcing artwork and quality assurance, developing proprietary tools and technology that reduce these costs, and leveraging the investments of our intellectual property partners in character development, art and animation creation, and consumer marketing.

We've been careful about capital investments and the strength of our balance sheet has enabled us to secure long-term control over new intellectual properties like James Bond and acquired products, like Guitar Hero.

We continue to use our capital to expand our distribution reach. In fact, this quarter we opened a publishing office in Seoul, one of the fastest-growing gaming markets in Asia, and we'll continue to add publishing operations in new geographies.

Our competitive position continues to improve and the barriers to entry in our industry continue to rise. As we have over the past 15 years, we believe over the long-term we can provide superior returns for our shareholders.

Later in the call, Mike will share more details of our plans for the next few fiscal years, but now Thomas will provide a review our operations during the last quarter and the progress we made this quarter with our cost optimization programs.

Thomas Tippl

Thank you, Bobby, and good afternoon. For the June quarter, net revenues were $188 million. This was higher than anticipated, driven by our market platform launches Over the Hedge and X-men, and the strong performance of our catalog, including Call of Duty 2.

For the quarter excluding equity-based compensation, we had a loss per share of $0.05. This is $0.05 better than our prior outlook due to product performance and disciplined execution of our cost optimization programs. As expected, quarterly revenues and earnings were down over their prior year, as we had fewer product launches and lower launch pricing, which we highlighted on our last call.

Before I continue with our financial review, I would like to note that all financial commentary will be made excluding the impact of equity-based compensation. Please refer to our earnings press release for a full reconciliation.

In the June quarter, manufacturing and distribution expense were 68% of revenues, up versus 57% in the prior year due to mix shift and continued current-gen software price erosion. Product creation cost for the quarter were 28% of revenues versus 22% in the prior year. We define product creation cost as the sum of cost of sales, software royalties, and amortization, cost of sales intellectual property licenses and product development expense. The increase year-over-year was due mainly to higher next-gen development costs.

Sales and marketing expense for the quarter was 19% of revenues, in line with the prior year. G&A spending in dollars was flat verse the prior year, excluding the cost associated with RedOctane and was down sequentially versus the Q4 run rate, reflecting the benefits of our cost reduction program. We generated higher investment income for the quarter due to rising interest rates. Our effective tax rate for the quarter was 27.3% than our prior outlook.

Now turning to the balance sheet. On June 30, we had $793 million in cash and short-term investments, an increase of $7 million versus last year and a decrease of $152 million versus the prior quarter due to seasonal increases in working capital, intellectual property acquisition, and the closing the RedOctane transaction.

The accounts receivable balance was $65 million, up $37 million versus the prior quarter as a result of launch timing of new releases, and the consolidation of RedOctane in our results. The accounts receivable reserve as a percentage of trailing nine months revenues was 7%, which is in line with the prior year.

Days sales outstanding were 32 days, which is an improvement of four days versus year ago. Activision inventories were $64 million, up $3 million versus last quarter due to the consolation of RedOctane in our results. On June 30, inventory for the publishing business was $42 million, and $22 million for the distribution business.

Capitalized software development cost were $77 million, up $16 million versus last quarter. The sequential increase reflects more titles going into development for future slates. Capitalized intellectual property costs were $97 million, up $10 million versus March 31. The increase was primarily due to the Bond licensing arrangement with MGM.

In summary, we ended quarter ahead of plan, with a strong cash position and financial base which gives us the flexibility to invest and leverage the many opportunities that the next few years will yield.

Before turning to our financial outlook, I would like to begin by saying that our outlook represents our views as of today, and there are a number of internal and external factors that could cause our actual results to differ materially, including, but not limited to: a dramatic shift in retail demand, a rapid decline in software pricing, delay in the launch of new hardware or our software for the new hardware, or a sizable reduction in hardware launch quantities. I refer you to our financial filings with the SEC for a full review of our risk factors.

Now on to Q2. As we said on our last call, Q2 will be down versus the prior year due to a very light release schedule. In Q2, we will launch only one SKU, Gun for the PSP, very late in the quarter. As compared to last year when we launched 16 SKUs, including the multiplatform releases of Spider-Man and X-men.

Previously, we had planned for the Q2 release of Enemy Territory: QUAKE Wars for the PC, but as you know, id Software decides when game will ship and they recently confirmed that the game will not release this calendar year.

As far as our financial outlook for the second quarter, we except revenues of approximately $130 million and a loss per share of approximately $0.13, which excludes equity-based compensation expense of approximately $0.01. This is down versus the prior year as we have no major releases and lower pricing for current-gen catalog.

For the quarter, we expect manufacturing and distribution costs of approximately 65% of net revenues. We expect operating expenses, including royalties and excluding equity-based compensation, of approximately 78%. We project a tax rate of approximately 27% that can be used throughout the fiscal year.

