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Electronic Arts Inc. (ERTS)

F3Q07 Earnings Call

February 1, 2007 5:00 pm ET

Executives

Tricia Gugler - IR

Warren Jenson - CFO and CAO

Larry Probst - Chairman and CEO

Frank Gibeau - EVP, and General Manager, North America Publishing

Analysts

Mike Hickey - Janco Partners Inc.

Todd Greenwald - Nollenberger

Colin Sebastian - Lazard Capital Markets

Chris Clark - SIG

John Taylor - Arcadia Investments Company

Jeetil Patel - Deutsche Bank

Lowell Singer - Cowen & Company

Heath Terry - Credit Suisse

Ed Irwin - Bear Stearns

Tony Gikas - Piper Jaffray

Presentation

Operator

Good day, everyone and welcome to the Electronic Arts Third Quarter Fiscal Year 2007 Earnings Call. As a reminder, today's call is being recorded. For opening remarks and introductions, I would like to turn the call over to Ms. Tricia Gugler, Director of Investor Relations. Please go ahead, ma'am.

Tricia Gugler

Welcome to our third 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 will 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 be included with a copy of Warren's remarks to be posted on our website. These non-GAAP measures are non-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 scheduled on our website.

During the course of this call, we may make forward-looking statements regarding future events and the future financial performance of the company. We caution you that actual events and results may differ materially. We refer you to our most recent Form 10-K 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 February 1st, 2007, and disclaim any duty to update them.

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

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Warren Jenson

Good afternoon everyone. We would like to begin with a few highlights. Our third quarter performance was solid, with bottom line results exceeding our expectation, and our top line, right at the top of the range. Revenue was $1.28 billion, up slightly year-over-year. Gross margin was 63.3% versus 60.5% a year ago. GAAP diluted earnings per share were $0.50 versus $0.83 a year ago, and non-GAAP diluted earnings per share were $0.63 versus $0.86 a year ago. In the quarter, several titles stood out. Need for Speed Carbon sold over 8 million copies and was the top five titles in both North America and Europe. FIFA 07 had a strong performance. Since launch, our revenue was up more than 30%.

In the UK, FIFA 07 was at the top of the charts across all platforms for five consecutive weeks. We estimate the overall FIFA franchise was number one in Europe in 2006. The Sims 2 Pets sold over 5 million copies, with more than 65% of our sales outside of North America. It is now our fastest selling Sims 2 expansion Pet. It was also a hit on the NDS selling over 1 million copies. Madden NFL 07 sold over 3 million copies in the quarter. Since launch, our revenue was up 25% year-over-year. Madden NFL 07 was the number one title in North America in 2006. In addition, we had six other titles that sold in excess of 1 million copies. Need for Speed Most Wanted, Tiger PGA Tour 07, The Sims 2, Superman Returns, NBA Live 07, and Battlefield 2142.

We continue to see growth in payback in online. On a trailing 12-month basis, our digital revenue reached a record $115 million. During the quarter, our digital revenue was $37 million, up 50% year-over-year. We sold 3.5 million pieces of digital content including micro transactions and digital downloads.

Pogo revenue for the quarter was $21 million, up 53% and total paying subscribers past through 1.4 million. In total more than 1.7 million Pogo-based micro transactions were completed, a sequential increase of 9x driven by the successful launch of Pogo Gems.

In Korea, FIFA Online continues to expand with December being the highest revenue grossing month since launch. Today we have completed 1.4 million micro transactions at an average retail price of approximately $1.60 per item. In the month of December, the average revenue per user was over $10, up from roughly $6 in the month of September. We're also pleased with our early performance on the PS3. We ended with the strong 32% segment share. All of our launch titles were in the top ten with an average rating of A.

In summary, while we have work to do, we entered calendar 2007 from a position of strength. Number one on the 360, PS3, PS2, Xbox, PC and the PSP. Number one in mobile phones and with the stream of digital revenue that is continuing to expand.

For the next few minutes, I'll focus my remarks in two areas. First, I'll review our Q3 financial results. Second, I'll go over our outlook and financial guidance. And then following my comments, Larry, Frank and I will open the call to your questions.

Q3, net revenue was $1.281 billion, up $11 million from last year. Absent the impact of foreign exchange, revenue would have been down 2%. Revenue was driven by Need for Speed Carbon, FIFA 07, the Sims 2 Pets and Madden NFL 07, all selling over 3 million copies in the quarter. All four of these blockbuster franchises experienced both unit and revenue growth year-over-year.

We released 41 SKUs in the quarter versus 49 a year ago. Deferred revenue increased $21 million sequentially. Were this deferral not required, our total revenue would have been $1.3 billion and EPS would have improved by approximately $0.04 and our operating margin by approximately 150 basis points.

Console revenue was $736 million, down 7% due to fewer releases, most notably Harry Potter. The increase in next-gen revenue of $166 million did not offset the decline from current-gen platforms.

Mobility, revenue was $229 million, up 19%. On mobile phones, revenue was an industry-leading $35 million. We had four of the top five games in both North America and in the UK. We estimate we had roughly 29% segment share in North America.

