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Activision Inc. (ATVI)

F1Q08 Earnings Call

August 2, 2007 4:30 pm ET

Executives

Kristin Southey - Vice President, Investor Relations

Bobby Kotick - Chairman and CEO

Thomas Tippl - CFO

Mike Griffith - President and CEO of Activision Publishing.

Analysts

Ralph Schackart - William Blair

Heath Terry - Credit Suisse

Michael Savner - Banc of America

Ben Schachter - UBS

Colin Sebastian - Lazard Capital Markets

Justin Post - Merrill Lynch

John Taylor - Arcadia Investment Corporation

Shawn Milne – Oppenheimer

Arvind Bhatia - Sterne Agee

Edward Williams - BMO Capital Markets

Presentation

Operator

Good day everyone, and welcome to this Activision first quarter fiscal 2008 financial results conference call. Today's call is being recorded. At this time for opening remarks and introductions, I'd like to turn today's call over to Vice President of Investor Relations, Kristin Southey. Please go ahead, Kristin.

Kristin Southey

Good afternoon and thank you for joining us today for Activision's Q1 fiscal '08 conference call. As always, I will start today's call with a review of our Safe Harbor disclosure, followed by comments from Bobby Kotick, Chairman and CEO; Thomas Tippl, Chief Financial Officer; and Mike Griffith, President and CEO of Activision Publishing.

With regard to our Safe Harbor disclosure, I would like to remind everyone that statements will be made during this call are not historical facts and are forward-looking statements. These forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties. We caution that a number of important factors could cause Activision's actual future results and other future circumstances to differ materially from those expressed in any such forward-looking statements.

Such factors include, without limitation, sales of our titles, shifts in consumer spending trends, the seasonal and cyclical nature of the interactive game market, our ability to predict consumer preferences among competing hardware platforms including next-generation hardware, declines in software pricing, product returns and price protection, product delays, retail acceptance of our products, adoption rate and availability of new hardware and related software, industry competition, rapid changes in the technology and industry standards, protection of proprietary rights, maintenance of relationships with key personnel, customers, vendors and third-party developers; international economic and political conditions, natural disasters, integration of recently acquired subsidiaries, and identification of suitable future acquisition opportunities’ limitations on our ability to issue stock and options, and foreign exchange rates; other factors include the further implementation, acceptance and effectiveness of the remedial measures recommended or adopted by the special subcommittee of independent directors established in July ’06 to review our historical stock option granting practices, the board and Activision. The outcome of the SEC’s formal investigation and the derivative litigation filed in July ’06 against certain of our current and former directors and officers relating to Activision’s stock option granting practices; and the possibility that additional claims and proceedings will be commenced, and other non-option-related litigation.

These important factors and other factors that potentially could affect the Activision’s financial results are described in our filings with the SEC, including the company’s most recent 10-K, and the cautionary statements therein and the exhibits thereto.

Activision may change its intentions, belief or expectation at any time and without notice based upon any changes in such factors in the company’s assumptions or otherwise. We undertakes no obligation to release publicly any revisions to any forward-looking statements to reflect events, circumstances or other changes after the date hereof or to reflect the occurrence of unanticipated events.

I would also like to highlight that certain financial commentary in this call will be made excluding the impact of equity-based compensation, therefore certain financial measures discussed in this call will not be in accordance with GAAP. Please refer to our earnings release for a full reconciliation of these non-GAAP financial measures to GAAP measures.

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

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Bobby Kotick

Thank you, Kristin. Today we are pleased to share with you our record results for the first quarter, and our increased financial outlook for the fiscal year. For the quarter, we substantially exceeded our net revenue and earnings outlook due to the strong sales of our proven franchises Guitar Hero, Spider-Man 3 and Shrek the Third and our newest intellectual property, Transformers.

Our company-wide focus on growth and operating margin expansion translated into the highest non-holiday quarterly revenues and earnings in our history. For the trailing 12 months, revenues have already exceeded $1.8 billion. For the first time, we ended the quarter and the first half of the calendar year as the #1 U.S. third-party publisher. For the quarter, we had the #1 and #3 top selling titles in the marketplace: Guitar Hero 2 and Spider-Man 3.

We also significantly strengthened our platform leadership. For the quarter, we were the #1 U.S. publisher overall on the two largest platforms, the PS2 and the X-Box 360; in addition, we were the #1 third-party publisher on the PS3 and Nintendo platforms. We also made excellent progress against two of our key strategic goals: growing our handheld and international presence.

In the U.S., we were the #1, third party handheld publisher for MTV and overall, we grew worldwide handheld revenues 113% year over year. Internationally, we continue to expand and strengthen our global presence and competitive position. For the quarter, international publishing revenues grew more than 240%, driven by better execution in our largest markets. Both of our new releases, Shrek the Third and Guitar Hero 2 captured top spots in the European markets, and for the quarter, Spider-Man 3 was the #1 best-selling title in the UK, Germany and France.

Our performance clearly illustrates how Activision is expanding its global scale and competitive advantage. Our increasing scale provides cost leverage across all facets of our business and we are beginning to see the benefits of this leverage reflected in our operating results. We continue to deliver against all of our stated financial objectives. A strong cash position, almost $1 billion, gives us the ability to make strategic investments that will expand our IP portfolio, extend our next generation development leadership and strengthen our global marketing and distribution footprint.

