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Electronic Arts Inc. (ERTS)

F2Q07 Earnings Call

November 2, 2006 5:00 pm ET

Executives

Larry Probst - Chairman, CEO

Warren Jenson – CFO, EVP, CAO

Frank Gibeau – EVP, General Manager, North America Publishing

Tricia Gugler - IR

Analysts

Lowell Singer - Cowen & Co.

Anthony Gikas - Piper Jaffray

John McPeake – Prudential

Colin Sebastian - Lazard Capital Markets

Evan Wilson - Pacific Crest

Justin Post - Merrill Lynch

Heath Terry - Credit Suisse

Elizabeth Osur - Citigroup

Arvind Bhatia - Sterne Agee

Mike Hickey - Janco Partners

Edward Williams - BMO Capital Markets

John Taylor - Arcadia Investments

Presentation

Operator

Good day, everyone and welcome to the Electronic Arts Second Quarter Fiscal Year 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. Please go ahead, ma’am.

Tricia Gugler

Thank you. Welcome to our second 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'd 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'll post a copy of Warren's remarks on our website.

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

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 to be posted 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 this 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 and 10-Q for a discussion of risk factors that could cause our actual results to differ materially from those discussed today. We make these statements as of November 2nd, 2006, and disclaim any duty to update them.

And now, I’d like to turn the call over to Warren.

Warren Jenson

Thanks, Tricia and good afternoon, everyone. We would like to begin with a few highlights from the quarter. Our second quarter was strong and exceeded our expectations. Revenue was a Q2 record $784 million, up $109 million or 16%. GAAP diluted earnings per share were $0.07 versus $0.16, and non-GAAP diluted earnings per share were $0.21, an improvement of $0.06 or 40%.

Q2 as usual was all about sports, Madden NFL 07 had another record year, selling 5million copies in just five weeks. Today we estimate sell through was up 15% year-over-year. NCAA Football ’07 hit an all-time high, selling over 2 million copies in the quarter and we estimate current sell through is up 16%. FIFA ‘07 current gen had a strong international launch, selling nearly 2 million copies in just one week. Tiger Woods PGA Tour 07, to date has sold more than 1 million copies. Tiger will be a PS3 launch title and we will ship on the Wii in our fourth quarter. NBA Live 07 sold over 1 million copies in the quarter and NHL 07 is having a strongest year ever with estimated sell-through up over 25%.

In the quarter we also moved forward on several strategic fronts. First, we are pleased to be partnering with Apple on the iPod. In September we launched Tetris, Mini-Golf and Mahjong.

Second, we have joined with Massive and IGA to introduce dynamic in-game advertising. We started with Battlefield 2142 a couple of weeks ago and Need for Speed Carbon is live.

Third, FIFA Online in Korea continued to do well. To-date we have completed over 700,000 micro transactions at an average retail price of approximately $1.45 per item. FIFA Online is currently in the top five online mid-session games in Korea.

Fourth, we launched Pogo in the UK. And finally, we acquired Phenomic Games, the talented European RTF’s developer. We welcome the team to EA. In summary, an excellent fall season for EA Sports, a record Q2 top line performance and a strongest strategic position.

For the next few minutes I will focus my remarks in two areas. First, I will review our Q2 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.

Q2, net revenue was $784 million up 16% driven my Madden NFL 07, Godfather, NCAA, FIFA and continued strength in catalog. By platform, the revenue increase was driven by Xbox 360 and cellular phones, partially offset by declines in current-gen consoles. We released 43 SKUs in the quarter versus 37 a year ago. During the quarter we had two titles Madden and NCAA that sold in excess of 2 million copies. Console revenue was $514 million up 10%. The increase was driven by Xbox 360 which more than offset the decline in current-gen platforms.

During the quarter 360 revenue was 21% of total revenue, up 6 points from last quarter. Year-to-date, we are number one on the 360, PS2, Xbox, PSP and PC in both North America and in Europe.

Mobility, revenues was $121 million up $59 million almost 2X that of last year. On mobile phones, revenue was an industry-leading $35 million. We had four of the top ten games in North America and in the UK. Since acquiring JAMDAT, eight of EA’s franchises are now available on mobile phones. As compared to JAMDAT’s year ago performance, revenue was up 75%.

On handheld, revenue was $86 million up 43%, driven by growth on our platforms. PC revenue was $86 million down 5% primarily due to last year’s strength of Battlefield 2. Co-pub and distribution revenue was $39 million, up 22% driven by the success of Dead Rising and Half-Life 2.

Internet licensing and other revenue was $24 million. Club Pogo subscriptions are up 39% year-over-year to $1.4 million. This quarter, we planned to introduce a gen based buying service on pogo.com, which will bring more premium content to our customers through micro transactions.

Geographically, North America revenue was $512 million up $69 million or 16% driven by Xbox 360, cellular phones and PSP, partially offset by declines in current-gen. We have three top ten titles across all platforms, Madden NFL and NCAA were number one and two respectively.

