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Electronic Arts Inc. (ERTS)

F4Q07 Earnings Call

May 8, 2007 5:00 pm ET

Executives

Tricia Gugler - Director, Investor Relations

Lawrence F. Probst - Executive Chairman of the Board

John S. Riccitiello - Chief Executive Officer, Director

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

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

Analysts

Bill Kreher - A. G. Edwards

John Taylor - Arcadia

Edward Urban - Bear Stearns

Mike Hickey - Janco Partners

Evan Wilson - Pacific Crest

John McPeake - Prudential Equity Group

Colin Sebastian - Lazard Capital Markets

Justin Post - Merrill Lynch

Shawn Milne - Oppenheimer & Co.

Tony Gikas - Piper Jaffray

Jeetil Patel - Deutsche Bank

Heath Terry - Credit Suisse

Michael Savner - Banc of America

Benjamin Schachter - UBS

David Joseph - Morgan Stanley

Dean Gianoukos - J.P. Morgan

Edward Williams - BMO Capital Markets

Presentation

Operator

Good day, everyone and welcome to the Electronic Arts fourth 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, Director of Investor Relations. Please go ahead, Madam.

Tricia Gugler

Welcome to our fourth quarter fiscal 2007 earnings call. Today on the call we have Larry Probst, Chairman of the Board of Directors; John Riccitiello, 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 will post a copy of our prepared 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 adjustment. Our earnings release provides a reconciliation of our GAAP to non-GAAP measures. In addition, we include a detailed GAAP to non-GAAP reconciliation on our website.

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

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

We have also included a summary of our financial guidance and our prepared remarks, as well as our trailing 12 month platform shares in a supplemental schedule on our website.

During the course of this call, we may make forward-looking statements regarding future events and the future financial performance of the company. We caution you that actual events and results may differ materially. We refer you to our most recent Form 10-K 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 May 8, 2007 and disclaim any duty to update them.

As most of you know, John Riccitiello became our Chief Executive Officer on April 2nd, so before we hear from Warren, Larry would like to say a few things.

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Lawrence F. Probst

Thank you, Tricia and good afternoon, everyone. My 16 years as CEO have provided me with a array of opportunities, experiences and insights into our business. One of the most rewarding elements has been to watch a group of talented individuals mature into a team of seasoned executives and creative leaders.

When it came time for our Board to choose a successor as CEO, the solution was obvious. In his first seven years at EA as our President and Chief Operating Officer, John proved himself as a leader with exceptional vision and an ability to inspire the people around him.

We are very fortunate to have a new CEO with a deep understanding of the industry, a proven ability to lead, and a strong commitment to growing our business. John is now running the company. He is doing a terrific job and I have every confidence that he and his team will take EA to the next level of success.

With that, let me introduce John Riccitiello.

John S. Riccitiello

Thank you, Larry. This experience has been both humbling and exhilarating. As I mentioned when my appointment was announced, EA is my dream job.

Since joining, I have been on the road with our teams and business partners. This past month I’ve had the opportunity to visit our studios in Vancouver, Montreal and Florida and then visited our major studio and publishing operations in Europe, Asia and the rest of North America.

In total, I have met with over half of our employees and had the chance to meet one on one with hundreds of our people. I have also had the opportunity to review our fiscal 2007 performance and our plans for fiscal 2008.

I’ve learned a lot and have come away with a few early impressions.

First, I would like to point out that Larry has done truly an extraordinary job in leading this company for the past 16 years. He’s led us through the most difficult transition in industry history and he’s focused us on a set of far-reaching goals for investing and growing the business. Larry has been the industry’s best CEO and we owe him a deep debt of gratitude. I am also personally grateful as Larry has made my transition back to EA easy and seamless.

Second, I’m impressed with EA’s talent and incredible portfolio of assets. No other company in our industry can match these strengths. I’m also very gratified by the reception I have received from all of EA’s employees.

Third, EA has done a great job of laying out its global priorities to lead on next-gen platforms, in online, wireless, Asia and on further building out our portfolio of owned intellectual properties.

With that, I will now turn the discussion over to Warren. After his remarks, I will come back and outline some thoughts on our priorities for fiscal ‘08 and beyond.

Warren C. Jenson

Thanks, John, great to have you back. Good afternoon, everyone. I’d like to begin with a few highlights. Our fourth quarter performance exceeded our expectations both on the top and bottom line. For the quarter, revenue was $613 million versus $641 million, down 4%. GAAP diluted loss per share was $0.08 versus a loss of $0.05 a year ago. Non-GAAP diluted earnings per share were $0.06 versus $0.14.

During the quarter, several titles stood out. We successfully re-launched the Command and Conquer franchise with C&C 3 Tiberium Wars selling over one million copies. The Sims 2 Seasons sold over one million copies, making it our fifth platinum Sims 2 expansion pack. We shipped four Wii titles in March; Tiger Woods PGA TOUR, SSX, Medal of Honor Vanguard and Godfather Blackhand Edition.

While we still have a way to go, we now have six Wii titles at retail. In North America, we were the number one third party publisher for the month of March and we estimate number two in Europe.

In addition, Def Jam ICON, Medal of Honor Vanguard, NBA Street and Burnout Dominator each sold over 500 thousand copies.

And finally, our catalog continued to perform well. Need for Speed Carbon, Need for Speed Most Wanted, The Sims 2 and Madden 07 each sold over a half million copies.

For the year, revenue was $3.091 billion, up 5% from a year ago. Our top four franchises were Need for Speed, The Sims, Madden and FIFA -- all experiencing double-digit unit and revenue growth year-over-year.