Please note that our outlook does include the potential passing of legislation to reinstate federal R&D tax credits which is currently under review by Senate. Should the bill pass, our tax rate could be materially lower. This could have about a $0.02 to $0.03 negative impact on EPS for the September quarter, since it is a loss quarter, but a positive $0.02 to $0.03 EPS impact on the fiscal year.

For Q2, we expect a basic share count of about 281 million shares outstanding. For the quarter, we expect operating expenses, including equity-based compensation of about 82%. All other line items are the same as I mentioned a moment ago.

For modeling purposes for the third quarter we expect revenues to be down versus the prior year as we have fewer releases, and EPS will be up due in to part to our continued focus on cost optimization.

For the fiscal year, we are raising our revenue outlook to $1.075 billion due to over performance in our distribution business and increased revenue expectations for Guitar Hero. Our EPS outlook remains $0.15, which excludes equity-based compensation expense of approximately $0.05. We're not increasing earnings per share as the incremental distribution business has a very low margin, and increased expectation for Guitar Hero is largely offset by the acquisition costs related to amortization of intangibles.

For the fiscal year, we expect manufacturing and distribution costs of approximately 51% of net revenues. We expect operating expenses including royalties and excluding equity-based compensation of approximately 46% and diluted share count of about 302 million.

For the fiscal year, we expect operating expenses including royalties and including equity-based compensation of approximately 48%.

We continue to make progress with regard to our cost optimization programs, and as we've said, our efforts are focused on three areas: G&A, sales and marketing, and product creation costs.

First, as you know, we undertook a workforce realignment last year, and we reorganized our European operation into four regions to create more synergy. These actions are driving year-over-year reduction in G&A expenses for fiscal '07, excluding the cost associated with the RedOctane acquisition. With accelerating revenue growth we should see a reduction as a percentage of revenue starting in fiscal '08.

Second, with respect to sales and marking expenses, as we said previously in fiscal '06, we over invested in certain areas such as broad-based TV advertising, while other programs like online delivered stronger payouts. We continue to leverage these learnings to bring sales and marketing spending as a percent of revenue down to proven historical levels over the next two years.

In Q1, we closely monitored our product performance and more conservatively allocated funds to post launch activities. Looking ahead to Q3, we're using a number of alternative vehicles including shorter, more efficient TV spots and rich media online ads to drive awareness.

Third, with regard to product creation cost, we're benefiting from our early leadership on the next-gen. The upcoming release of Call of Duty 3 and Tony Hawk's Project 8 will make Activision one of the first companies to offer second-generation Xbox 360 titles. Today, all of our next-gen titles are utilizing proprietary tools that enable us to more easily develop games across multiple platforms.

In addition, we continue to drive efficiencies by increasing our development schedules to facilitate a longer pre-production phase and more predictable workflow timelines.

Finally, we continue to ramp up outsourcing areas of game development, like artwork and quality assurance, to other parts of world, such as Asia. In fiscal '06, we outsourced development on two of our titles as compared to today, where we have outsourced certain game development elements on eight of our titles.

These are just a few of the areas in which we are realizing savings, and we will continue to update you on our progress.

Now I would like to turn things over to Mike Griffith, President and CEO of Activision Publishing, who will provide his thoughts on the balance of fiscal '07 and fiscal '08.

Mike Griffith

Thanks, Tom. Today my comments will focus on two areas: first our overall market expectations, and second, what we plan to deliver in fiscal 2007 and 2008.

Looking at the overall market, on June 30th, the installed base of hardware in North America for current and next-generation systems, including handhelds, was approximately 105 million units. We continue to expect the installed base over the next few years will accelerate, driven by strong and growing consumer demand for the Xbox 360, Sony's PlayStation 3, and Nintendo's Wii, in addition to continued growth in hand-held platforms and lower priced current-gen hardware.

With respect to the hardware market, even though we have more information from the first parties than we did on our last call, there is still risk in the short-term, primarily surrounding next-gen launch dates and quantities, and current-gen hardware pricing and support. But for now, we still expect the following hardware increases in North America during the calendar year:

We're estimating PS2 up by 4 million to 5 million units and we're anticipating approximately 1 million PS3 units. We expect regular Xbox to be up 500,000 units while Xbox 360 grows by 4 million to 5 million units. We anticipate GameCube up by 800,000 units and we expect a million units plus from the Nintendo Wii system. Finally we expect handhelds, which include the GBA, the NDS, and PSP will grow approximately by 10 million units.

In the near term, we've been pleased with the increased supply of Xbox 360s into the marketplace and the performance of Nintendo DS in both the U.S. and Europe.

