Geoffrey Mogilner - Director of IR
David F. Zucker - President and CEO
Tom Powell - CFO
Miguel Iribarren - VP of Publishing
Daniel Ernst - Hudson Square Research
Heath Terry - Credit Suisse
Midway Games Inc. (MWY) Q3 2007 Earnings Call November 1, 2007 4:15 PM ET
Good day, ladies and gentlemen, and welcome to the third quarter 2007 Midway Games Earnings Conference Call. My name is Tolicia, and I will be the operator for today. At this time, all participants are in a listen only mode. We will facilitate a question-and-answer session towards the end of this conference. (Operator Instructions). I would now like to turn the call over to your host for today, Mr. Geoffrey Mogilner, Director of Investor Relations. Please proceed, sir.
Thank you very much. Welcome to our third quarter 2007 earnings conference call. With us on the call today are Midway President and CEO, David F. Zucker, our Chief Financial Officer Tom Powell, our Senior Vice President of Worldwide Studios, Matt Booty and our Vice President of Publishing, Miguel Iribarren.
I will begin today's call with the customary legal disclosures, after which Tom will discuss our financial performance for the third quarter. David will then provide his comments and thoughts regarding our strategy and direction going forward including our financial guidance. After David's remarks we will open the line for questions.
Throughout this call we will present both GAAP and non-GAAP financial measures as they relate to our outlook for our 2007 full year and quarterly earnings. These non GAAP financial measures exclude items related to stock option expense, non-cash convertible debt interest expense and deferred tax expense related to goodwill. Midway does not intend for the presentation of the non-GAAP financial measures to be isolated from or substitute for or superior to the information that has been presented in accordance with GAAP. And we encourage investors to consider all measures before making an investment decision.
A reconciliation of the differences between the GAAP and non-GAAP measures is available in our press release posted under the tab, Current Headlines, on our website at www.investor.midway.com.
During the course of this call, we may make forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 concerning future business conditions and the outlook for Midway Games Inc. based on currently available information. Midway's actual results could differ materially from those described in the forward-looking statements as a result of a number of risks and uncertainties, including without limitation, the performance of the interactive entertainment industry, dependence on new product introductions and the ability to maintain the scheduling of such introductions; the new console platform cycle and other technological changes; dependence on major platform manufacturers and other risks more fully described under Item 1, Risk Factors in the company's annual report on form 10-K for the year ended December 31, 2006 and in other filings made by the company with the Securities and Exchange Commission.
Each forward-looking statement, including, without limitation, the financial guidance, speaks only as of the date on which it is made. And the company undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which it is made or to reflect the occurrence of anticipated or unanticipated events or circumstances except as required by law.
Thanks, Jeff, and good afternoon. During the third quarter, Midway released Stranglehold on the Xbox 360 and PC worldwide. Net revenues for the quarter total $36.7 million compared to third quarter 2006 net revenues of $27.4 million and compared to our updated guidance of $39 million. Next generation console products contributed 76% of third quarter net revenues while current generation console products contributed 5%.
Handheld products contributed 9% and PC another 10%. Our international business made up approximately 49% of total revenues. For the quarter, the net loss was $0.37 per basic and diluted share or $33.5 million compared with the 2006 third quarter net loss of $22.2 million and compared with our updated guidance of $30 million. Included in quarters' results were charges of $5 million, $400,000 and $200,000 related to non-cash convertible debt interest expense, deferred tax expense related to goodwill and stock option expense respectively.
On a non-GAAP basis excluding the impact of these charges, the loss was $0.31 per basic and diluted share or $28 million compared with 2006 third quarter net loss of $20.3 million and compared with our updated guidance of $24.6 million. The third quarter shortfall to revenue guidance is largely attributable to accruing reserves at a higher level than was previously projected and certain royalty revenues that were expected to be recognized in the third quarter but ultimately won't be recognized until the fourth quarter.
Gross revenues actually came in a little bit favorable to our expectations. The shortfall on EPS guidance is due in part to the revenue shortfall, but was also due to the decision to launch for sale in the US, the PC version of Hour of Victory as a digital download only, which resulted in increased amortization of capitalized software during the quarter.
At September 30, our cash balance stood at $31.1 million and Q3 cash used in operations was $25.1 million. During this holiday shipping season, we have and we will continue to actively monitor and manage our working capital. We expect to end the year with $20 million in cash and over $60 million in gross accounts receivable.
During the quarter, cash invested in next generation technologies and product development projects totaled approximately $27.4 million, and overhead costs were in the range of $9 million.
At the end of the quarter, the balance of capitalized product development costs was approximately $74.1 million, an increase of $600,000 from the previous quarter. The total capitalized balance approximately 15% relates to products already in the marketplace as of the end of the quarter, 30% relates to products that we expect to introduce during the remainder of 2007, and the remaining 55% relates to products that we expect to ship in 2008.
