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Executives

Kristin Southey - Vice President, Investor Relations and Treasurer

Robert A. Kotick - Chairman of the Board, Chief Executive Officer

Thomas Tippl - Chief Financial Officer

Michael J. Griffith - President & Chief Executive Officer of Publishing Unit

Analysts

Tony Gikas - Piper Jaffray

Michael Savner - Banc of America Securities

Mark Wienkes - Goldman Sachs

Brent Thill - Citigroup

Ben Schachter - UBS Securities

Shawn Milne - Oppenheimer

Heath Terry - Credit Suisse

Jeetil Patel - Deutsche Bank

Ralph Schackart - William Blair

Activision, Inc. (ATVI) F2Q08 Earnings Call November 5, 2007 4:30 PM ET

Operator

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

Kristin Southey

Good afternoon and thank you for joining us today for Activision's Q2 fiscal 2008 conference call. As always, I’ll 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 that are not historical facts and are forward-looking statements. These forward-looking statements are based on current expectations and assumptions and are subject to risk and uncertainty. The company cautions that a number of important factors could Activision's actual future results and other future circumstances to differ materially from those expressed in any such forward-looking statement.

Such factors include without limitation sales of the company’s titles during fiscal year 2008, shifts in consumer spending trends, the seasonal and cyclical nature of the interactive game market, the company’s 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 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, integration of recent acquisitions and the identification of suitable future acquisition opportunities and foreign exchange rates.

Other such factors include the further implementation, acceptance and effectiveness of the remedial measures recommended or adopted by the special sub-committee of independent directors established in July 2006 to review our historical stock option grant practices, by the Board and by Activision, the outcome of the SEC's formal investigation and derivative litigation filed in July 2006 against certain current and former directors and officers of Activision relating to Activision's stock option granting practices, and the possibility that additional claims and proceedings will be commenced, including additional action by the SEC and/or other regulatory agencies, and other litigation unrelated to stock option granting practices.

These important factors and other factors that potentially could affect the company’s financial results are described in the company’s most recent annual report on Form 10-K and the cautionary statements therein and the exhibits thereto. The company may change its intentions or expectations at any time and without notice based upon any changes in such factors in the company’s assumptions or otherwise. The company undertakes no obligation to release publicly any revisions to any forward-looking statements to reflect events or circumstances after the date hereof, or to reflect the occurrence of unanticipated events.

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

Robert A. Kotick

Thank you, Kristen and thank you all for joining us today. We are pleased to share with your our record second quarter results, a preview of our third quarter, which we expect to be our first billion-dollar quarter, and our increased outlook for the fiscal year.

In the second quarter, net revenues and earnings exceeded our expectations and grew significantly over the prior year, driven by the Guitar Hero franchise and our newest intellectual property, Transformers.

For the first half of the fiscal year, we delivered record revenues and earnings, driven by strong market conditions and the success of our balanced franchise portfolio, both in the U.S. as well as Europe.

For the quarter, Guitar Hero was the number three franchise overall and remains the number one videogame franchise in North America for all of calendar ’07. Transformers was the number two third-party title in Europe and the number one third-party handheld title worldwide. To date, we have shipped more than 3 million units of Transformers worldwide.

In North America, our console and handheld market share increased from 5% to 10% over the prior year. For the quarter, international publishing net revenues grew 80% over last year and are up 145% for the first half of the year, due to better execution in our largest markets.

Strategically, we continue to make the organizational infrastructural changes necessary to ensure our long-term leadership. Our institutionalized processes and thoughtful approach to our business has fueled growth and diversified our franchise portfolio. We continue to identify new market opportunities and reinvent our core brands through innovative game play that we validate through our consumer testing and support services with the very highest quality development resources we believe in our industry.

In September, we acquired Bizarre Creations, one of the preeminent U.K. based development studios. They have over 160 employees, a strong track record of success, and the acquisition will bolster our development resources and enable Activision to enter the $1.4 billion global racing genre, which is the largest genre that we currently don’t participate in.

With almost $1 billion of cash, we’ll continue to make strategic investments that will expand our intellectual property portfolio, extend our next generation development leadership, and strengthen our global marketing and distribution footprint.

We continue to reap the benefits of the investments we have made over the past few years, which this holiday we expect will result in our first billion-dollar quarter and $2 billion of revenues for the fiscal year.

As of tomorrow, we will have launched all of our major holiday titles in North America well in advance of the Thanksgiving selling season.

On October 28th, we launched in North America Guitar Hero 3 on multiple platforms, including the long-awaited debut of Guitar Hero on the PS3 and the Nintendo Wii. Week one consumer sales of Guitar Hero 3 have already exceeded $100 million. The Guitar Hero franchise is one of the most successful entertainment properties in any medium -- film, television, music, or videogames, and Guitar Hero 3 is by far the most successful product launch in Activision's history.

Additionally, the multi-platform release also ranked as the largest hardware unit launch this cycle and is likely the largest hardware launch in the history of videogames.

Competitively, we expect the Guitar Hero franchise to be the winner at retail this holiday. We have huge, early consumer response well before the heavy selling periods of Thanksgiving or Christmas. We have an unprecedented amount of global supply, the product is available now on all console platforms, we have more than 30 million demonstration kiosks that will drive consumer awareness and purchase intent, and in the international markets, this is the only game of its genre available.

While we have worked hard to increase our global supply, given the exceptionally strong early consumer response, there is a probability that this holiday, we won’t be able to satisfy all the demand for every platform, but we will have millions of Guitar Heroes around the world.

