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Executives

Julie MacMedan - Vice President of Investor Relations and Corporate Communications

Brian Farrell - President and Chief Executive Officer

Colin Slade - Executive Vice President and Chief Financial Officer

Analysts

Colin Sebastian - Lazard Capital Markets

Brent Thill - Citi

John Taylor - Arcadia Investment Corporation

Doug Creutz - Cowen and Company

Ralph Schachter - William Blair & Company

Edward Williams - BMO Capital Markets

Arvind Bhatia - Sterne Agee

Tony Gikas - Piper Jaffray

Ben Schachter - UBS

THQ Inc. (THQI) Q4 2008 Earnings Call May 6, 2008 5:00 PM ET

Operator

Good afternoon. My name is Chris and I will be your conference operator today. At this time, I would like to welcome everyone to the THQ Inc. Fiscal 2008 Fourth Quarter and Year-End Results Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. (Operator Instructions). Thank you.

I would now like to turn the call over to Miss. Julie MacMedan, Vice President of Investor Relations and Corporate Communications. You may begin your conference.

Julie MacMedan - Vice President, Investor Relations and Corporate Communications

Thank you and good afternoon everyone. On today’s call, management will make forward-looking statements and projections regarding our expectations, estimates and predictions of the future. These statements about our business are based in part on assumptions made by management and are not guarantees of future performance. Therefore, actual results may differ materially from today’s forward-looking statements due to the risk factors that are described in our March 31, 2007 Form 10-K. A copy of this filing may be obtained from our website. THQ disclaims any obligation to update its view on any such risks or uncertainties or to revise or publicly release the results of any revision to these forward-looking statements.

In describing THQ’s financial performance, we will discuss non-GAAP measures including net sales and net income. Please refer to the reconciliation of these measures to GAAP results in the tables provided in today’s results release.

On today’s call Brian Farrell, THQ’s President and Chief Executive Officer, will review our performance and key initiative and will then turn the call over to Colin Slade, our Executive Vice President and Chief Financial Officer, who will discuss THQ’s results for our fiscal 2008 fourth quarter and our guidance for fiscal 2009. Brian will then provide closing remarks before we conduct a question-and-answer session.

I would now like to introduce Brian Farrell, our President and Chief Executive Officer. Brian?

Brian Farrell - President and Chief Executive Officer

Thank you, Julie, and good afternoon everyone. In fiscal 2008, THQ did not achieve our revenue and profitability goals. While we grew revenues for the 13th consecutive year, we did not deliver profitability to our shareholders for the first time in many years. For the second quarter in a row, we exceeded our top line objectives, but we are disappointed that charges related to additional accounts receivable reserves and increased software amortization resulted in profitability well below our expectations.

The challenges we faced during the year are principally the result of three factors. First, a few of our PS3 and Xbox 360 releases namely Juiced, Stuntman and Konan were simply not competitive. Insufficient game quality led to inadequate sell-through resulting in markdowns of retail as well as the accelerated amortization, I referenced a moment ago.

Second, the kids market was extremely competitive during fiscal ’08. In fact, it was the most crowded market for video games for kids in recent memory. With a tough Pixar comparison to cars and new competition from Nintendo First Party as well as new music games, our traditionally strong kids business did not meet expectations.

Finally, our cost structure in fiscal ’08 did not reflect our revenue levels as we spent heavily the market games like Juiced and Stuntman that ultimately did not reach our sales objectives. Our cost in the year were also affected by investments we were making in our studio system to support our long term growth. These fiscal ’08 challenges represent issues that are being addressed through the continued implementation of three key initiatives.

First, the introduction of a stronger product slate in fiscal 2009 and fiscal 2008. Second, it’s a continued focus on the important measures we discussed on our last call to improve product quality and competitiveness, and third is a realignment of our cost structure in order to create operating leverage.

I would like to discuss each of these areas of focus now. With respect to our fiscal 2009 pipeline, we believe we have a much more competitive slate for several reasons. First, our pipeline includes sequels to proven owned intellectual properties, Saints Row and Red Faction. We recognized the strength of GTA, but remain confident that Saints Row II has a differentiated competitive position with its focus on cooperative play, character customization, and over-the-top combat. Red Faction Guerrilla features advanced destruction technology providing the player with a unique gaming experience of a fully destructible world.

Second, we are introducing promising new intellectual properties including de Blob for the Nintendo Wii and Darksiders for the PS3 and 360. Both of these games were featured in our recent Gamer’s Day press event and have received strong praise.

Third, we believe we have products that are better positioned for Nintendo’s fast growing Wii platform. In addition to de Blob and games based on some of our key licensed franchises, we will also be releasing All Star Cheer, which is targeted at the expanding girl demographic and which utilizes the popular new Wii Fit Balance Board.

We are also excited about the potential in fiscal 2009 of our key license brands. We expect our WWE franchise to grow in fiscal 2009 based on the continued success of our SmackDown versus Raw brand and the introduction of an exciting new game Legends of WrestleMania. Our new Legends game is scheduled to launch in conjunction with the WWE’s Annual WrestleMania Event next March.

Because of our leadership and expertise in the fighting genre, we are very excited about the ultimate fighting championship license, which we announced about a year ago. We now plan to launch our first UFC games in the first quarter of fiscal 2010 in conjunction with the major UFC event scheduled in that time period. This new game will also ensure that we deliver a quality game as we establish and build the UFC brand in the game category.

