Electronic Arts F3Q06 (Qtr Ending Dec 31, 2005) Earnings Conference Call Transcript (ERTS)

Electronic Arts (ERTS)
Q3 2006 Earnings Conference Call
February 2nd 2006, 5:00 PM.

Executives:

Tricia Gugler, Director, Investor Relations
Warren C. Jenson, Chief Financial and Chief Administrative Officer
Larry Probst, Chairman and Chief Executive Officer
Frank Gibeau, Executive Vice President and General Manager of North American Publishing

Analysts:

Elizabeth Osur, Citigroup
Brian Pitz, Morgan Stanley
Heath Terry, Credit Suisse
Evan Wilson, Pacific Crest Securities
Jeetil Patel, Deutsche Bank
Mike Wallace, UBS
Edward Williams, Harris Nesbitt
Chris Quast, FIG
Helen Fleming, Merrill Lynch
Gary Cooper, Banc of America
John Taylor, Arcadia
JP McNealy, American Technology
Lowell Singer, SG Cowen
Robert Haley, Gabelli & Company
Mike Hickey, Janco Partners
Mark Schumacher, Hallum Capital
Brendan McCabe, CIBC World Markets
Tony Gikas, Piper Jaffray

Presentation

Operator

Good day everyone and welcome to the Electronic Arts third quarter fiscal year 2006 Earnings Conference Call. Today’s call is being recorded. For opening remarks and introductions, I would like it turn the call over to Ms. Tricia Gugler, Director of Investor Relations. Please go ahead.

Tricia Gugler, Director, Investor Relations

Good afternoon, and welcome to our third quarter fiscal 2006 earnings call. Today on the call we have Larry Probst, Chairman and Chief Executive Officer, Warren Jenson, Chief Financial and Administrative Officer, and Frank Gibeau, Executive Vice President and General Manager of North American Publishing.

Before we begin, I’d like to remind you that you may find copies of our SEC filings, our earnings release, and a replay of the webcast on our website at investor.ea.com. Shortly after the call, we’ll post a copy of Warren’s remarks on our website. Throughout this call, we’ll present both GAAP and non-GAAP financial results. Non-GAAP results exclude charges associated with restructuring, asset impairment, other than temporary impairment of investments and affiliates, acquired in-process technology, and other acquisition-related charges, amortization of intangibles, employee stock-based compensation, and certain non-recurring litigation expenses and their related tax effects. In addition, the company’s non-GAAP results exclude the impact of tax adjustments. A supplemental schedule to our earnings release provides a reconciliation of non-GAAP to GAAP measure. In addition, a supplemental schedule demonstrating how we calculate return on invested capital will be included on our website. All non-GAAP measures are provided as a complement to our GAAP results and we encourage investors to consider all measures before making an investment decision. All comparisons made in the course of this call are against the same period for the prior year unless otherwise stated. We have included our trailing 12-month platform shares in our 2006 estimated market outlook in a supplemental schedule that we will post on our website.

During this course of this call we may make forward-looking statements regarding future events and the future financial performance of the company. We caution you that actual events and results may differ materially. We refer you to our most recent form 10-K and form 10-Q for a discussion of risk factors that could cause our actual results to differ materially from those discussed today. We make these statements as of February 2, 2006, and disclaim any duty to update them. Now, I’d like to turn the call over to Warren.

Warren C. Jenson, Chief Financial and Chief Administrative Officer

Good afternoon and thanks for joining us. The December quarter was one in which we essentially held our own competitively, but overall sales were disappointing and well below our expectations. That said, on a relative basis, many of our titles did well. Five titles sold over 2 million copies, Need For Speed Most Wanted, FIFA 2006, Harry Potter and the Goblet of Fire, The Sims 2, and Madden NFL 2006. Need For Speed Most Wanted sold over 7 million copies with over 60% internationally. It charted in the top 5 on the PS2, XBox, XBox 360 and PSP in both North America and Europe. Harry Potter and the Goblet of Fire sold over 4 million copies. The Sims Franchise continues to thrive. Over 7 million copies were sold in the quarter, up over 40% from last year. FIFA 2006 and Madden 2006 continued to deliver. Year-to-date, unit sales are up over 15% on FIFA and up 8% on Madden. Our 360 revenue share was 30% in North America and we estimate approximately 24% in Europe.

In the quarter, there were several meaningful long-term events. We announced an agreement to acquire JAMDAT. We expect the deal will close later this month. We are well down the road with our integration planning and we look forward to having the JAMDAT team join us. In Online, we successfully launched our PC digital distribution platform with Battlefield Special Forces and Sims 2 Holiday Pack. We also recorded our first micro transaction revenue. Club POGO offered badge books to our customers. To date, there have been 280,000 downloads with each customer spending roughly $12. We entered into a long-term exclusive agreement to bring the Simpsons to next generation consoles. And we’re please to announce we’ve extended our exclusive relationship with Tiger Woods for another six years.