International revenue was $272 million, up $40 million or 17%. Excluding a $10 million positive impact from foreign exchange, international revenue would have increased 13%. Europe revenue was $245 million, up $54 million or 28% driven by the Xbox 360, PS2 and PSP, partially offset by declines in Xbox. In Europe, Our PS2 business grew 18% due to the strong launch of FIFA 07. Asia revenue was $27 million down $14 million, Xbox 360 revenue did not offset the declines in current-gen.

Moving on to the rest of the income statement. Gross profit in the quarter was $445 million, up 14%. Gross margin was 56.8% versus 57.9%, down a 110 basis points driven by higher licensing costs and lower average selling prices, partially offset by lower sales return charges.

OpEx, first as you know at the beginning of the fiscal year we adopted FAS 123 R. In the second quarter, this resulted in stock-based compensation of $33 million. Marketing and sales; marketing and sales expense was $108 million relatively flat to last year. Excluding stock-based compensation marketing and sales would have decreased by 3% due to lower ad spending.

G&A; G&A was $72 million, up $20 million primarily due to personnel-related costs including stock-based compensation. Excluding the impact of stock-based comp and the impact of acquisitions, G&A would have been up $7 million or 13%.

R&D; R&D was $238 million, up $56 million, primarily due to the expensing of stock-based compensation, the addition of studio headcount and the impact of our acquisitions. Excluding stock-based comp and the impact of acquisitions, R&D increased approximately 15%. R&D headcount was approximately 5,600 up roughly 400 from last quarter, and up 17% from a year ago. The JAMDAT, Mythic, and Phenomic acquisitions accounted for 10 points of this increase.

Our GAAP tax rate for the quarter was 42%. 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 earnings per share were $0.07 versus $0.16 a year ago, non-GAAP diluted earnings per share were $0.21 versus $0.15. The $0.14 difference between GAAP and non-GAAP EPS is principally due to stock-based compensation $0.09, amortization of intangibles approximately $0.03, restructuring charges of $0.01, and acquisition charges of roughly a $0.01.

Our trailing 12 month operating cash flow was $571 million versus $592 million for the comparable period. Our return on invested capital on a trailing 12-month basis was 17% versus 39% a year ago.

Now on to the balance sheet. Cash, short-term investments and marketables were $2.4 billion, down $21 million from last quarter primary due to our acquisition of Mythic. Gross accounts receivable were $439 million versus $465 million a year ago, a decrease of 6% due to the timing of our release schedule. Reserves against outstanding receivables totaled $172 million, up $35 million. Reserve levels were 14% as a percentage of trailing six month net revenue, up 1 point. As a percentage of trailing nine month net revenue, reserves were 9%, consistent with last year.

Inventory was $67 million down $7 million from a year ago. Other than FIFA, no one title represented more than $4 million of net exposure. We recorded $86 million of intangibles related to our acquisition of Mythic. Of this amount, $22 million will be amortized to the P&L over three to five years.

Now our outlook and guidance. Before getting into the numbers a few observations. First, while things can change very quickly the current sales environment appears to be healthy. The strength of the year-to-date numbers back this up. As a result we have increased our industry software growth estimates for the year.

Second, we are very much looking forward to the holidays; it’s the beginning of primetime for next generation technology and entertainment. On the Xbox 360 we will have four titles and lots of downloadable content. On PS3 we will also have four titles: Madden NFL 07, Need for Speed Carbon, Tiger Woods PGA Tour 07, and Fight Night Round 3. On the Wii, both Need for Speed Carbon and Madden NFL will be available at launch. In the quarter we will release three titles on the DS, five on the PSP, nine on Mobile phones and one on the iPod.

Third, don’t forget about current-gen, particularly the PS2. This remains the largest platform globally and we are the leading publisher.

Fourth as a result of our first half performance and the relative strength in the marketplace we are taking our numbers up for the year. That said, we have also made some adjustments to our SKU plan that will move a couple of titles into fiscal 2008, specifically Army of Two and Crisis.

In summary, the industry appears to be healthy and we are looking forward to having all next-gen platforms in the marketplace. Longer term we are building a power global lineup for fiscal 2008 and beyond. We have some great titles in the works and expect to extend our position of leadership.

I will now conclude my portion of today’s call with our market outlook and financial guidance. 2006 market outlook. As I mentioned earlier, we’ve revised our software estimates. We now expect software sales in North America and Europe to be flat to up 5% for calendar 2006. You can find a summary of our estimates on our website.

Now our financial guidance. Once again, I would like to lead with a few points of caution. First, transition is not over. While we are bullish on the long term, many short-term uncertainties exist. There could easily be hardware delays and shipments quantities could fall short.

Second, demand and/or pricing for current-gen platforms and software could fall below that which is in our forecast.