In Europe, we estimate our segment share was north of 15%, up more than 200% year-over-year. On handhelds, revenue was $194 million, up 2%. NDS revenue increased over 50% driven by the Sims 2 Pets, slightly offsetting the decline in GBA. PC revenue was $218 million, up 47% driven by the Sims 2 Pets and the Sims 2.

In North America, EA had nine of the top 20 PC titles, with the Sims 2 franchise holding seven of them. In Europe, the Sims 2 Pets was the number one PC title in the quarter. Co-pub and distribution revenue was $49 million, down 51% due to significantly fewer releases and last year's strength above Black & White and Half-Life 2.

Internet licensing, advertising and other revenue was $49 million, up 29% driven by advertising and Club Pogo. Total advertising revenue was $13 million, up 140% year-over-year.

Geographically, North America revenue was $637 million, up $19 million or 3%. Console revenue was roughly flat with next-generation revenue offsetting the declines in current-gen platforms. In addition, growth in PC and Mobility offset the declines in co-pub and distribution. We had two top five titles with Madden at number one and Need for Speed Carbon at number five.

International revenue was $644 million, down $8 million or 1%. Excluding $33 million positive impact from foreign exchange, international revenue would have decreased 6%. Europe revenue was $583 million, up $6 million. Increases in Xbox 360, Wii, PC and Mobility were partially offset by the declines in current-gen and co-pub and distribution. We estimate the EA had three of the top five chart positions; Need for Speed Carbon, FIFA 07 and Sims 2 Pets. Asia revenue was $61 million, down $14 million driven by last year's performance of Harry Potter, Burnout and Star Wars Battlefront.

Moving on to the rest of the income statement. Gross profit in the quarter was $811 million, up 6%. Gross margin was 63.3% versus 60.5%, up 280 basis points driven by lower sales return charges, and a lower mix of co-pub and distribution.

OpEx, as you know at the beginning of the fiscal year, we adopted FAS 123R. In the third quarter, this resulted in stock-based compensation of $35 million.

Marketing and sales, marketing and sales expense was $165 million, up $18 million, primarily due to higher incentive and stock-based comp and the impact of acquisitions partially offset by lower ad spend in Europe. Excluding the impact of stock-based comp and acquisitions, marketing and sales would have increased to approximately 6%.

G&A and administrative; G&A was $91 million, up $33 million, primarily due to higher incentive and stock-based compensation, professional fees and the impact of acquisitions. Excluding the impact of stock-based comp and acquisitions, G&A would have increased approximately 31% year-over-year.

R&D; R&D was $330 million, up $124 million, primarily due to personnel-related costs, acquisitions, higher contract services and facility-related expenses. Excluding the impact of stock-based comp and the impact of acquisitions, R&D would have increased approximately 42%. R&D headcount was roughly 5,800, up 16% from a year ago. Acquisitions including JAMDAT, Mythic, Phenomic and Headgate accounted for 11 points of this increase.

Please remember that in contrast to last year, we anticipate that higher employee bonus payout providing we meet our Q4 objectives. This is materially impacting our expense comps year-over-year. Our GAAP tax rate for the quarter was 35% versus 29% a year ago. As I have mentioned you can expect our rate this year to be volatile and potentially fluctuate dramatically quarter-to-quarter.

Looking ahead, while things could change, we expect our GAAP tax rate for fiscal '07 to be around 50% and our non-GAAP rate to be around 30%. GAAP diluted earnings per share were $0.50 versus $0.83 a year ago. Non-GAAP diluted earnings per share were $0.63 versus $0.86. The $0.13 difference between GAAP and non-GAAP EPS is principally due to stock-based compensation of roughly $0.09, amortization of intangibles roughly of $0.03 and restructuring charges of a penny.

Our trailing 12-month operating cash flow was $520 million versus $733 million for the comparable period. Our return on invested capital on a 12-month basis was 10% versus 27% a year ago.

Now, onto the balance sheet. Cash, short-term investments and marketables were $2.6 billion, up $270 million sequentially, primarily due to cash generated from operations. Gross accounts receivable were $779 million versus $829 million, a year ago. Reserves against outstanding receivables totaled $228 million, down $34 million from last year. Reserve levels were 11% as a percentage of trailing six-month net revenue, down 2 points from last year. As a percentage of trailing nine-month net revenue, reserves were 9%, also down 2 points.

The channel was in great shape, heading into calendar 2007. Inventory was $72 million, down $4 million from a year ago. Other than Need for Speed Carbon, no one title represented more than $4 million of net exposure.

Now, our outlook. Before we get into the numbers, let me share our thoughts on the year ahead toward the industry and EA. Calendar 2007 and our upcoming fiscal year are all about three things; growth, reward and changing business models. Let me talk about each for a moment.

Growth; in a traditional console, handheld and PC segment, we see a healthy year ahead. We expect growth in North America and Europe software sales to be between 13% to 18% driven by an expanding installed base and healthy tie ratios. When we exit calendar year 2007, we are expecting installed base of roughly $80 million next-generation systems in North America and Europe, an increase of roughly 100% year-over-year. For EA, our growth will be fueled by our strong line up. We expect to launch more than 10 wholly owned titles. Just to name a few; Army of Two, Burnout 5, Medal of Honor, Airborne, SKATE, MySim, SimCity, Need for Speed and Spore. In entertainment, Harry Potter, Warhammer and The Simpsons. Through EA partners, we will co-publish both Crisis and Hellgate: London. We have also reached an agreement with Pandemic Studios for global distribution of Mercenaries 2: World in Flames. In sports, our full line up will be back. Net, while we expect a very competitive year, we have our own slate of blockbusters on the way.