Today, we have more opportunities to grow our franchises and increase our revenue and profitability than ever before. We are also seeing new consumers increasingly interested in gaming. These are consumers like females and older audiences and audiences in new geographies. The new physical interfaces used in Guitar Hero on the Wii as well as the innovative use of new technologies like Wi-Fi and touch screen on the handhelds continue to expand our markets.

The processing power contained in the PS3 and the 360 are enabling new features like realistic facial animation, that allows for spoken words that in the past would not be possible at an acceptable quality level. These changes, along with more people playing video games over the Internet, whether casual or core, are making video gaming a more desirable leisure time activity. We see this trend continuing.

While growth in the next few years will come from our continued focus on our core package goods business, new opportunities are emerging in areas like in game advertising, downloadable content and online gaming. These opportunities will contribute to our long-term margin expansion goals. We remain focused on shareholder value creation as we have for the past 17 years. Our first quarter results and our updated fiscal 08 outlook demonstrates the investments we have made in intellectual property, development resources and human capital as well as our focus on operating margins are providing superior financial results for our stakeholders.

Later in the call, Mike will share some more details of our plans for the remainder of the fiscal year, but now Thomas will provide a review of our operations for the quarter and our updated outlook for the year.

Thomas Tippl

Thank you, Bobby and good afternoon. I will start today with a review of our first quarter financial performance as well as our increased guidance for the fiscal year. For the June quarter, net revenues were $495 million, $70 million higher than our prior outlook, and up $307 million versus the prior year. As Bobby mentioned, our record performance was fueled by strong sales of our proven franchises Guitar Hero 2, Spider-Man 3 and Shrek the Third as well as our new intellectual property, Transformers.

Before I continue with our financial review, I would like to note that certain numbers that I will be giving you, including operating income, earnings per share, program creation costs, sales and marketing spending and G&A spending will be made excluding the impact of expenses relating to equity-based compensation and are not in accordance with GAAP. Please refer to our earnings release for a full reconciliation.

For the June quarter, we delivered earnings per share of $0.11. This is higher than anticipated and a significant improvement versus the prior year loss of $0.05. The main drivers were unparalleled performance and operating leverage. We shipped more than 4 million U.S. and worldwide of Spider-Man 3; 2 million of Shrek the Third and more than 1 million units of Guitar Hero 2 on the X-Box 360. Additionally, in the last few days of the quarter, we shipped more than 1 million units of Transformers to U.S. retail for the July Fourth movie release.

In the June quarter, manufacturing and distribution expense was 44% of net revenues versus 58% in the prior year, due to improved product mix. As previewed at our recent analyst day, the disproportionate growth of our publishing business as the consumer shifts to higher priced, next generation product is generating significant gross margin expansion.

Product creation costs for the quarter were 28% of revenues, in line with the prior year. We define product creation costs as the sum of costs of sales, software royalty amortization, cost of sales, intellectual property licenses, and prior development expense.

Sales and marketing expense for the quarter was 14% of net revenues. This compares favorably to our prior outlook and last year’s first quarter sales and marketing expense of 19%. We continue to see improvement in this area as we closely monitor our programs and utilize more efficient spending vehicles like the Internet to reach our consumers.

G&A as a percentage of revenue was 7% compared to 10% last year. As expected, we are making progress versus the prior year; however, the 7% still reflects the impact from legal and professional fees related to the stock option review as well as intangible amortization related to the Red Octane acquisition. For the quarter, we generated high investment income due to higher cash balances and rising interest rates and our effective tax rate was 33%.

Now turning to the balance sheet. On June 30 we had $964 million in cash and short-term investments, an increase of $171 million versus the prior year. The accounts receivable balance was $198 million, up $49 million versus the prior quarter due to higher [ratings] in the quarter. Inventories were $93 million, in line with the prior quarter. On June 30, inventory for the publishing business was $70 million and $23 million for the distribution business. We expect our inventory balance at the end of Q2 to be substantially higher as we prepare for the first multi-platform launch of [Spider-Man 3] for which we already have significant and firm customer orders on hand.

Capitalized software development costs were $107 million, an increase of $17 million over the last quarter, due mainly to the [acquisition of Q1 radius]. Capitalized intellectual property costs were $82 million, down $18 million versus the prior quarter, also due to the [acquisition of Q1 radius].

In summary, fiscal 08 is off to a terrific start. Our slate is strong and balanced, and we have made good progress in the recent supply imbalance for our Guitar Hero franchise. We finished the quarter ahead of the revenue and earnings outlook we had previously provided, and based on our strong performance and confidence in the slate for the remainder of the year, we are raising our fiscal ’08 outlook.

Activision remains committed to operational excellence and cost optimization, and we continue to execute against our stated financial goals. Before getting into the specifics of our financial outlook, I would like to begin by saying that our outlook presents our views as of today and there are a number of internal and external factors that could cause our actual results to differ materially. I refer you to our financial filings with the SEC for a full review of our risk factors.