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

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

Now the numbers. For the quarter ending December 31, we expect revenue to be between $1.2 billion and $1.3 billion. GAAP diluted earnings per share to be between $0.33 and $0.43. Non-GAAP diluted earnings per share to be between $0.50 and $0.60. Overall, we expect our non-GAAP EPS to be roughly $0.17 better than our GAAP results.

The estimated breakdown of these adjustments is as follows:

  • Stock-based comp approximately $0.09.
  • Acquisition charges roughly $0.04 associated with our acquisition of Mythic.
  • Amortization of intangibles roughly $0.03.
  • Restructuring charges of approximately $0.01 related to our international reorganization.

In Q3, we expect to ship 41 SKUs compared to 49 a year ago. To date we have released Battlefield 2142 on the PC, which by the way, is off to great start. Medal of Honor Heroes on the PSP, Need for Speed Carbon on eight platforms and the Sims 2 Pets on four platforms. This title has already gone platinum in just three weeks.

In addition, we expect to release Fight Night Round 3 on the PS 3, Madden NFL 07 on the PS 3 and wii; NFL Street on two platforms, Superman Returns on five platforms, Tiger Woods PGA Tour on the PS 3, the Sims 2 Pets on two platforms, the Sims 2 Holiday Edition on the PC, the Sims 2 Happy Holiday on the PC, Cricket 07 on 2 platforms, Dark Age of Camelot, Labyrinth of the Minotaur on the PC, Lord the Rings, The Battle for Middle-Earth II, Rise of the Witch King on PC, and EA replay on the PSP. Also in the quarter we will offer new in-game content on Xbox Live Marketplace for Tiger Woods PGA Tour 07, Godfather and Need for Speed Carbon.

On mobile phones, we planned to launch nine games. NBA Live 07, EA Sports Fight Night Round 3, Texas Hold'em II, Medal of Honor, NCAA Basketball, Sims Pets, FIFA 07, The Car 2007 and Scrabble. On the iPod, we have planned to release a game pack which will include both Sudoku and Solitaire.

Now our full year guidance. For the full year we expect revenue to be between $2.950 billion and $3.125 billion. GAAP diluted earnings per share to be breakeven to $0.15. Non-GAAP diluted earnings per share to be between $0.55 and $0.70. Overall we expect our non-GAAP EPS to be roughly $0.55 better than our GAAP results. The estimated breakdown of these adjustments is as follows:

  • Stock-based comp roughly $0.33.
  • Amortization of intangible assets approximately $0.13.
  • Acquisition charges approximately $0.05 related to our acquisition of Mythic and Digital Illusions.
  • Restructuring charges of roughly $0.04 related to our international reorganization.

Looking ahead, we again ask you to keep in mind that with the introduction of next-gen 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.

I will now conclude with a couple of closing thoughts. First, this is a great time to be in this business. As traditional media battles technology and the Internet, we embrace them. As I said a few minutes ago, this is the beginning of primetime for interactive entertainment.

Second our long-term priorities are clear, next-gen leadership, winning in online, Asia, and mobility, expanding our wholly-owned IP portfolio while at the same time delivering long-term value to our shareholders.

Of course these priorities are not without complexity and we will make mistakes along the way. All that said, EA has the best team in the business to lead us through this changing, challenging and exciting time.

With that Larry, Frank and I will open the calls to your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Lowell Singer - Cowen & Co.

Lowell Singer - Cowen & Co.

Hi, thanks. Good afternoon, Warren. Actually I have a couple of questions about share and how you guys think about your share by platform. Obviously, you’re well under [Annex] on the DS right now. What is your long-term goal for the kind of software share you think you can have on that platform?

Secondly, though the platform is clearly less important over the long term, PS2 sales have held up very well this year and it looks like you maybe losing a little bit of share there. (a) Do you can incur with those numbers? (b)How much do you really care about that, if you look out for next year? Thanks.

Larry Probst

With regard to the DS platform, year-to-date through September we’ve got about a 5% market share, and obviously that’s a number that we want to see increase. Longer term, we certainly want to see a market share that is double-digit, and we think we’ve got a pretty significant lineup of products in the pipeline, and we believe that we can move that needle in a positive direction longer term.

Frank Gibeau

In terms of the PS2 share, year-to-date North America we are trailing our last year’s market share on the PS2, just slightly, but we have a fairly robust line-up of going into Q3, will still half the business yet to go on an annual basis. If you look at Europe, we’re tracking very well on the PS2. So, we feel pretty good about the relative health in the PS2, and our global position. Going forward, we believe that’s a platform that still has couple of years left in it in terms of business.

Warren Jenson

Then I would only add that overall in North America, our segment share year-over-year is up a couple of points, Europe is roughly flat.

Lowell Singer - Cowen & Co.

Okay, thank you.

Operator

Your next question comes from Anthony Gikas - Piper Jaffray.

Anthony Gikas - Piper Jaffray

Hi, good afternoon guys, great quarter. A couple of questions. Could you just give us a quick update on R&D spending? I’m sure you have seen a lot of the R&D estimates on The Street, do you think that they are appropriate or have they been moving a little higher than you think they should?

