Midway Games Q3 2007 Earnings Call Transcript

Nov. 1.07 | About: Midway Games (MWY)

Midway Games Inc. (MWY) Q3 2007 Earnings Call November 1, 2007 4:15 PM ET

Executives

Geoffrey Mogilner - Director of IR

David F. Zucker - President and CEO

Tom Powell - CFO

Miguel Iribarren - VP of Publishing

Analysts

Daniel Ernst - Hudson Square Research

Edward Williams

Heath Terry - Credit Suisse

Operator

Good day, ladies and gentlemen, and welcome to the thirdquarter 2007 Midway Games Earnings Conference Call. My name is Tolicia, and Iwill be the operator for today. At this time, all participants are in a listenonly mode. We will facilitate a question-and-answer session towards the end ofthis conference. (Operator Instructions). I would now like to turn the callover to your host for today, Mr. Geoffrey Mogilner, Director of InvestorRelations. Please proceed, sir.

Geoffrey Mogilner

Thank you very much. Welcome to our third quarter 2007earnings conference call. With us on the call today are Midway President andCEO, David F. Zucker, our Chief Financial Officer Tom Powell, our Senior VicePresident of Worldwide Studios, Matt Booty and our Vice President ofPublishing, Miguel Iribarren.

I will begin today's call with the customary legaldisclosures, after which Tom will discuss our financial performance for thethird quarter. David will then provide his comments and thoughts regarding ourstrategy and direction going forward including our financial guidance. AfterDavid's remarks we will open the line for questions.

Throughout this call we will present both GAAP and non-GAAPfinancial measures as they relate to our outlook for our 2007 full year andquarterly earnings. These non GAAP financial measures exclude items related tostock option expense, non-cash convertible debt interest expense and deferredtax expense related to goodwill. Midway does not intend for the presentation ofthe non-GAAP financial measures to be isolated from or substitute for orsuperior to the information that has been presented in accordance with GAAP.And we encourage investors to consider all measures before making an investmentdecision.

A reconciliation of the differences between the GAAP andnon-GAAP measures is available in our press release posted under the tab, CurrentHeadlines, on our website at www.investor.midway.com.

During the course of this call, we may make forward-lookingstatements within the meaning of the Private Securities Litigation Reform Actof 1995 concerning future business conditions and the outlook for Midway GamesInc. based on currently available information. Midway's actual results coulddiffer materially from those described in the forward-looking statements as aresult of a number of risks and uncertainties, including without limitation,the performance of the interactive entertainment industry, dependence on newproduct introductions and the ability to maintain the scheduling of suchintroductions; the new console platform cycle and other technological changes;dependence on major platform manufacturers and other risks more fully describedunder Item 1, Risk Factors in the company's annual report on form 10-K for theyear ended December 31, 2006 and in other filings made by the company with theSecurities and Exchange Commission.

Each forward-looking statement, including, withoutlimitation, the financial guidance, speaks only as of the date on which it ismade. And the company undertakes no obligation to update any forward-lookingstatement to reflect events or circumstances after the date on which it is madeor to reflect the occurrence of anticipated or unanticipated events orcircumstances except as required by law.

Tom Powell

Thanks, Jeff, and good afternoon. During the third quarter,Midway released Stranglehold on the Xbox 360 and PC worldwide. Net revenues forthe 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. Nextgeneration console products contributed 76% of third quarter net revenues whilecurrent generation console products contributed 5%.

Handheld products contributed 9% and PC another 10%. Ourinternational business made up approximately 49% of total revenues. For thequarter, the net loss was $0.37 per basic and diluted share or $33.5 millioncompared with the 2006 third quarter net loss of $22.2 million and comparedwith our updated guidance of $30 million. Included in quarters' results werecharges of $5 million, $400,000 and $200,000 related to non-cash convertibledebt interest expense, deferred tax expense related to goodwill and stockoption 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 with2006 third quarter net loss of $20.3 million and compared with our updatedguidance of $24.6 million. The third quarter shortfall to revenue guidance islargely attributable to accruing reserves at a higher level than was previouslyprojected and certain royalty revenues that were expected to be recognized in thethird quarter but ultimately won't be recognized until the fourth quarter.

Gross revenues actually came in a little bit favorable toour expectations. The shortfall on EPS guidance is due in part to the revenueshortfall, but was also due to the decision to launch for sale in the US, thePC version of Hour of Victory as a digital download only, which resulted inincreased amortization of capitalized software during the quarter.