The Sims franchise continues to thrive with 22 million copies sold. Both units and revenue were up a strong 49%.

For the year, we had 24 platinum titles, down from 27 a year ago. Our trailing twelve month segment share was roughly 20% in both North America and Europe, down roughly two to three points for the comparable period.

In Sports, our business continues to grow, with revenue up over 20%. Madden 07 was our top selling title for the year with units and revenue up over 15%. This year we launched Madden on 11 platforms. Our soccer business had a banner year. We sold over 13 million games across our soccer portfolio -- FIFA, FIFA World Cup, Champions League and FIFA Street.

In online, we grew digital revenue 47% to $127 million. Our Club Pogo subscriptions have now surpassed 1.5 million, up 23% from last year. In addition, we sold over 9 million pieces of digital content.

In cell phones, revenue reached $140 million as we continued to expand in both North America and Europe. In the first year of our acquisition, EA Mobile delivered $40 million of non-GAAP operating profit at a margin of 29% -- well ahead of our expectations. Also, on a GAAP basis, the acquisition of JAMDAT was accretive for the year.

And finally, over the last 12 months we further strengthened our long-term position. EA Partners signed agreements to bring Rock Band, Mercenaries 2 and Hellgate London to consumers. We acquired five companies: Digital Illusions, Mythic Entertainment, Headgate Studios, Phenomic and Singshot. In Asia, we announced an agreement with Neowiz to bring online games to market and acquired a 19% stake in this company.

For the next few minutes, I’ll focus my remarks in two areas. First, I’ll review our Q4 results, and second, I’ll go over our outlook and financial guidance.

Q4 Net revenue was $613 million, down 4% from last year, primarily due to the decline in sales from current gen platforms. Revenue was driven by Command and Conquer 3, Need for Speed Carbon, Def Jam ICON and Sims 2 Seasons. Absent the impact of foreign exchange, revenue would have been down 8%.

We released 27 SKUs in the quarter versus 29 a year ago.

Console revenue was $298 million, down 17% primarily due to the strength of last year’s release of Black, Godfather and Fight Night and the decline in sales from current gen platforms. Next gen revenue was $170 million driven by the launch of the PS3 and Wii and growth in revenue from the 360. Next gen revenue was 57% of total console revenue.

Mobility revenue was $105 million, up 19%. On mobile phones, revenue was an industry-leading $36 million. We had four of the top-ten games in North America and three of the top-ten in the U.K.

On handhelds, revenue was $69 million, down $4 million. NDS revenue of $27 million was over 2X that of last year, driven by Theme Park and The Sims. Revenue from both the PSP and GBA were down year-over-year.

PC revenue was $128 million, up 23% driven by C&C 3 and the continued strength of The Sims franchise. In North America and Europe, C&C was the number one PC title for the month of March.

Co-pub and distribution revenue was $45 million, down $7 million principally due to last year’s strength of Half Life 2.

Internet, Licensing, Advertising and Other was $37 million, flat to last year. We launched Pogo in Germany during the quarter. We are also pleased that Pogo is now a top three casual game site in the U.K. just six months post launch.

Geographically, North America revenue was $307 million, down $33 million or 10%. The increase in next gen, cellular handsets and subscription revenue did not offset the decline from current gen platforms. NBA Street, Def Jam ICON and March Madness did not offset last year’s performance of Fight Night, Godfather and Black.

International revenue was $306 million, up $5 million or 2%. Excluding a $22 million positive impact from foreign exchange, international revenue would have decreased six points.

Europe revenue was $264 million, up $2 million. Increases in next gen, PC and favorable foreign exchange essentially offset the decline from current gen.

Asia revenue was $42 million, up $3 million. Increases in NDS and PS3 offset lower co-pub and distribution revenue. In Japan, Sim City NDS broke at number one in its launch week and was the number 11 NDS title for the quarter.

Moving on to the rest of the income statement, gross profit in the quarter was $378 million, down 5%. Gross margin was 61.7% versus 61.9%, primarily due to higher sales return charges which were partially offset by lower co-pub and distribution royalties.

Op-ex -- as you know, at the beginning of the fiscal year we adopted FAS-123R. In the fourth quarter, this resulted in after tax stock-based compensation expense of $24 million.

Marketing and sales expense was $116 million, up $14 million primarily due to increased ad spend and higher personnel-related costs, including stock-based compensation. Excluding the impact of stock-based comp and acquisitions, marketing and sales would have increased approximately 8% year-over-year.

G&A was $66 million, up $12 million primarily due to stock-based compensation and higher facility-related costs. Excluding the impact of stock-based comp, G&A would have increased approximately 9% year-over-year.

R&D was $257 million, up $69 million primarily due to stock-based comp, acquisitions, facility-related expenses and third party development spend related to our EA Partners titles. Excluding the impact of stock-based comp and the impact of acquisitions, R&D would have increased approximately 20%. R&D headcount was roughly 5,900, up 14% from a year ago and up 2% sequentially. Acquisitions accounted for five points of the year-over-year increase.

GAAP diluted loss per share was $0.08 versus a loss of $0.05 a year ago. Non-GAAP diluted earnings per share were $0.06 versus $0.14. The $0.14 difference between GAAP and non-GAAP EPS was principally due to: stock-based compensation, $0.08; amortization of intangibles, $0.04; and acquisition-related charges of $0.02.

Our trailing 12 month operating cash flow was $397 million versus $596 million for the comparable period. Our return on invested capital on a trailing 12 month basis was 10% versus 21% a year ago.