Second question, do you know what the retail take away number was for the quarter, not only in the U.S., but on a worldwide basis?

Warren Jenson

Let me go ahead and address the R&D number. I think there is a short-term answer and then a couple of things for the long-term, Tony. In the short-term we do expect R&D to increase in the back half of the year looking at the year-over-year comps.

There are couple of things going on. Obviously we are getting ready for our ’08 launch line-up. The second thing just to note generally because this will affect all of our expense lines is when we went into the third quarter of last year became clear that we would not hit our operating plan and as a result we dramatically reduced our planned bonus accrual. This year as we sit today, we will expect to meet our operating plan therefore we will have a full bonus accrual and that will increase the expense comps, if you will, year-over-year. Overall, for R&D for the year I would put it up in the 25% to 30% range given those two issues.

Larry Probst

Tony, we aren’t clear on your retail take away question, what specifically are you asking for?

Anthony Gikas - Piper Jaffray

At the retail level what were the sales increases during the quarter on a worldwide basis? We know at the NPD number was, but maybe a little bit more broadly speaking?

Frank Gibeau

The feedback from Europe is that they have been tracking fairly close to the results that we have had in North America. In terms of current-gen and in handheld they had a very robust run in the handheld business. The 360 business is a little bit stronger in North America than in Europe, but in general they are roughly similar.

Anthony Gikas - Piper Jaffray

Okay. And then may be an update on download transactions through the Xbox 360, and how do you expect them to ramp on the PlayStation 3 over the course of the next year? Thanks.

Frank Gibeau

The Xbox Live Service is proving to be a great marketplace for content. We have a solid position there in terms of what we have produced to-date. In fact looking forward into Q4 we have a very robust set of pay downloadable content that’s coming from games like .DEF JAM ICON and NBA Street 4. At launch on the PlayStation 3, I don’t anticipate that we will have downloadable content, but going into Q4 is when we will start to make that available.

Warren Jenson

I would have one thing to Frank’s comment, because a lot of this is scattered in various lines of our income statement or various platform categories. In the quarter if you look at total what we would call digital revenue, meaning in-game advertising, Pogo, micro transactions, all of that across the board Xbox Live. We had about $28.5 million of revenue, and that’s up about 40% year-over-year. So, we are on a very nice healthy run-rate in our digital business.

Anthony Gikas - Piper Jaffray

Thanks.

Operator

Your next question comes from John McPeake - Prudential.

John McPeake - Prudential

Thank you very much, guys. Could you give us a sense as to what you are thinking about in terms of the potential for in-game advertising over the longer term? What percentage of your revenues could that be in let’s say ’08, ’09 timeframe? Fiscal ’08 ’09? What kind of margins do you think that carries? Thanks.

Frank Gibeau

We are very bullish on dynamic in-game advertising, as you know we have got a couple of deals going right now that are just starting in operations, so we are literally just starting to get the data back on how they are flowing. So I would hesitate to forecast a percentage or talk about the business model too much at this point in time until we get a little bit more time under our belts with Massive and IGA. Having said that, we are extremely bullish on this segment and our business going forward.

John McPeake - Prudential

Great fair enough. Thanks.

Operator

Your next question comes from Colin Sebastian - Lazard Capital Markets.

Colin Sebastian - Lazard Capital Markets

Thanks and congratulations on the quarter. A couple of questions. I know you are not providing any guidance for fiscal ’08, but how is the development plan shaping up for that year versus this year?

Secondly, there have been some price reductions on a couple of sports titles, just hoping that you can provide some background on the catalyst for those changes. Related to that, how are you feeling more broadly about $59 pricing on the 360 and PS3? Thanks.

Larry Probst

We think we’ve got a great line-up of titles for fiscal ’08. Just to give you a sense of what would be new next year that was not in our SKU plan this year. As Warren mentioned that we are moving Army of Two and Crisis from fiscal ’07 to fiscal ’08, everyone knows about SPORE, we are very excited about that, we think that has tremendous potential, there was the Sims title that is being specifically developed for the Wii platform, there is Command & Conquer Tiberium, there is a Harry Potter title in conjunction with the movie, there is a new Road Rash game, we think we will be deploying Warhammer, that is being developed by Mythic. We’ve got Simpsons, which is also being released in conjunction with the movie. There will be a new Lord of the Rings game next year, there was not one of those in our SKU plan year. There is a new SKATE game to compete with Tony Hawk. There is a new SimCity game in the pipeline and the next generation version of Black. So, just those things alone are all new relative to fiscal ’07.

Frank Gibeau

With regard to the $59 price point we are seeing that’s holding very nicely through this year. We anticipate that will hold going forward. When we look at individual pricing moves on a given franchise that’s really a case-by-case analysis done by the publishing teams to put us in maximum position for holiday, and so we have been getting things in position for the November rush and the December finish.