Tomorrow, we’ll launch one of our remaining third quarter release, Call of Duty 4: Modern Warfare, in North America, and Call of Duty 4 is extremely anticipated, it’s already receiving rave reviews from the gaming press, including a perfect 10 from the official X-Box Magazine.

The team has done an incredible job delivering a product with production values and game play that truly capture the best of next generation videogames. The combination of our record first half results, our strong holiday lineup, and the increased visibility that comes with launching all of our major holiday titles well before Thanksgiving has enabled us to increase our full year revenues and earnings outlook.

Our global leadership position continues to strengthen and our competitive advantage is derived from our focus on expanding our balanced franchise portfolio into opportunistic genres, leveraging our strong portfolio with best-in-class marketing programs, the exploitation of emerging market growth, and by ongoing initiatives to reduce expenses through organizational efficiencies.

All of these efforts should lead to continued margin expansion and higher returns on invested capital in the future. We believe over the long term, we can continue to provide superior returns to our shareholders, as we have over the past 17 years.

Later in the call, Mike will share more details on our Q3 titles and the remainder of this fiscal year and provide a look at fiscal ’09. Now, Thomas will provide a brief review of our operations during the last quarter. Thomas.

Thomas Tippl

Thank you, Bobby, and good afternoon. For the September quarter, net revenues were $318 million. This is $68 million higher than our prior outlook and up $130 million versus the prior year, due to the strong performance of premium-priced Guitar Hero Rocks the 80s and the European launch of Transformers, in addition to continued sales of our first quarter launches.

Before I continue with our financial review, I would like to note that certain numbers I’ll be giving you will not be in accordance with GAAP. Please refer to our earnings release for a full reconciliation. I would also like to remind everyone that after the beginning of this call, some of the numbers I will be sharing with you, particularly the outlook for Q3, Q4, and the full fiscal year 2008 and beyond, are forward-looking statements and not historical facts and are based on current expectations and assumptions that are subject to risks and uncertainties identified at the outset of this, in our press release, and in our most recent annual report on Form 10-K.

So for the September quarter on a GAAP basis, we delivered break-even earnings per share as compared to a loss per share of $0.09 in the same period of the prior year. Excluding the impact of equity-based compensation, we delivered earnings per share of $0.02. This is higher than anticipated and a significant improvement versus the prior year quarterly loss of $0.08. The main drivers were strong title performance and operating leverage.

Manufacturing and distribution expense for the quarter was 48% of revenues, down significantly from 68% in the prior year, due to improved mix and higher price realization, as consumers continue to trade up to next generation platforms.

Product creation costs for the quarter on a GAAP basis were 27% of revenues and excluding the impact of equity-based compensation, were 26% of revenues. We define product creation costs as the sum of total sales, software royalties and amortization, cost of sales intellectual property licenses, and product development expenses. Product creation costs were higher than the prior year due mainly to a higher mix of licensed properties.

Sales and marketing expense for the quarter on a GAAP and non-GAAP basis were 16% of revenues, an improvement of more than 100 basis points versus a year ago. G&A as a percentage of revenues on a GAAP basis was 12% and excluding equity-based comp was approximately 11%, an improvement over 140 basis points over last year. We continue to make good year-over-year progress; however, the numbers still reflect the impact of higher legal and professional fees, intangible amortization related to the Red Octane and Demonware acquisitions.

We generated high investment income for the quarter due to higher cash balances and higher interest rates versus the prior year.

Our effective tax rate for the quarter was 73%. Our tax rate this quarter was higher than expected due to a tax law change in the U.K. However, we still expect our full-year tax rate to be around 34% to 35%.

Turning to the balance sheet, on September 30, we had $962 million in cash and short-term investments. This is in line with the last quarter and more than $210 million higher than last year, due to strong operating performance.

The accounts receivable balance was $110 million. This is down $88 million versus the prior quarter due to collections of first quarter revenues. The accounts receivable reserve as a percentage of trailing nine-month revenues was 9%.

Inventory was $189 million, up $97 million versus last quarter. As noted on our last call, we expected inventories to be substantially higher as we prepared for the multi-platform launch of Guitar Hero 3. On September 30, inventory was $155 million for the publishing business and $34 million for the distribution business.

Capitalized software development costs were $132 million, an increase of $25 million versus the prior quarter due to the large number of titles releasing in Q3. Capitalized intellectual property costs were $82 million, in line with the prior quarter.

In summary, we finished the quarter well ahead of the revenue and earnings outlook we provided and based on our strong business momentum and increased visibility, we are raising our fiscal ’08 outlook.

Specifically for Q3, we are expecting net revenues of approximately $1.05 billion. For the third quarter, on a GAAP basis, the company expects manufacturing and distribution costs of approximately 43% of revenues and operating expenses, including royalties, of about 35%. We project a tax rate of about 34% to 35% that can be used throughout the fiscal year, and a diluted share count of about 316 million.

Finally, we expect earnings per share of approximately $0.51.

For the third quarter, excluding the impact of equity-based compensation, we expect operating expenses including royalties of 33% and earnings per share of approximately $0.55. All other line items are the same, as I mentioned a moment ago.

For the fiscal fourth quarter, on a GAAP basis we expect a loss per share of $0.05; excluding the impact of equity-based compensation, we expect a loss per share of $0.03.