Moving to software, we define our market to include all major platforms in North America and Europe. For calendar 2006, we still expect the combined North America and European software markets for current-gen and next-gen consoles, handheld, and PCs will decline by as much as 5%.

With respect to software pricing, this still remain ones the major risk to our operating plans. We expect that software launch pricing for Xbox 360 and PS3 will be $59, and that frontline current-gen console titles will be made on a title-by-title basis. Absent the Nintendo Wii, we expect premium products to command premium pricing.

So turning now to our fiscal year 2007. As we said on our last call, this fiscal year we have a more focused slate than in fiscal 2006, which should align well with the challenging current-gen environment and the slow, although promising, ramp of the next-generation platforms. Concurrently, we're allocating more development resources against our large and growing fiscal year 2008 and fiscal year 2009 line up when market conditions should be significantly more favorable.

For this coming Q3, our holiday lineup is well-aligned against the market, and our next-generation lineup is the strongest in Activision history. Our slate is focused against our largest proven franchises, plus the fall release of Guitar Hero II. We're pleased with our early presence for Sony's PlayStation 3 and Nintendo's Wii, and we have three launch titles for each platform. We're also pleased with the progress we've made against our development activities for these new platforms.

Call of Duty 2 remains the No. 1 selling title on the Xbox 360 since the launch of hardware. In addition, we've been offering downloadable multiplayer maps for a fee on the Xbox 360 that feature new World War II map locations. To date, we've had over 500,000 downloads and we're learning a tremendous amount about this new business model.

During the quarter, our Call of Duty maps generated approximately $1 million in revenue, a critical first step in exploiting the online revenue potential and extending the shelf life of our games. This holiday we'll look to further capitalize on the success of the franchise and its online capabilities.

In the fall, Call of Duty 3 will launch on the PlayStation 3, Nintendo Wii, and the Xbox 360, in addition to the PSP, PS 2, and Xbox. Call of Duty 2 established itself as the No. 1 online multiplayer game on Xbox Live, and we're especially excited about building on this strength with a very robust online experience that Call of Duty 3 will offer.

When we launched Call of Duty 2 for the Xbox 360 last year, eight players could play online at once, whereas in Call of Duty 3, 24 players can play online, both in vehicles and on foot. As you can see, we're working hard to maintain our next-generation leadership with the Call of Duty franchise.

Our strategy with Tony Hawk this holiday is to broaden the franchise. Tony Hawk’s Project 8 has been completely rebuilt for the PlayStation 3 and the Xbox 360. The title targets the core consumer and it'll also launch on PS 2 and the regular Xbox. But we'll also target the casual and younger gamer with the release of Tony Hawk's Downhill Jam, a downhill racing game which will launch exclusively on the Nintendo Wii, DS, and GBA platforms.

The recent success of the Nintendo DS and the excitement around the Nintendo Wii should benefit this exclusive launch and add another leg to the stool for the Tony Hawk franchise.

During Q3 we'll also launch our next Marvel title, Marvel Ultimate Alliance. This game received a very high level of buzz and multiple awards at this year's E3. This is an all-new action RPG where you can play as 20 different superhero characters, including Spider-Man and Captain America. We're very excited about this title, which will debut on all three of the next-gen consoles in addition to PS 2, Xbox, PSP and the PC.

This holiday will also mark the worldwide launch of Guitar Hero II, our newest and wholly-owned intellectual property. We're obviously very pleased with the performance of the original Guitar Hero that launched in the U.S. last November and in June reached its highest-ranking yet as the No. 4 game overall according to NPD.

For those of you not familiar with Guitar Hero, it's a tremendously fun, music-based game targeted towards the mass market consumer. Guitar Hero keeps you engaged because it's easy to pick up and play, yet features game play that's increasingly challenging to master. The easy to play, difficult to master formula is exceptionally well-suited to drive mass market success.

The PS 2 title comes with a guitar and currently retails for about $69 to $79 US dollars. The soon-to-be-released Guitar Hero II on the PlayStation 2 will allow you to experience everyone's fantasy of becoming a rock star by allowing you to play not only the lead, but also rhythm and base guitar tracks. Combine this with the new multiplayer co-op and competitive game play modes, and we believe Guitar Hero II will be a key sought offer holiday gift item this year.

During the holiday quarter, we'll also launch two titles for handhelds only. Hammy Goes Nuts, a follow-on to the Over the Hedge title, and Spider-Man: Battle for New York. Looking to Q4 for planning purposes only, we have QUAKE Wars: Enemy Territory for the PC slated for a very late Q4 launch, but as you know, id Software makes the final decision on the game's release.

As we come closer to launching our first full slate of next-gen console games, we have a better feel for the capabilities of each system and their potential development synergies.