Finally, we believe our fiscal 2009 licensed kids line up is much stronger this year and will face a less crowded family movie slate than last year. This quarter we will begin launching games based on Wally, the next Disney Pixar film, which has a videogame friendly robot and outer space theme.

Our Nickelodeon lineup this fall will include TAC which is now supported by a strong television franchise as well as new games based on the ever popular Sponge Bob.

With respect to our second key initiative of improving product quality and competitiveness, we have added new management talent to our product development organization and enhanced our processes including the depth and frequency of product reviews. We have also introduced a revised green life process, a four stage green life process with the objective of limiting investment in new games until key technological and game play features are proven to be critical competitive factors. We have canceled projects that do not meet our creative for financial objectives and are focusing our resources on products with a highest future potential.

Finally, we are streamlining our studio system, emphasizing efficiency and focusing our resources on our most strategic brands.

Our third key initiative is to realign our cost structure so that we gain increased operating leverage while continuing to invest in profitable growth. We are taking a number of important steps in this area, but I will let Colin speak to these in more detail in a few moments.

We also plan to continue to execute on our strategy to develop new revenue streams through digital distribution. Our Company of Heroes online is on track for a fiscal 2009 release and we continue to work with Shanda to bring this critically acclaimed IP to the Chinese market.

Company of Heroes online marks our first entry into the free to play, pay for download model and we are excited about the opportunity for future projects of this nature. We are also looking to grow our wireless business as we plan to launch new wireless games based on Star Wars and the new Indiana Jones film as well as extensions of our popular console brands.

Looking further out, we have a robust pipeline of both licensed and owned franchises. In addition to our proven annual WWE, Disney Pixar and Nick franchises, we are obviously excited about the potential to build a new franchise with the launch of our first UFC games next spring.

We will also introduce sequels to established intellectual properties and new IP introductions from our studios like our new RPG from recently acquired Big Huge Games. We are also excited about our new partnership with DreamWorks Animation, which underscores our strategy of managing some of the biggest brands in entertainment in the videogame category. DreamWorks Animation is one of the most proven brands in entertainment with their exceptional creative talent and box office success.

In short, we believe we have a strong product pipeline for fiscal 2009 and beyond and that we have a solid strategy to return to profitable growth. But we also understand that now it is all about execution and we are committed to demonstrate the high level of execution that THQ is known for.

For those of you who do already know him, Colin Slade joined us from Tektronix a few months ago. Colin has the right profile to help us improve both the top and bottom line, so please join me in welcoming him on his first earnings call. Colin?

Colin Slade - Executive Vice President and Chief Financial Officer

Thanks Brian. Good afternoon. As Brian mentioned, this is my first earnings release conference call at THQ and I look forward to getting to know all of you over the next year. Today I will recap our full fiscal year 2008 results and review our Q4 financial results. In addition, I will provide guidance for fiscal 2009 and for the June quarter.

As I discuss our financial performance in more detail, I will use non-GAAP results, which are comparative to prior quarter's non-GAAP results. There will be two adjustments to GAAP reporting to get to non-GAAP reporting and one of the adjustments is new. First, non-GAAP results will exclude the impact of stock-based compensation expense and this is consistent with prior quarter and prior year treatment.

Second, this quarter for the first time we will defer a portion of revenue for GAAP reporting. This is because we determined that both the Xbox 360 and PC versions of Frontlines: Fuel of War contained significant online functionality and we have continuing performance obligations beyond the sale of the game.

However, for purposes of non-GAAP reporting, we will treat this revenue in the same way we have historically and we will not defer any portion of the revenue or related cost of sales. We believe this will allow investors to better see the full impact of the introduction of new products during the quarter.

Now I would like to briefly recap the fiscal year. For the full fiscal year ended March 31, 2008, THQ net sales were up slightly at $1.061 billion. This represented 3% growth over the prior year. Good growth in the WWE franchise. Strong performance of MX verus ATV: Untamed and other owned IP including Frontlines Fuel of War and Drawn to Life was largely offset by weakness in our kids’ line broadly and underperformance of the Juiced, Stuntman, and Konan titles relative to our expectation.

The operating loss for the fiscal year was $55.5 million or around negative 5% of net sales. This compares with the positive $100 million or around 10% operating margin for the prior year. The year-over-year change is mostly the result of higher sales returns and allowances and accelerated amortization expense driven by the softer sell-through of several titles, most of which were discussed in prior quarters. Write-offs related to the cancellation of project in development, most of which were also discussed in prior quarters and higher product development and selling and marketing expenses.

When combined with interest and other income of $15.4 million, a tax benefit of $24.9 million and $1.5 million gain on sale of discontinued operations, THQ had a full year loss of $13.6 million or $0.20 per share.

Turning next to the fourth quarter. Net sales for the fourth quarter of fiscal 2008 were $218 million excluding the impact of the deferral of a portion of the Frontlines revenue as I discussed before. This represented 26% growth versus the prior year quarter and exceeded our expectations on both a GAAP and non-GAAP basis.