Now on to the second quarter outlook. To date, we have already begun shipping Transformers internationally on multiple platforms. Guitar Hero 4 for the PS2. We also plan to release Enemy Territory on the PC in the last week of Q2 or early Q3, but as you know, ID Software makes the final decision on the release date.

As for our financial outlook, on our last call we said Q2 revenue earnings would be higher than the prior year but that we were still expecting a loss in the quarter. For Q2, we are expecting net revenues of approximately $250 million. Including FAS 123 R which relates to the expensing of stock options and other share-based compensation, we expect a loss per share of approximately $0.04. The company’s loss per share outlook, excluding the impact of FAS 123 R, is approximately $0.03.

For the quarter, we expect manufacturing and distribution costs of approximately 50% of net revenues. We expect operating expenses including royalties and the impact of FAS 123 R of approximately 61%. A tax rate of 34%, that can be used throughout the fiscal year and the basic share count of about 286 million.

For the quarter, excluding the impact of FAS 123 R, we expect operating expenses, including royalties, of about 59%. All other line items are the same as I mentioned a moment ago.

As for our outlook for the full year, we’re increasing our revenue outlook and today we expect fiscal ‘08 net revenue of $1.87 billion. We expect operating income, excluding FAS 123 R, will reach almost $250 million, more than doubling year over year.

Operating margin is expected to reach a new all time high exceeding 13%. Fiscal ‘08 EPS, including 123 R, are expected to be $0.51. The company’s EPS outlook excluding the impact of FAS 123 R is approximately $0.61.

For the fiscal year, we expect manufacturing and distribution costs of approximately 44% of net revenues. We expect operating expenses including royalties and the impact of FAS 123 R of approximately 45%, and a diluted share count of about 315 million.

For the fiscal year, excluding the impact of FAS 123 R, we expect operating expenses including royalties of approximately 43%. This is higher than the prior year as we highlighted on our last call, due to increased publishing business mix, higher costs associated with our large and growing slate, and our anticipation of the more competitive environment.

Here are the details for P&L line items. Starting with sales and marketing expense, we expect it will be up versus the prior year due to the factors I just highlighted. However, we believe it will fall within the range of 13% to 15%, which is better than our previous outlook due to better than expected sales and marketing efficiencies during the first quarter.

As for product creation costs, we expect it will be up versus the prior year due to the larger slate of next gen products and an increase in licensed properties. In our publishing business, if you exclude the cost of licensing, our projected product development costs as a percentage of revenue continues to improve year over year.

Looking ahead, you should see even better realization against our product creation expense as we continue to ramp the next gen learning curve and increase the amount of game development that is being outsourced and/or offshored to lower-cost locations.

Finally, with respect to G&A expense, we expect to see a meaningful improvement year over year and believe the line will come in as we have said, around the top end of our 4% to 6% target range.

In summary, we expect fiscal 2008 will be the largest and most profitable year in Activision’s history. Our record first quarter performance and the way our holiday slate is shaping up has improved our visibility for the full year, and today we are increasing our operating margin outlook by 130 basis points, to an all-time high of 13.3%.

Our substantial increase in operating income will mark another significant step forward towards achieving our peak operating margin target of 15% to 18% .

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

Mike Griffith

Thank you, Thomas. Today my comments are focused on two areas: where we see the hardware and software markets for the year ahead, and how we’re looking at the balance of fiscal 2008 and beyond. Overall, industry fundamentals are very strong and continue to improve. On June 30th, the installed base of hardware in North America for current and next generation systems, including handheld, was approximately 131 million units. The very large installed base of the PS2, combined with the growing installed base for all three of the next-gen systems, bodes well for our performance this year. We believe growth will also be fueled by continued strength in handheld platforms and eventually lower price current gen hardware.

With respect to the hardware market as of today, we expect the following increases in North America during the calendar year. We’re estimating PS2 will be up 4 million to 5 million units, and we’re anticipating 3 million PS3 units. We expect Xbox 360 growth of 4 million to 5 million units. We also expect about 5 million plus units from the Wii and finally expect handhelds will grow approximately 12 million to 13 million units.

Moving to software, as you know, we define our market to include all major platforms in North America and Europe. For calendar 2007, we expect the combined North American and European software markets for current and next-gen consoles, handheld and PC, to grow approximately 12% to 15%, driven in part by a strong installed base of hardware.

With respect to software pricing, to date we continue to be pleased by the consumer and retail acceptance of the higher next gen pricing. We expect that traditional software launch pricing for the Xbox 360 and PS3 will hold at $59.99 and for the Wii at $49.99. Of course, pricing decisions for front line current gen console titles will be made on a title by title basis, based on quality and other factors. As always, we’ll be monitoring pricing conditions very closely and remain mindful of competitive practices.

Turning now to our fiscal 2008, our record Q1 performance was driven by a broad slate and strong commercial execution, both in the U.S. and Europe. We’re pleased with our success in driving the top line while continuing our margin expansion agenda. Our focus on consumer marketing, retail sales category management, and in-store execution focused against our largest market and our largest customers is paying off, and will continue to be a key focus for the company.