At September 30, our cash balance stood at $31.1 million andQ3 cash used in operations was $25.1 million. During this holiday shippingseason, we have and we will continue to actively monitor and manage our workingcapital. We expect to end the year with $20 million in cash and over $60million in gross accounts receivable.

During the quarter, cash invested in next generationtechnologies and product development projects totaled approximately $27.4million, and overhead costs were in the range of $9 million.

At the end of the quarter, the balance of capitalizedproduct development costs was approximately $74.1 million, an increase of$600,000 from the previous quarter. The total capitalized balance approximately15% relates to products already in the marketplace as of the end of thequarter, 30% relates to products that we expect to introduce during theremainder of 2007, and the remaining 55% relates to products that we expect toship in 2008.

Gross receivables at September 30 were $48.3 million.Reserves for price concessions, returns and uncollectible accounts were $19.7million or approximately 41% of the gross receivable. For the quarter, theaverage days sales outstanding were 71 days.

Third quarter weighted average basic and diluted sharesoutstanding were approximately 91.2 million, and I would use that same figurefor both the fourth quarter and for the full-year shares outstanding. David?

David Zucker

Thanks, Tom. During the third quarter, we launchedStranglehold for the Xbox 360 and PC in North America and Europe.Stranglehold was generally well-received by consumers and critics alike. Themajority of the individual review scores for the game have been 80% or above.And while it is currently averaging slightly below 80% overall, ongameregs.com, it has averaged north of 80% across the European territories andhas remained a top 10 selling Xbox 360 title for the first five weeks followinglaunch 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 unitsof Stranglehold. The PS3 version is expected to ship in Europeat the end of November. As we have mentioned in the past, Stranglehold is animportant milestone for us as a company. Aside from being our firstmultiplatform next-gen game, Stranglehold has provided an ideal platform to developour standardized technology toolset for all of our next generation titles.

And market and consumer feedback has validated that we areon the right track with a core underlying gameplay, technology and animationsystems. 1UP.com wrote, "Stranglehold certainly delivers, largely due tothe positively otherworldly tech that underpins the game: Being able to destroynearly every object in the world just never really gets old."

With this technology foundation in place, we believe we arepoised to further improve quality as we add game play variety and additionalfeatures to future games from our internal studios and teams.

Turning to guidance, we are lowering our outlook for thefull year 2007, primarily to reflect the underperformance in the third quarterand 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 expectationsfor the PS3 product sales in the fourth quarter due to delays in split releasestates and shorter holiday selling periods.

Specifically, we are moving the European releases ofFoster's Home for Imaginary Friends for the DS, as well as Cruis'n for the Wiiinto the first quarter of next year and out of this fiscal year. In addition tothe movement of these Nintendo platform titles, we are also expecting reducedavailability of Wii product to meet reorder demands for our existing Wiicatalog sale titles as a result of Nintendo's softer production constraints.

For the full year earnings December 31, 2007, we now expectnet revenues of $160 million with a net loss of approximately $0.95 per basicand diluted share. On a non-GAAP basis, we expect a loss of approximately $0.76per basic and diluted share, which excludes approximately $0.03 of stock optionexpense and deferred income tax expense related to goodwill, and $0.16 ofnon-cash convertible debt interest expense.

In the fourth quarter, in addition to Stranglehold for thePS3, which is already released in North America, The Bee Game for the GBA and DSin North America and Cocoto Racing in Europe, we expect to release worldwideBlackSite: Area 51 for Xbox 360 and PC, Unreal Tournament 3 for the PC and AquaTeen Hunger Force: Zombie Ninja Pro-Am for the PS2.

In North America, only we expect to ship BlackSite: Area 51for the PS3, Foster's Home for Imaginary Friends for the DS and Game Party andCruis'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 $80million with a net loss of approximately $0.21 per basic and diluted share. Ona non-GAAP basis, we expect a loss of approximately $0.13 per basic and dilutedshare, which excludes approximately $0.01 of stock option expense and deferredincome tax expense related to goodwill and $0.07 of non-cash convertible debtinterest expense.

As we mentioned on our financial update call at thebeginning of October, we regret that the necessity to delay certain titles willcause us to lose some holiday sales in the near-term, as well as shift somerevenue out of fiscal 2007 into 2008. Our management team believes that ourinitiative to unify our internal product development to run a common core setof technology and tools, and to seek to build great games and high potential, mass-marketgenres 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 individualtitle development costs, usability of resources, art assets and code and timeto market of various upcoming internal projects. We've attracted and retainedsome of the best talent in the interactive entertainment industry.