Now, on to the balance sheet. Cash, short-term investments and marketable securities were $2.976 billion, up $544 million from a year ago, primarily due to cash generated from operations and an increase in the value of our marketable securities.

Gross accounts receivable were $470 million versus $431 million a year ago.

Reserves against outstanding receivables totaled $214 million, down $18 million from last year. Reserve levels were 11% as a percentage of trailing six month net revenue, down one point. As a percentage of trailing nine month net revenue, reserves were 8%, also down one point. Inventory was $62 million, relatively flat to last year and down $10 million sequentially. No other titles, other than Need for Speed Carbon, represents more than $3 million of exposure.

Deferred net revenue from packaged goods and digital content was $23 million, up $14 million from a year ago and $9 million sequentially.

Now, our outlook. As I mentioned in our last call, fiscal 2008 for us is all about growth and return on investment.

Growth -- we continue to expect industry growth in North America and Europe software sales to be between 13% to 18% for calendar 2007. For EA, our projected growth will be fueled by a strong line up.

We expect to launch over 15 wholly-owned titles, five of which are franchise debuts -- Army of Two, SKATE, Playground, Boogie and a Wii Spielberg title. In addition, our blockbusters, Need for Speed and Sims, will be back.

We continue to have enormous confidence in SPORE as a franchise but have made the call not to include this title in our fiscal year financial plan.

In entertainment, we plan on launching Harry Potter and the Order of the Phoenix, Warhammer, and The Simpsons.

Through EA Partners, we will release Crysis, Hellgate London, Mercenaries 2: World in Flames, Half Life 2: Orange Box and Rockband.

In sports, our full line will be back: Madden NFL, FIFA, NBA Live, Tiger Woods PGA TOUR, NCAA Football, MVP NCAA Baseball, NHL and NFL Street.

While we love our lineup, it really starts to kick-in with the launch of Harry Potter in late June. The timing of our SKU plan will clearly pressure our first quarter results and near term segment shares. Once we move into our second quarter, we would expect to see much improved financial comps and shares.

By platform for fiscal 2008, you can expect us to ship between 20 and 23 SKUs on both the 360 and PS3. On the Wii and on the NDS, we expect to launch 10 to 13 SKUs for each platform, including: originals like My Sims, Playground, Boogie, and a new title that is being developed with Steven Spielberg.

For the NDS, we expect to launch Sim City, and for the Japanese market, we plan to release a beverage series, Sommelier, Sake and Bartender.

In sports, Madden ‘08, FIFA ‘08, Tiger Woods PGA TOUR and NBA Live, and in entertainment, Harry Potter and The Simpsons.

In short, we are on it and more to come.

In mobile, we expect global industry growth of 20% to 25% for calendar ’07, fueled by new handset sales, increased consumer adoption of mobile entertainment and more great games. In the coming fiscal year, mobile revenue will likely pass through $175 million.

Online for fiscal 2008, we think our non-GAAP online revenue could exceed $175 million, up close to 40% year over year, driven by digital downloads, dynamic in-game advertising, micro-transactions, Warhammer in the MMO space, POGO, and in Asia we will aggressively ramp up our mid-session game offerings. We anticipate that FIFA Online will go live in both China and Japan. We also plan to roll out NBA Street.

Now on to our financial guidance. Before jumping into the specifics, let me again take a moment to remind you that we will no longer charge for online hosting as it relates to our online enabled packaged good titles. As a result, for online enabled games on the 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.

We estimate that between $400 million to $500 million in revenue that would have otherwise been reported in fiscal 2008 will now be deferred and recognized in fiscal 2009. We estimate that roughly 40 SKUs will be impacted, 30 of which are sports games. We do not intend to defer any product costs.

Please keep in mind this change does not in any way impact the economic fundamentals of our business and will not adversely impact our cash flows.

As we discussed on our last call, through our non-GAAP reporting you will have comparability year-over year. We added a line to our non-GAAP reconciliation where we plan to add or subtract the change in deferred revenue related to packaged goods and digital content.

Once again, if you go to our website, you will see an expanded set of schedules and reconciliations including an FAQ that should assist you in understanding the impact of this change and our other non-GAAP adjustments.

Now the numbers -- before I begin, we wanted to let you know that a one-page summary of our financial guidance will be included with the call script on our website. Hopefully this will assist you to build your GAAP and Non-GAAP models.

First, our GAAP guidance: for the full year, we expect revenue to be between $3.1 billion and $3.4 billion; diluted loss per share to be between $0.77 and $0.23; gross margin to be between 50% and 55%; and basic share count to be 317 million.

We expect our GAAP revenue for the rest of the year to land in roughly the following percentages: 9% to 11% in Q1; 19% to 23% in Q2; 39% to 43% in Q3; and 25% to 30% of the total in Q4.

For gross margin, we expect the following percentages by quarter: for the first quarter, 49% to 52%; 35% to 38% in Q2; 49% to 52% in Q3; and 66% to 69% in Q4.

Now, on to our non-GAAP guidance. For the full year, we expect non-GAAP revenue to be between $3.6 billion and $3.8 billion; non-GAAP diluted earnings per share to be between $0.90 and $1.20; non-GAAP gross margin to be 58% to 60% -- given the increase in our EAP titles in fiscal ‘08 relative to fiscal ’07, we expect our gross margins to be negatively impacted; diluted share count to be 328 million.

Overall, we expect our non-GAAP EPS to be roughly $1.42 to $1.68 better than our GAAP results.