By platform, for fiscal 2008 you can expect us to ship between 20 and 25 SKUs on both the 360 and PS3. On the Wii and the NDS, we are all over above. We have more than 15 SKUs in development for both the Wii and NDS, including several originals. We have shifted and acquired resources and are attacking these successful platforms.

First, the Sims; you can expect a new title My Sims, on both platforms. In addition, we are developing SimCity for the NDS. Second, SPORTS; not only we will be focusing on the PC and online, we are launching this innovative experience on the NDS. And finally, EA SPORTS; we think our brand coupled with the right sports content can win on both platforms. In short, we are on it. In Mobile, we expect global industry growth of 20% to 25% fueled by new handsets sales, increased consumer adoption of mobile entertainment and more great games. For EA, we expect to continue to expand internationally, most notably in Europe. In the coming fiscal year, mobile revenue will likely pass through $175 million.

Online; for fiscal 2008, we think our online revenue before deferrals could pass through $200 million, up close to 60% year-over-year driven by digital downloads, dynamic and game advertising, micro transactions, Warhammer in the MMO space, POGO and in Asia, we will aggressively ramp our mid-session game offerings. We anticipate that FIFA Online will go live in both China and in Japan. We also plan to roll out NBA Street.

Reward; the last few years have clearly been about investments. In the coming years including fiscal '08 it's about reward. Looking ahead to fiscal 2008, we expect significant improvement in our non-GAAP operating margin. This should be driven by a strong top line growth in gross profit and comparatively slower growth in our expense base. We expect R&D to grow in the single-digits in fiscal 2008. If you strip out the growth from mobile and online, our core studio R&D should increase by no more than 5%.

Changing business models; as we have mentioned, given the expansion of online game play in too many of our titles, you should expect to see more deferred revenue. The challenge we have been wrestling with is how to optimize the customer experience and expand our online service offering, but at the same time navigate the complexities of SOP 97-2, which deals with software revenue recognition where services are included as a part of the software sale. From the customer perspective, we have now made one simple call. That is, beginning in fiscal 2008, we will continue to expand our online offering and we will not charge for online hosting as it relates to our packaged goods title.

Further, we now know that Sony will not charge for its online service. So, what does all this mean? Beginning in fiscal 2008 where online-enabled games on PS3, PS2, PSP and PC all packaged goods revenue will be amortized over the length of the online service period which we currently estimate to be six months. Given the significance of the holiday season this means of likely more than $400 million in revenue that would have otherwise been reported in fiscal 2008 will now be deferred and recognized in fiscal 2009. We do not intend to defer any product cost.

Now, it's important to keep in mind that this change first, will not impact any of your estimates for fiscal 2007. Second, does not in anyway impact the economic fundamentals of our business. Third, will not adversely impact our cash flows, and finally, you will hear in a moment that through our non-GAAP reporting, you will have comparability year-on-year, so you will on an apples-to-apples basis easily be able to judge our performance. In short, a big change in our GAAP results for fiscal 2008, but no change in the economics of our business, our cash flows or your ability to judge our performance.

Now, let me talk about our reporting and comparability. How you will be able to judge our performance year-over-year given this change. If you look at our financial presentation this quarter, you will see we've made a few changes. Most significantly, we added a line to our non-GAAP reconciliation, where we plan to add or subtract the change in deferred revenue in order to determine our non-GAAP EPS. We have modified our non-GAAP measures in this manner for several very important reasons. First, the simple addition of this one line item will provide you with year-over-year comparability. Again, we do not intend to differ any of the product cost. Therefore, this one added line will normalize our year-over-year cost.

Second, modifying our non-GAAP measures this way is more reflective of the cash characteristics of the business. Remember that the deferral of revenue does not adversely impact cash flow, the business has not changed. Third, it is how we will manage our business, assess our operating performance and measure management. We want our team focused on the costumer, improving cash generation and increasing our ROI. In addition, if you go to website, you will see an expanded set of schedules and reconciliations including an FAQ that should also assist you in understanding the impact of this change and our other non-GAAP adjustments.

A few things to note, packaged goods revenue associated with the 360 and Xbox will not be impacted in large part because Microsoft charges for its online service. As a result, we expect no change from current practice. As it relates to the Nintendo platforms, our revenue recognition will be depended upon the ultimate service offering. For our MMO offerings, we will continue to recognize revenue as we do today. The packaged goods portion of the product is recognized over this service period.

Micro transaction revenue will continue to be recognized as we do today. For downloadables, revenue was recognized immediately. Where the micro content is only playable while connected to EA servers, it is due to this service and recognized over this service period.

To summarize on this point; while our GAAP results for fiscal 2008 will be impacted significantly, this change is all about putting the customer first and letting the accounting follow. The economics and cash characteristics of our business are not changing, no adjustment to your GAAP or non-GAAP estimates for fiscal 2007 is required, as this is a prospective change we will make in fiscal 2008. And finally, you will have comparability through our non-GAAP measures. You will be able to evaluate our fiscal 2008 performance in all material respects the same way you do today.