Gross receivables at September 30 were $48.3 million. Reserves for price concessions, returns and uncollectible accounts were $19.7 million or approximately 41% of the gross receivable. For the quarter, the average days sales outstanding were 71 days.
Third quarter weighted average basic and diluted shares outstanding were approximately 91.2 million, and I would use that same figure for both the fourth quarter and for the full-year shares outstanding. David?
Thanks, Tom. During the third quarter, we launched Stranglehold for the Xbox 360 and PC in North America and Europe. Stranglehold was generally well-received by consumers and critics alike. The majority of the individual review scores for the game have been 80% or above. And while it is currently averaging slightly below 80% overall, on gameregs.com, it has averaged north of 80% across the European territories and has remained a top 10 selling Xbox 360 title for the first five weeks following launch according to Chart Track in the UK.
With the PS3 version arriving in stores this week in North America, we have now shipped over one million units of Stranglehold. The PS3 version is expected to ship in Europe at the end of November. As we have mentioned in the past, Stranglehold is an important milestone for us as a company. Aside from being our first multiplatform next-gen game, Stranglehold has provided an ideal platform to develop our standardized technology toolset for all of our next generation titles.
And market and consumer feedback has validated that we are on the right track with a core underlying gameplay, technology and animation systems. 1UP.com wrote, "Stranglehold certainly delivers, largely due to the positively otherworldly tech that underpins the game: Being able to destroy nearly every object in the world just never really gets old."
With this technology foundation in place, we believe we are poised to further improve quality as we add game play variety and additional features to future games from our internal studios and teams.
Turning to guidance, we are lowering our outlook for the full year 2007, primarily to reflect the underperformance in the third quarter and the movement of certain Nintendo Wii and DS titles out of the fiscal year, primarily in the European territories as well as to reflect lower expectations for the PS3 product sales in the fourth quarter due to delays in split release states and shorter holiday selling periods.
Specifically, we are moving the European releases of Foster's Home for Imaginary Friends for the DS, as well as Cruis'n for the Wii into the first quarter of next year and out of this fiscal year. In addition to the movement of these Nintendo platform titles, we are also expecting reduced availability of Wii product to meet reorder demands for our existing Wii catalog sale titles as a result of Nintendo's softer production constraints.
For the full year earnings December 31, 2007, we now expect net revenues of $160 million with a net loss of approximately $0.95 per basic and diluted share. On a non-GAAP basis, we expect a loss of approximately $0.76 per basic and diluted share, which excludes approximately $0.03 of stock option expense and deferred income tax expense related to goodwill, and $0.16 of non-cash convertible debt interest expense.
In the fourth quarter, in addition to Stranglehold for the PS3, which is already released in North America, The Bee Game for the GBA and DS in North America and Cocoto Racing in Europe, we expect to release worldwide BlackSite: Area 51 for Xbox 360 and PC, Unreal Tournament 3 for the PC and Aqua Teen Hunger Force: Zombie Ninja Pro-Am for the PS2.
In North America, only we expect to ship BlackSite: Area 51 for the PS3, Foster's Home for Imaginary Friends for the DS and Game Party and Cruis'n for the Wii and in Europe, Stranglehold for the PS3 and Hour of Victory for the PC.
We expect fourth quarter net revenue of approximately $80 million with a net loss of approximately $0.21 per basic and diluted share. On a non-GAAP basis, we expect a loss of approximately $0.13 per basic and diluted share, which excludes approximately $0.01 of stock option expense and deferred income tax expense related to goodwill and $0.07 of non-cash convertible debt interest expense.
As we mentioned on our financial update call at the beginning of October, we regret that the necessity to delay certain titles will cause us to lose some holiday sales in the near-term, as well as shift some revenue out of fiscal 2007 into 2008. Our management team believes that our initiative to unify our internal product development to run a common core set of technology and tools, and to seek to build great games and high potential, mass-market genres is heading in the right direction.
We believe we have made great strides toward these goals, and we are seeing return on our investment in terms of our future individual title development costs, usability of resources, art assets and code and time to market of various upcoming internal projects. We've attracted and retained some of the best talent in the interactive entertainment industry.
With our core engine predominantly in place now, we believe our PD team will be able to leverage the work done on early next-gen titles like Stranglehold, BlackSite and Wheelman for products already in development as far out as 2009 and 2010. One example of this initiative is the close work of the TNA and Mortal Kombat teams on a fighting engine that leverages our core, centralized technology base and the synergies are producing fantastic results, as was shown a couple of weeks ago at the TNA Bound for Glory event at which we debuted our wrestling title.