For the second half of the fiscal year, we expect the acquisition Bizarre Creations will be dilutive to earnings by approximately $0.02 to $0.03, and this is incorporated in the outlook I just provided.

As for the full fiscal year, we are increasing our outlook and we now expect net revenues of approximately $2.7 billion. On a GAAP basis, we expect manufacturing and distribution costs of approximately 44% of revenues and we expect operating expenses, including royalties, of about 45%.

We project a diluted share count of about 316 million.

Finally, we expect earnings of approximately $0.55 per share.

For the fiscal year excluding the impact of equity-based compensation, we expect operating expenses, including royalties, of about 43% and earnings per share of approximately $0.65.

The last item I wanted to touch on was our balance sheet philosophy, since this is a topic frequently brought up at our investor and analyst meetings. Our strong cash position enables us to continue making strategic investments in the future, like we recently did with Red Octane, Transformers, Demonware, and Bizarre Creations. We are sharply focused on investment opportunities that expand our intellectual property portfolio, expand our next generation development leadership, strengthen our global marketing and distribution footprint, and most importantly create long-term shareholder value.

Our track record over the past few years has been strong in this area, especially with respect to return on invested capital. Our acquisition process is thoughtful and rigorous, with a very strict set of criteria that must be satisfied.

At a minimum, we require that our investments provide scale across geographies and platforms, the ability to generate an annual revenue stream, and matched with a proven development solution and strong financial returns based on proven benchmarks. It is this institutionalized process that has kept us from justifying speculative investment in unproven business models and rewarded our shareholders with superior returns over many years.

We see more opportunities that fit this approach and we plan to continue to capitalize on them with the help of our strong balance sheet and operating performance, and this brings me back to the near-term.

We expect that fiscal 2008 will be by far the largest and most profitable year in Activision's history. This year, we will more than double our operating income and expect to deliver industry-leading operating margins and net income, all while still in the early phase of the cycle.

I will now turn things to Mike Griffith, President and CEO of Activision Publishing, who will provide his thoughts on the balance of fiscal ’08 and fiscal ’09.

Michael J. Griffith

Thank you, Thomas. Today, my comments will focus on where we see the hardware and software markets for the balance of the year, our market position as we enter this holiday season, and our initial thoughts on fiscal 2009.

Overall, industry fundamentals are very strong and we expect they’ll continue to improve. On September 30th, the installed base of hardware in North America for current and next generation systems, including handhelds, was approximately 137 million units. The large installed base of the PS2, combined with the growing installed base for all three of the next gen systems plus handhelds continues to provide an attractive market dynamic. And recent hardware price reductions on next gen platforms are further building opportunity.

With respect to hardware, the hardware market in total as of today, we expect the following increases in North America during the calendar year. We are estimating PS2 will be up by 4 million to 5 million units and we are anticipating 3 million units of PS3.

We expect X-Box 360 growth of 4 million to 5 million units. We also expect about 5 million to 6 million units from Nintendo's Wii, and finally, we expect handhelds will grow approximately 12 million to 13 million units.

Moving to software, we define our market to include all major platforms in North America and Europe. For calendar 2007, we expect a combined North American and European software markets for current and next-gen consoles, handheld and PCs, to grow in excess of 15%, driven in part by a strong installed base of hardware. The overall market growth has been broad-based across platforms and across geographies, and even if you exclude the strong growth of the Nintendo consoles year over year, the software market would still be growing at a double-digit pace.

With respect to software pricing, to date we continue to be pleased by the consumer and retail acceptance of the higher next gen pricing and we expect that traditional software launch pricing for the X-Box 360 and PS3 will continue to 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, and as always, we intend to monitor pricing conditions very closely this holiday and remain mindful of competitive practices.

Turning now to the balance of fiscal 2008, our Q3 performance will be driven by our slate and strong commercial execution, both in the U.S. and internationally. Our emphasis on consumer marketing, retail category management, and in-store execution against our largest markets and largest customers continues to be our focus.

This quarter, we’re bringing an exceptionally strong game lineup to a marketplace that’s poised to reward companies with well-established brands. Our slate is anchored by high quality games based on our most successful franchises, including Tony Hawk, Spider-man, Call of Duty, and Guitar Hero, as well as Enemy Territory, QUAKE Wars, and a game based on Dreamworks’ new Bee Movie.

On October 16th, we launched our first Q3 title, Tony Hawk’s proving ground. The game builds on the core assets associate with Tony Hawk and deeper customization of the features most appreciated by the mass consumer.

Tony Hawk is still the only skateboarder with mass market appeal and the Proving Ground game is targeted squarely at the broad holiday audience, with strong merchandising and advertising throughout the season.

Proving Ground will also be available on more platforms than any other skateboarding game and it will be the only game of its kind on the PS2 platform with the largest installed based.

Next, we continue to diversify our superhero portfolio and broaden our leadership in the category with the release of our new Marvel title, Spider-man: Friend or Foe, which is targeted toward a younger demographic and is a perfect title for the holiday season. This game is off to a strong start and is likely to benefit from the momentum and advertising spend created by the recent DVD launch of Spider-man 3.

Beyond providing a positive environment for Spider-man: Friend or Foe, this should also benefit continued sales of the Spider-man 3 game, which was launched initially in Q1.

On October 29th, we released the Bee Movie game, based on the Dreamworks film that stars Jerry Seinfeld and opened this past weekend. Bee Movie is our first full console title to come from our internal studio in Canada where we’ve been building capability to help match costs with opportunities. For this title, we were able to significantly lower the cost of the development spending and early reviews are strong.