I'll now conclude my portion of today's call with our market outlook and financial guidance. 2007 market outlook; for calendar 2007, we expect overall North America and Europe console, handheld and PC software sales to increase 13% to 18%, and mobile software sales to increase 20% to 25%. You can find a summary of our console, handheld and PC estimates on our website.

Now the numbers; for the quarter ending March 31, we expect revenues to be between $550 million and $600 million. GAAP diluted loss per share to be between $0.17 and $0.12. Non-GAAP diluted earnings per share to be between roughly breakeven and $0.03. Overall, we expect our non-GAAP EPS to be roughly $0.15 better than our GAAP results.

The estimated breakdown of these adjustments is as follows:

Stock-based comp, approximately $0.08; amortization of intangible assets, roughly $0.03; restructuring charges, approximately $0.02; and acquisition charges of roughly $0.02 associated with our acquisition of Mythic.

On share count; for positive earnings the appropriate share count would be roughly $320 million. For a net loss, the appropriate share count would be approximately $315 million. In Q4, we expect to ship 27 SKUs compared to 29 a year ago. We expect to have 16 next-gen SKUs including five for the 360, four for the Wii, three for the PS3, and 2 on both the NDS and PSP.

In addition, for the launch of the PS3 in Europe, we will have at least five titles. In January, we released NCAA March Madness 07 on the 360 and PS2. This title is already off to great start.

During the quarter, we expect to release DEF JAM: ICON on the 360 and PS3 which will include Dynamic Ads, Medal of Honor Vanguard on the PS2 and Wii, Burnout Dominator on the PS2 and PSP, NBA Street Homecourt on the 360 and PS3, Command & Conquer 3 Tiberium Wars on the PC, Champions League on four platforms Godfather: The Game on the PS3 and Wii, MBPO 7, NCAA Baseball on the PS2, Arena Football, Road to Glory on the PS2. SSX Blur on the Wii, Tiger Woods PGA Tour on the Wii, Theme Park on the NDS, Pogo Island on the NDS, The Sims Life Stories on the PC, the Sims 2 Seasons Expansion Pack on the PC, and Battlefield 2142 Northern Strike Booster Pack on the PC.

On mobile phones, we plan to launch six games, EA Sports Nascar 07, MBP Baseball 07, Pool Multiplayer, Tetris Multiplayer, Pictionary and the next-generation of Bejeweled.

Full year guidance; for the full year, we expect revenue to be between $3.025 and $3.075 billion. GAAP diluted earnings per share to be between $0.15 and $0.20. Non GAAP diluted earnings per share to be between $0.70 and $0.74.

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 $0.34; amortization of intangible assets, approximately $0.13; restructuring charges of roughly $0.05; acquisition charges, approximately $0.03 related to our acquisition of Mythic.

One final housekeeping item, as you begin building out your models for fiscal 2008, please remember that we faced a challenging comp in Q1, given the strength of last year's World Cup. That said, we do expect that Harry Potter will be a June release.

Before we open the call to your questions, I'll conclude with a couple of closing thoughts.

First, it's a great time; it's great to have all next generation platforms in the marketplace. These platforms and online are beginning to open up a new digital age for interactive entertainment. We believe that we are uniquely positioned to take advantage of these opportunities given the investments we have made in next-gen, online and in mobility.

And second, our long-term priorities are clear, next-gen leadership, including the Nintendo platform, 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 call to your questions.

Question-and-Answer Session

Operator

(Operator Instructions). We will take our first question from Mike Hickey.

Mike Hickey - Janco Partners Inc.

Thanks guys. Great job on a quarter.

Larry Probst

Thanks.

Mike Hickey - Janco Partners Inc.

Could you please provide us with your initial observation for the PS3 launch and install-based growth, as well as maybe the 360 install-based growth?

Larry Probst

Sure, the PS -- the PS3 release in Q3 met expectations as per our earlier guidance on hardware quantity and the rollout was definitely successful from a demand generation standpoint. The one area that we saw a little bit of disappointment was in the tie ratio. It was lower than expected. On the 360, we are very pleased with the tie ratio that came in above expectation and while the hardware total didn't quite need guidance, it was very strong and when you combine that with the tie ratio been higher, we are largely right there.

Mike Hickey - Janco Partners Inc.

Okay. And can you remind us the strategic importance for the aging gaming market. It looks like over the last several quarters you are experiencing negative year-over-year growth. Is that still as important as it used to be and what steps are you taking to accelerate growth in that region?

Warren Jenson

This is Warren. I think you have to look at it in two respects. One, you have to look at it in terms of the package goods business which flows down year-over-year, and as I mentioned in my prepared remarks, that was really is a result of the SKU plan. As we look at the online market going forward, we think it's very important. And as you know, we so far had we think really a strong launch and strong kick off with FIFA Online in Korea. And further as I mentioned, in my prepared remarks, this coming year we plan to roll FIFA Online out hopefully in both China and Japan. And also it's our intention that we begin the rollout of NBA Street into the Asian markets. So, longer term, we think it's very valuable. We think the learnings that we are getting from the micro transaction marketplace in Korea and other parts of Asia will also be invaluable to us in the western markets in the years ahead.