The estimated break-down of these adjustments is as follows: change in deferred revenue related to packaged goods and digital content to be between $0.98 and $1.23; stock-based comp, approximately $0.31; amortization of intangible assets, roughly $0.13; and restructuring charges, approximately $0.02.

We expect our non-GAAP revenue for the rest of the year to land in roughly the following percentages: 9% to 11% in Q1; 25% to 30% in Q2; 39% to 43% in Q3; and18% to 23% of the total in Q4.

On the expense side, we expect R&D to increase in the high single digits for the year. Both G&A and marketing and sales should decline one to two points as a percentage of non-GAAP revenue.

On taxes, first our GAAP numbers: given the revenue deferral, we expect a GAAP loss for fiscal 2008. That said, for the fiscal year on a GAAP basis we expect to incur an absolute level of tax expense of up to $40 million.

For Q1 and Q2, we estimate our GAAP tax benefit rates to be between 15% to 20%.

For non-GAAP, we estimate our rate for the year to be roughly 30% consistent with last year. For Q1 and Q2, we expect our non-GAAP tax rate to be between 15% to 20%.

Finally, effective this quarter, we will adopt FIN-48, which deals with how to account for certain income tax positions. We are in the process of evaluating this new standard. Accordingly its effect, if any, is not reflected in our guidance.

From EA studios, we plan to release roughly 35 titles and 120 SKUs. EA Mobile plans to release 30 to 35 games on cellular handsets and four games on the iPod.

Now the quarter; for the quarter ending June 30, first our GAAP guidance. For the quarter, we expect revenue to be between $300 million and $360 million; diluted loss per share to be between $0.66 and $0.56; gross margin to be between 49% and 52%; and basic share count to be 310 million.

Now our non-GAAP guidance; for the quarter, we expect non-GAAP revenue to be between $350 million and $400 million; non-GAAP diluted loss per share to be between $0.40 and a loss of $0.34; non-GAAP gross margin to be roughly 60%; and basic share count to be 310 million.

Overall, we expect our non-GAAP EPS to be roughly $0.22 to $0.26 better than our GAAP results. The estimated break-down of these adjustments is as follows: change in deferred revenue related to packaged goods and digital content to be between $0.10 and $0.14; stock-based compensation, approximately $0.08; amortization of intangible assets, roughly $0.04.

In Q1, we expect to ship 13 SKUs compared to 16 a year ago including: Harry Potter and the Order of the Phoenix on six platforms; Command and Conquer 3 Tiberium Wars on the Xbox 360; Sim City on the NDS; The Sims 2 Pets for the Wii; Sims Pet Stories for PC; Two Sims 2 stuff packs; The Sims 2 Deluxe for the PC.

At EA Mobile, we plan to launch four games on cellular handsets -- ESPN Fishing, Harry Potter, Sims Bowling, Bejeweled Multiplayer, and Sims Bowling on the iPod.

With that, I will turn it back to John for some closing thoughts.

John S. Riccitiello

Thanks, Warren. Before we open the call to questions, I would like to take you through a few general priorities on which we will focus.

First, we will focus on improving execution and predictability. EA is blessed with a team that is unmatched in creativity and professionalism. Our intent is to lead this team to deliver on our obligations to our consumers and our shareholders.

Second, I will be working to align our teams for increased accountability, agility and speed to market. My sense is that we can be faster and better focused on capturing opportunities, increasing segment share and overall growth.

Third, it’s time to accelerate. We plan to set new goals for where we want to be at the peak of this cycle and beyond. Our intent is to create a stronger long-term performance trajectory.

Larry has brought me in to drive an agenda of change. I am very optimistic about EA’s future and our ability to deliver on our fiscal ‘08 operating plan and I look forward to telling you more about our plans and progress in the months ahead.

Now, we would be happy to take all of your questions.

Question-and-Answer Session

Operator

(Operator Instructions)

Our first question comes from Bill Kreher with A. G. Edwards.

Bill Kreher - A. G. Edwards

Thanks, guys, for taking my question. Just curious on the $175 million of online revenue expected, how much of that is the dynamic game advertising and how is that environment, from your perspective? And just maybe what the contribution from Warhammer is expected, as far as that $175 million? Thanks.

Frank D. Gibeau

I won’t get into all of the specifics. I’d tell you that in terms of advertising, you can count on, you know, it could be anywhere from call it $20 million to $35 million or so. The MMO looking at Warhammer, again, I’d put it in the maybe $30 million to $50 million range.

John S. Riccitiello

The other thing on dynamic in-game advertising is we are going to be dramatically increasing the number of titles that will be supporting it, both on the PC and the 360. We will also be looking at opportunities for advertising on other platforms, including mobile, in the new fiscal year.

Frank D. Gibeau

Let me just clarify, because I mentioned Warhammer specifically, but the number I was giving you is total MMO revenue, which includes all of our MMO titles, Dark Age of Camelot, UO, as well as Warhammer.

Operator

Next from Arcadia we’ll hear from John Taylor.

John Taylor - Arcadia

I wonder if you could talk a little bit about the growth drivers for the year and break it down maybe into baskets, like EA partners with a lower margin segment, how much your thinking is coming from the publishing side, the traditional side, and then if you look at all the new businesses, the advertising piece, the mobility piece, digital download pieces, advertising, all that stuff kind of as a third basket, maybe give us a sense of what that mix might look like in the new fiscal year. Thanks.