For the calendar year, EA was the number one publisher on PS2, XBox, PSP, and PC in North America and in Europe. Specifically on the PSP we ended the year with 31% revenue share in North America and we estimate 25% in Europe. In 2005, we had 4 of the top 10 titles in North America, Madden NFL 2006, Need for Speed, NCAA Football ‘06 and NBA Live ‘06. And 6 of the top 10 in Europe, Need for Speed Most Wanted, FIFA 2006, The Sims, Need for Speed Underground 2, Harry Potter and the Goblet of Fire, and FIFA Street. In sports, we had 70% category share on console in North America. We had 15 of the top 20 sports titles on the PS2 and 14 on both the Xbox and PC. In January, we launched NCAA 2006 MVP Baseball, which is off to a great start. In the first two weeks since launch, we have sold through over 200,000 copies at retail. Overall across all platforms in North America, our segment share grew roughly 1 point to 22%. And in Europe, we estimate we have lost roughly 1 point to 23%. Net-net we held our own in a tough market.

For the next few minutes, I’ll focus my remarks in two areas. First, I’ll review our Q3 financials; second I’ll go over our outlook and financial guidance. Following my comments, Larry, Frank, and I will open the call to your questions. Q3 performance, net revenue was 1.27 billion, down 11%, driven by lower current gen in PC revenue partially offset by an increase in revenue from handhelds and the Xbox 360. We released 49 SKUs in the quarter compared to 40 SKUs a year ago. 13 of the SKUs this quarter related to the 360 and PSP. Console revenue was 793 million, down 21% year-over-year driven by a 29% decline in current gen. 360 revenue or 76 million essentially offsetting the decline in Xbox-related revenue. PC revenue was 148 million, down 38% primarily due to last year’s strength of the Lord of the Rings, Medal of Honor, and The Sims 2.

Mobility, revenue more than tripled to 192 million, driven by 120 million from the PSP and to a lesser extent the NDS. During the quarter, we had 5 of the top 10 PSP titles in North America and 3 of the top 10 in Europe. Co-pub and distribution revenue was 99 million, up 20 million year-over-year due to the strong launch of Half Life 2 and Black & White 2. Internet services, licensing and other revenue was 38 million, down 8 million primarily due to lower license revenue.

Geographically, North America revenue was 618 million, down 74 million or 11%. Current gen revenue declined 32% in the quarter. 360 related revenue more than offset the decline in Xbox revenues. International revenue was 652 million, down 84 million or 11% year-over-year. Changes in foreign exchange rates negatively impacted our top line by 21 million. Europe revenue was 577 million, down 89 million or 13%. Current gen revenue was down 26% in the quarter. Our European revenue was down in large part due to last year’s launch of FIFA in Q3. Asia revenue was up 7% year-over-year driven primarily by the introduction of the PSP. In Australia, we had 36% revenue share on the PSP with 6 of the top 10 titles.

Moving on to the rest of the income statement. Gross profit in the quarter was 768 million, down 17%. Gross margin was 60.5%, versus 64.8% a year ago. The decline was driven by higher price protection and sales returns, and an unfavorable shift in product mix, partially offset by lower effective manufacturing royalty rates. Operating expense, marketing and sales, marketing and sales expense was 147 million, up 14 million over last year. As expected the increase relates to the support of our key titles around the world. General and administrative, G&A was 58 million, down 20 million year-over-year. The decrease was driven primarily by lower employee-related litigation costs and other personnel-related expense.

R&D, R&D was 206 million, up 21 million or 11% driven by overall higher personnel and facilities-related cost, partially offset by lower third-party development costs in the quarter. R&D related headcount was up 28% to roughly 5,000. The consolidation of Digital Illusions and the addition of Hypnotics accounted for 6 points of the increase. As you may know, yesterday, we moved to reduce headcount in some of our studio teams. This was done to align our resources against our product plan for the coming year and strategic opportunities in next gen platforms online and mobile. This is an unfortunate but a natural part of transition.

Diluted earnings per share were $0.83 versus $1.18 a year ago. Non-GAAP diluted earnings per share were $0.86 versus $1.23. The $0.03 difference between GAAP and non-GAAP diluted EPS relates primarily to charges associated with our reorganization and establishment of international publishing headquarters in Geneva. Our effective tax rate was 29% versus 31% a year ago. Our diluted share count was 311 million versus 317 million a year ago, had stock option expense been included in our results, GAAP diluted earnings would have been reduced by roughly $0.06 per share. As you know, we will begin expensing options next fiscal year.

On to the balance sheet. Cash, short-term investments and marketable equity securities were 2.7 billion, up from 2.6 billion a year ago, despite the completion of our 750 million shares repurchase program. Gross accounts receivable were 829 million versus 1.1 billion a year ago, a decrease of 24%, due to lower overall revenues and the timing of our release schedule. Reserves against outstanding receivables totaled 262 million, up 27%. Reserve levels were 13% as a percentage of trailing 6-month net revenue, up 3 points from last year. As a percentage of trailing 9-month net revenue, reserves were 11%, also up 3 points. Inventory was 76 million, down 10% from last year. Need for Speed Most Wanted represented roughly $10 million of net exposure. No other title represented more than $4 million of net exposure.