Larry Probst

And the one comment I would add to that is that we think there is significant opportunity on the mobile platform in Asia and we are just getting started in that respect as well.

Mike Hickey - Janco Partners Inc.

Great, thanks guys.

Operator

Moving on, we’ll take our next question from Todd Greenwald with Nollenberger.

Todd Greenwald - Nollenberger

Hi, thanks. Just wondering going back to the PS3, I wondered if you are expecting a price cut this year, I was just wondering how [good] trend you are about to have for that installed base? And also any of your thoughts on the recent Xbox 360 forecast production?

Larry Probst

With regards to the price change that the question that we would refer to Sony, looking at the early January results, the trends on the PS3 are good, its selling through at a comfortable clip, again you have to recall that this is a price point, it is much higher than the PS2. So when you are setting expectations looking at a PS2 for example, you would expect that the PS3 would be a bit slower in terms of its ramp, but we were confident that on the full year number it will be good. And with regards to the Todd, in the 360 forecast, we see the strong lineup of software in 360 this coming year will drive strong demand for that platform and we don’t anticipate that there will be any big problems there.

Todd Greenwald - Nollenberger

Great, thank you.

Operator

Next we will hear from Colin Sebastian with Lazard Capital Markets.

Colin Sebastian - Lazard Capital Markets

Good afternoon, thanks for taking my questions. I have a couple, the first the significant increase in the support of the Nintendo platforms, that you referred to is that coming with the expense of any other platforms, that's the first question. And then secondly, excluding the impact of the accounting change is there anything on the competitive landscape you see that would make you think it might be difficult to maintain market share in 2007?

Warren Jenson

With regard to the first question the support for the Wii and NDS, platforms is not at the expense of the other platforms that we deems strategic, so you will continue to see us being very prolific on the PlayStation 3 and Xbox 360 platforms as well the PC. We are -- one of the things that we have done is acquired the Headgate Studio, in Salt Lake City, up to this point they have been exclusively developing titles for the Wii platforms so that will give us some additional development capacity on the Wii, and we are redirecting some other resources towards Wii and NDS. So, by the end of this fiscal year, we will have six titles in the market which other than Ubisoft, we will be most prolific publisher on the Wii Platform through March. And you can expect to see us ship a number in the low to mid-teens next year in fiscal '08 on both the Wii Platform and on NDS. So, we have very aggressive market share goals on both those platforms as well as PS3, Xbox 360 and the PC.

Larry Probst

Your final question on competition next year, it certainly will increase. However, if you look at the lineup that we have planed for calendar year, it's pretty impressive in terms of lineup of the blockbusters. We are very confident on the lineup that we have. If you listen to the list that was read off earlier in the script, things ranging from Medal of Honor Airborne to Army of Two, SKATE, Burnout 5, Spore, SimCity, The Simpsons, Harry Potter, Warhammer, Hellgate, Crisis, Mercenaries 2, it's quite an impressive list in the non-sports categories, and obviously next year we will be back with a very strong lineup in EA Sports.

Warren Jenson

And let me just clarify one thing, the online deferral will not impact how segment shares are measured, as that's being done on a sell through basis. So, this is purely a GAAP measurement. So, no one should walk away with any level of confusion that segment shares would be negatively impacted as a result of 97-2.

Colin Sebastian - Lazard Capital Markets

Okay. And that's helpful. And I guess just following up on this lead quickly, The Lord of the Rings title I think that was originally planned for next year. I am just curious if you can provide any color on what happened to that title and what was behind the decision to cancel it? Thank you.

Larry Probst

The Lord of the Rings product is back in development in terms of being on hold and we were looking at the creative positioning and features set on the Lord of the Rings franchise. We do not sight to move forward with releasing it this year for those reasons.

Colin Sebastian - Lazard Capital Markets

Okay. Thank you very much.

Operator

Next, we will hear from Chris Clark with SIG.

Chris Clark - SIG

Great, just a couple of questions. On the first one, when you look at the online business, you projected it to be around $200 million, including ads and digital downloads and micro transactions and MMOs. What's your expectation for gross margins? It's hard to I know understand that from a blended basis, but what do you think the general idea of the gross margin should be? Should it be higher than the corporate average today?

Warren Jenson

By and large, I would say, yes, higher than the corporate average. You have to take a look at a couple of things. For example, on micro transactions, you have to look at, are you starting after the platforms splits with say Microsoft for example. So, on a micro transaction, it just started with absolute gross, you might be lower than our averages. But if you look at the net proceeds coming to us then you could very easily be higher. Overall, when I take a look at the whole mix, it's between in-game advertising subscription, what's going on in micro transactions and why I would expect higher gross margin.

Chris Clark - SIG

How would you -- as of this moment, would you be leaning towards the gross for the net revenues recognition for things like micro transactions?

Warren Jenson

Micro transaction is a little bit easier. We will play it as we go, but pretty much net.

Chris Clark - SIG

Okay. And then, just looking at the gross margins, obviously very strong this quarter, it looks like it was largely a revenue mix issue with PC being higher and the co-pub and distribution being lower. But overall, the console gross margins did that change markedly this quarter?