1UP.com said after the event, "After finally having the controllers ripped out of our hands by Midway security, we came away very optimistic. When you combine a team experienced in developing wild sports titles with the TNA brand, you end up with a game that has big opportunity to mix up the wrestling genre, which become set in its ways in recent years."
We are building interest around our upcoming release of BlackSite: Area 51. We expect to release the game on Xbox 360 and PC in mid November, and soon after on PS3 in North America. In addition, we expect to shortly release a second, more in-depth demo, on Xbox LIVE to follow our heavily downloaded teaser from last May.
The game takes place in a highly realistic and contemporary setting, taking you on missions and locations that span from the front lines in Iraq to the streets of a small American town. And introduces some pioneering and genre expanding features that we think will broaden the appeal for this game beyond the traditional hardcore audience.
As we mentioned on our call a few weeks ago, we expect to release worldwide Unreal Tournament 3 from the highly acclaimed developer of the hit title, Gears of War, also in November on PC. Unreal Tournament 3 is a worldwide phenomenon. To date it has appeared in over 20 covers around the world and has been nominated or has won Best of E3 awards for the past few years.
With a feverishly passionate fan base to propel this title, we believe the new features and single player campaigns in Unreal Tournament 3 could make this title more mass-market and successful than in the past. Epic is working hard to finalize the PS3 version, as well, and we are confident that the console release will live up to the Unreal Tournament tradition. Complete with the ability to create robust user-generated content that has multiplayer maps, custom game modes and much more, introducing a new level of creativity and replayability to the console systems.
Looking ahead to 2008, we are excited about our release schedule for next year. As we communicated on our last call, we continue to expect significantly higher revenues in 2008 and we expect that our 2008 lineup will have more front-line console title releases than our 2007 lineup. In the first half of next year, we expect to launch console versions of Unreal Tournament 3; a new next-gen installment of our over-the-top fantasy lifestyle basketball franchise, NBA Ballers; Wheelman, starring Vin Diesel, an innovative, high action, cinematic driving game; and TNA iMPACT based on the television wrestling franchise that is rapidly growing in popularity.
Then in the second half of the year, we expect to launch a new version of our 1.5 million unit selling, hard-hitting, unlicensed football franchise, Blitz: The League; the next generation debut of our perennial top-selling franchise, Mortal Kombat, along with one or two new ambitious, high potential, mass-market open world games that we plan to announce in the near future.
As we move into 2008 after working out most of the kinks with our first few next generation game launches, we expect to release some reinvigorated franchises with well-established fan bases, as well as new IP with broad market appeal that leverages the technology foundation built by Stranglehold and BlackSite into a market hungry for quality content.
We believe that our investment has put Midway in a position with the potential to gain market share and produce profits as we move into the heart of this console cycle. The management team and all Midway employees are laser focused on these goals, as we now have in place the systems, tools, processes and talent that can lead to the ability to repeatedly and efficiently develop high-quality, next generation games that span a wide variety of mass-market genres.
That concludes our prepared remarks. Operator, please open the line for questions.
Thank you. (Operator Instructions). And our first question comes from the line of Daniel Ernst with Hudson Square Research. Please proceed
Daniel Ernst - Hudson Square Research
Good evening. Thanks for taking the call. Three questions, if I might and maybe the first you addressed, but just to clarify it. You have had a few delays in releasing some of the PS3 versions of your games, notably Stranglehold and obviously Unreal pushed into next year. Can you talk about whether you think that is any issue with that or stalls on a going forward basis so that for feature releases we are not looking for a split release?
And then second, kind of related to that what now happens to the semi-exclusive window that Unreal was going to have on the PS3? Does that now become a simultaneous release in '08? And then third, can you give a little color on your comments on Nintendo software production constraints?
I'll let Miguel answer the third. In terms of the PS3, obviously our first wave of next-gen games, our lead development has been in the Xbox 360, due to its earlier introduction in larger installed base. We ran into some technical issues developing for the PlayStation 3 that have taken more time to finalize than we expected, and these includes for example, making sure the frame rate, networking and graphical features are at parody between the two platforms.
We've also encountered challenges as a result of shipping two of the very first PS3 games, using Epic's Unreal Engine 3 and of course, we just this week shipped Stranglehold on the PS3 and expect to ship shortly BlackSite: Area 51 on the PS3. But we do believe these technical issues are now completed at a core level in our engine, and now that we have the systems working, looking ahead to 2008 we expect the PS3 versions of our titles to ship day-and-date with our other versions.
In terms of the Sony exclusive, nothing has changed there; our expected product plan is to release a PC version of UT3 this November and a PS3 version as soon as it is ready. And then at this point we have not announced any timing for an Xbox 360 version of Unreal Tournament 3. Miguel, do you want to talk about Nintendo?