Colin Sebastian - Lazard Capital Markets

Okay. And just one last question, what is the percent of sales from catalog in the quarter?

Larry Probst

It was 24%.

Colin Sebastian - Lazard Capital Markets

Okay, thanks a lot guys.

Operator

Your next question comes from Evan Wilson - Pacific Crest.

Evan Wilson - Pacific Crest

First, does your forecast include any meaningful price reductions like the 3-for-2 deal you did on sports games last year for the December quarter? That’s my first question.

What are your expectations on industry- wide ratios for the PS3 launch? And then can you talk a little more about the gross margin and separate out that licensed piece? The gross margin was better than your guidance. Just curious if the license portion of that was also better than your expectation? Thanks.

Warren Jenson

I will comment just generally on pricing to say that we compete in the marketplace and it’s really the marketplace that will determine what the price is, so whatever we need to do in that context, we will be competitive. I don’t believe there is a 3-for-2 promotion in the works, and in fact for last year, it really had very minimal economic impact from that promotion.

Frank Gibeau

In terms of the tie ratio, the tie ratios on the Xbox 360 is a fantastic 5.2 at this point. We definitely see that there is going to be a higher tie ratio probably on the PS3 going forward. We have that as part of our modeling, but I think the 5.2 at this point in the 360 is fairly unprecedented and it’s pretty exciting to us.

Evan Wilson - Pacific Crest

So, you think the PS3 tie ratio will be higher than the Xbox 360? Is that what you mean?

Frank Gibeau

No, I think it will be within range, maybe a little bit less, but it will be certainly higher than prior cycles.

Warren Jenson

To the last question on the license royalty rates, I think it was pretty much right in line with our forecast. So, there was nothing that we really didn’t expect in the quarter.

Evan Wilson - Pacific Crest

Great, thank you.

Operator

Your next question comes from Justin Post - Merrill Lynch.

Justin Post - Merrill Lynch

As we look back to May, I’m just wondering, what has really changed here with your outlook and your guidance? You have been beating numbers for a quarter here, and it looks like your outlook is pretty good, given you are pushing out a couple of titles.

It looks like sports are up nicely over 10% as far as units year over year, it is trending really well. What’s really driving that growth for those franchises?

Warren Jenson

Justin, I would comment as to what changed is I think we have a little more time and certainty under our belt. I think as, we all know, we are in the midst of transition and things have to shake out. The net of that is what we’ve seen is a very healthy marketplace; our titles have overall been performing very well. PS2 sales remain strong, and there is a great reception for next-generation hardware. So, I think, we’ve got a little more time under our belt, a little more certainty and we are seeing a healthy marketplace.

Frank Gibeau

With regards to the EA Sports brand, what we’ve seen as key drivers to growth is a better execution on the launches in terms of retail with The Street dating, that was something that we had introduced prior year and it’s been taking off with even more momentum. We’re seeing product quality up in the EA Sports launches with MT-2 and Madden year-over-year. We’ve got a more robust 360 and PS2 market than anticipated. So that’s where we are seeing a lot of the growth.

Our relationship with ESPN is also helping us to market in new ways and to market to a broader market. And so, I think that’s opening up new segments for us that traditionally we haven’t reached.

Justin Post - Merrill Lynch

And one follow-up, on the gross margin for next quarter, can you give me some of the positive drivers and some of the negatives for gross margins on a year-over-year basis?

Warren Jenson

I would say on a year-over-year basis, we are going to be roughly in the same sort of scenario as to where we were a year ago. So, a kind of put it in a 60% to 62% sort of percent range. I don’t know, there is always going to be ins and outs depending upon the mix of our product. It’s just a fact overall that we have higher licensing costs, in particular on many of our sports products.

The good news is that we have things like Sims 2 Pets that will be in which were owned IP, so there will be a lot of ins and outs, probably some higher licensing costs, some lower product costs too, given the health that’s in the channel. But overall, we would expect to have it be somewhere in that 60% to 62% range.

Justin Post - Merrill Lynch

Thank you.

Operator

Your next question comes from Heath Terry - Credit Suisse.

Heath Terry - Credit Suisse

Great, thank you. I was wondering if you could just talk to us about how your strategy in Asia is progressing? Both from a revenue generating standpoint in that market, but also as you start to explore some of the cost-saving opportunities in outsourcing in those markets.

Warren Jenson

Heath, I will take a swing at that and then my partners here can jump in. I think the most encouraging that we have seen this past year in Asia has been the success of FIFA Online so far. Today it’s not making a huge revenue contribution, but the fact that it’s one of the top five online mid-session games in Asia is great. The fact that we are over 700,000 micro transactions is great. It’s very positive learnings for us in how to do that in the Asian marketplace.

The trick for us going forward is to take that success that we’ve had in Korea and replicate in Taiwan, replicate in China, and in other Asian countries in order to build a long-term, more powerful revenue base.