As you know, the next-generation platforms are allowing us to bring significant visual enhancement and sophistication to game play experience; and importantly, we're also beginning to share technologies across platforms using advanced techniques, such as 3D laser scan technology which allows us to capture a person's likeness and transfer them into a game; shading technologies that enable us to simulate the effects of light and shadows on objects in the world; motion capture, lip syncing and facial expression techniques; the proliferation of online and multiplayer technology; the migration away from pre-scripted game encounters to true emergent AI. All of these are able to be applied across platforms.

Today, building from our early lead on the 360, we have more development resources and expertise earlier in the console cycle than ever before. We're garnering efficiencies across platforms by leveraging development and porting capabilities between the Xbox 360 and PlayStation 3, and our current-gen development expertise against the Nintendo Wii platform and their innovative controller.

Near term, because of uncertain market conditions, fiscal 2007 continues to be a year of caution, investment, and learning as we manage through the reminder of the hardware transition and focus resources to prepare for accelerated growth in the next few years.

In fiscal 2008, we'll begin to reap the benefits of leveraging next-generation development, a larger installed base of hardware, and a growing, broader and deeper franchise portfolio.

We'll start the first quarter of the fiscal with three strong movie-supported franchises: Spider-Man 3, Shrek the Third, and Transformers. Spider-Man 2 and Shrek 2 alone generated $1.7 billion in worldwide box office sales, and collectively, the franchises have sold in excess of 30 million game units to date.

Additionally there's tremendous buzz in Hollywood surrounding the Transformer's movie, and we're very excited about the potential of this proven toy property. There's also an added benefit to releasing well-known movie-supported franchises early in the year as you get additional revenue opportunities during the holiday season.

Also, anchoring our slate in fiscal 2008 will be strong new titles from a number of our core franchises: Tony Hawk, Call of Duty, Marvel, and Cabela's, in addition to an all-new Guitar Hero and World Series of Poker. We'll also have a new intellectual property based on DreamWorks' Bee Movie starring Jerry Seinfeld. Our fiscal 2008 line-up continues to shape up as one of the strongest ever, and we'll share with you the specifics of our full line-up on future calls, but as of today we continue to expect that fiscal 2008 revenues will exceed $1.6 billion.

Our growth and results in fiscal 2008 will be driven by double-digit market growth, our expanding balanced franchise portfolio, growing our international presence, the full benefits of a more efficient cost structure, and continued successful focus on winning big with winning customers around the world.

So we thank you for your time and the opportunity to share our initiatives for the future with you, and I'll now open up the call for your questions. Thank you very much.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Tony Gikas - Piper Jaffray.

Tony Gikas - Piper Jaffray

A couple of questions. Micro transactions during the quarter sounded like Call of Duty did $1 million. That's an impressive number. How did the pay downloads compare to the free downloads that were available for that game?

Second question, any update from Sony or at least your expectations on the PS 3 online network and how that's progressing?

Third question would be my understanding is the Transformers movie has about a $250 million budget for production and marketing. Is this a title that could hit your multi-platinum ranking?

Bobby Kotick

Well, I think going to your first question on the micro transactions, yes, we were very pleased with the performance of Call of Duty, which is the primary vehicle right now that we're getting experience with this model. We downloaded about 0.5 million maps on Call of Duty. As we said, we got slightly more than $1 million in revenue. It was a combination of free giveaway trial maps and full purchases. About half of them were given away, and the others were purchased for a combination of a couple of different price points depending on how many maps were downloaded.

In terms of the update from Sony, that's an area we're staying close to obviously on PlayStation 3. We expect to take full advantage of the capability as it becomes clearer. So I don't have anything more specific to share with you today on that, except that it's our intention to take full advantage of that capability.

Finally, to your question on Transformers, I think we'd agree. We think has a tremendous potential on the franchise. I like how they're thinking about the movie. I think it's going to have a very broad and mass market appeal and we think the game is going to respond accordingly.

Tony Gikas - Piper Jaffray

On the PS 3 network, do you think that at least over the first two or three years does it evolve to be as rich of an opportunity as the 360 Xbox Live network?

Bobby Kotick

I don't see any reason why it shouldn't, Tony.

Tony Gikas - Piper Jaffray

Okay. Thanks, guys.

Bobby Kotick

You are welcome.

Operator

Our next question comes from Jeetil Patel - Deutsche Bank.

Jeetil Patel - Deutsche Bank

Thank you. A couple of questions, guys. As you look forward into fiscal '08, you've kind of talked about over $1.6 billion in revenue, not much on the margin side, but just curious, what do you think are the one or two single biggest points of levers in terms of margins or variability out there in the landscape that you think about?

Second, it looks like overall retail environment was a little healthier in the quarter. I guess, can you give us a sense of are you seeing the retailer buzz around the category remain strong for the holiday season, or does it really a hinge upon marketing dollars from the hardware vendors to drive the excitement in the category? Can you give us a sense of what you think the overall landscape looks like from a distribution and retail standpoint going into the holiday season? Thanks.