Next, as Bobby mentioned, tomorrow will mark the highly anticipated launch of Call of Duty 4: Modern Warfare. The Call of Duty franchise was our largest selling in fiscal 2007 and this title marks the fourth consecutive annual release. This is a wholly-owned, internally developed title and we are very pleased with the exceptional reviews it’s been receiving.

We are also encouraged the introduction of the modern day element to this franchise significantly increases future opportunity for the Call of Duty brand with a new leg on the stool.

With game quality and reviews comparable to Halo 3, consumer interest is very high and preorders are up significantly versus the prior year and set a new company pre-sell record, although only briefly as it was surpassed by Guitar Hero 3 preorders, which I’ll discuss in a minute.

We also plan to continue to drive momentum on Call of Duty through the holiday and into next calendar year with a variety of downloadable content available in the months ahead.

Finally, October 28th marked the largest product launch in Activision history with Guitar Hero 3: Legends of Rock. Guitar Hero is another internally developed, wholly-owned franchise that continues to build the genre it created. Sell-through to consumers topped $100 million in its first week, setting a new company record.

As you know, we’ve been working vigorously for the last nine months to increase our guitar manufacturing capacity. We’ve put an experienced product supply organization in place with on-the-ground resources in North America, Europe and China to manage the complex logistics.

And thanks to the hard work of this group around the world, we were able to increase our production significantly to launch across four different console platforms with an unprecedented level of supply and significantly more units than a year ago.

A week ago, we would have told you we had adequate supply in place. But given initial consumer demand, it’s possible the demand will outstrip supply on certain platforms before Christmas.

The strength of this product has resulted in extraordinary interests from our retailers, the media, and consumes. To help ensure we continue our momentum, we have over 30,000 in-store kiosks worldwide where consumers can demo the game, and this is more than triple the number of kiosks we had last year.

Guitar Hero 3 offers tremendous value with over 70 songs available at purchase. The game features a strong soundtrack, including master tracks by such artists as Aerosmith, Sex Pistols, Metallica, Guns ‘n Roses, the Rolling Stones, Beastie Boys, and Pearl Jam, as well as new original songs by Slash and Tom Morello.

Guitar Hero 3 will also offer a robust slate of new downloadable content for the X-Box 360 and the PS3. The game builds on its signature easy-to-play but difficult-to-master game play, and adds new features including boss battles, where players can challenge Slash and Tom Morello in side-by-side, head-to-head play. And finally, the all new wireless guitar controllers are available for all platforms.

We are equally excited about the upcoming launch of Guitar Hero 3 in Europe later this month. The large and growing European market offers us tremendous opportunity and Guitar Hero 3 will for the first time provide localized song content with music from a selection of popular European bands in addition to being the only game of its kind available this holiday season.

As you know, one of our core tenets to achieving sustainable growth in margin expansion is driving our independent studio model as a long-term competitive advantage, and our execution this holiday reaffirms our strategic choice.

A prime example of the strength of our model was the seamless transition of bringing Guitar Hero development in-house. The team at Neversoft has done an exceptional job bringing innovation to the franchise while keeping the game true to what has made it part of pop culture, all in a relatively short period of time.

Another example of our studio strength is that our large Q3 product lineup was completed early this year, giving us additional sell-through potential and making us the only independent publisher who did not delay a holiday release.

In terms of expertise, our studios are executing at a high level on the PS3, a technically challenging platform where many are struggling. To understand the significance of this, play Call of Duty 4 on the PS3 and compare the experience to other PS3 games.

Finally, the acquisition of Bizarre Creations significantly [inaudible] our internal development expertise and bolsters our development resources. The 160 developers are working on two major properties, including one new intellectual property for the large and profitable racing genre.

So in summary, our fiscal 2008 lineup is the strongest in the company’s history and with our improved visibility and strong execution, we are once again increasing our fiscal 2008 outlook, marking our first $2 billion year and our 16th consecutive year of growth.

Beyond this, fiscal 2009 already looks robust. The market conditions are expected to improve further and we intend to have a broad lineup of titles for both movie and non-movie games.

Movie games will include the new upcoming James Bond, which has been significantly revitalized by Casino Royale; Dreamworks’ Kung Fu Panda, which we are expecting to be the next Shrek-sized franchise; Madagascar 2; and the newly added Monsters Versus Aliens late in the fiscal year.

Next year we’ll also focus on driving Guitar Hero further globally, as it’s likely we’ll still be trying to catch up with consumer demand, and we have a number of new exciting dimensions for the franchise. We’ll also broaden our core franchises, like Call of Duty with a new title across more platforms next year than this year, and Tony Hawk.

In addition, we’ll be supporting our leadership position in the superhero category with two new releases, and of course we expect to have an especially strong catalogue coming from our fiscal 2008 lineup.

More details of our fiscal year 2009 slate will be announced on a later call, but in fiscal 2009 we see the market continuing to expand at a double-digit rate, see our portfolio of brands continue to grow and continue to find upside opportunity on our largest franchises, see increasing revenues from emerging markets, and lastly, we’ll continue to focus on shareholder value creation through operational discipline.

With that, thank you very much for listening and the opportunity to share our initiatives with you for the future, and I’ll now open up the call for your questions. Thank you.

Question-and-Answer Session

Operator

(Operator Instructions) We will take our first question from Tony Gikas with Piper Jaffray.