The second key to building is to take other titles like NBA Street, for example, and do the same thing in Korea times Taiwan times China and other marketplaces. Over the course of the coming years, that is exactly what you are going to see us do. So that’s I think step number one in terms of progress.

I think step number two is that we now have roughly a 100 people or so on the ground in Shanghai doing game development. One of the things that I think we all feel will help us tremendously is having actual developers, EA developers on the ground in Asia, where you really become part of the development marketplace in order to build better and more applicable local content, and also to just better understand the complexities of those marketplaces.

So, that’s not a revenue driving opportunity for us today. But it’s something that we do believe will result in long-term revenues, and hopefully long-term success in the overall marketplace.

With respect to the cost side, candidly our first priority is really all about local content development and about quality. So, our first effort is going to be to go develop content that we believe will be applicable and whatever the local markets might be like China and/or Korea and Taiwan or India for that matter. So our focus right now is not on the cost side. We think development in those parts of the world over the long term will be an advantage; in the near term it’s really all about building our capacity, and also building local content.

Heath Terry - Credit Suisse

Great thank you.

Warren Jenson

Thank you, Heath.

Operator

Your next question comes from Elizabeth Osur - Citigroup.

Elizabeth Osur - Citigroup

Thanks, I just had two questions, one is a follow-up on Asia. Can you talk about what kind of outsourcing you might be doing in lower-cost countries, and just how long it will be before you think about using the Chinese studios to develop Western games?

I assume you have now finished at least a couple of upcoming PS3 games. Can you give us an update on next-gen development cost, what you’ve learned now that you are further into the process?

I may have missed this earlier, but can you just reiterate what the R&D target might be for this year and next year as a percentage of sales? Thanks.

Warren Jenson

I will take a couple of parts to the question. First on the outsourcing side, I think you have to recognize that in our business across EA, outsourcing has always been our part of our business. It’s fundamentally nothing new; we work with a lot of outside vendors in virtually every areas of the company.

The second thing that, coming back to Heath’s question, the number one rule for us, it has to be about quality. Because you can save $2 in development, and if you blow $100 in revenues, it is just not worth it. So, for us our entire move has to be about product quality first and then slowly working your way into taking advantage of new lower cost development options.

Where we are doing offshoring today is we are moving some of our transaction processing to India, that’s ongoing as a matter of fact, this quarter to that transition. Secondly, our mobile business is very active with a high quality development organization in both Romania and in India, and in fact we are significantly increasing the size of those two development organizations this year. We have a lot of content or art that is being done today in our core games business in a place in Korea, as an example.

So over time we, like the overall entertainment business and other software, will become increasingly global and every respect whether it’s our top line, and/or whether it’s development but it has to be a process where the first focus is quality and you take your time to ensure that we are doing everything we can to make sure our products are the best and most locally relevant.

Larry Probst

With regard to development cost on PS3 games, clearly these next generation titles both on Xbox 360 and PlayStation 3 are going cost more than the previous generations. I think its probably too early in the game to speak specifically about how much more, and as we get further into the development process, I think we will become more knowledgeable about that and can share that information with you.

With regard to R&D, this year it’s going to end up around 30% of revenue and our goal is to bring that down over the next few fiscal years as we get further into the next generation cycle, and start to the leverage some of the investments that we got in the last couple of years.

Elizabeth Osur - Citigroup

That’s great, thanks guys.

Operator

Your next question comes from Arvind Bhatia - Sterne Agee.

Arvind Bhatia - Sterne Agee

Good afternoon guys. My question first of all is more long-term. I am wondering if you can comment on what you think is a reasonable operating margin goal towards the peak versus your 26.5% during the last cycle? In general, what are the factors that would cause potential margins to be higher or lower than what you achieved in the past? What are the new different dynamics, for example the new revenue stream which will obviously have some impact? That’s the first long-term question.

If you can provide some color on your best guess in terms of the launch quantities or maybe what if the launch quantities are different than what you expect, a little lower. How should we think in terms of the delta, and the impact to your bottom line?

Larry Probst

I will take a swing of the launch quantity question, and I suspect you’re asking about PlayStation 3 and Nintendo Wii?

Arvind Bhatia - Sterne Agee

Right.

Larry Probst

We are thinking that on the PlayStation 3 in North America, the range is probably 500,000 to 800,000. And if you take the middle of that range, that’s approximately what Microsoft sold last year on the Xbox 360. So, I think from our consumer standpoint it’s probably going to be as challenging to find a PlayStation 3 this year as it was to get an Xbox 360 last year.

On the Nintendo Wii, we are ranging that from 900,000 units to 1.4 million units in North America, and in Europe, we got a pretty broad range there on the Nintendo Wii from anywhere from 200,000 to 900,000 so it is probably somewhere in the middle of that range.