Yes, the Wii has been a little bit of a victim of its own success. The demand for Wii product has put a pretty big strain on Nintendo's production capacity. And that has in turn for us, turned into longer lead times for some of our Wii product. And that, during the holidays, given the amount of product that is coming out in a short timeframe, has resulted for us reduced ability to get product to shelf. I know Nintendo is obviously trying to solve that as quickly as possible. And I think for front-line releases, I believe that is largely solved, but it is a bigger issue for reorders for us right now.
Daniel Ernst - Hudson Square Research
So the problem is more on Wii, which is disc-based software, not so much the DS which has a different production capacity; so you are not seeing a DS issue?
Daniel Ernst - Hudson Square Research
Okay. Great. Thank you.
Our next question comes from the line of Edward Williams. Please proceed.
Just a couple of quick questions for you. Can you talk a little bit about the European market and what you expect to generate out of the European market and looking into 2008 relative to '07? And also looking at your studios, can you give us an idea as to what your development headcount is like today? The number of games you have in development? And as we look into '08 versus '07 how the release schedule may be different in terms of the number of games or the number of premium SKUs and just give us some color with regards to how '08 versus '07 will look?
In terms of the European market -- it is actually one of the real bright spots for Midway; as we set out a couple years ago we were doing less than 20% of our overall revenue out of Europe. As you know, we've hired Martin Spies over there. We went direct and now fully operational in both Germany and France in addition to the UK. And we, our goal was to get to 35% revenues coming out of Europe, and we'll hit that this year, which is actually a year ahead of plan.
And we expect into next year, as well as we begin to put that plan together that we will achieve 35% or more of our revenues out of Europe. And we see, especially with Stranglehold is a good case of an example we are seeing very good results and numbers for Stranglehold out of Europe with historically higher percentages for us than we've had in the past. So, we are very happy with the sales performance of the team that is now in place and running in Europe.
In terms of product development, roughly $675 million or so people in our product development group; it is 10 or 11 internal teams, depending how you count them. And I think, as we've said, if you just look at what we've announced today and we've announced on our last call, we essentially had three front-line console SKUs this year with Hour of Victory, Stranglehold and BlackSite: Area 51. Next year you have UT3 that we've announced UT3 NBA Ballers, TNA iMPACT, Wheelman, Mortal Kombat franchise and Blitz: The League, as well as at least one game that we will be announcing shortly, which is a very ambitious open world game. So those are, -- you just can do the math, it is obviously bigger front-line console release next year.
Okay, and looking at next year are there any games besides Unreal that are owned by someone beside Midway? As far as these front-line SKUs are concerned?
No, Mortal Kombat, of course, and Blitz now is our franchise. The two that would be licensed next year would be NBA Ballers, that's an NBA license and TNA iMPACT. It's is a license with the TNA wrestling organization but all the other titles, correct, I believe would be wholly-owned. Am I right about that?
Yes, that's correct.
Okay, great. Thank you.
(Operator Instructions). And our next question comes from the line of Heath Terry with Credit Suisse. Please proceed.
Heath Terry - Credit Suisse
When you look at the success you've had in your European business, can you talk about what component of that has come from better distribution of your products, versus what component has been just better kind of general reacceptance of your products in Europe versus the US?
I think it's a combination of both, but I think if you look at the market, 70% of the revenues come out of UK, Germany and France. And you really need to -- we think you need to be direct in those three markets to have, to really get the bank out of the markets. So, I think we have our team in France that has come up with the last two years has really done a good job. Germany is doing well. So, it is a good team and being direct in those markets has made a big difference. And I think also Stranglehold as an example, Stranglehold reviewed much better in Europe as it was really in the mid-80s, in some cases above and through most of the European territories it was slightly below 80% overall here. So I think it was a combination of both.
Heath Terry - Credit Suisse
Great. And when you look at kind of the, where you would consider the high watermark for distribution in Europe in terms of what you would want to do given all the opportunities, where would you say you are right now in terms of achieving complete direct distribution in Europe?
I think we feel very good about it. I think if you look at -- I think for the quarter we were over 40%, and as I said we are looking at 35% to 40% as a very healthy number competitive to what other people are doing. So, like I said, we are direct in the major territories, that cover 70% of the market. We will look at addition. We continue to look at additional places to go direct, but you know you need the right level of sales volume to make that make sense. So, we are continuing to assess that, but we feel very good about what we have right now.
Heath Terry - Credit Suisse
Great. Thank you very much.
(Operator Instructions) There appears to be no additional questions at this time. I would now like to turn the call over to Mr. David Zucker for any closing remarks.
Thanks for your time. We look forward to talking again to you soon.
This concludes your presentation. You may now disconnect and have a great day.
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