For the second quarter, we’ll continue to support the multiplatform launch of Transformers worldwide. Transformers had a very strong launch in the U.S. coming in as the number 3 product overall in June for NDD. The European launch is now underway. In the UK, Transformers recently debuted as the number one title on all formats. This title should also get another boost in the holiday with the DVD launch.

In addition, we’ll continue to roll out our Shrek launch internationally as the movie opens in new countries. We recently launched Guitar Hero Encore, Rock the 80s for the PS2. This SKU had the highest first day sell through in Activision history, demonstrating continued strong growth potential for this franchise.

Finally, we’re planning to ship Enemy Territory Quake Wars for the PC in the last week of Q2 or early Q3. This title was nominated as best action game and best PC game by the E3 game critics.

Looking at Q3, we’ll come to market with an exceptionally strong line-up in a market that’s poised to reward big titles. We’ll start by leveraging the theatrical promotions surrounding the DVD releases of our movie-based titles, Spider-Man 3, Shrek the Third and Transformers, as these titles take advantage of renewed marketing support, a larger installed base and stronger seasonality.

In addition, our holiday line up will be anchored by a high quality slate based on the most successful franchises in our company’s history, including Tony Hawk, Call of Duty and Guitar Hero, all of which were nominated for the Best of E3 Awards and will launch before Thanksgiving.

Last year, we grew the Tony Hawk franchise and we’re particularly excited about Tony Hawk’s Proving Ground, this year’s new title which is getting strong feedback and will launch across multiple platforms this fall. This year, we’re allocating a portion of our marketing spend on the Tony Hawk brand towards interactive demos on the 360 and PS3 ahead of the game’s launch.

We consistently see in our testing that trial is one of the key drivers of purchase intent for this title, and offering consumers a compelling demo will highlight the competitive advantage we’ve built on this franchise over the last nine years.

Next, we’ll look to further capitalize on the success of the Call of Duty franchise, with Call of Duty 4, Modern Warfare. The Call of Duty franchise was our largest seller in fiscal 2007, and this title marks the fifth consecutive annual release. The game is designed to take true advantage of the next gen technology and will release on the Xbox 360, PS3 and the PC. Consumer interest is very high for this title and pre orders are up significantly versus the prior year. The title will also come with a variety of downloadable content. Many of you got to see this title firsthand at E3 and the incredible leap forward it represents for the franchise. Not surprisingly, it was named by the E3 game critic as the best action game ahead of other high profile games.

Third, we’ll continue to broaden our leadership in the super hero category, with the release of our new Marvel title, Spider-Man, Friend or Foe which is targeted at the younger demographic, and perfect for the holiday season. This title will benefit from the momentum and advertising spent created by the theatrical release and DVD launch of Spider-Man 3 and provide a nice differentiated complement to our Spider-Man 3 game.

Next in terms of new intellectual property, we’ll release Bee Movie, our next DreamWorks movie-based title which will coincide with the holiday theatrical release starring Jerry Seinfeld. Also launching worldwide this holiday will be Guitar Hero 3, Legends of Rock across multiple platforms. Guitar Hero is currently the number one franchise in the U.S. market and to-date has only been released on the PS2 and the Xbox 360.

To put the opportunity in perspective this holiday, Guitar Hero 3 will launch on the PS2, Xbox 360, PS3 and Nintendo Wii which today represents a 50 million unit installed base in the U.S. and nearly 90 million units worldwide. This compares to a potentially competitive product which will launch on the PS3 and the 360 which represents only a 7 million unit installed basis in the U.S. We feel Guitar Hero will continue to build the genre it created.

The strength of this product has resulted in unprecedented interest from our retailers who are already placing their Q3 orders, providing us with increased visibility for the holiday. To ensure we continue our momentum with the consumer, we’ll have over 30,000 in store kiosks worldwide where consumers can play the game. This is more than triple the number of kiosks we had last year.

To support the launch, we have significantly increased our capacity for guitar production and will be ready for the multiplatform and worldwide demand this holiday. In addition, we’ll offer a full selection of internationally relevant music and downloadable content. We also plan to expand the depth and breadth of the franchise through continued emphasis on Guitar Hero I and 2 which will provide additional content for our new Guitar Hero 3 consumers.

Guitar Hero has the right music and right innovative features to continue expanding. Our song list is extensive, featuring bands including Metallica, the Rolling Stones, Red Hot Chili Peppers and Guns and Roses. The game builds on its competitive play strengths by introducing battles for players to challenge legends of rock and roll in side by side play. Finally, the guitar has been innovated and will be wireless across all platforms.

So in summary, our fiscal 2008 line up is the strongest in the company’s history. With our improved visibility on the year, we’re increasing our fiscal 2008 net revenue guidance to $1.87 billion marking our 16th consecutive year of growth. In fiscal 2008, we will more than double operating income and expect record earnings per share in operating margin.

Beyond this, fiscal 2009 already looks robust driven by blockbuster movie games such as James Bond, DreamWorks Kung Fu Panda and Madagascar 2. We’ll also focus on driving Guitar Hero further and continuing to broaden our core franchises like Tony Hawk and Call of Duty, in addition to supporting our leadership position in the super hero category with two new releases.