Warren Jenson

The only thing that I would correct there is, I mentioned that the principal driver of our higher gross margins was lower sales returns charges. So, as oppose to just console mix, which had a factor and lower royalty rates which was a factor, roughly two points of the increase came as a result of lower sales return charges.

Chris Clark - SIG

Okay.

Warren Jenson

That said again, let me clarify, as I mentioned in my prepared remarks, we think the channel is in great shape.

Chris Clark - SIG

Okay.

Warren Jenson

It's in great shape both in North America and in Europe.

Chris Clark - SIG

Okay. Just a final question. You mentioned on the online business, given that PS3, PS2, PSP and the PC being deferred, it sounds like all of its going to be on the balance sheet as short-term deferred revenue. But you also gave us $400 million number, if I have not mistaken, as I recall. Is that the ending balance number for the fiscal year or is that sort of the volume of deferred revenue you expect to generate?

Warren Jenson

That would be the ending balance. But again, let me remind everybody that with online deferral, this is tricky. So, depending upon the month of shipment that can impact what that ending number would be. So, this number could easily go down and it could easily go up. So, that gives a little bit weight, but what we are talking about is the $400 million being an ending balance.

Chris Clark - SIG

And…

Warren Jenson

I am sorry?

Chris Clark - SIG

And that's on the top of the 75 you currently have as of today?

Warren Jenson

That is correct.

Chris Clark - SIG

Great. Thank you very much.

Warren Jenson

Yeah.

Operator

Moving on, we will take John Taylor with Arcadia Investments Company.

John Taylor - Arcadia Investments Company

Hi. I've got a couple of questions too. First, could you give us what catalog was in the December quarter, and what do you expect it to be in March? Second question is, Larry, I wondered if you could talk a little bit about, may be market share goals on the Nintendo platforms, given that Nintendo tends to kind of have the primary share on their own. So, may be, give us a sense of kind of how you're thinking about that? And then, on this deferred revenue issue; one, may be talk a little bit about -- okay, I understand the development cost and support cost and all that, hosting costs are going to be absorbed real time, what are you going to do with advertising and allocating that over six months and G&A load and the other pieces of operating on that? Thanks.

Larry Probst

With regard to the split between frontline and catalog in Q3, it was 51% frontline and 38% catalog. With regard to market share goals, it's always our goal to have a leading market share on the platforms that we believe are strategic. So, clearly we have number one market share goals on all of platforms where we're currently number one and that would include PS2, PS3, PSP, Xbox 360 and the PC platform. On the Nintendo platforms, we think that we can be a very strong number two. Clearly, Nintendo is going to always be number one on the Wii platform on the NDS platform. We believe that we can be number two and our market share goals would be in the 15% to 20% range on those platforms.

Warren Jenson

And then, J.T., on revenue deferral, what would be deferred is in essence net revenue. So, for example, if we had a sale of call it $40 million versus inventory and we had an SRA reserve of say $4 million, we would then over the period, we would put $36 million on the balance sheet and amortize that into revenue over the following six months. And what I mean by the following six month if that sale were to occur in December, we will begin amortizing that revenue into -- that deferred revenue into revenue beginning in January. Relative to all other costs, product cost, as well as G&A, R&D, everything else that will all be expensed currently as really try work it past on the sale of the packaged goods. Therefore, we feel that the obligation is out there and it's more appropriate for us just to go ahead and recognize the expense.

The silver lining of all of that, as I mentioned, is that now when our non-GAAP measures is a result of adding that one line in terms of the change in deferred revenue, it completely normalizes our results. So, while this can have a dramatic impact on our GAAP results, what it won't have is it will not change our non-GAAP results to where you should have complete comparability in all material respects year-over-year.

John Taylor - Arcadia Investments Company

Okay. So, let me try this one. On the 400 additional, how should we think about the cost side of that which is going to be recognized in fiscal '08, which the revenue piece is going to get pushed out? In other words, should we assume that costs are going to take up, say 80% of that or 70% of that revenue amount because that will be reported in your -- captured in your fiscal '08, right?

Warren Jenson

So, I think you have to -- first, let me tell you focus on cash and the pattern for expense recognition and/or cash receipt will be exactly what it is today. So, the economics of this business have not changed in any way. Now, on the GAAP results, the cost for all of those products consistent with your sort of non GAAP margin forecast would be recognized currently without the revenue. So, that would increase the expense -- would increase the expense relative to the revenue in a quarter where there is the deferral. So, GAAP results, you will see expense without the revenue and then as the revenue is amortized then that will tend to offset each other. But in that let me come to the macro point, through our non-GAAP measures, you will have complete comparability. The economics of the business have not changed. So, the cash flows incoming to EA will be no different than and the outflows will be no different. But given the dynamics of 97-2, the revenue will be have to be amortized over the length of our service obligation.

John Taylor - Arcadia Investments Company

Yeah, so I think it's great that you guys are doing this simply so that we can just add the revenue back and see what that delta is. I guess maybe to ask it one final way. So, on the 400, what do you think EPS difference is going to be between the reported GAAP in '08 and between GAAP and non-GAAP, on that 400?

Warren Jenson

It would be 400.