Our top line growth was driven by the release of Frontlines Fuel of War as well as the continued strength of MX versus ATV and WWE SmackDown versus Raw 2008. In addition, currency exchange rate increased our net sales during the quarter by $10 million or 6%. However, the product cost at 41% of net sales were up 4.5 points versus the prior year quarter. Roughly 3 points of this increase was due to the impact of the additional sales returns and allowances during the quarter. The additional sales returns and allowances were primarily the result of softer sell-through of several titles released earlier in the year. Most of the remaining 1.5 points were due to the lower mix of higher margin PC titles compared with the prior year.

Softer amortization and royalties at 31% of net sales was 17 points above the prior year quarter. This was partly due to $13 million more in non-cash accelerated amortization expense related to projected lower sales for several titles and $4 million more in non-cash charges related to a few smaller product cancellations in connection with efforts to streamline our cost structure. The combination of these two factors explains about half of the 17 point variance.

In addition, we saw an overall higher rate of amortization primarily related to the softer sell-through I mentioned earlier and this explains the remainder of the difference. In the case of sales returns and allowances, the accelerated amortization and the product cancellation, we took a close look at these amounts at quarter-end given the recent performance. License amortization and royalty costs of 6% of net sales decreased by about 1 point compared to the fourth quarter of last fiscal year due primarily to the greater sales mix of owned intellectual properties this year.

Venture partner expense was roughly flat at about 1% compared to the prior year. As a result, the mostly non-cash impact of higher sales returns and allowances accelerated softer amortization and a mix shift away from higher margin PC titles. The gross margin was 21% versus 41% in the prior year.

Product development expenses of $33 million were up $11 million compared to the prior year period. This increase is a result of increased product development activity to support future growth. As a percent of net sales, we expect product development to trend down during fiscal 2009 consistent with actions Brian discussed to manage our cost structure.

Selling and marketing expenses were $39 million or 18% of net sales, up from 13% in the prior year quarter. The increase reflects the relative increase in sales of owned IP, a higher level of spending for Frontlines Fuel of War to establish its new title as a core franchise going forward and higher spending in a variety of other areas. Looking forward to the next fiscal year, we anticipate selling and marketing trending down as a percent of net sales driven by actions to manage our cost structure consistent with projected revenue.

G&A expenses were $16 million, down from $16.7 million in the prior year quarter. Interest and other income for the quarter were $2.1 million, down $1.7 million from the prior year quarter primarily as a result of lower interest earnings driven by lower average cash balance. Combined with the tax benefit of $16.1 million, the net loss for the fourth quarter was $24.8 million or $0.37 per diluted share. This compares with net income of $10.1 million or $0.15 per diluted share in the prior year quarter.

In summary, relatively strong sales for the quarter was offset by the mostly non-cash impact of higher sales returns and allowances, accelerated softer amortization and higher operating expenses resulting in a net loss.

Now let’s turn to the balance sheet. THQ ended the year with $370 million or $5.57 per share in cash and investments including $53 million in long term investments, which I will discuss in a moment. This balance grew sequentially by $45 million from Q3 and primarily reflects collection of the relatively high accounts receivable balance at the end of the last quarter.

Net accounts receivable of $113 million increased from $68 million at the prior year end. The increase is primarily due to the growth in net sales for the fourth quarter and a higher mix of sales from our international territories, which generally have longer collection cycle.

Our day sales outstanding was 47 days versus 35 days in the prior year period. Increased DSO reflected sales timing within the quarter. Accounts receivable reserves were over a $110 million at quarter end, up from the $81 million balance at the prior fiscal year end. The coverage ratio was 10%, up from 7% in the prior year quarter end. This increase reflects the higher level of sales, returns and allowance charges I discussed before.

Inventory was $38 million, an increase from the $27 million at the prior fiscal year end. Inventory turns were 11, up modestly from 10 last year. Our investment in licenses was $87 million, down from the $91 million at the prior fiscal year end. This reflects the timing of payments and amortization of existing licenses.

Capitalized software development increased modestly to $181 million at the year end, up from $164 million at the prior fiscal year end. This growth reflects investments in key titles including Saints Row II, Wally, Red Faction Guerilla, Darksiders and WWE SmackDown versus Raw 2009. Investments in new titles were offset by regular amortization as well as the impairments and the write-offs, which I discussed earlier.

Goodwill of $122 million was up $34 million from the prior year end balance, due to the acquisition of Big Huge Games and Universomo during the fiscal year. Long term marketable securities were $53 million at fiscal year end. This balance reflects auction rate securities, which we are now classifying as long term. Beginning in mid February, we have seen auctions for these securities fail in the ARS market due to disruption in the credit market.

All of the securities are investment grade and we have no reason to believe that any of the underlying issuers of these securities are presently at risk or that the underlying credit quality of the assets backing these securities has been impacted by the reduced liquidity of these investments. However, because we are uncertain when liquidity will return to this market, we determine that we should reclassify these securities as long term and we have recorded a temporary impairment of approximately $1.4 million to other comprehensive income stockholders equity.

Total current liabilities were $289 million, up from the prior year end balance of $197 million. The increase was a result of one, establishment of a deferred revenue balance related to the Frontlines revenue deferral on a GAAP basis, which I discussed before. Two, routine increases related to the timing of product purchases and other normal accruals. And three, additional accruals related to our joint venture with Jakks Pacific. We are accruing amounts related this joint venture at the payment rate that expired almost two years ago. The current balance is $38 million. Until a new rate is determined through arbitration, this accrued balance will grow.