Thomas Tippl

First on the margin expansion, I think as we've said consistently, it remains a focus area for the Company, so nothing has change in that regard. Near term, I think the margins will remain under pressure as we navigate our way through the console transition and have a smaller '07 slate.

We are balancing short-term cost control at this stage with the investments that are necessary to drive growth in '08 when the market conditions should be more receptive.

The drivers of margin improvement in '08 are obviously are going to be more scale, more revenue coming out of our titles behind our stronger market growth and our stronger slate. We will attempt to continue to keep our cost control tight, but we also need to recognize that fiscal '08 is still early in the cycle. So we'll see some improvement at this stage.

Bobby Kotick

We're looking, obviously at improvement on the gross margin line, on variable selling and marketing, on G&A, and in all of our programs that we've put in place this year should yield benefits over the next few years.

Mike Griffith

To answer your second question on the retailer environment, there is certainly a lot of optimism out there that the launch of this second round of new hardware from Sony and Nintendo really kick off the new cycle in earnest. Retailers are ready to step up to this. There continues to be heavy near term pressure on inventories and we're working closely with retailers on that, but we're seeing full support on our titles and full support for the category.

The real driver in the end is really not going to be so much the marketing dollars that are available out there, but the launch quantities that the new hardware hits with. And as long as those are in line with what the first parties are indicating, I think that retailers are really going to step up and support it very well.

Bobby Kotick

But to your question, Jeetil, in terms of retail environment, I think we see a lot of enthusiasm. The retailers themselves are committing a lot of capital to the launch of the new hardware, and I think you'll see that continue next year when Vista is launched. So you'll have the new consoles coming out this year with a lot of first party marketing dollars, and then Microsoft will follow on with Vista marketing next year. So the whole video games category is going to get the benefit of a lot of marketing dollars to the consumer.

Jeetil Patel - Deutsche Bank

Thanks.

Operator

Our next question comes from Lowell Singer - Cowen and Co..

Doug Kriss - Cowen & Co.

Hi. This is actually Doug Kriss in for Lowell. Could you talk about how easy or not easy your developers are finding it to port code between the 360 and PS 3? Thanks.

Mike Griffith

Well, I think this was obviously an area of concern going into the new transition, the new hardware, because the different devices from Microsoft, Sony, and Nintendo are in fact, quite different from each other. But this has always been a core focus and strategy of ours and I would say while we're early in the process, we're encouraged.

We are starting to port elements from the 360 to the PlayStation 3, and also from current-gen platforms into Nintendo Wii. We are finding tools like the 3D laser scan, the shading technologies, motion capture, some online capabilities. This is where we're investing our resources now to find the ability to leverage our resources and assets across platforms.

So this is something that we're going to continue to learn and advance on over some period of time, but I’d say for being where we are in the cycle, we're encouraged.

Bobby Kotick

So one thing, Doug, what we are seeing is that there are much more similarities between 360 and the PS 3 and we are getting the benefit across all three of the platforms in our art and animation investments.

Doug Kriss - Cowen & Co.

Great. Thanks.

Operator

Our next question comes from Elizabeth Osur - Citigroup.

Elizabeth Osur - Citigroup

Thanks. I know you guys don't want to give too much guidance for fiscal '08, but any chance we could get a number of titles that are in that $1.6 billion revenue target?

Mike Griffith

Yes. In terms of SKUs and titles, we're about 50% higher than what we'll launch in fiscal '07.

Elizabeth Osur - Citigroup

Okay. Thanks. That's really helpful. You also spoke about expanding sales in Europe, but no comments on Asia. Can you talk a little bit about whether or not you're thinking of any opportunities there now?

Mike Griffith

Well, we continue to be interested in the Asian market. I think as we've said before, we think that there is substantially more near-term return from continuing to put our focus on building our presence in Europe.

But as evidenced by our recent opening of the publishing office in Seoul, Korea, we're committed to a worldwide presence, continuing to learn and built appropriately, but cautiously in the Asian market.

Elizabeth Osur - Citigroup

Just one final question on next year. Any way you could talk about the size of the operating leverage that we'll get from things like G&A next year? Could we just expect a modest increase in G&A growth, or do we need to think about a significant increase?

Mike Griffith

It's too early right now, Liz, to talk about specifics.

Elizabeth Osur - Citigroup

Thank you.

Operator

Our next question comes from Heath Terry - Credit Suisse.

Heath Terry - Credit Suisse

Great. Thank you. I was hoping you could talk a little bit about what you're expecting in terms of the attach rate for your online downloads like the ones that you've done with Call of Duty going forward?

Do you think the kind of strong attach rate that you've seen here in this early stage is going to hold up? Can you also talk a little bit about the margins around that business?