Warren Jenson

And then on the margin question, the factors are going to be the likely list of suspects. First it’s going to be how much larger is the next cycle than the current one? Secondly, is how will price fall? Third, our success in building new and more wholly owned intellectual property. Next will be our success in building larger high margin revenue streams from things like online mobile, Asia, micro-transactions, in-game advertising, digital distribution and the like.

Then on the on cost side, it’s really a matter of keeping fixed cost fixed, and what we can do to leverage our fixed infrastructure in order to scale our overall operating expense base on all the lines, not just R&D.

Arvind Bhatia - Sterne Agee

So, I mean, once you’ve put all of this together, is it fair to say that you could still do the peak operating margins in the next cycle as you did in the last one?

Warren Jenson

We are going to leave it just the way I left it.

Arvind Bhatia - Sterne Agee

The launch quantity that you’ve mentioned, those are I assume for the end of the year, not at launch?

Larry Probst

Those are through the end of the calendar year, yes.

Arvind Bhatia - Sterne Agee

Okay, great. Thanks guys.

Operator

Your next question comes from Mike Hickey - Janco Partners.

Mike Hickey - Janco Partners

Thanks. Just a follow-up to Tony’s question, on the R&D year-over-year, you said 25% to 30%, is that with option expense or without?

Warren Jenson

That is non-GAAP so without.

Mike Hickey - Janco Partners

So, we are looking at a number that all in could be over $1 billion for this fiscal year?

Warren Jenson

Again you can do the math; but it could be with option expense, yes.

Mike Hickey - Janco Partners

You haven’t talked about Ubisoft for a while. Can you remind us why you initially took your investment into Ubisoft? Update us on how you feel about that investment today. Perhaps, characterize your conversations with management today versus what they were like a year ago?

Warren Jenson

I would say we feel great about our investment, and we are very happy to be long-term shareholders. We own roughly 20% of the company, we think the world of the management team, we think they’ve just done a great job in building some excellent titles and a strong position in next-gen and on the handheld. We are prepared to be great long-term shareholders.

Larry Probst

And I would characterize our conversations with management as cordial and professional.

Mike Hickey - Janco Partners

Okay. Thank you. And then on SPORE, how is that progressing, and can you confirm or deny whether you guys have a Sims 3 in development at this time?

Frank Gibeau

I am sorry, Sims 3?

Mike Hickey - Janco Partners

Yes.

Frank Gibeau

The development on SPORE is going great. As you know it’s an extremely ambitious and innovative game. Will and the team over in Emeryville are making strong progress, and we are excited about that shipping in the next fiscal year.

Larry Probst

Yes, there is a Sims 3 in development, and it’s likely to be a fiscal ’09 title.

Mike Hickey - Janco Partners

Great, thanks guys.

Warren Jenson

Thank you.

Operator

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

Edward Williams - BMO Capital Markets

Taking a look at your digital revenue streams you were alluding to Warren. How should we look at that $28.5 million, how does it breakdown between the in-game ads, or some of the digital download content and micro-transactions?

Secondly, what are the margins like there relative to the traditional business? What are the principal near-term drivers that could affect that 40% growth rate that we saw on this past quarter?

Warren Jenson

Let me just try to give you a general breakdown. Right now, and also you kind of have to think about sort of what also will happen obviously with some of the products like Warhammer that we have in development. I would put today over half of the revenue associated with subscription, and that’s coming principally from Club Pogo, and then also our various online products that we have both through Ultima Online, and also through Dark Age at Mythic. Obviously we feel, I mean so far great about what’s going on with the development of Warhammer as well.

The advertising pieces and micro-transactions, advertising would be the next largest followed by micro-transaction, and our objective on each on those fronts is to continue to build them and make them larger as we go forward.

Frank Gibeau

And just to build on that, with regards to advertising as we expand the list of titles that are supporting dynamic in-game advertising that number is going to lift dramatically as well as looking at the amount of content that we provide through our systems like Episodic Content, downloadable levels and maps and that sort of thing. Not only on the Xbox Live but also on the PC, the PS3 and a lot of the other connect systems.

Edward Williams - BMO Capital Markets

Okay, and just to be clear on it, the IGA relationship and the Massive relationship. Did those contribute much in the quarter or is that incremental going forward?

Frank Gibeau

That will be going forward.

Edward Williams - BMO Capital Markets

If you could touch upon the approximate margin contribution of these revenues just collectively, relative to the traditional shrink wrap business.

Warren Jenson

It’s going to vary, and then you also have to get into different royalty rates that you might have with the platform guys, but I think you can basically figure our overall margins after development are going to in the 70% sort of range.

Edward Williams - BMO Capital Markets

Okay, and then just a quick question, more housekeeping. Can you just give us an idea Warren I know this is a challenging question but the tax rate for the December quarter how that should shake out?

Warren Jenson

I would put the GAAP rate around 40%, and on the non-GAAP I would say right around the 30% range.

Edward Williams - BMO Capital Markets

Okay. And same thing for the March quarter?