In fiscal 2009, we see the market continuing to expand at a double-digit rate. We see our portfolio of brands continuing to grow. We see increasing revenues from emerging markets, and lastly, a continued focus on shareholder value creation.

So with that, I’d like to thank you for your time and the opportunity to share our initiatives with you for the future and I’ll now open the call up for your questions. Thank you.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Ralph Schackart - William Blair.

Ralph Schackart - William Blair

Good afternoon. Another great quarter, guys. You alluded to and talked about it on the call in terms of increasing guitar production. Do you think you’re at a very good point in front of the holiday season to be able to anticipate demand? If it is an increased demand than you anticipated then can you gear up production to make sure the product is available in the stores?

Mike Griffith

Well, as you know, there is certainly a lead time associated with the hardware production along with its game. But as I said on the call, we have put a lot of effort against increasing and streamlining our product supply situation for guitars on Guitar Hero. We anticipate that we’re fully ready for the demand. If for some reason, we find ourselves short of supply, I think we’re all going to be extraordinarily happy.

Ralph Schackart - William Blair

Great, one follow up, Mike. Now that GTA Force slipped into calendar ‘08, does that change your market outlook for the installed base of hardware platforms through the balance of the year?

Bobby Kotick

No, Ralph. Because it’s such a new development we haven’t had a chance to really assess what the changes would be. I would say one possibility is that now Call of Duty 4 is likely to be the number one product on the PS3. But I think it’s a little early to figure out just yet how all of that will get reallocated and what that will do to our business in the quarter.

Ralph Schackart - William Blair

Bobby, do you want to give us any insight as to what Guitar Hero looks like on the Wii at this point?

Bobby Kotick

As you know, we’re very, very excited about it. It’s one of those products that takes full advantage of the capabilities of the Wii and we think consumers are going to be especially excited by it as well.

Operator

We’ll take our next question from Heath Terry - Credit Suisse.

Heath Terry - Credit Suisse

To touch on the GTA issue on a little bit of a different angle. We spent probably the last year-and-a-half so far hearing questions about how you would plan around Halo and GTA. Given what we’ve heard today, is it too late for you to be able to make adjustments on the timing of product that might have been moved around to create room in that September/October timeframe, to take advantage of what looks like will be a big gap during the big month of October from a product standpoint?

Mike Griffith

Again, as Bobby said, this is brand new news and we’ve got to digest it. Certainly within a reasonable window of time we have flexibility to adjust our release dates. That’s something we’ll look at. Obviously, we’ve got some big titles coming out. Competitively there’s of course Halo. But Guitar Hero and Call of Duty I think are also going to be huge holiday titles. So in the end, I think we’ll make appropriate adjustments, if we see the need. We’ve got flexibility to do that to a certain extent.

Heath Terry - Credit Suisse

Great.

Bobby Kotick

We’re definitely going to allocate resources and trade marketing and sales to gap filling.

Heath Terry - Credit Suisse

On the Guitar Hero side of things, obviously it seems like we still have a lot of stock out, particularly on the stand-alone guitars for the Xbox system. Do you have a sense for how big the gap is in terms of supply and demand for the hardware on Guitar Hero? Can you quantify for us, when and to what degree you think the increase of production needs to be for you to catch up with where demand is?

Mike Griffith

Well, we think we’ve been chasing the supply since we launched this game. We are now getting to the point where we’re satisfying the consumer demand which will spike up considerably again when we launch Guitar Hero 3 in the fall. As I said earlier, based on the best visibility we have of retailer commitments and they stepped up early with commitments recognizing the lead time of hardware. Based on all of our consumer research, we expect a sizable increase in this business on the year and we think we’ve got it covered on the hardware front.

Operator

We’ll take our next question from Michael Savner - Banc of America.

Michael Savner - Banc of America

I know you planned to answer most of the questions about Grand Theft so I’ll follow up as well – just kidding. Just to dig in a little bit more on Guitar Hero as we look at the fall. Can you give us more color on what you are hearing from the retailers in terms of their ability to physically handle the inventory coming in for guitars and the competitor instruments?

Also, is that kiosk support you have confirmed support or is that still somewhat fluid from now through the holidays? Lastly, will the compatibility of your guitar be compatible with competitor products or will your guitars not work with the Rock Band product.

Mike Griffith

First of all, you raise a very good point on retailer space. This is a big issue, and I think an area that we have a very large advantage for with category management capabilities that we put in place and our focus over time on building our retail selling and merchandising capabilities. So we’re very well positioned to work with retailers. They’re very interested in stocking full quantities across all SKUs on Guitar Hero. It’s obviously in their best interest in doing that. We’ve got 30,000 demo stations lined up, very strong in-store and off-shelf merchandising support lined up with key retailers. So we’re very encouraged by retailer support.

Now that said, I think it does prevent an obstacle for more product to be placed in distribution side by side. I think as long as Guitar Hero does what we think it will do and meets the consumer need and sells well, we’re going to have a major advantage in that area.

Michael Savner - Banc of America

The part about interoperability?