Frank D. Gibeau

I’ll take a high level cut at and then -- you know, obviously a lot of this really boils down to the strength of the SKU plan. Our packaged goods business, I think you can take a look exactly at the SKU plan and the strength of it. I think obviously we got a slow start in Q1 relative to the size of our lineup but it really kicks in in late June with Harry Potter. We are forecasting 13% to 18% market growth for packaged goods across Europe, and that’s going to be the principal driver of that business.

The mobile business, as we’ve said, did $140 million. We think those revenues could pass through $175 million. In online, which is comprised of a host of things, obviously, all the way from digital downloads to micro-transactions to our subscription revenue and the like, as I mentioned last year was $127 million, and as I just mentioned on the call, we think that could go through $175 million.

For the full year geographically, I think we would be safe to say we expect strong growth from all geographies -- North America, Europe and in Asia.

Operator

From Bear Stearns, we’ll hear from Edward Urban.

Edward Urban - Bear Stearns

Good afternoon, thanks. I wanted to ask a question on the mobile side. You’ve talked about $175 million in revenues. Just looking at the trailing 12 months, quarter over quarter, those revenues have been up slightly but now you are forecasting 20% to 25% growth. I’m wondering if you can just talk about the key drivers on the mobile side.

Warren C. Jenson

I’ll take a cut at that. Looking at JAMDAT, JAMDAT has actually had a very, very healthy year year-over-year and the comps are not up just slightly. This has been a very, very strong year for the entire business.

As an example, and I’m using JAMDAT comps, now the EA Mobile, so this is pretty much apples-to-apples, FY07 to FY06, revenues were up 63% to north of $140 million. And then equally as impressively, they delivered $41 million of operating profit at a 29% operating margin, which is I think pretty darn spectacular.

For the fourth quarter, again just to show the strength of the growth performance, JAMDAT revenues went from $25 million a year ago to EA Mobile this year of $37 million, which is up 48%. So this is a business that has actually done very, very well and it’s done very well competitively. In terms of the market, I believe -- and I’m using rough terms -- our segment shares have doubled in Europe during the course of the year, which is exactly what we said we want to do.

Hidden underneath this performance is the fact that we have a well-integrated business that is also leveraging the EA portfolio of titles. I think we’ve just gotten going with about 10 of our titles so far really being integrated into that platform and portfolio of products. So just as a point of clarification, this has been a very healthy segment. It’s been thus far a very successful acquisition and we are very, very pleased with Michael Marchetti and his entire team and their leadership.

Looking forward, we’ve stated that we expect 20% to 25% market growth for the mobile segment and we’ll report on our progress.

Operator

From Janco Partners we’ll hear from Mike Hickey.

Mike Hickey - Janco Partners

Thanks for taking my call. John, welcome back. I think you hit at the end there a little bit of your vision for the firm moving forward, and certainly we’ve heard the word acceleration before, but can you give us a little bit more granularity on where you think you could have the greatest impact near-term and perhaps longer term?

John S. Riccitiello

That’s a pretty broad question, Mike. I’ll do my best to come back to you on that. I think probably the most important thing right now is getting the company increasing its accountability, agility, speed to market, the second point that I was making in my last comment.

What I’m speaking to there is just moving faster in the marketplace to drive segment share. We’ve had some issues with predictability on our titles, a little bit that we’re focused on to bring up the quality. It’s not always met our objectives.

So harder driving on the front that you’d expect us to -- driving segment share.

Operator

With Pacific Crest, we’ll hear from Evan Wilson.

Evan Wilson - Pacific Crest

Thanks for giving us a little bit of detail on what exactly you expect from each of the elements of operating expenses, but I remember on the last call you guys talking about significant operating margin leverage. Don’t see that in these numbers, wondering what you’ve seen change over the last three months. Thanks.

Warren C. Jenson

What I would tell you is that we -- clearly fiscal ’07, we talked about making it being a year of investment, and it was. What I can tell you of what has happened over the past three months is we’ve gone through our budgeting process. We’ve also set financial goals, which are consistent with where the operating plan has come out. We’ve tried to take a realistic assessment of our SKU plan and make sure that we’ve got the right titles in the right quarters and that we can ship them, and we built an operating plan. And it’s on the basis of that operating plan that both our revenues and expenses are built, and that’s what we intend to deliver.

Operator

Next we’ll hear from John McPeake with Prudential Equity Group.

John McPeake - Prudential Equity Group

Thank you for taking my question. It sounds like, based on your guidance, you’re expecting to begin to win back share in fiscal year ’08. There are some important launches in the calendar fourth quarter -- Halo 3 and Grand Theft Auto. I’m just trying to get a sense as to your confidence in your ability to start to win back share, and then I just have a quick follow-up.

Frank D. Gibeau

Sure. That is our -- absolutely our key challenge. I think if you look at the way that our SKU plan is set up, you are really going to start to see that share win-back occur with the launch of Harry Potter at the end of June. Our portfolio from that point forward is pretty strong. It’s across all genres and all platforms, and it’s broader than just our sports business, which has traditionally been our strength.

Just to mention some of the sports titles, once Harry Potter releases, you are quickly going to get a rolling effect with NCAA Football, John Madden Football. You are going to have NBA Live. You are going to have FIFA, and then we are also going to have an NFL Street product coming for the fall, so you are going to have a very broad and stronger base of sports titles that we believe will benefit from a growing market.

Secondly, you are going to see some big entertainment launches. It starts with Harry Potter in June, but coming back in the fall with Simpsons, that’s a title that we’re very bullish on. We think we’ve got a unique twist in the positioning and the way that we’ve built that game, and it is the year of The Simpsons, with the film and a major DVD release. We believe that that’s going to be a major media event for us.