Mike Griffith

Well, I think, Keith, in terms of attach rate, the experience we've had so far on Call of Duty, the attach rate's been quite robust. It's been well-ahead of the typical download attach rates we've seen on the PC category. It's been closer to the 40% range. We're going to continue to learn about it, there's tremendous consumer enthusiasm for it, so I think for the right product there's every reason to believe that we can continue to achieve a healthy, robust attach rate.

In terms of the margins, I think what we can say to date is that it looks like it's accretive, and so as the revenue opportunity presents itself, this'll be a key focus area.

Bobby Kotick

And just to give you some of the details. For starters, the Bonus Pack, which is the free downloads, that's the two free maps, that was 334,000 units. The Skirmish Pack, which is essentially 400 points, was 105,000 units generated $368,000 in net revenue. And the Invasion Pack, which was 800 points, was 66,000 units and generated close to $0.5 million in revenue. So when you look at it, it's a very, very profitable endeavor for us.

Now, it's early days, but I think it's one of those things where you're starting to see continued enthusiasm for the franchise. I think one of the reasons why the 360 version of Call of Duty has done to so well and continues to do so well and continues to demand a premium price is that we have infused the audience with new opportunities for game play that they're definitely responding to.

So with 40% attach rate and these kinds of economics, we're excited, but again, you're talking about the No. 1 product on the platform. So before it's going to move the dial, you're going to need to see a much, much bigger installed base of hardware and a lot more people taking advantage of these capabilities.

Heath Terry - Credit Suisse

Based on what you've seen and what you have planned in the product portfolio, should we just assume that nearly every game that you do over the next few years is going to have some kind of downloadable content associated with it?

Bobby Kotick

Yes, that is our intention.

Mike Griffith

For the new generation, yes.

Heath Terry - Credit Suisse

Great. Thank you.

Operator

Our next question comes from Edward Williams - BMO Capital Markets.

Edward Williams - BMO Capital Markets

Good afternoon. Just to follow-up quickly on Heath's question for a moment. If you look at the downloads in June quarter, how did they vary between North America and the European markets?

Bobby Kotick

The bulk of them were North America. It was 400,000 of the 500,000 were North America.

Edward Williams - BMO Capital Markets

Okay. And then looking at the development headcount for a moment, you suggested or alluded to that a lot of your developers are working on releases for FY '08 and FY '09. Can you give us an idea as to, first of all, where your headcount is today in development? And then roughly how it breaks down as far as the percentage of assets that being applied to the FY '07 releases, '08 and beyond releases?

Mike Griffith

Well, in total we've got about 1,300 people employed across our 10 studios. In terms of the split in terms of what title are they are working on, we're really not prepared to get into that.

Bobby Kotick

I think as Mike pointed out, we have a 50% bigger SKU count for next year than this year, and you can do the math.

Edward Williams - BMO Capital Markets

Okay. And then as far as -- these new revenue streams, at this stage, when are you thinking the digital downloads, in-game ads, micro transactions are really become meaningful to Activision? Is this something that's going to be in the heart of the next-generation of the cycle or is something that could happen earlier based on how this early stage with Call of Duty 2 looked?

Bobby Kotick

I think you won't see a real impact, Edward, until you have a big installed base of next-generation hardware.

Edward Williams - BMO Capital Markets

Going to Korea for a moment, what are your plans with publishing in the Korean market? It's obviously a very big MMO market. Can we assume that you're looking to tap into the MMO landscape, or are you looking for more bringing traditional Activision titles into that market?

Mike Griffith

Well, Edward, we've sold our titles in Korea for a while now through a distributor, and this is a step taking that model and going direct. So this is a natural next step for us to take in the Asian geography, given the importance of the Korean market.

In terms of the MMO space itself, it's not a near-term strategic focus for us, but we're continuing to stay close and monitoring the space and with our office in Korea -- as you point out, Korea is one of the largest online markets in the world, so we're well-positioned to stay close and learn and watch and see if an opportunity to enter the space in a way that makes sense, we'll obviously entertain it. But for now, our near-term focus on direct publishing of our titles in Korea and more broadly worldwide, focusing on the execution and increasing our international presence overall is really the right near-term focus and priority for our resources.

Bobby Kotick

One thing you have to think about is we've always said that we're going to map to the market with respect to the way that we plan our platform publishing strategy. So to the extent that you start to see new categories and new platforms, or let's say multiplayer products represent more than just the small single-digit percentage of the market, we recognize that in order to maintain balance on our platform strategy that we'll have to support new categories of business. So I think as you see those businesses get bigger, you'll start to see us take them more seriously.

Edward Williams - BMO Capital Markets

Okay. Good. Thank you very much.

Operator

Our next question comes from Ralph Schackart - William Blair.