Mike Griffith

Well, I really can’t speak to that. We’re focusing on our guitar and our software and innovating our guitar and hardware, excuse me, hardware and our software together. We think that’s a very important strategic factor. For other pieces of software to work with our guitar, they’re going to have to have some knowledge about how the buttons have been mapped and so forth. So I think it’s really premature for me to be able to comment on what other products might do interacting with our guitar, except to say that as an innovator of the hardware and software together, there’s a major advantage.

Operator

We’ll take our next question from Ben Schachter - UBS.

Ben Schachter - UBS

Congratulations on a nice quarter. Can you help us understand more about Guitar Hero and how it plays internationally. Can you give a break out of what sales are like today and what you think the localization of the music may mean going forward.?

Also on Guitar Hero for the download, is this just going to be a 360 product for this year. Also, how do you feel about the pricing of the 360 downloads? Thanks.

Mike Griffith

On the international side of things, we have a major opportunity on Guitar Hero. It was really launched internationally a year behind US and the development remains that way. We have, for the first time, with Guitar Hero 3, adopted local music content for specific European tastes, which I think was a major initiative that we needed to get after, and we’re very encouraged by that.

But the majority of Guitar Hero sales over the past year have still been skewed toward North America. By achieving the split we have in the balance of our company also on Guitar Hero, there is an enormous upside potential there for us. I’m sorry, I forgot the second part of your question.

Ben Schachter - UBS

Online, will that be only on 360 for Guitar Hero and what do you think about the pricing for Guitar Hero downloads right now?

Mike Griffith

The downloads are primarily a 360 program. We had about almost a 30% attach rate on Guitar Hero 2 and the 360. We’re pricing about $2 a song. We’re selling a three-song pack for approximately $6. So the consumer seems to be responding well to that.

Bobby Kotick

Ben, there is a real focus on broad, a whole host of initiatives to broaden the appeal of Guitar Hero in the international markets. You’ll continue to see us using that as a big advantage against potential competition, really leveraging our international presence.

Operator

Your next question from Colin Sebastian - Lazard Capital Markets.

Colin Sebastian - Lazard Capital Markets

You mentioned pricing for PS2 titles would be made on an individual basis. Can we assume other than maybe Guitar Hero that most of those titles will be $39 or less?

My second question is you mentioned a little bit for the next fiscal year and I know you’re not in a position to provide guidance at this point but can you give us some indication of whether you think you can gain market share again next year?

Mike Griffith

First of all on your PS2 question, there’s no doubt the market is predominantly at $39 now for PlayStation 2 release titles. But based on the quality of games, we make individual pricing decisions and you’re right to point out that our Rock the 80’s Guitar Hero pack just released at $49 and set a record initial sell through for the company. So it shows with the right products, we’ve got the robust pricing opportunities.

For fiscal ‘09, we’re not going to say a lot about it yet on this call. It’s obviously too early but we’re bullish on how the program’s coming together. It’s always our intention to build year-over-year revenue and share.

Colin Sebastian - Lazard Capital Markets

Did you mention the impact of legal and professional fees in the quarter?

Bobby Kotick

No, we haven’t. As expected, the impact is coming down a little bit quarter over quarter. The first quarter was about $4 million in addition the expenses related to the stock option review. Just to preempt another question, the amortization was about $3.5 million.

Operator

Your next question comes from Justin Post - Merrill Lynch.

Justin Post - Merrill Lynch

Could you first comment on how the channel is for Shrek and Spider-Man in the U.S.? How are you feeling about that?

Mike Griffith

We feel comfortable with where we are. If you look at the channel inventory of Spider-Man and Shrek versus their competitors, Shrek 2 and Spider-Man 2, we’re in about the same position relative to the ratio we’ve sold through and expect the future opportunity to hold.

We’ve got the theatrical DVD or the DVD releases for the theatrical films coming in the fall, continued increase in installed base, stronger seasonality, good marketing programs. So we think there’s an awful lot more opportunity on these titles. But we feel comfortable where the inventory is today.

Justin Post - Merrill Lynch

The company has a really strong track record of growth, as you mentioned 16 years. How can you manage maybe your marketing investment this year or your product release calendar to really help your growth given that this year’s off to such a strong start, in next year?

Bobby Kotick

That’s really not how we’re thinking about it. We’re trying to maximize the opportunities that present themselves at the earliest possible time. So we’re going to drive very hard this year and build the business as far as we can, while at the same time we’re planning ahead not just for next year but for the next three years and making sure we can keep our track record of growth going.

Justin Post - Merrill Lynch

When you think about the 250 guidance for next quarter, is Quake in that number? The final question, is Call of Duty ready for the PlayStation 3 in the quarter? Are you really confident in the salability of that game?

Thomas Tippl

We’re very confident in the stage of our slate for the holiday season. So that’s reflected in our guidance and in the fact that we felt comfortable to increase it this early in the fiscal year. With regards to Quake, we don’t expect it to have a material impact on the quarter, whether it’s going to ship in the last week or the first week of Q3.

Operator

Your next question comes from John Taylor - Arcadia Investment Corporation.

John Taylor - Arcadia Investment Corporation

Could you give us a sense of how big you think the Guitar Hero franchise might be, either total revenues or published revenues? Give us a sense of how concentrated revenues will be in that product. And/or how they’re going to be spread throughout the year by quarter, give us maybe some sense of that.