Our outlook. Before we get into the numbers, let me share our thoughts on the year ahead for the industry and EA. As we look ahead the calendar 2006, we anticipate the emergence of many long-term positives. But to be balanced, we also see several near-term challenges.

First the positives, XBox 360. The 360 will continue to build momentum throughout the year. We believe Microsoft will step up production as the year progresses and as a result, the financial significance of this platform will continue to build. PS3 and Revolution, the likely launches of the PlayStation 3 and Nintendo Revolution will add fuel to the excitement of owning a next generation console and software. As we enter late fall, we expect that all pieces of the next generation engine will be in place and ready to go. At the same time, next generation software will keep getting better, more plentiful and more exciting. This should also naturally increase demand.

Online. Online will continue to grow in importance and new revenue streams will likely emerge and expand, including dynamic in-game advertising, micro transactions and digital downloads. These new revenue streams will be additive to our existing $80 million internet-based business. Handheld revenue will continue to build. Year-to-date, our handheld revenue is over 300 million, up more than 210 million year-over-year. Mobile phones, as more game-enabled handsets are sold, this category will continue to grow. As a result of our pending combination with JAMDAT, we could easily see revenue from mobile phones exceed $130 million in our next fiscal year.

Now, let me talk about the challenges, lower current-gen demand. In the calendar 2006, we expect significant declines in the demand for current-gen software both in North America and in Europe. And as a result, we expect total software sales for the industry to be flat to down 5%, despite the new platforms and continued growth in the handheld segment. Current-gen price, while implicitly included in our estimates for the industry, we want to again call out that prices will continue to climb for current-gen software. Investments, the investment phase of this transition is not over. Talking about EA specifically, there are several areas where we plan to invest for the long term. In every case, these investments will negatively impact next year’s P&L.

In the coming year, we expect to do the following. First, spend on the PS3 well ahead of revenue and do everything we can to lead the way in the launch of this platform. We will also continue to build out our 360 portfolio and prepare for the launch of Revolution. Second, significantly expand our online business and content portfolio, both domestically and internationally. Third, increase our portfolio of new intellectual property. Fourth, aggressively grow our mobile business globally. And finally, continue to evaluate acquisition and investment opportunities.

In summary, as we look ahead to 2006, we see the emergence of several positive trends that bode well for our customers and our long-term shareholders. Our confidence in the potential for interactive entertainment remains intact. That said you should expect a tough 2006 where profits are again squeezed given the challenge of transition and our focus on investing for long-term growth. I’ll conclude my portion of today’s call with our 2006 market outlook and our fourth quarter financial guidance.

Hardware. In North America we expect the following hardware unit sales; consoles between 12 and 14.5 million units, handhelds between 10.5 and 11 million units. In Europe, we expect the following hardware unit sales; consoles between 7 and 9.5 million units, handhelds between 8.5 and 9.5 million units. We expect total North American and European software sales to be flat to down 5%, with current generation software sales down 35 to 45%, and total console sales down 10 to 15%, handheld software sales up 20 to 25% and PC software sales down 5 to 10. On mobile phones, we expect global publisher game revenue to be up 25 to 30%.

Now, on to our financial guidance. The following forward-looking statements reflect our expectations as of February 2, 2006. Actual results may be materially different and are affected by many factors such as consumer spending trends, the popular appeal of our products, development delays, current gen and next gen hardware availability, the seasonal and cyclical nature of our industry, the overall economy, competition, changes in foreign exchange rates, our effective tax rate, and other factors detailed in our earnings release and in our SEC filings.

For the fourth fiscal quarter, we expect revenue to be between 550 million and 600 million. GAAP net loss per share to be between $0.15 and $0.23, non-GAAP diluted earnings per share to be between $0.06 and $0.14. Please note that our expected GAAP results include approximately $0.17 of estimated acquisition-related charges associated with the likely closing of the JAMDAT transaction, $0.09 related to a possible decision to repatriate up to $500 million in foreign earnings under the Jobs Creation Act of 2004, $0.04 associated with the reorganization and establishment of an international publishing headquarters in Geneva and other restructuring activities.

Specifically in Q4 we expect to ship 32 SKUs. Our expected lineup includes Arena Football on two platforms, two Battlefield booster packs on the PC, Black on two platforms, Command & Conquer, The First Decade on the PC, FIFA Street 2 on five platforms, Fight Night Round 3 on four platforms, Godfather on three platforms, Godfather’s Collector Edition on two platforms, James Bond, From Russia With Love on the PSP, Lord of the Rings, Battle for Middle-earth 2 on the PC, Lord of the Rings, Battle for Middle-earth Collector’s Edition on the PC, MVP NCAA Baseball on two platforms, Rugby ‘06 on three platforms, The Sims 2, Open for Business Expansion Pack on the PC. On the XBox 360, we plan to ship three titles, Battlefield Modern Combat, Burnout Revenge, and Fight Night Round 3. In addition, on mobile phones we plan to launch four games, NASCAR, FIFA Street, POGO Harvest, and POGO Word Whomp. With that, Larry, Frank, and I will open the call to your questions.

Questions & Answers

Operator

Thank you, Mr. Warren. And the question and answer session will be conducted electronically. If you wish to ask a question please press “*