Tony Gikas - Piper Jaffray

Good afternoon, guys. Congratulations on a good quarter. A couple of questions; given that you continue to exceed sales estimates, could you give us a little update on your outlook for operating margin prospects and what line items do you see the most leverage on? Is that R&D?

And then the second question, retail sell-through on Guitar Hero 3, could you break that down or give us some visibility on the platform, platform breakdown?

Thomas Tippl

I’ll take the first one and then Mike is going to speak to Guitar Hero. Our plan for margin expansion hasn’t changed. We are supremely focused on it. To date, we are tracking ahead of the plans we set originally. There is a good chance that this year is going to be a year of record margins for us, higher than in the previous peak and we are early in the cycle. We’ve set a goal for 15% to 18% for the peak of this cycle and obviously the fact that our strategies so far are tracking ahead are giving us confidence that we can get there.

In terms of where that expansion is coming from, it’s really coming from all line items. So we are expanding gross margins with a couple of drivers. The first one being that our publishing business, which is higher margin, is growing faster than our distribution business. Within publishing, the shift, the trading up of consumers to next generation consoles gives us further gross margin expansion because we are selling those at a 20% price premium, as you know.

And then lastly, we’ve also started to tackle the supply chain in order to optimize it and get efficiencies from there and we’ve done that in most of our business except Guitar Hero, where we are so far extremely focused on expanding capacity, so that’s going to be a priority for that franchise next year.

Product creation costs, we’ve made good progress. I think we’ve explained on previous occasions that we are very deliberate with that, qualifying every step of the way the interventions that we are making and Mike mentioned the Bee Movie success we have seen with off-shoring a complete game. So all of this is going in the right direction but because that’s the life of the company, we’re taking very [inaudible] approach.

And then lastly, you have already seen the efficiency improvement in trade and marketing spending and we would expect to continue to see scale leverage on the G&A line as the top line is growing at a double-digit pace.

Michael J. Griffith

Tony, on your Guitar Hero question, as we said, we are pleased that we sold through more than $100 million in the first week. But I can tell you it’s broad-based across platforms and proportional. We started the franchise on the PS2 and then migrated it to the X-Box 360 last March. We’ve now franchise life to date sold more than 7 million units through to the consumer and I think our initial experience with Guitar Hero 3 across all platforms reinforces that it’s a proposition that plays wells across all platforms on which it is offered.

Tony Gikas - Piper Jaffray

Just a quick follow-up then; are there any key markets that Guitar Hero 3 will not launch in that might come next year?

Robert A. Kotick

In terms of geographies, you mean?

Tony Gikas - Piper Jaffray

Correct.

Michael J. Griffith

No, it’s going to launch in all of our key Activision geographies. It has launched first in North America. It launches across all our European geographies in late November, and then will also be available in Asia-Pacific, although we expect most of the business there to be our more traditional market, such as Australia.

Robert A. Kotick

But as we’ve pointed out, Tony, there may be some supply constraints as we get into the balance of the year.

Tony Gikas - Piper Jaffray

Okay. Great job, guys. Thanks.

Operator

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

Michael Savner - Banc of America Securities

Thanks very much. If I could also follow up on the margin question, in light of Thomas’ comments, even after adjusting for the Bizarre acquisition, I would have expected maybe a little bit more flow-through of earnings from that revenue upside, given that presumably your increased optimism on revenue is coming from success of higher margin titles like Guitar Hero and Call of Duty, so is there something that could be offsetting? Is there pricing weakness away from the core titles that could offset or are you just being conservative? Because if I do the math correctly for the adjustment, it’s a little bit over 100 basis points of incremental op margin that you are forecasting, so how should we think about that flow through?

Thomas Tippl

I think first of all, [inaudible] in the holiday season, so I don’t think there is any reason to get ahead of ourselves for the whole year. I think this is very much in line with the philosophy that we have employed over the last couple of years.

Second, part of the revenue gain and increase in guidance is also related due to the weaker dollar and the strength of the Pound the Euro specifically, and of course that’s revenue increases that just falls through to the bottom line because the costs that are associated with those revenues go up more or less at the same ratio, since we are producing the product in Europe and we are marketing them in Europe and people in Europe are paid in Pounds and Euros.

Michael Savner - Banc of America Securities

Great, that’s helpful, thanks. And then one follow-up; as we think about Guitar Hero in ’09, and I know you are obviously very happy with the success here and don’t want to get ahead of yourselves, but as we think about what the opportunity is in ’09, is there anything that would prohibit you from adding new functionality, like additional instruments to a version further down the road? And can you talk a little bit about the -- how the economics of the game have changed at all as you’ve gone to master tracks, if at all?

Michael J. Griffith

I think on Guitar Hero, as we’ve said before, we are blessed with a title that has an awful lot of opportunity and different directions that you could go and our key challenge is prioritizing those for the broadest appeal, so we are looking at a number of exciting new vectors and directions to take the franchise for next fiscal and as Bobby had said, we’re adding capacity quickly to take full advantage of international markets.

So we’re not ready to talk to specific plans for Guitar Hero on ’09, but suffice it to say that it will continue to have a broad-based launch across platforms and across geographies, and certainly working actively toward adding additional functionality to the brand.

Michael Savner - Banc of America Securities

And the part about the economics on master tracks?