Thomas Tippl

I don’t think we’ll be going into that level of detail from a guidance perspective. But obviously it’s been the number one title in the U.S. and therefore we would expect it from our perspective for the year to be the number one title in the portfolio. Beyond that, we really don’t provide by title guidance.

Mike Griffith

The only other thing I could say on that is it’s a title that has proven to be at least modestly less seasonal than the industry or the balance of our business.

John Taylor - Arcadia Investment Corporation

On Guitar Hero 3, can you give us a sense what you’re assuming in either Q3 or Q4 combined, the mix between domestic and international?

Mike Griffith

Well, as I said, we’re primarily a domestic business last year on Guitar Hero. We’re looking for significant growth internationally. We certainly, over time, fully anticipate that we can get to the same split we see in our other franchises if not even more, given the universal nature of music. But it’s going to take us a little bit of time to get fully split.

John Taylor - Arcadia Investment Corporation

Looking in detail at the sell through on Spider-Man and Shrek by platform, I wonder if you have noticed anything in terms of consumer demand by platform that is likely to influence the mix decision you’re making by platform as you go into the holidays?

Any changes in the mix between the next gen or the older platforms or handhelds?

Mike Griffith

We don’t really look at it that way in terms of where we put support. Obviously the consumer sell through is going to guide reorders and that’s going to guide how we build future quantities of it. We see it strong across all the platforms on which it’s been launched. Continuing to see more robustness than we had originally expected in the PlayStation 2. So to some extent that is factored into our future planning. But we think it’s pretty balanced across all SKUs. We expect to continue to see a ramp up on PlayStation 3 as well.

Bobby Kotick

Even though we can’t give you the forward forecast on the Guitar Hero, but for the quarter, guitar is roughly 30% of the consolidated number.

John Taylor - Arcadia Investment Corporation

Last question, so if you take a title like Call of Duty or Guitar Hero 3 and I wonder if you can contrast what your marketing spend for one or two of your leading titles -- the big, big titles -- is going to be this year versus last year, say the average budget?

Mike Griffith

On the marketing spend?

John Taylor - Arcadia Investment Corporation

Yes.

Mike Griffith

Marketing spend, on a percent of revenue basis is in line across most of our titles. We don’t really break it out on a specific title basis for competitive reasons. But our overall guidance that we provided varies somewhat, but having a good working range.

Operator

We’ll take our next question from Shawn Milne - Oppenheimer.

Shawn Milne - Oppenheimer

I just wanted to follow up on the sales and marketing question. Certainly you seem pretty positive on your outlook for that for the year. What in the quarter seemed to perform better if you can just drill down on that, what marketing programs perform best for you?

Secondly, you gave a Wii number, I believe if I heard it right, the Wii unit number for the U.S. was 5 million. Why so low? Lastly, housekeeping, can you give us a catalog percentage number for the quarter? Thank you.

Bobby Kotick

Let me start with the catalog number, catalog for the first quarter was at 23% of consolidated net revenue.

Mike Griffith

For the Wii number, we said 5 plus million.

Shawn Milne - Oppenheimer

What was most effective on the sales and marketing front?

Mike Griffith

Well, on the sales and marketing front, we have a good balance of activity. We continue to see strong merchandising, effectiveness in stores, particularly with display activity. We see continued encouragement that our online marketing programs are working and driving pre-sales, which have been strong indicators of success.

But, you know, we have a balance of activity across television, print, online and so forth. So we study all those elements pretty carefully and do a lot of post analysis with continuing to make adjustments as we go forward.

Bobby Kotick

One thing we’ve been getting very good at on the trade marketing front is being able to evaluate effectiveness of the trade programs. I think we’ve taken some of those processes now into the international markets where we’re going to do a better job of evaluating effectiveness at trade programming in Europe.

Shawn Milne - Oppenheimer

Thank you. Great quarter.

Operator

We’ll take our next question from Arvind Bhatia - Sterne Agee.

Arvind Bhatia - Sterne Agee

A question on the James Bond franchise. I wonder if you could provide some color on that? Sorry if I missed that, but how big are you planning that particular franchise? Give us some sort of idea of, you know, how big it can be, is it a Call of Duty type number of we’re looking at? If you can refresh us on the number of SKUs in development today in your pipeline?

Mike Griffith

Sure. On Bond, the premise and the reason that we acquired the rights to that intellectual property is we think it’s going to be one of our core franchises. So we expect it to be one of our largest opportunities going forward. The game is under development now. We’re very encouraged by it. Obviously encouraged by what the first movie has done to the franchise. So we think these an awful lot of upside potential and of course time has to play out to see exact here where that’s going to go. But we really think that one’s got a lot of potential for us.

Our SKUs under development, I don’t think we can get into specifically what we’re producing now. We’ve got about 55 SKUs that are going to hit the market this fiscal year.

Bobby Kotick

One thing, Arvind, you know very well the history of James Bond has been across all platforms and especially on the Nintendo and when we acquired control of that franchise, it was with the idea that it could be one of the most successful franchises going forward as it has been historically. So that’s our commitment to the franchise. That’s what we’re looking to get out of it.