Other long term liabilities were down $9 million from last year to $39 million primarily reflecting payments to licensors. We had no borrowings at quarter-end and total stockholders’ equity was $741 million.

That concludes the financial results for the fourth quarter of fiscal 2008.

Now before I discuss THQ’s financial guidance for the first quarter and full year of fiscal 2009, I would like to review our industry software dollar growth rate assumption. Expectations for calendar 2008 software dollar growth for North America and Europe vary widely. At this time, we are reaffirming our previously stated assumption of 10 to 12% growth rate for calendar 2008. We considered this growth rate conservative and we see upside to this assumption.

Turning to THQ’s fiscal year 2009, we expect net revenue in the range of $1.175 billion to $1.2 billion. We see potential upside to this based upon both market growth and our execution against key titles. As Brian discussed, our revenue will be driven by a strong product line up, which includes a well balanced mix of owned and licensed intellectual properties and should be a stronger set of products than we had in fiscal year 2008.

We are projecting operating margins in the high single digits. We are projecting an effective tax rate of 37% and this reflects the absence of an R&D tax credit. We are not projecting an R&D tax credit because of the expiration of this credit at the end of the calendar year.

Combined with 68.4 million estimated average outstanding shares, we are projecting earnings per diluted share in the range of $0.95 to $1.05 for next year excluding the impact of the stock-based compensation expense, the impact of the deferral of revenue and restructuring charges of around $5 million most of which we will see in Q1 and Q2.

Looking forward to the 2009 fiscal first quarter, we expect net sales of approximately 115 to $125 million and a net loss of about $0.38 to $0.42 per share excluding the impact of stock-based compensation expense, the impact of the deferral of revenue and related costs and restructuring charges.

The loss per share in the first quarter is higher than last year’s first quarter as a result of several factors. First, product development expenses are higher in Q1 entirely related to the timing of expenses within the fiscal year.

Selling and marketing costs are also up significantly compared to the prior year as a result of stepped up investments related mostly to the slate of new releases scheduled after Q1. In addition, the prior year’s first quarter included a $0.10 per share R&D tax benefit, stemming from the resolution of an IRS tax exempt. This benefit will not repeat in the current year. Based on our current projections, future quarters should show significant improvements in profitability as our sales ramp and our cost management actions take effect.

Now before I close, I would like to spend a moment talking about our initiative to improve our cost structure for fiscal year 2009. As Brian mentioned, we have three key initiatives focused on driving shareholder value in fiscal year 2009. One of these initiatives is to realign our cost structure; there are four key elements to the cost structure realignment plan. First; we are undertaking a companywide plan to reduce infrastructure and overhead cost with the goal of improving efficiency and productivity.

Second; we will be realigning resources in our studio system with the objective of achieving greater efficiency and focusing our resources on our most strategic franchises.

Third; we've established an operating budget for the year, which funds our strategy and at the same time grows our operating costs more slowly than sales in order to drive significant leverage.

Fourth; we are implementing several new processes to ensure that both the product development and marketing dollars we spend are spent more efficiently by focusing the largest investments on the best opportunities.

In closing, as Brian has said, fiscal year ’08 was a very tough year. Looking into fiscal year ’09, our focus is on execution. Our stronger products slate should drive sales growth. Combined with deliberate and powerful cost structure management; we expect significant operating leverage to drive improved earning.

I would now like to turn the call back to Brian.

Brian Farrell - President and Chief Executive Officer

Thanks Colin. As we’ve already said on this call, fiscal 2008 was a tough year for THQ. We faced a number of challenges, but I believe we have the right strategy to overcome these challenges and return to profitable growth. It’s important to note that fiscal 2008 was not without significant wins that give us a strong foundation as we move ahead. We shipped 6 million units of WWE SmackDown versus Raw 2008, demonstrating the growing strength of that brand and our expertise in the genre. With our upcoming UFC launch, we are without question the leader in the rapidly growing fighting category, which is a position that I know will service well for many years.

We also shipped more than 1.5 million units of internally developed and owned franchise MX versus ATV Untamed, bringing lifetime shipments to more than 6.5 million units. We established two new owned franchises: Frontlines Fuel of War and Drawn to Life. And we continued to invest in our portfolio of owned intellectual properties and studio system creating a solid pipeline of titles for the future.

Our international revenues grew by 27% this year fueled by the continued expansion of our global footprint. This business is global and THQ has true scale both domestically and internationally. And we strengthened our online and casual game offerings with our co-publishing agreement with Shanda to bring Company of Heroes online to the Chinese market and the recent acquisitions of Elephant Entertainment.

Looking forward, a strong slate of drive titles including Saints Row II, Red Faction Guerilla, de Blob, Wally and WWE along with changes to our product development organization and processes and the realignment of our cost structure give us confidence in our ability to increase revenue and profitability in fiscal 2009.

That said, we know that we have to execute at a high level and deliver on our strategic initiatives in order to generate strong results in fiscal 2009 and to create enhanced shareholder value over the long term.

With that I would like to ask the operator to open the call up to questions. Operator?

Question-and-Answer Session

Operator

Absolutely, sir. (Operator Instructions). And your first question comes from the line of Colin Sebastian with Lazard Capital Markets.