John Taylor - Arcadia Investments Company

No, no, no. The revenue would be 400, but the EPS -- the delta between GAAP EPS and non-GAAP based on that 400 will be roughly what?

Warren Jenson

We'll give specific guidance at year-end, J.T.

John Taylor - Arcadia Investments Company

Yeah.

Warren Jenson

But in the hypothetical, what you can assume is that if $400 million of revenue is deferred and given the fact that we currently expense everything, in effect if you were to, that will fall directly to operating margin. Do you follow me? So, in other words, if $400 million of revenue leads fiscal '08 that will indirectly impact our operating margin.

John Taylor - Arcadia Investments Company

Yeah, when it's added back on a non-GAAP basis. Okay. All right, we can go over this later. Thank you.

Operator

Next, we'll hear from Jeetil Patel with Deutsche Bank.

Jeetil Patel - Deutsche Bank

Great, thank you. Going back to the 400 million question -- $400 million question. Can you just give us a sense I guess what percentage of the Sony and PC titles will have that online component versus just a peer package software play? And I have a quick follow-up.

Warren Jenson

We will give you that guidance as we get into our call. The next quarter we'll talk more specifically about FY '08. You can sort of figure it today where give or take roughly 50%. So, it will depend upon our exact plans which will go through when we get to our call here in three months, but today it's roughly 50%.

Jeetil Patel - Deutsche Bank

Okay. And as it relates to the R&D spending, you've talked about I think 5% core and then when you add in online you get to the mid to high single-digits, is that kind of what you said about fiscal -- kind of going forward into the upcoming year?

Warren Jenson

Yes.

Jeetil Patel - Deutsche Bank

Okay. And there won't be any sort of amortization of R&D expense. It will all hit the P&L in the upcoming year.

Warren Jenson

That is correct.

Jeetil Patel - Deutsche Bank

Excellent. Thanks.

Operator

Lowell Singer with Cowen & Company will have our next question.

Lowell Singer - Cowen & Company

Hi, it's a Lowell Singer. I have a couple of questions. First, in your 13% to 18% category growth assumption, Warren, for calendar '07, can you talk about your assumptions for pricing on both PS2 and next-gen titles, what's embedded in that forecast? And second, there has been a lot of discussion on the Wii whether there is success this early on is sort of fattish or whether they have a favorable platform that's going to challenge for a much bigger share throughout this cycle than they had last cycle on the hardware side. And I am wondering, how you think the sort of three to five-year forecast on console sales is shaping up? Whether you think that Microsoft and Nintendo are going to be much more competitive with Sony, and potentially even past Sony this time around compared to the last generation? Thanks.

Warren Jenson

With regards to the pricing question, we were looking at the current trends and front line pricing about next-gen and current-gen and moving those assumptions forward. There doesn't appear to be a lot of resistant for the $59 price point for frontline next-gen titles. On the current-gen, it's becoming more of a $39 market, but there still is room for premiere title to come in at $49 price point. So, in our forecast assumptions, we have a mix based on these assumptions.

Larry Probst

With the regard to the Wii platform at least initially it seems like its expanding the overall market and expanding the demographic of users and people who purchase software. So, we think that's a good think. And we will have to see whether that's sustainable over time, but certainly they have gotten off to a very encouraging start. And over the next cycle whether it's three to five year's or longer. It appears as though both Microsoft and Nintendo are positioned to gain some share. So, we think that Sony will continue to do extremely well. They are very strong, in particular in Europe. And so, we think that there are three viable hardware platforms out there and we are going to be very proactively supporting all of them.

Lowell Singer - Cowen & Company

Okay. Thank you.

Operator

Moving on, we will hear from Heath Terry with Credit Suisse.

Heath Terry - Credit Suisse

Great. Thank you. Warren, I was just hoping that -- or Larry, you could maybe look out a little bit, when you think about, what you are seeing right now in terms of the attached rate for the incremental revenues from both advertising and from the digital downloads that you are doing on a per title basis, is there a number that you feel like is appropriate for us to be thinking about in terms of the incremental revenue from those two opportunities?

Warren Jenson

Heath this is Warren. I think it's just too early to tell. I think some of the more interesting things that we are clearly seeing is that take people online in Korea, these models really work and people like playing mid-session online games like FIFA Online. I think the numbers that we've seen just this quarter in Pogo by introducing the Jump as sort of a payment model are fascinating. Need for Speed in the quarter in game advertising was roughly 5 million bucks. So, we'll see, but I think there are a lot of very positive things that we are seeing. And most importantly, they are things that are making games better and if we can continue to come up with ways to make the games better these revenue streams will just continue to grow in importance.

Heath Terry - Credit Suisse

So, you said that Need for Speed that $5 million in the quarter in incremental advertising revenue or…?

Warren Jenson

In game advertising, both static and dynamic.

Heath Terry - Credit Suisse

So, when you mention the other titles that you have got that are going to having game advertising in this March quarter, should we be thinking that those are able to do similar type numbers, of course, adjusted for the size of the installed base on the game?

Larry Probst

That's a fair assumption.

Heath Terry - Credit Suisse

Okay, great. And at our conference back in December you have talked about Need for Speed having done at that point roughly $1 million in incremental downloads, is there an update to that number that you can provide us with?