Arvind Bhatia - Sterne Agee

I think somebody tried to get this question answered, but when you look at the next year’s slate, which you kind of hinted at, you obviously have the compares to Spider-Man. But you do have James Bond as you mentioned. Do you feel confident about continued growth given what you know today on your slate for next year?

Mike Griffith

We don’t comment on next year’s guidance other than to give a preview of some of the titles that are going to be. When we started the calls, we have historically grown at rates of growth greater than rates of growth in the market and that’s something that we hope to do over the next 17 years as we have the last 17.

Operator

We’ll take our final question from Edward Williams - BMO Capital Markets.

Edward Williams - BMO Capital Markets

First of all, looking at the publishing revenues this year, what percentage do you expect to come out of international territories?

Thomas Tippl

Let me just put the question the other way around. We expect about half of the revenue to come out of our North America publishing business. Then the rest is international which is the combination obviously of our publishing business in international and our distribution business international, and as we said, I think on a previous occasion, we expect our distribution business to be about 15% to 20% of our business.

Edward Williams - BMO Capital Markets

If we were to take a look at your comments about operating margin expansion towards peak, how long do you think it would take to get to the proverbial peak of the platform cycle?

Thomas Tippl

I would say, you know, so far we’re certainly tracking ahead of when we set the goals originally, the fact that we’ve taken the margin up, I think our guidance was like industry leading operating margins at this point. So I think we have made better than expected progress to date, but there’s no, this is not a time to get complacent so we’re going to continue to drive as hard as we can, not just the top line as I mentioned earlier but also make sure we don’t lose our focus on cost optimization and progress so we can get that operating leverage to the bottom line.

Edward Williams - BMO Capital Markets

Can you guys just compare the relative performance that a Transformers versus Spider-Man? Are they on par with each other, or how would Transformers compare to Spider-Man?

Bobby Kotick

It’s early to tell because Transformers hasn’t been theatrically released into all the international markets yet, but we’ll have a better sense of that on the next conference call.

Edward Williams - BMO Capital Markets

What were the allowances at the quarter end date?

Thomas Tippl

We had reserves of about $160 million and that represents about 37% of gross.

Edward Williams - BMO Capital Markets

Michael, can you talk a little bit about the efficiency of TV and print marketing at this point? Bobby, maybe you can pipe in with how it compares to what you’ve seen in the efficiency in print marketing versus several years ago?

Mike Griffith

I think we’re definitely seeing, we’ve become a lot more efficient in the way that we’re evaluating and managing our sales and marketing programs. On the sales side, as I commented earlier, trade marketing, we’ve gotten much more effective at evaluating what we can do in the trade and what works well for us. On the sales and marketing side, I think you’ve already seen some of this, but we are taking a much harder look at television and what works on TV and how to get the most out of our dollars there; likewise with print.

In our online initiatives, we have seen the benefits of our customer relationship management programs, a lot of what we’re doing with free media instead of paid media. Those initiatives are continuing. They’re an important part of some of the changes that we’ve recently made in which advertising agencies we’re working with and so we’re continuing to see the benefit of more pay for performance, lower costs generally online as compared to traditional forms of media like print and television. The organization is moving towards those as key components of integrated marketing programs.

Edward Williams - BMO Capital Markets

How effective do you see Xbox Live downloads as being for you for demos?

Mike Griffith

Demos on some of our franchises in particular, are a very important tool. We’ve seen Xbox Live be an important contributor to that. This goes a little bit extending your question, but we announced that Call of Duty 4 Modern Warfare would have a beta version available via Xbox Live. That continues to play an important role in our marketing mix.

Bobby Kotick

One of the things we found out that has really been helpful in developing selling and marketing programs in the franchises is we have so much history, whether it’s Tony Hawk or Call of Duty, even Guitar Hero; if you look at the DreamWorks success, Spider-Man, Shrek. What we’ve got now so much history and really being able to evaluate what has worked and what hasn’t that I think we’re doing a much better job than we ever have in evaluating selling and marketing programs and getting the best out of our selling and marketing programs.

Edward Williams - BMO Capital Markets

Lastly, what’s your thought on getting into Asia and the MMO category as a whole? Is that something you said Activision making a meaningful move into over the course of the next year or two or is that something that is a little bit longer term for you?

Bobby Kotick

Right now we have so much opportunity in Europe that’s low-hanging fruit. If you listen to Thomas’ answer about the percentage of revenues that are represented by our European territories today and how much upside we have introducing Guitar Hero that’s localized, the really low hanging fruit for us right now is in these European markets that we haven’t gotten our fair share of penetration as compared to EA. We’re the number one market share company year-to-date in the U.S., but we still have work to do in the European territories.

I think the nice thing about the Asian market opportunities and the MMO business as well as the casual gaming opportunities is that when you think about the next three to five years, those are going to be the opportunity to continue expanding operating margin and gaining greater growth while today, the next few years we’ll likely continue to be focused more on things that are lower-hanging fruit opportunities. But we’re very enthusiastic about the categories, we’ve got to really figure out how to compete.

Kristin Southey

On behalf of everyone at Activision, we thank you for your time and consideration.

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