Colin Sebastian

Thanks and good afternoon. First question related to the fiscal ’09 guidance. What portion of revenues are you expecting from wholly owned properties and also from an internally developed franchisees? And then secondly a question on the wrestling franchise, I am wondering if you can talk about with the addition of WrestleMania, how much growth you might see from WWE overall for the year and how much cannibalization might you see from UFC even though you did push that out a little bit? Thank you.

Colin Slade

Well, this is Colin. First of all, regarding the mix of products, we’re expecting around 35 to 40% wholly owned IP and that’s up from this fiscal year '08 and in terms of the internal development versus external development, we’ll be at about 50/50. And, Brian?

Brian Farrell

Yeah, Colin, with respect to the wresting, as you probably know with both the WWE and UFC licenses, our objective is to truly own the fighting category. And since we do that, we do have a strategy to manage both of those brands in a way that they are both spaced out and launched around true marketing windows or vehicles and so we’re very comfortable with Smackdown versus Raw positioning. It's always in the December quarter, usually in the month of November. The Legends of WrestleMania, which is a game using the lot of the older and retired legends of wrestling in a brand new game that will be launched right around the WrestleMania marketing event, and then we’ll follow up a few months later with our first UFC game, again in conjunction with the prime UFC event. So, we think the two brands are positioned very differently, and we’ve also given them a spacing and marketing windows we think are appropriate, so again our objective is to own the fighting category.

Colin Sebastian

Okay, thanks, that's helpful. In terms of the cost cutting, what are your head plans for headcount sort of before and after you've completed those restructuring? Thank you.

Colin Slade

Okay. Well, first of all in terms of the restructuring action in the near term we’re probably going to be taking at about 200 headcount. However, over the course of the year, we do expect to see overall headcount growth from around 2,400 as we exit this fiscal year to under 2,700 at the end of next fiscal year. I want to point out that that level of headcount growth as well as the overall expense growth will be well below the anticipated sales growth even at the conservative levels that we’re talking about.

Colin Sebastian

Okay, thank you.

Operator

Your next question comes from line of Brent Thill with Citi.

Brent Thill

Thanks, you characterized the guidance for fiscal ‘09 as conservative. Can you just walk through where you see the potential levels in the model related to the guidance you just gave for the year?

Colin Slade

Well I’ll start and Brian might have some additional thoughts here. First of all in terms of levels in the model, I mean the two most important things that are going to improve our results next year is we definitely don’t anticipate the same levels of sales return and allowances and impairments to capitalize software we saw this year. Those well above historical averages and although, we taken a conservative view looking into the next fiscal year, just a well below those levels and I think that would be -- we believe that is we are taking a prudent, but appropriate look at that. Secondly, when we set out to budget out cost structure this year, we put in place a sales plan that was conservative and then we structured our individual cost structure investments to produce significant bottom line or operating leverage. Now, during that same process we made sure that we were funding the most important strategic investments. So, while we were managing the cost structure carefully we are making sure that we are adding cost in the appropriate places. So, bottom line next year the leverages around introducing great games. It’s like Brian said its execution, introducing great games and carefully and powerfully managing our cost structure leverage will come around that fixed operating cost structure as well as leverage on individual game. Brian if you got any thought there.

Brian Farrell

Yeah, what I would add to that Brent, in it’s really as long the same theme. As you know the key to our operating margin and leverage in this business is more units per title ship and the good news is, we think our gun is a little more loaded for bared issue than it was last year. Clearly we’re optimistic about the comp of Wally over Ratatouille and we certainly think games like Saints Row and -- Saints Row II and Red Faction Guerilla should come very well against things like Juiced to Stuntman last year and then new titles like de Blob and Darksiders certainly have a lot of potential, so real focus as Colin says, two fold. Make sure the cost structure inline, but drive our unit upsides on the big titles.

Brent Thill

Thanks.

Operator

Your next question comes from the line of John Taylor with Arcadia Investment Corporation.

John Taylor

Hi, I got couple of questions; I think you gave us what your goal was for internally owned IP for this year. What’s the starting point for last year?

Colin Slade

I think we’re around, let me check real quickly. I think we were in the last year we were internally owned was around 37% something like that. That’s internal development.

Julie MacMedan

Are you talking about owned versus licensed?

John Taylor

I am talking about owned properties you think.

Colin Slade

Owned it was closer to 30%

John Taylor

30%.

Colin Slade

We’ll be going from 30 up to about 40, just under 30 to about 40.

John Taylor

Great, 10 points then. Okay. When you guys calculate the DSOs and accounts receivable and all of that is there any impact from deferred revenue on that, is that in or out or have any distorting impact on comparisons?

Colin Slade

It has no distorting impact because as you probably can see the deferral is only accounting deferral and has nothing to do with the actual collection of cash, so when we do those calculation do this all on a GAAP basis.

John Taylor

Okay, perfect. And then, if you take the total cash amount that you spent on product development last year whether it was booked as R&D, whether it was capitalized and then amortized, I wonder if you can compare what this number what you expect the number to look like in fiscal ‘09 versus ‘08, and I really think it would be helpful if there was a way you guys could help us quantify specifically what the delta is between the historic norms you’re talking about in terms of additional accounts receivable reserves and then the amortization piece?

Colin Slade

Okay. Yeah. So we’re in terms of total spending last year in product development, whether capitalized or expensed, we were under, just under about $350 million, and we expect to spend in the next fiscal year something closer to $390 million, so that would be kind of in the range of incremental spending, and that we’re going to be very careful about managing that spend during the year as Brian said we’re going to make sure we’re spending on only the most successful products, and that kind of reflects that. What was your second question?