With our core engine predominantly in place now, we believeour PD team will be able to leverage the work done on early next-gen titleslike Stranglehold, BlackSite and Wheelman for products already in developmentas far out as 2009 and 2010. One example of this initiative is the close workof the TNA and Mortal Kombat teams on a fighting engine that leverages ourcore, centralized technology base and the synergies are producing fantasticresults, as was shown a couple of weeks ago at the TNA Bound for Glory event atwhich we debuted our wrestling title.

1UP.com said after the event, "After finally having thecontrollers ripped out of our hands by Midway security, we came away veryoptimistic. When you combine a team experienced in developing wild sportstitles with the TNA brand, you end up with a game that has big opportunity tomix up the wrestling genre, which become set in its ways in recent years."

We are building interest around our upcoming release ofBlackSite: Area 51. We expect to release the game on Xbox 360 and PC in midNovember, and soon after on PS3 in North America.In addition, we expect to shortly release a second, more in-depth demo, on XboxLIVE to follow our heavily downloaded teaser from last May.

The game takes place in a highly realistic and contemporarysetting, taking you on missions and locations that span from the front lines inIraqto the streets of a small American town. And introduces some pioneering andgenre expanding features that we think will broaden the appeal for this gamebeyond the traditional hardcore audience.

As we mentioned on our call a few weeks ago, we expect torelease worldwide Unreal Tournament 3 from the highly acclaimed developer ofthe hit title, Gears of War, also in November on PC. Unreal Tournament 3 is aworldwide phenomenon. To date it has appeared in over 20 covers around theworld and has been nominated or has won Best of E3 awards for the past fewyears.

With a feverishly passionate fan base to propel this title,we believe the new features and single player campaigns in Unreal Tournament 3could make this title more mass-market and successful than in the past. Epic isworking hard to finalize the PS3 version, as well, and we are confident thatthe console release will live up to the Unreal Tournament tradition. Completewith the ability to create robust user-generated content that has multiplayermaps, custom game modes and much more, introducing a new level of creativityand replayability to the console systems.

Looking ahead to 2008, we are excited about our releaseschedule for next year. As we communicated on our last call, we continue to expectsignificantly higher revenues in 2008 and we expect that our 2008 lineup willhave more front-line console title releases than our 2007 lineup. In the firsthalf 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 basketballfranchise, NBA Ballers; Wheelman, starring Vin Diesel, an innovative, highaction, cinematic driving game; and TNA iMPACT based on the televisionwrestling franchise that is rapidly growing in popularity.

Then in the second half of the year, we expect to launch anew version of our 1.5 million unit selling, hard-hitting, unlicensed footballfranchise, Blitz: The League; the next generation debut of our perennialtop-selling franchise, Mortal Kombat, along with one or two new ambitious, highpotential, mass-market open world games that we plan to announce in the nearfuture.

As we move into 2008 after working out most of the kinkswith our first few next generation game launches, we expect to release somereinvigorated franchises with well-established fan bases, as well as new IPwith broad market appeal that leverages the technology foundation built byStranglehold and BlackSite into a market hungry for quality content.

We believe that our investment has put Midway in a positionwith the potential to gain market share and produce profits as we move into theheart of this console cycle. The management team and all Midway employees arelaser 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 efficientlydevelop high-quality, next generation games that span a wide variety ofmass-market genres.

That concludes our prepared remarks. Operator, please openthe line for questions.

Question-and-AnswerSession

Operator

Thank you. (Operator Instructions). And our first questioncomes from the line of Daniel Ernst with Hudson Square Research. Please proceed

Daniel Ernst - Hudson SquareResearch

Good evening. Thanks for taking the call. Three questions,if I might and maybe the first you addressed, but just to clarify it. You havehad a few delays in releasing some of the PS3 versions of your games, notablyStranglehold and obviously Unreal pushed into next year. Can you talk aboutwhether you think that is any issue with that or stalls on a going forwardbasis so that for feature releases we are not looking for a split release?

And then second, kind of related to that what now happens tothe semi-exclusive window that Unreal was going to have on the PS3? Does thatnow become a simultaneous release in '08? And then third, can you give a littlecolor on your comments on Nintendo software production constraints?

David Zucker

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 inthe Xbox 360, due to its earlier introduction in larger installed base. We raninto some technical issues developing for the PlayStation 3 that have takenmore time to finalize than we expected, and these includes for example, makingsure the frame rate, networking and graphical features are at parody betweenthe two platforms.