If you move into the place where we have wholly-owned IP, it’s a tremendous lineup year over year. You’ve got another Need for Speed title coming as one of the key tent-poles, but stepping out from that you have a tremendous lineup of Sims titles, our EAP business is bringing things like Mercenaries 2, Hellgate, Crysis, we’ve got titles in the action sports category with Skate. Medal of Honor in the shooting category, Army of 2. And then we have a very large bet this fall with a title that we’re working with MTV and Harmonix on called Rock Band that we’re extremely excited about.

So our goal is absolutely to be the biggest this fall, and it starts in late June and it’s a rolling set of titles that just hit hard.

Operator

Moving on, next we’ll hear from Colin Sebastian of Lazard Capital Markets.

Colin Sebastian - Lazard Capital Markets

Good afternoon. Thanks for taking my question. I guess two parts; first, in terms of your growth assumptions for the year, in terms of guidance as well as the industry outlook, I was hoping you could talk about your assumptions for pricing on both the new hardware platforms as well as on software.

Secondly, I realize that Spore may not make it into the year, so I was curious if you could expand a little bit on the progress of that title. Thank you.

John S. Riccitiello

Sure. First off, in the last month, I’ve had the opportunity to visit with all the major first party, Microsoft, Sony and Nintendo. To be honest with you, while we are in the position to know more about this than we could talk about today, it is not our view of our role in the world to pre-announce their plans for the fall. We remain confident though that in our prognostication of 13% to 18% growth across the business.

We also believe that there are three strong valid platforms that will survive and prosper through this cycle, and we are going to support all of them and take the lead on each of these platforms.

I’m not going to give you more granular than that because frankly to do so would be getting ahead of the announcements that each of the major platform owners need to bring to you.

Beyond that, Spore; Spore right now is a title that we’ve got enormous confidence in. I’ve had the chance to review the title three times in my short return to EA and it looks fantastic.

I will also tell you that it’s right on the bubble in Q4, if not some time in early fiscal ’09, so we don’t feel comfortable in forecasting it. Our focus is quality over speed to make sure that we build a franchise that feels more like The Sims than a franchise that we ship once and hope to sequel at some point in the future.

Operator

Next we’ll hear from Justin Post with Merrill Lynch.

Justin Post - Merrill Lynch

Thank you. John or Warren, you might want to answer this, but when you go back to ’04, you had $511 million in R&D, and in 2007, excluding the stock comp, we’re about 965, so it’s almost doubled and revenues are up around 5%. Is there a way to, and I know if you benchmark it against some of your competitors as far as publishing revenue to R&D adjusting for their capitalization, it looks like you’re spending quite a bit. Is there a way to reign that in? How do you expect the R&D spend to affect your peak margins when we look out a couple of years from now?

John S. Riccitiello

I’ll give you a couple of broad thoughts to start. One is you are comparing peak of the last cycle to trough of this cycle, so you invariably get compression, meaning you get less return on your investment. I am very pleased that Larry led the team to make strong investments in new intellectual property, strong investments in new technology to lead on the new platforms, strong investment in the past year to get us in a better position on Nintendo and Wii, which we had initially under-forecast by a bit, so it put us in a great position. Those are investments that don’t pay out in the year that you make them -- those are investments that are going to pay out beginning in ’08, moving into ’09 and fiscal ‘10.

You’ve accurately pointed out that we’ve nearly doubled R&D while revenue has been relatively flat in that timeframe. That is exactly what happens as you move from peak through to transition. These investments need to pay out as we come through the cycle in the coming months, or coming years, excuse me.

One other observation; having visited with most but not quite all of EA Studios, I do see an opportunity both to generate more revenue from our portfolio and to be strong on the cost management side to make sure we realize what we ought to realize as we move through the cycle.

Warren, do you want to add anything to that?

Warren C. Jenson

No, I think at the end of the day, we understand the issue, Justin, and the nature of it is that we, over the course of the coming years, need and want to get more out of every dollar of expense we have on our income statement.

Operator

Next we’ll hear from Shawn Milne from Oppenheimer.

Shawn Milne - Oppenheimer & Co.

Thank you, and good afternoon. I’m trying to again reconcile the expectations for a little bit more to drop to the bottom line next year or this fiscal year. The marketing costs were also up in the current quarter. Has there been any change in how aggressive you want to be on the marketing front heading into ’08, or is that more a reflection of the title count we saw in the quarter? Thanks.

John S. Riccitiello

Well some of that is going to be the comp issue year over year. Our ad spends are pretty much in line. In a year like that we have upcoming, it is a big competitive year. We are very confident in the power of our brands and how the marketing spend will be deployed. We don’t expect to see anything unusual with regard to the percent that we spend on marketing versus titles.

Warren C. Jenson

I would say that if you cut through the ins and outs of that, Shawn, we had $5 million of higher marketing spend directly on our products, some hired contracted services supporting our products in Europe. About $4 million of that was stock-based comp and roughly $4 million was higher headcount related costs.

Operator

Next we’ll hear from Tony Gikas from Piper Jaffray.

Tony Gikas - Piper Jaffray

Thanks, guys and John, welcome back. Looking forward to working with you again. Real quickly, relative to industry growth during the next cycle, do you guys have a goal in terms of EA growth relative to the industry? In terms of a potential share repurchase, or let’s address the cash position, which is now $3.3 billion in cash, a very strong cash flow in the next few years here. Any comment on what to do with excess cash at this point?

John S. Riccitiello

Warren’s going to pick up on share repurchase and I’ll come back on the share targets.