John Taylor

It was little bit related but not really because so that’s what your costs or your cash budget kind of is for fiscal ‘09. And if does the 350 include the, was there an impact of the accelerated amortization in that 350 or is that kind of the fresh cash budgeted and cash spent?

Colin Slade

That’s just cash spent. That does not reflect any accelerated anything that’s just cash out. And by the way little quick correction that was more or like 340 in fiscal year ‘08 up to around 376 in ‘09, we will be having a little bit of internal debate about that. And I wanted to point out that is actually growing more slowly than we project sales to grow. So, that in keeping with managing the cost structure. So, not going with the expenses grow more slowly. In other words generate leverage but the actual spending will grow more slowly.

John Taylor

Okay, great. And then yeah, so the second part of the question it was little related by now really has to that amortization and the additional reserves. So, you mentioned it’s kind of a historic norm is there can you give us a sense of how big the sort of delta was from what you have ended up taking off in fiscal ‘08 versus what the historic norms would have suggested you would have taken?

Colin Slade

Yeah, and you’re talking -- are you talking right now about for the full fiscal year?

John Taylor

Yeah. But, if the fourth quarter as well. I mean if you want to talk about both of those would be great?

Colin Slade

Yeah, okay. Let me say this first of all that in the fourth quarter it was a ramp that delta between the amortization and the sales returns and allowances there is basically explain the entire variance from our forecast to our actual operating margins. The total delta between on quarter-over-quarter only for software development and amortization from what would be the normal what we kind of saw last year would be kind of in the range of $20 million.

John Taylor

Okay. And then on the additional reserves for -- I take that’s the markdown stuff that was booked in previous quarters?

Colin Slade

Mostly, yes.

John Taylor

Yeah. Can you give us a sense of what that was?

Colin Slade

In terms of the price protection of the sales returns and allowances?

John Taylor

Yeah.

Colin Slade

Also about a $20 million delta that was in kind of in the same range, and that primarily had to do with the softer sales group.

John Taylor

All right, okay. And was most of that…

Colin Slade

What the delta was, versus what we would have expected or projected.

John Taylor

Okay. And that was in -- most of it in the fourth quarter?

Colin Slade

I’m sorry, I've just been talking about the fourth quarter numbers.

John Taylor

Okay, perfect.

Colin Slade

Both the numbers are just for fourth quarter.

John Taylor

I’m on the same page. Okay, and then let me see last question so, when you guys are doing your deferred revenue and deferring the costs, can you help us understand how that cost number is derived? Is that kind of a fixed number regardless of the number of people actually who buy and come online to play or is it a pure per user? How do you generate that, the cost side of that revenue number?

Colin Slade

Yeah, in terms of the costs, really the cost is the majority of the costs related that’s deferred and then ultimately amortized is based upon a per unit sold pro rata amortization of the developed or the capitalized software and it’s over six months. So what we do is we start amortizing that over six months in equal -- along with an equal increments along with the cost beginning the month after the product is introduced. And then six months amortization rate is based upon both sort of industry averages and our own internal work to identify that period of time a person would be using the game or staying online.

John Taylor

Okay. So you assume a per unit cost and then you work it out that way?

Colin Slade

Yeah, exactly.

John Taylor

Okay, thank you.

Colin Slade

You are welcome.

Operator

Your next question comes from line of Doug Creutz with Cowen and Company.

Doug Creutz

Hi, could you guys give some guidance to where you are expecting gross margins to come in for the fiscal year? Thanks.

Colin Slade

You are looking forward to fiscal year ‘09?

Doug Creutz

Yeah.

Colin Slade

Yeah okay. The gross margin for fiscal year ‘09 for the full year and then again I want to differentiate between gross profit and gross margin. This is full gross margin should be coming in around 37%.

Doug Creutz

And that’s on a non-GAAP basis?

Colin Slade

That’s under nonGAAP basis.

Brian Farrell

Colin that includes both software development amortization and license expenses part of that calculation.

Colin Slade

Everything exactly, but every thing but operating expenses that kind of way differentiated between that and gross profit, which we considerably high it only includes the product cost of its own.

Doug Creutz

Okay, thanks.

Colin Slade

Okay.

Operator

Your next question comes from line of Ralph Schachter with William Blair & Company.

Ralph Schachter

Good afternoon, when I look at the guidance for fiscal ‘09 at $1.175 billion and compare that to your fiscal ‘07 result of 1.025 billion and then in ‘07 you did a dollar 20 plus in the bottom line and you are guiding for $0.95 with dollar five. This year roughly 150 more and revenues and I know you have a tax rate now working your favor this year, but I guess that would have expected a little more leverage of this part in the cycle, just kind to get some color on that? Thanks.

Colin Slade

It’s a good question. First of all we are being a little bit conservatives around these or forecasting a slightly higher level of software amortization and also slightly higher level of sales returns and allowances, and that’s what I talked about before we are trying to be little bit conservative or conscious there. And that’s one of the things that resulting in a overall level operating margin and lower earnings per share. The other thing is that we do as you pointed out have considerable different tax rate and that’s must be worth half of that delta in term of EPS.

Ralph Schachter

Great, and then Brian last --

Colin Slade

Last point is tax and fairly conservative posture regarding expenses.