Michael J. Griffith

The economics are pretty solid across versions of the brand and we really don’t anticipate a significant change in the economics. There are -- while today we are focusing largely on increasing our capacity, we’ve also found some logistics efficiencies along the way. We think over time we are going to find substantially more efficiencies on the supply side of this franchise, and so while master tracks are a little bit more expensive than re-records and we have a blend of those in our game, they are not substantially more and thus far we’ve been successful offsetting them.

Robert A. Kotick

Michael, remember we have a higher price, wholesale price on virtually all of the products that have just been released in Guitar Hero 3 and I think when you see -- next year, we’d like to provide more insight into the details for next year but there is no shortage of opportunity on this franchise. As Mike pointed out, it’s prioritization of opportunity that continues to be the challenge.

Michael Savner - Banc of America Securities

Thanks, Bobby.

Operator

We’ll take our next question from Mark Wienkes with Goldman Sachs.

Mark Wienkes - Goldman Sachs

Thanks. Good afternoon. First, I was wondering, can you share your thoughts on any divergences you are seeing in the retailer positioning for the holiday period, meaning the big box retailers versus -- you know, are they on the same page as the specific game retailers? Any differences there?

And then, any prospect on pricing? And then on Skate versus Tony Hawk at retail specifically, any surprises versus your expectations, and how are those sales trending?

Michael J. Griffith

Could you just give me a little more clarification on your retailer positioning question?

Mark Wienkes - Goldman Sachs

As far as retailers are seeing some tough times right now, I guess from a square footage allocation perspective, have you seen them increase the square footage making available for videogames this holiday season?

Michael J. Griffith

I got it. Thank you. We’re seeing across all geographies very strong retailer support to the videogame space in general and certainly to our titles. The one trend that continues from previous years is that retailers are certainly focusing disproportionately on the largest opportunities, so I think that publishers with disproportionately, well-established slates are going to continue to see disproportional benefit from retailers. But in total, we’re seeing strong support across all retailer formats this year.

On your second question on Tony Hawk, no, I don’t think it’s anything that we haven’t expected here. Obviously it’s a competitive year for Tony Hawk and I think in the near-term, having an additional title out there is going to help drive awareness to the total segment, which is still a relatively small percentage of total videogames.

So while near term, I think we’re probably sharing some of the hardcore and early adapters, longer term we think the market has expansive potential in this. Tony has always been a mass market oriented game and it’s always skewed late in the quarter. It’s really a December title. It’s a good game. This year, we’ve got very strong merchandising and marketing set up really through the quarter and thanksgiving and on to December.

We’ve got a broader number of platforms available than the competitive title and we expect strong performance on Tony through the balance of the quarter. But like always, Tony is going to be a back end quarter game.

Mark Wienkes - Goldman Sachs

Right, thanks. Just one quick follow-up, if I could; using your new targets for 2Q, 3Q, implied revenue for 4Q is roughly a little over $200 million, or two-thirds of fourth quarter a year ago. Is that a reflection for an expectation for the increased competition from some of the other titles from publishers that have pushed them out into the March quarter, or just less visibility that far out?

Thomas Tippl

I think we -- let’s don’t forget last year we had the launch of the PS3 in Europe, so that’s in the -- we don’t have that this year. We are getting all the PS3 titles out in all geographies already in Q3. That’s probably the bigger factor here.

Mark Wienkes - Goldman Sachs

Okay. Thanks very much.

Operator

We’ll take our next question from Brent Thill with Citi.

Brent Thill - Citigroup

Thanks. Tom, I was just curious if you had a percent of revenue as it relates to Guitar Hero in the quarter and how you are thinking about that for the year?

Robert A. Kotick

You’re asking for Q3?

Brent Thill - Citigroup

For Q2.

Thomas Tippl

Guitar Hero, we don’t provide the revenue numbers for a specific title but it was in the -- between roughly 30% range, so not surprising, it was the one title that had a new launch this quarter with Rock the 80s on the PS2 and that performed very well. Guitar Hero downloads, all of the song packs continue to perform very well, so it is one -- it is our leading franchise at this point.

Brent Thill - Citigroup

And just as it relates to the European rollout, any different dynamic that you expect as it rolls out there?

Thomas Tippl

As we said, in Europe, the way we look at the business is we are one year behind with establishing the brand in Europe because initially, we were supply constrained and focused on North America. This is really the first year where we are providing our international markets the tools to be successful as we have been in the U.S. We have much more supply available. We have for the first time localized content available with European bands, which allowed us to establish the same kind of marketing and promotional programs that we have executed over the last two years in North America, and of course retailers in Europe are watching what’s happening over here in the States and are now getting fully behind the product. And over the original space constraints that we faced maybe back a year ago, so we are very bullish about the prospects we have in Europe. Music is a universal genre. From our perspective, there is really no reason why this business can’t be successful in Europe and you’ve already seen this in other parts of the music genre with Sony SingStar being extremely successful in Europe. So we think we are going to make major progress there not only this year but even more so the next year.

Brent Thill - Citigroup

Thanks.

Operator

We’ll hear from Ben Schachter with UBS Securities.

Ben Schachter - UBS Securities

Congratulations on a nice quarter. Bobby, for as long as I can remember, you’ve been talking about the idea of having more concentration among the top tier publishers. And if you look at some of the NPD data, there have been months where 80% plus of revenues have come from the first party and the top five. How much more concentrated can that really get? How do you position yourself there to continue to gain share against some of the other big guys?