Warren C. Jenson

Tony, I would say, and this question, as you know, has come up several times, that I think our -- and in the meetings we’ve had together as a management team and with the Board and with John, is our first and primary objective is going to be to grow this business and to drive shareholder value.

As we move into the cycle and as we continue and build upon our cash position and build our cash flow generation capability, I certainly can’t speak for the Board but I know the Board is wide open to any and all alternatives that will help to drive shareholder value, and on an ongoing basis will consider all alternatives, including acquisitions, including partnerships, including investing in new business, but also including things like a share repurchase and/or dividend.

John S. Riccitiello

Turning to your question regarding market share, first off I’d tell you that we generally do not give out multi-year forecast on market share, revenue or margin. Frankly, it is a little bit early for me to be providing those in any case, even if we were to have them.

I will point out two broad thoughts here that are very important. One is share growth is in the DNA at EA. It is what we’re after. It’s what we intend to do. As I mentioned before, we are blessed with an incredible talent pool, the best intellectual property in the industry and the strongest studios. It is our job to harness those assets to drive growth.

Secondly, I mentioned that there is going to be some work done to realign our organization to help us get to increased accountability, agility and speed. Frankly, we think that’s the perfect combination -- drive for speed with these assets and the goal will be market share growth.

Operator

Next we’ll hear from Jeetil Patel with Deutsche Bank Securities.

Jeetil Patel - Deutsche Bank

Thank you. Can you -- it looks like your European growth on a constant currency basis has been generally flat over the last couple of years, three years. Can you talk about what you think the European market grows? I know you’ve bracketed 13 to 18, but can you give us a sense of what the growth rate looks like, and then the contribution from an FX standpoint?

Second, can you just give us a sense of the partner revenue contribution for fiscal ’08 in your assumptions? Thanks.

Warren C. Jenson

Jeetil, I would put the revenue growth for Europe in the 13% to 18% range. I don’t think it falls outside of that range. I can’t argue with the fact that revenues over the past couple, three years have been flat. That just is a fact and I think it’s pretty well recorded in our financial statement.

FX as I mentioned was $22 million for the quarter. For the full year, it was $53 million, and partner revenue, at least to this point, is pretty insignificant. Our biggest partner that at least comes to mind most recently is what we’re doing with Neowiz in terms of FIFA Online in Korea and then on into Japan. Right now, that is just not a material part of our international revenue streams.

John S. Riccitiello

Just to add a little bit to that, one is complexity and one is just a broader definition of partner.

On the broader definition of partner, nearly all of our EA partners business does in fact go out into Europe, so titles like Rock Band and Mercenaries and Hellgate that you heard Frank speak to earlier are generally worldwide deals, so those will also fall through to Europe and generate revenue.

Secondly, for those of you who write analyst reports, all of you reported back that Europe is a much more complex market than it’s ever been before. One of the things I’d point out as we grow our business in Europe is frankly the diversity from market to market. Eastern Europe still being very much a PS2 market, the U.K. standing alone in terms of how Microsoft and Sony are performing and continental Europe being different, with the exception there of Germany, which remains a strong PC market.

So one of our challenges in Europe is frankly the nature of it being a bit of a patch quilt, different strategies really by market.

Operator

Next we’ll hear from Heath Terry with Credit Suisse.

Heath Terry - Credit Suisse

Thank you. Warren, just making sure that we understand the guidance on the expense line the right way. On the last call, I seem to recall you saying that R&D costs would be up in the mid single digits this fiscal year. It sounds like from your guidance today that that’s actually going to be higher. Is that a function of the acceleration that John’s talking about? And if so, is that from putting more products into development or is it from the cost of the current products in development being higher?

Also John, if you could talk to the balance that you want the company to have between license and newly created intellectual property and how you see that rebalancing that was started at the company a couple of years ago progressing.

Warren C. Jenson

Let me try to answer that question. I was just trying to recall my exact words in the last conference call. As I recall, I talked about single digit growth for R&D, and this is really a clarification on, to allow you to be more specific. So I don’t think our view has actually moved from three months ago.

What I did say on the call, and it holds true again, is that we talked about spending in our core studios being less than 5% and that is in fact the case, and that has not changed.

So net net is I think this is pretty consistent with where we were three months ago -- core studio growth under 5%, the bulk of the growth in spending is coming in various online investment on the R&D line.

John S. Riccitiello

Back on your question regarding license versus owned intellectual property, you mentioned newly created properties. I would like to come back and give you a broad answer. In the past, we’ve talked about getting to as much as 50% of our business being owned intellectual properties. Frankly, I’ve never seen a stronger portfolio of new property starts at EA in its history, whether it’s Army of Two or Boogie or what we’ve got going on with Spore -- unbelievable portfolio of new property.

We’re also building on the strength of our existing fully-owned properties, like Medal of Honor, importantly The Sims -- these are great contributors to our business, so in general I’d say that if you go back five or six years, EA was probably over-tilted to licensed property. We saw the writing on the wall in terms of the cost of licensed properties rising. Larry and the team redirected resources to owned intellectual property. That has paid dividends and there is big investment made in the last 12 months to further enhance that strategy with the list Warren and Frank have mentioned on the call so far.

Operator

Next we’ll hear from Michael Savner with Banc of America.

Michael Savner - Banc of America

Good afternoon. Thanks. Sorry if I’ve missed this, but have you given a firm release date for The Simpsons game? Is that going to coincide with the theatrical release in August, and if not, what would be the strategy or was it just not planned to not have them coincide?