Ralph Schachter

Brian may be could help us rationalize the focus and confidence on increase and game quality, talk about last call, talk about this call. Are you trying to be constructive and the numbers to get back to the period of beating with increase in return allowances just trying to understand those two points?

Brian Farrell

Well, as you know Ralph, we have a long history of putting up the numbers in this category and was certainly I am not happy with the results in fiscal ‘08 and we just think its prudent, Colin and I have talked about this for very long time and it is the best thing to do is and make sure we have operating plan that makes lot of sense, as Colin points out is conservative but I think it would be also wise to understand that this management team is committed to driving the upside on the properties where appropriate because as I said earlier when increased units per title ship, that drivers above upside a revenues and margins. So, we want to have a plan that is both credible and workable but also allows us to drive the upside where we received it as appropriate.

Ralph Schachter

Great, one last sort of near term question, can you give us some color and headlines of the good on PS3 shipments since the GTA launch? Any color on what you are seeing in the marketplace from where you sit as it relates to PS3 and I guess 360 for that matter?

Brian Farrell

I think it is a fair comment, I mean obviously, all we heard is a things were sort of anecdotal but we do hear from some of our key retailers particularly in the core game of channel that the hardware is moving along with GTA and again as you point out probably more weighted to the PS3. So, we are seeing and we mentioned in our last call, even before that we have seen PS3 pick up in all of our relevant markets. So, I think that the big headline that they were confident in is we have seen some great hardware sales in the calendar ‘07 and the first part of ‘08 and as you know great software years tend to fall these great hardware sales you know we did not take advantage of the winded our back in the last fiscal year but it is certainly our intention with our strong 360 and PS3 line up along with a much more revamped Wii lineup to take advantage of those strong winds this fiscal year.

Ralph Schachter

Okay good. Thanks Brian.

Operator

Your next question comes from the line of Edward Williams with BMO Capital Markets.

Edward Williams

Good afternoon, couple of questions. First of all can you give us a little bit of color about your headcount? You had said that you are taking about 200 out of the 2,400 right now, but you will end the year close to the 27. Where are those heads getting added? And are you moving any of your studio expense structure to offshore locations?

Brian Farrell

Well, Edward, we’ve always been a leader in our outsourcing efforts with our XDG group, and we’re continuing to do a lot of outsourcing in a variety of low cost environments through that group. As Colin mentioned, we will be removing about 200 heads at various studio locations around the world mostly with an emphasis on people with more of last GEN skills around PS2 et cetera and then most of the headcount ramp back up during the year is around our key studios behind our key products mostly on next GEN platforms.

Edward Williams

Okay. And then if you look to the market growth expectations for calendar 2008, can you give us the color as to how you see the North American market performing relative to the European market?

Brian Farrell

Yeah, one thing I will say at the beginning, while we pull out some of the data there, Edward, is that the real wild card this year in our view is what’s going to be the impact year-over-year of the peripheral based music games and that’s why you see such a wide range of different numbers out there, and again as Colin point out we think we’re taking a fairly conservative view of the marketplace, but we think that North America is probably going to be at the lower end that far 10 to 12 range and Europe at the higher end of that range.

Edward Williams

And can you give us an idea again as to what the economics are like or what you’re looking for out of the Shanda relationship?

Colin Slade

Well, I guess we said before what I love about the Shanda relationship is it allows to us learn a new business model, and that’s the free to play pay for download model working with what we would argue is the industry leader in that segment. Also, they are the expert in the largest operated games in China, which allows us to take one of our key owned IP Company of Heroes and exploit it in the market where we really have no direct publishing or operational knowledge. We like that model going forward We think there is a future for the free to play paper download model, so this is just a first of many deals. This deal as we’ve talked about we are getting reimbursed for the costs to revamp a Company of Heroes to say the online model, and then we will participate in a royalty stream. We don’t have any visibility on there’s going to because it is a brand new initiative. I wouldn’t put big numbers in there, but I do think it’s a great initiative importance sort of our intended leadership in that category.

Edward Williams

Do you envision taking that free to play model outside of China?

Colin Slade

As we mentioned before, we do have those right, and we’re currently working on which markets are the most addressable with that particular product, and stay tuned on future calls as we outline that strategy.

Edward Williams

Okay, and then just one final question. How should we think about the deferred revenue and in FY ‘09? How significant is that number likely is as kind of quarters progressions the year?

Colin Slade

You know. Yeah thanks, thanks. It is going to bounce around during the year, and it is primarily the intraquarter impacts of that the distort our performance, but for the year end total the net result of deferring revenue should in terms of the difference between GAAP and non-GAAP should be less than $30 million, so a very small part of our total revenue.

Edward Williams

Okay, and this is primarily again 360 and PC, looking backwards at 360 in PC and looking forward, do you expect to have PS3 deferred revenue?

Colin Slade

Yes, and it will be just in right now our projection is just around two or three titles with significant online functionality.

Edward Williams

Can you elaborate as to what those titles are?

Colin Slade

Two of them would be Saints Row II and Red Faction guerilla.

Edward Williams

Okay thank you.

Operator

Your next question comes from the line of Arvind Bhatia with Sterne Agee.