Warren Jenson

Hold on and I will grab you when I'll come back with that Heath.

Heath Terry - Credit Suisse

Great, thanks a lot.

Operator

[Ed Irwin] with Bear Stearns will have our next question.

Ed Irwin - Bear Stearns

Thanks. I was wondering if you could provide a little more detail on the increase in R&D in the quarter, excluding stock compensation. R&D was still somewhat ahead of expectations. Was that primarily the Wii?

Warren Jenson

The R&D is really -- the growth is a function of several things. Obviously, the stock-based compensation 123R, second thing is overall incentive compensation, which last year we did not meet in our operating plan objective. This year, so far we're meeting them, now we thought to bring the [quarter home]. So, this is not a done deal yet. But that resulted in an overall significant increase in the expense stage. The third thing would be overall acquisition. If I were looking at kind of normalizing all those things, and looking at kind of a run-rate expense, I would put the growth in R&D in the quarter around 10ish, slightly higher but not a lot more.

Ed Irwin - Bear Stearns

Okay. Great, that's helpful. And then, I was wondering if you could comment on how the co-development of SKUs for the PS3 and Xbox 360 is going and what sort of benchmarks are you looking for during the coming year?

Larry Probst

In terms of co-development, can you describe what do you mean by that?

Ed Irwin - Bear Stearns

Well in terms of currently, co-development of SKUs on separate teams or together. Just trying to get a sense of how that's progressing as you look for sort of efficiencies as that process goes on?

Warren Jenson

I can speak about it generally -- we have single franchise teams that are approaching each of these businesses. And when we look at the PS3 and the 360, the development of those two platforms is more alike and has more asset sharing than when you look your current genre or the Wii, for example. Just given the architecture, the systems, the multiple processors, the high definition graphics etcetera. So we do see that that will continue in the future where there will continue to be 360, PS3 development being mostly the same. We will do some things on one versus the other to optimize and to make them better, but on the Wii and the current-gen stuff that still continues to be a different type of development.

Ed Irwin - Bear Stearns

Okay.

Larry Probst

And while we are waiting for the next question, let me just come back Heath, to your question. Need for Speed in Q3 and micro transactions, our average revenue per person purchasing content was about $11. In total retail revenue that amounted to roughly three quarters of $1 million, the average purchase per item was about $2.50.

Operator

Moving on, we will take our next question from Tony Gikas with Piper Jaffray.

Tony Gikas - Piper Jaffray

Hi. Good afternoon guys, few quick questions for you. As we enter a period here of improving cash flows over the next couple of years; could you just comment on your thoughts for additional share repurchase? Second question, I have heard from a couple of retailers here recently that sales during the month of January were particularly strong and gift cards continue to increase each year. Do you have a view on what tie ratios have been for the PS3, have they picked up now that, most of that hardware is in the hands of the ultimate owner. And then the third question, any update on China opportunities and growth there, any partnerships or potential partnerships that you see in that market?

Frank Gibeau

This is Frank. I'll take the second question first. January has been a very good month and in terms of the tie ratio on the PS3, we have seen a great improvement on that. The interesting thing to note about December was that, weeks 4 and 5 were historically high as a percentage of the business. Lot of that is fueled by the increase in gift card consumer behavior, and also I think the PS3 tie ratio was depressed a little bit at the initial release because of the eBay effect. Lot of people were out there by buying them and then flipping them to other people for a premium. As this ended up, as you stated, in the end users' hands, we have seen the tie ratio really go up appreciably.

Warren Jenson

And Tony, I will take the second question, and that has left Larry for the third. On the share repurchase, this is something we talk about in terms of returning capital to the shareholders all the time with our Board and we will continue to do so. Our priority is to stay strategically flexible, but as cash continues to increase depending upon our other cash needs, it's something that is front-end centered with our Board of Directors all the time and will continue to be.

Larry Probst

And with regard to China, we're continuing to develop our local development capability in that market and we are exploring potential partnerships with multiple people as we speak.

Tony Gikas - Piper Jaffray

Okay. Great job

Larry Probst

Thanks Tony. Operator we'll take one more question.

Operator

Okay. Our last question will come from John Taylor with Arcadia Investments.

John Taylor - Arcadia Investments Company

Hi. I am -- I was going to ask about the reported story that this too was going to block online gaming and I wonder if -- its sounds like as that gets setup people are going to have to make a bunch of choices in terms of panel controls and stuff. I wonder if you could talk about that in relation to Pogo and give some assurance or tell us what they told you on that front?

Warren Jenson

You will be able to play Pogo going forward on Vista as you can't on XP. We don’t consider -- we don’t anticipate that there are any problems. Obviously we are constantly talking with Microsoft about their future plans and from our perspective we don't see any of it materially changing in Pogo going forward.

John Taylor - Arcadia Investments Company

Does it -- is it going to impact anybody's ability to download games in case you move to that kind of a format?

Warren Jenson

We don't believe that's the case.

John Taylor - Arcadia Investments Company

Okay. Great thank you.

Warren Jenson

Alright, thanks everyone for joining us.

Operator

Thank you, ladies and gentleman this does concludes today's Electronic Arts conference call. We would like to thank everyone for their participation. Have a wonderful rest of your day.

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