Separately, there’s been a lot of activity in Asia, capital markets, looking at that, and the margins over there are just spectacular compared to what you get with Europe, for business models. How does Activision potentially play in that space? Thanks.

Robert A. Kotick

Well, as we’ve said, share gains are going to be something that you see concentrated in the top tier publishers and that’s happening. We are probably the best example of that this year, but when you look out over the next few years, we continue to see franchise consolidation, developer resource consolidation, retail distribution consolidation to only the very, very top tier companies. You will see the benefit of that at retail and with the consumer, with our product line this year or next year.

As far as what’s happening in Asia, we are looking at it very carefully. You are starting to see some great dynamics. The great news for us is that in the markets like the U.S., the U.K., France and Germany, there is still a lot of upside for us to grow our business, especially in Europe. And so we are going to capitalize on that for the next few years, but we are starting to see some great opportunities emerge in Korea and in China and we are going to be looking actively at those markets for the long term for growth.

Does that answer your question, Ben?

Ben Schachter - UBS Securities

Yes, thanks. One quick follow-up; just how important are some of the ancillary hardware pieces for Guitar Hero? You see all the guitar face plates and all that kind of stuff all over the stores at Best Buy, et cetera.

Robert A. Kotick

You know, when you have a popular cultural phenomenon like this, all of these things are additive and they demonstrate the investment the consumers are making into the brand and we are seeing Guitar Hero is being integrated into TV shows now, like Gossip Girls and it’s just -- it’s a phenomenon that we haven’t seen before where it’s one of these few videogame properties that has really infiltrated popular culture. And when we talk about the prioritization of opportunity, you are really seeing the strength of this brand, the power of this franchise and it’s one of those things where how much is up? When you look at the opportunities for downloadable content, when you look at some of the opportunities we’re pursuing in new categories that relate to new types of experiences with the guitar for next year, it really is one of the -- it’s a great problem of prosperity to have, but prioritization of opportunity is the great challenge.

When you think about $100 million of revenues in the first week generated by this product, it’s now -- you start to see this is a property that has transcended videogames and it is now one of the most valuable franchises in entertainment.

Ben Schachter - UBS Securities

Thanks.

Operator

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

Shawn Milne - Oppenheimer

Thank you. Good afternoon. Just a couple of quick questions; one on the Bizarre Creations acquisition -- when you made that acquisition, I believe there was no specific time for the racing title, and actually I think it was in the release, you said it wasn’t in fiscal ’09. Can you update us on that?

And then Bobby, can you just talk a little bit more about Guitar Hero on the supply side? Are you feeding North American retail hand-to-mouth? Or are you building inventory along the supply chain? Just more color on to the extent that you think you may see stock-outs. I mean clearly, we’re seeing some on our checks already but it obviously got a very big push out the door. Anymore color there?

Thomas Tippl

Let me start with the answer on Bizarre. These guys have been historically on a two-year development cycle and that has worked well for them. That is how they consistently launched 90-rated games and that’s why we said when we announced the acquisition that the first title coming in the racing genre will be after FY09. So that hasn’t changed.

Robert A. Kotick

And as far as the supply chain is concerned, without getting into too much detail, we think we’ve got a very good handle. As Mike pointed out, we’ve got a terrific team on the ground here, in Europe, in Asia. We are working really hard at managing both the cost of goods and our ability to secure inventories to supply to the demand, and so -- as compared to last year, we were able to launch millions of units around the U.S. in every retailer and we had some fantastic trade marketing and consumer marketing programs. I would say they were probably the best in the history of the company.

So we are continuing to manage through the supply and I guess the good news here is that even we didn’t anticipate the popularity of the product in the first week.

Shawn Milne - Oppenheimer

Thomas, can you break out Guitar Hero as a percent of inventory?

Thomas Tippl

That increase that you saw from the end of the first quarter to the end of the second quarter was driven by Guitar Hero.

Shawn Milne - Oppenheimer

Thank you.

Thomas Tippl

And just to be clear, we are on a continuous manufacturing process here, so we keep cranking out new guitars for all platforms every week, so we will be able to continue to supply the retail channel with additional units during this holiday season and in Q4.

Operator

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

Heath Terry - Credit Suisse

Forgive me if this sounds like I’m harping on the issue but I was wondering if you could give us an idea of what kind of tie ratio you have seen for the guitar, for extra guitars? So what percentage of users are buying multiple guitars, and to what degree you feel like there is still a significant gap between supply and demand? This is the third year of you -- or the third iteration of Guitar Hero and it seems like really from nearly from the start, there hasn’t been a consistent supply of the extra guitars on shelves at retail. So we’ll just trying to get an idea how much pent-up demand is out there for you ultimately to be able to fill as you are able to get hardware to consumers.

Thomas Tippl

It’s in our interest to drive the installed base of the game and therefore, during the period of time there were supply constraints, our priority was to use the guitar supply in bundled products in order to get the product in the hands of as many consumers as we possibly could. And that’s what you are also seeing still with Guitar Hero 3. It was the mass majority of product being sold is a bundled product.

As we catch up with demand, we will see the percentage of standalone guitars also increase, but there is no doubt that there is at this point probably some pent-up demand there, although we will have to see how we come out of the Guitar Hero 3 launch. This is an opportunity for people that bought Guitar Hero 2 on the X-Box 360 to buy another bundle and that way get to their second guitar, and we are going to monitor and read this carefully throughout the holiday season.