We've also encountered challenges as a result of shippingtwo of the very first PS3 games, using Epic's Unreal Engine 3 and of course, wejust this week shipped Stranglehold on the PS3 and expect to ship shortlyBlackSite: Area 51 on the PS3. But we do believe these technical issues are nowcompleted at a core level in our engine, and now that we have the systemsworking, looking ahead to 2008 we expect the PS3 versions of our titles to shipday-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 aPS3 version as soon as it is ready. And then at this point we have notannounced any timing for an Xbox 360 version of Unreal Tournament 3. Miguel, doyou want to talk about Nintendo?

Miguel Iribarren

Yes, the Wii has been a little bit of a victim of its ownsuccess. The demand for Wii product has put a pretty big strain on Nintendo'sproduction capacity. And that has in turn for us, turned into longer lead timesfor some of our Wii product. And that, during the holidays, given the amount ofproduct that is coming out in a short timeframe, has resulted for us reducedability to get product to shelf. I know Nintendo is obviously trying to solvethat as quickly as possible. And I think for front-line releases, I believethat is largely solved, but it is a bigger issue for reorders for us right now.

Daniel Ernst - Hudson SquareResearch

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 notseeing a DS issue?

David Zucker

That's correct.

Daniel Ernst - Hudson SquareResearch

Okay. Great. Thank you.

Operator

Our next question comes from the line of Edward Williams.Please proceed.

Edward Williams

Just a couple of quick questions for you. Can you talk a littlebit about the European market and what you expect to generate out of theEuropean market and looking into 2008 relative to '07? And also looking at yourstudios, can you give us an idea as to what your development headcount is liketoday? The number of games you have in development? And as we look into '08versus '07 how the release schedule may be different in terms of the number ofgames or the number of premium SKUs and just give us some color with regards tohow '08 versus '07 will look?

David Zucker

In terms of the European market -- it is actually one of thereal bright spots for Midway; as we set out a couple years ago we were doingless than 20% of our overall revenue out of Europe.As you know, we've hired Martin Spies over there. We went direct and now fullyoperational in both Germanyand France in addition tothe 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 putthat plan together that we will achieve 35% or more of our revenues out of Europe. And we see, especially with Stranglehold is agood case of an example we are seeing very good results and numbers forStranglehold out of Europe with historically higher percentages for us thanwe've had in the past. So, we are very happy with the sales performance of theteam that is now in place and running in Europe.

In terms of product development, roughly $675 million or sopeople 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 atwhat we've announced today and we've announced on our last call, we essentiallyhad three front-line console SKUs this year with Hour of Victory, Strangleholdand BlackSite: Area 51. Next year you have UT3 that we've announced UT3 NBABallers, 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 veryambitious open world game. So those are, -- you just can do the math, it isobviously bigger front-line console release next year.

Edward Williams

Okay, and looking at next year are there any games besidesUnreal that are owned by someone beside Midway? As far as these front-line SKUsare concerned?

David Zucker

No, Mortal Kombat, of course, and Blitz now is ourfranchise. 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 wrestlingorganization but all the other titles, correct, I believe would bewholly-owned. Am I right about that?

Miguel Iribarren

Yes, that's correct.

Edward Williams

Okay, great. Thank you.

Operator

(Operator Instructions). And our next question comes fromthe line of Heath Terry with Credit Suisse. Please proceed.

Heath Terry - CreditSuisse

When you look at the success you've had in your Europeanbusiness, can you talk about what component of that has come from betterdistribution of your products, versus what component has been just better kindof general reacceptance of your products in Europe versus the US?

David Zucker

I think it's a combination of both, but I think if you lookat the market, 70% of the revenues come out of UK,Germany and France. And youreally need to -- we think you need to be direct in those three markets tohave, to really get the bank out of the markets. So, I think we have our teamin Francethat has come up with the last two years has really done a good job. Germany isdoing well. So, it is a good team and being direct in those markets has made abig difference. And I think also Stranglehold as an example, Strangleholdreviewed much better in Europe as it was really in the mid-80s, in some casesabove 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 - CreditSuisse

Great. And when you look at kind of the, where you wouldconsider the high watermark for distribution in Europe in terms of what youwould want to do given all the opportunities, where would you say you are rightnow in terms of achieving complete direct distribution in Europe?

David Zucker

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 at35% 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 themarket. We will look at addition. We continue to look at additional places togo direct, but you know you need the right level of sales volume to make thatmake sense. So, we are continuing to assess that, but we feel very good aboutwhat we have right now.

Heath Terry - CreditSuisse

Great. Thank you very much.

Operator

(Operator Instructions) There appears to be no additionalquestions at this time. I would now like to turn the call over to Mr. DavidZucker for any closing remarks.

David Zucker

Thanks for your time. We look forward to talking again toyou soon.

Operator

This concludes your presentation. You may now disconnect andhave a great day.

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