Warren Jenson

In March quarter, again given the guidance, could be one of those weird quarters just given where breakeven may be on a GAAP basis, which as you know they can do some crazy things with the tax rate. So, in that rate I may assume a GAAP rate that’s sort of mid 20s and a non-GAAP rate that could even be down like we have in Q1 in the teens. Now that we will update you on that rate as we move into Q4 because there is a lot of volatility potential. There is volatility in the tax rate this year.

Edward Williams - BMO Capital Markets

Okay.

Warren Jenson

We will take one more question.

Operator

Your final question comes from John Taylor - Arcadia Investments.

John Taylor - Arcadia Investments

Hi. I have got a couple of questions. I wonder if you could talk a little bit about revenue per unit implications now that the direct digital download of micro transactions, the advertising components are starting to kick in. Can you give us any sense of how you think that’s going to ramp in a year or two years, three years down the road?

The second question is with platform dynamics, I noticed on your sell-through numbers there are some numbers up and some numbers down so could you talk a little bit about the SKU implications that has for your planning for fiscal ’08, when platforms are going up and down, and maybe magnitude wise?

The third thing was as you book the advertising stuff for some of these, the non-publishing revenues, I wondered how you are thinking about percentage breakdown between what gets deferred and goes on the balance sheet and what actually runs through? Give us a sense of the mix of timing of when those things are going to hit the P&L as they get announced down the road, just to get us thinking about that? Thanks.

Larry Probst

I will take the question on our SKU plans for fiscal ’08. It’s premature to give you specific numbers, butt what I would say is that you could expect a similar number of titles on the PlayStation 3 and Xbox 360, we are working very hard to increase the number of SKUs that we will publish next year on an Nintendo Wii and the number on the PC will be similar to what we have done in the past.

Frank Gibeau

In terms of looking at the average revenue per user goals, it’s clearly a goal inside our management team to grow that number. What we’ve seen in our Battlefield and Sims businesses led us to believe that we can do that over the next cycles fairly comfortably. I don’t really have hard numbers I can give you at this point in time in terms of what we’re shooting for, but it’s the management goal and working to do that.

John Taylor - Arcadia Investments

Thank you, before I go on, can you follow up on that real quick. So, when Massive was doing their outreach and so on, they used to talk in terms of $1 and $2 per unit kind of thing. It seems like those numbers are to be relatively easy to achieve, given the concentrated nature of the audience and that sort of thing. Would you agree or disagree with that comments?

Frank Gibeau

I believe that we will be able to raise average revenue per user; one component of that will be dynamic in-game advertising. The rates that you call out aren’t necessarily outside the realm of possibility. There are other things you have to look at though, which include paid downloadable content and other sources.

Warren Jenson

I’ll take the last question, which the answer is going to be, it depends upon the content. I will try to explain what I mean by, it depends upon the content of product. So, for example there are two things that will determine over the period over which revenue was recognized. The first thing is whether you can determine specific evidence of value of the online service, they are called VISO per software rev rec. The second thing is to determine really the estimated life of that service you’re going to provide.

So, what could revenue deferrals be? Revenue deferrals could be if there is three month usage, it could be three months, if its six months usage, it could be up to six months. If there is specific evidence of value that would be the dollar value of deferral.

On micro transactions, there is an example on Club Pogo, we have transactions today that are being deferred over three months, over a year. The reason for that is, that transaction lives on for the estimated life of the customer. In fact we have a couple of pieces of revenue in Pogo that are being deferred by as much as three years or amortized over a three-year period.

Now the good news is that builds. As the cash comes in, it doesn’t affect cash flows. The second good piece of news is that once you get through the transition period, things start to equal out as you build revenue and get good year-over-year comps.

So, this is a matter of just understanding that which is coming in, the cash is cash, some will go on the balance sheet but as we work our way through whatever sort of transitionary period may occur, all things in the long term will equal out.

John Taylor - Arcadia Investments

So, there is no back of the envelope, one-third, two-thirds, any wild guess in terms of what that mix might look like over say a 12-month period two or three years down the road?

Warren Jenson

I’m not in a position that I can really estimate that today. There is still a lot of defining to do relative to the service we will provide and the determination as to what vendor-specific evidence of value truly is.

John Taylor - Arcadia Investments

Okay, great. And let me just follow-up on one thing if I could. The $28 million in direct digital kind of stuff, I think you gave us a like a $4 million number in the June quarter which probably did not include subscription. So, I’m wondering if you take the basket that you gave us today, what was the June equivalent of that?

Warren Jenson

The June equivalent would have been roughly $28 million. So sequentially relatively flat, but up in both quarters year over year about 40%.

John Taylor - Arcadia Investments

Okay, great. Thank you very much.

Warren Jenson

Great, thank you.

Operator

And gentlemen, do you have any further comments?

Warren Jenson

Thanks everyone for joining us.

Operator

Thank you. That does conclude today's conference. We do thank you for your participation.

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