Ralph Schackart - William Blair

Good afternoon. I was wondering if we could look over the horizon a little bit into '07 perhaps beyond, and maybe you could give us a sense what you're seeing for industry growth rates on the software side? I believe there's some other people in this space calling for what they believe is going to be easily double-digit growth in calendar '07. Just update us on your thoughts on that?

Mike Griffith

Well, in fiscal '07, which is largely calendar '08, as we've said, near term the category would be kind of flat to down 5. But in calendar '07 we do expect a return to double-digit growth.

Ralph Schackart - William Blair

Okay. Great. Not to beat the in-game advertising and micro transaction too hard, but is there a way you could quantify it for us at a high level, perhaps Bobby or Mike, is this an opportunity that could be single-digit as a percentage of your revenue? Is it an opportunity that could perhaps be double-digits? Just sort of give us a sense of the order of magnitude here.

Bobby Kotick

Here's how we start at very highest levels, Ralph, we look at the amount of hours that are consumed by consumers and let's take 18 to 35-year-old males in the U.S. in front of a video game screen. So last year that was roughly 30 billion hours. Then you compare that to television watching which was to the same demographic roughly 30 billion hours. There was $8.5 billion spent on television advertising to 18 to 34-year-old males and there was less than $50 million spent in-game advertising last year. So it's somewhere between $50 million and $8.5 billion.

You have to remember that in our medium, there are a number of products that are entirely inappropriate for any kind of advertising and when you look at way that you incorporate advertising into these products, you need to be unusually sensitive to the audience because the audience is, after all, paying for the retail product.

We've now had four separate studies that we've conducted with Nielsen towards the creation of a rate card and what we've said all along is the biggest limiter right now in establishing a rate card and generating any kind of reasonable revenues is that you don't have a big enough installed base of next-generation hardware that you can use for measurement purposes. That will not change until you have 20 or 30 million units of always-on Internet capable next-generation consoles in the installed base. So you won't start to see it have an impact on our business until, let's say, two or three years from now.

Then you look at what is that opportunity and how big could it potentially be for a company like ours? Well, we start with the notion that because it is a more targeted, more measurable media, it probably could command over time a higher CPM than you see in typical broadcast advertising. But it's going to take a lot of behavior change and a lot of effort on the part of evangelizing consumer product companies of the value of this advertising before you're going to see it really make a difference in our operating results.

Ralph Schackart - William Blair

Great. That's helpful, Bobby. Thank you.

Operator

Our next question comes from John McPeake - Prudential.

John McPeake - Prudential

Thank you. Could you talk a little bit about what the percentage of your development budget is in '06 and '07 and maybe '08? I guess by then it's all next-gen games. As a percentage of your revenues for the same years, '06, '07, and '08, roughly what percentage of revenues in those years will come from next-generation consoles?

Bobby Kotick

I don't think we can do that right now, but if you wanted to call Kristen offline, I'm sure she'd be happy to provide that to you.

John McPeake - Prudential

I just have a quick follow-up. What's your confidence level that the online capabilities of PS 3 are going to be competitive with the Xbox 360?

Bobby Kotick

We're confident.

John McPeake - Prudential

What was that?

Mike Griffith

We're confident about that.

John McPeake - Prudential

Okay. Got it. Thanks.

Bobby Kotick

So confident, we all talk at the same time.

Operator

Our next question comes from John Taylor - Arcadia.

John Taylor - Arcadia

Hi, I have a couple of housekeeping questions and then a bigger question.

Bobby Kotick

It wouldn't be a conference call without you.

John Taylor - Arcadia

Yes. Thanks. Appreciate that. Thomas, I don't think you gave us accounts receivable reserve dollar number. Could you give us that? That's housekeeping.

I think I may have heard a veiled allusion to premium price points for premium product on Wii. Should we assume that you're going for a $59 market retail on that? Those are the two housekeepers.

The bigger one is I wonder if you could talk a little bit more about some of the issues around Guitar Hero? I'm particularly interested in the supply side of the guitars and kind of what kind of capacity issues you might have there? As you're thinking about Guitar Hero this year for fiscal '07, kind of give us a sense of what you think the mix might be of version 1 versus version 2 and whatever your expectations are? Thank you.

Mike Griffith

Well, Guitar Hero obviously, we're very excited about that title and it does bring a new dimension with a plastic guitar controller added to the software as a bundle. We source those guitars out of China. That's been a primary focus of ours since making the acquisition and we put considerable amount of time and energy against this and increased available capacity of guitars quite substantially. So we think we've got a good handle on the supply side on Guitar Hero.