Robert A. Kotick

I will say, Heath, I think we’ve been surprised at the sell-through in the first week and I think that there is an enormous amount of pent-up demand, especially that the product is now available for the first time on platforms like the Wii, so while we didn’t accurately anticipate the demand on launch, I think over the next year or so, we’ll get production in line and start to be able to deliver more to the demand.

Heath Terry - Credit Suisse

Great, but not to try and nail you down to a number, but is there a sense that you have of what percentage of those Guitar Hero -- of that Guitar Hero installed base that is out there actually has been able to buy multiple guitars?

Robert A. Kotick

It’s a very small percentage today.

Heath Terry - Credit Suisse

Thank you.

Operator

Moving on, we will take our next question from Jeetil Patel with Deutsche Securities.

Jeetil Patel - Deutsche Bank

Hey, guys, a couple of questions; I guess from a platform development standpoint, it’s probably early thinking right now but do you have to now start to make decisions on which platforms you are going to be supporting with your entire lineup as you look at calendar 2008, fiscal ’09? I guess relating specifically to the PlayStation 3, given the lower installed base there, or is it too early to tell?

And then second, can you talk about in fiscal ’09, obviously there’s still another good growth here coming for the industry as a whole. Do you think that the overall year will be characterized as more of a margin expansion type of opportunity or a market share gain type of opportunity in terms of how you prioritize your product lineup and your targets as you look at the upcoming year?

Michael J. Griffith

Let me tell you first on the platforms as we make development decisions going forward. Our strategy is to support all viable platforms and we really don’t see that changing. We think all platforms that are out there now continue to be viable through fiscal ’09. We are seeing encouraging growth from the PlayStation 3, particularly as they’ve started to implement their price reductions in Europe. We think Sony across both the PS3 and the PSP will continue to be a major factor, so our development strategy is broad-based against all of the viable platforms.

I think in terms of fiscal ’09 specifically, we are planning on year-over-year growth, just as we have every year. We’ve got a robust slate shaping up, anchored by a strong movie schedule with Kung Fu Panda, which as I said earlier we think will be one of the larger Dreamworks offerings.

Madagascar 2 -- Madagascar 1 performed very well for us, so we are encouraged by that. We’ve got another Dreamworks film, Monsters Versus Aliens, coming late in the year and we’ve got James Bond, which as you know is a revitalized franchise.

We’ve talked already about upside on Guitar Hero and Call of Duty, which will be a major focus for ’09 and a number of other titles, of course, including Tony Hawk and more superheroes.

I think the slate, along with increasingly attractive fundamentals in the market and a foundation of strong catalog titles that we are launching now for next year will really put us in a very attractive position to continue our growth and margin expansion into fiscal ’09.

Jeetil Patel - Deutsche Bank

Got it. And a quick follow-up just on Ben’s question, but it seems like Guitar Hero has obviously quite a -- a big social phenomenon, almost resembles what Audition is doing in the Asia-Pac region between Korea and increasingly China, but have you thought about porting that title into more of the MMO space for Asia? How fast can you do that if you were to go into Asia-Pac with that type of a product offering?

Robert A. Kotick

We probably don’t want to get into too much of the product plans for next year now, but obviously we said that we think that there’s a great strategic opportunity for certain kinds of products in the Asian market, particularly in Korea and China, and remember this is a category of product that has had some success, even in Japan. So when we look out at all of the prioritization of opportunity that we need to do, clearly those are things that fall into the realm of opportunity for us for the future.

Operator

Mr. Patel, do you have anything further?

Jeetil Patel - Deutsche Bank

I’m set. Thanks.

Operator

We have time for one more question. This comes from Ralph Schackart with William Blair.

Ralph Schackart - William Blair

Good afternoon. Congrats on another good quarter. You touched on it briefly about the catalogue sales of Spidey 3. Just curious if you could give us a little bit more color on your thoughts of the catalog for Spidey 3, Shrek, and Transformers for the holiday quarter with the DVD releases. Thanks.

Michael J. Griffith

I think if you go back to the beginning of the year, we are pleased that between Shrek, Spider-man movie 3, and Transformers, we had a leading share -- in fact, a majority share of all the movie related games thus far this year. And all three of these games are supported by DVD launches in Q3 -- Shrek, Spidey, and Transformers.

As we also mentioned earlier, Spider-man: Friend or Foe launches as well as Shrek: Ogres and Donkeys. Both of these, besides opportunities in and of themselves, combined with the DVD launches and give us a real umbrella merchandising opportunity to continue to sell the catalogue from the Q1 movie titles. And we are focused on strong programs throughout the gift-giving holiday season on that.

Transformers, as we said, is really a breakout title for us. It’s already shipped more than 3 million units and we fully expect both Spider-man and Shrek franchises to grow year over year as well.

Robert A. Kotick

And Ralph, we have really -- I’ll tell you, being so dominant at retail right now and having what we believe is probably the best-selling organization in video games, we are finding that the opportunities to tie into trade marketing programs on the DVD, having now had so many years of expertise and experience doing it, this is where you really get the benefit of the combined trade marketing expertise of the studios, DVD organizations, and our selling organization. So we are getting a great benefit there.

Operator

This does conclude the question-and-answer session. At this time, I will turn it back over to Kristin Southey for any additional or closing remarks.

Kristin Southey

I would like to say we would like to thank you all for your time and the opportunity to share our initiatives for the future. Thank you very much.

Operator

Once again, this does conclude today’s call. Thank you for joining us and have a great day.

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