Frank D. Gibeau

The title is planned to launch in the fall. It will be near the DVD release in the late Christmas timeframe. When we originally did the deal, it was never the intention to make the movie date due to the timing.

Operator

Next we’ll hear from Benjamin Schachter from UBS Securities.

Benjamin Schachter - UBS

John, welcome back. Given your time over on the private side, I was wondering how that has changed your view on looking at acquisitions and how you might bring that over to EA, and if you could address that maybe by geographic area in the U.S., Europe and Asia. Thanks.

John S. Riccitiello

First, I could probably point out that EA did more acquisitions in the last 12 months than I did on the private side, with six separate transactions, so this has been an inquisitive group.

In terms of broad new perspectives, we have clearly made an investment with Neowiz in Korea. We have a strong interest in growing our platform in Asia, Europe and in the North American marketplace, so we really don’t differentiate further in terms of wanting to get to any particular geography.

I would suggest that our priorities on the M&A side first would be growing the strength of our intellectual property portfolio, the breadth and depth of our property list. We’d like to grow that.

We are always looking to expand talent where talent can be found. That is the, if you will, the shortest commodity in our industry. We are trying to build on EA Mobile. Now, our mobile business through JAMDAT is doing a great job of building internationally, but in particular we are interested in further international throughout, and of course we are expanding our online presence.

So by and large, we are looking at M&A as a strategic way to enhance the same list of priorities this company’s articulated in recent calls, whether it’s next-gen platforms, online and wireless in Asia.

Operator

Next we’ll hear from David Joseph with Morgan Stanley.

David Joseph - Morgan Stanley

I just have a minor question at this point. Warren, it seems like your expectations for deferred revenue in fiscal ’08 went up since last call, and it sounds like you’ve gone through a budgeting process, but I’m wondering if there’s anything else there that might have increased that number.

Warren C. Jenson

No, the range is roughly $400 million to $450 million, so it’s modified to $500 million, so yes, it is a range and honestly, we’re just trying to be a little bit conservative with that range, hopefully. The reality is this is our first year through it, as it’s your first year through it, and slight movements in ship dates can make a big difference. So we felt like it was probably pretty smart on the GAAP side in putting a relatively sizable spread on that, David.

Operator

Next we’ll hear from Dean Gianoukos with J.P. Morgan.

Dean Gianoukos - J.P. Morgan

Can you just touch on specifics as to what you are going to do to improve game quality? It seems like game quality at EA has deteriorated over the past few years. Is there anything you are planning to get quality up and bring a better slate of games to the market? Thanks.

John S. Riccitiello

First off, I would tell you that, sort of just a fact pattern for you, if you take a look at all of the major publishers -- Microsoft, Sony, Nintendo, in addition to our more direct competitors on the third party side, you’ll see that pretty much all of them have seen slight reductions on their meta-critic scores on average over the last three to four years if they’ve tackled next-gen consoles. EA frankly does not stand out from the crowd as having missed more than others have.

That’s not a good answer for where we want to go. I have been trying to be somewhat generic in addressing the need for increased accountability, agility, speed to market and that we want to align our team to tackle that opportunity. I’m frankly not in a position today to try to expand on that in great detail, but I think there’s a number of things we can do. Expect some changes at EA. Expect the change to be both in how we align ourselves organizationally and then the focus that we intend to get in terms of cost leverage as we build our business through the balance of the cycle.

We’ve got to climb both a revenue curve and a relative ratio of expense to top line to drive the business to where we want to drive the business. So if you want to understand what our agenda is -- driving our organization for more accountability, driving our business for top line, driving our bottom line for margin. That’s what we’re focused over the next few years.

Operator

Our final question comes from Edward Williams with BMO.

Edward Williams - BMO Capital Markets

Good afternoon, guys. A couple of quick questions for you. As you look, John, to the midpoint of the next platform cycle, how do you see the geographic revenue mix as well as the new revenue streams, the digital downloads, the mobile phone and such? How significant do you think they’ll be to the total revenue from the company?

John S. Riccitiello

We may end up splitting that question up a little bit. First off, one of the things that I think in general we try not to do is be precise about fiscal ’10 and fiscal ’11. I think it’s very difficult to do that. So understand EA’s strategy -- it’s not frankly hugely important to us what the relative market shares are between one console and the other. Our intent is to lead on all of them.

It is not necessarily critical to us if online grows a little bit faster than wireless or vice versa. Our intent is to lead them. We have the best portfolio of assets. In fact, I believe we are the only major publisher with strengths in wireless, online, all three major consoles, PC, micro-transaction models, online subscription models and the handheld.

So we’ve got that breadth so we can make sure that we generate the revenue regardless of how the market develops.

In terms of broad prognostication, we think it’s a pretty safe bet that the biggest business over the course of the next three years is still the console business, with an increasing share driven to new revenue models, in particular in Asia. What we are most pleased by there is we have learned in the last 12 to 15 months that our intellectual property is strong in Asia. SimCity rising to the top of the charts in Japan, and we’ve got the platform right, the NDS. FIFA rising to the top of the charts in Korea, and we’ve got the right business model and the delivery mechanism right.

So what we want to do is push EA’s intellectual property to the right business model, the right platform at the right margin structure, and that’s what we’re focused on.

Warren C. Jenson

Any final questions, Operator?

Operator

There are no further questions.

Warren C. Jenson

Great. Thanks everyone, for joining us.

Operator

Ladies and gentlemen, that does conclude today’s presentation. We do thank everyone for their participation and have a wonderful day.

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Source: Electronic Arts F4Q07 (Qtr End 3/31/07) Earnings Call Transcript
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