We don't expect to be in any near-term supply-constrained situation. So we're expecting a very strong launch of Guitar Hero II. We think just because of the variety of songs and people's desire to play a wide variety of songs, we think that the original Guitar Hero, Guitar Hero 1, will continue to have legs, but our focus will predominantly be on selling Guitar Hero 2, and we think the mix will shift to that pretty rapidly toward the back end of the year.

John Taylor - Arcadia

Can we assume maybe a one-third, two-thirds mix in terms of units of the two versions?

Mike Griffith

I think probably even more aggressively towards version 2.

John Taylor - Arcadia

Okay. Great. Can you give a sense of what the mix might be U.S. or North America versus European demand for Guitar Hero?

Mike Griffith

Well, this is a title that launched first in North America last November, and only launched into Europe later on and Asia even more recently, but we fully expected that with the universal appeal of music and the genre that this competes in, that we ought to at least be able to achieve our historical business splits between geographies.

Bobby Kotick

We've been making good progress on the manufacturing front in getting the local guys and trying to improve the output. As you know, we're just at the point where we're getting to the point where we can satisfy demand. There's a lot of enthusiasm, but we're going to keep focusing selling it on the highest margin territories.

John Taylor - Arcadia

Great. And then anything on those housekeeping things?

Thomas Tippl

Yes, sure. The AR reserve was about $87 million which is down where we were at the end of March, reflecting good sell-through performance over the course of our first quarter.

Mike Griffith

On the Wii pricing, we think it's premium content is going to generate premium pricing. We think Wii launch pricing will be at least $49.

John Taylor - Arcadia

Okay. All right. Thank you.

Operator

Our next question comes from Colin Sebastian - Lazard Capital.

Colin Sebastian - Lazard Capital

Thanks for taking my questions. Just a couple. First, on the cost optimization program, good to hear you're already seeing some efficiencies on the next-gen development. I guess I'm wondering if you're running a little ahead of schedule as to what you thought a couple of months ago on that, and if you could quantify a little more specifically the areas you outlined which is providing the bigger boost?

Thomas Tippl

Well, I think on the product development progress, I would characterize the status of the progress as being on track. I think there's still many uncertainties and we're climbing the learning curve rapidly. So we're encouraged by that, but there's more work to be done and that's why we expect that we're going to generate some efficiencies over the next couple of years that's going to get us back to our historical percentage of 20% to 21%, which is where we have been in the last cycle.

Now, where we've made that, probably as we anticipated the fastest progress was on the marketing and in the G&A area. I think the whole organization, including the studios, have embraced the need of a heightened level of cost consciousness. It's important because it allows us to reinvest in making better games and to gain technology content as well as the intellectual property.

I think from the marketing side, variable sales and marketing, we said that we would get back to historical levels, which we define as a range of 14% to 16%, and I think you will see this year already a significant step in that direction.

Mike Griffith

On the PD side, Colin, the one thing we've had some good early experience with is we did some offshore quality assurance. We actually, for X-men, did some testing in India. And it turned out to be lower cost, very high quality, so I think that that's an area that will pay dividends even this year.

Colin Sebastian - Lazard Capital

Okay, we also heard from a couple of your competitors that they're increasing the number of titles in development for the Wii platform, and I'm just curious if there've been any shifts in your own SKU plan for this year or next year?

Mike Griffith

It sounds like they may be trying to catch up with the plans we've already put into place. So we're encouraged by the Wii platform. As we said, we've got three launch titles planned for it this year. We'll see how the market responds to it, but it's got tremendous potential to broaden the market, and we've got a full, solid plan against the Wii into the future.

Colin Sebastian - Lazard Capital

Okay. Just lastly, can you break out the contribution in the quarter from RedOctane? Thank you.

Thomas Tippl

Well, as we said, we closed transaction on June 6th, so we basically had only three weeks of RedOctane business in our numbers. So it was a small amount on the revenue side, it was less than $10 million.

Colin Sebastian - Lazard Capital

Thank you.

Operator

Our final question comes from Robert Haley - Gabelli & Co.

Robert Haley - Gabelli & Co.

Hi. Thanks for the question. Just wondering in fiscal year '08, what are your thoughts for growth of the distribution business with the PS 3 launch? I might have missed it, but thoughts on the launch of the Bond game?

Mike Griffith

Yes. First of all, on the Bond game, MGM have announced the release date for the next Bond movie following this holiday for May of 2008. That's where we would focus to have our first game. On the distribution business, we think the distribution will grow, not only behind the hardware launches, but also behind our increased slate robustness in that year.

Bobby Kotick

And everybody else's as well. Obviously, we participate in the overall increases in the marketplace with all publishers' releases.

Kristen Southey

Okay. Well, thank you, everyone, for joining us today. We look forward to speaking with you in the future.

Operator

That does conclude today's conference call. Thank you for your participation.

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Source: Activision Q1 2007 Earnings Conference Call Transcript (ATVI)
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