Arvind Bhatia

Product related questions, Brian, I know you talked about Wally versus Ratatouille being you can do better numbers in Wally, but can you maybe give us some more color on what you’re thinking there in terms of units? Should we be looking at historical title says like cars and then on world wrestling you talked about growth in the franchise. Are you saying that the core product will grow as well or are you talking about including the new game and then on same-store wondering if you can comment on maybe the marketing of that game in light of GTA this year, kind of what different steps you’re taking, and then separate question is what was catalog during the year and during the fourth quarter and how much would you expect in the next twelve months?

Brian Farrell

Trying to check them in order, Arvind. Wally as we said before, and I will just reiterate, we certainly think it is going to be better in terms of videogame sales than Ratatouille, but it is not our expectation that it will reach the level of cars, so you can think about it being sort of between those two numbers, so that’s currently consistent with our thinking. The WWE, yeah, I don’t want to be misleading at all. We think we can actually grow the core brand as well. What drives that is install based growth of PS3, 360 and Wii, yes the PS2 will be down this year or at least that’s our expectation, but we think that will be more than taken up by PS3, 360 and Wii growth along with as you probably know we’ve been seeing very strong growth of the WWE brand outside of the US and we think that will continue, so we think strong growth in WWE augmented by the new legends game, but still growth in the core SmackDown versus Raw brand.

On Saints Row II, I don’t want to get too far ahead of the curve in terms of our marketing because we have a lot to unveil over the next four months, but you’ve probably seen some of the online sites. We continued to run online ads on some of the key online sites right during the GTA promotion. We’ve run a pre-sell campaign with some major retailers. We’ve been downloading video and other assets to key online sites, so there is a very long and well-orchestrated ramp-up to the launch. We think we have again a highly differentiated product, GTA is a great product, and we congratulate them on their success, but we think we can compete with a very well differentiated game, and then on catalog, Colin.

Colin Slade

Catalog for fiscal year 2008 was about 24% of our net sales. As we look forward to fiscal year 2009, be down a little bit into the low 20s. In terms of the fourth quarter for fiscal year 2008 it was around 22%.

Arvind Bhatia

Okay, and then Brian, going back to Wally for a second, can you handicap the risk factor there meaning I know for rated to you I the expectations I think a lot of people had were in the 5 million range and I believe it did something like 4 million plus, so as you look at Wally, a lot of it depends on obviously the success of the movie, but again point to some data points that might suggest increased confidence, perhaps things you might have seen on the movie front or from a game review standpoint, anything coming out that would provide people with more confidence on that title?

Colin Slade

Well, I will say that we think we have a very high quality game on Wally just as we had on Ratatouille. I think the fact that it's a bit more kid and boy friendly with the robot and outer space theme and something we take a lot of comfort, but in terms of hard data points, no. I mean, as you know, we are very reliant on the box office of the film that Disney and Pixar establish. Again, we have a much higher level of confidence both internally and at retail with Wally versus Ratatouille, but we will be launching in about 45 days, so stay tuned.

Arvind Bhatia

And again, last question on that, the seasonality on that would be you'd launch I guess a small fraction in the initial launch and then internationally in the September quarter or maybe just help us understand how that’s going to be shipped?

Colin Slade

Excellent question. As you know, the movie is very very late in the quarter. In fact, we’ll be shipping the game on the last day of our fiscal quarter and only in the US and a few small international markets where the film is opening. Like they normally do, Disney and Pixar are rolling out the film throughout the world, and our objective is to have the games on the shelf when the movies open in the various territories. And as you suggest, there will be a rollout throughout the September quarter in international territories, and in the last calendar quarter, our fiscal third quarter, we’ll do some re-promotion along with the home video that’s scheduled to do launch around the holiday time. So that’s how we’re thinking about Wally throughout the year, and then obviously next year we’ll come back at the market with greatest hits titles like we normally do.

Arvind Bhatia

Great. Thank you, guys.

Julie MacMedan

We probably have time for one or two more questions, so we’ll go to the next caller and see if we can take two.

Operator

The next question comes from the line of Tony Gikas with Piper Jaffray.

Tony Gikas

Good afternoon. Sorry if you said this on the call, I did get dropped off shortly. Did you give the Q1 release slate? And then a couple of housekeeping questions. Did you comment on the G&A expense for the year, how that is expected to trend, and also could you repeat the tax rate? I just kind of missed writing that down. And then my fourth question, on the UFC, can you quantify for us how big you think that franchise can be, do you think that’s half the size of WWE or larger, and what are your expectations internationally for UFC?

Brian Farrell

Yeah, I will take the first and last of those, Tony, and then kick it over to Colin. In terms of the release slate for Q1 as Colin pointed out in his prepared remarks, it is led by Wally, but it really is the last day of the quarter in predominantly the US and then we have a couple of fairly small Wii titles, Battle of the Bands and Big Beach Sports. They’re not really what I would call marquise titles, so it's Wally and a couple of small titles, which is the reason that the first fiscal quarter is our quietest of the year from a revenue standpoint.

The UFC, we’re looking at that brand as a great long-term driver of the business and the whole focus here is to make sure we launch it right with a quality product around a great marketing event, and we’ve now selected Q1 of next year for that time. We are not currently modeling it as being as big as WWE, but certainly the internal objective is to fill that brand over time both domestically and internationally into a brand that competes with WWE.

Tony Gikas

Okay. Then the G&A and tax rate?

Colin Slade

G&A, I didn’t talk about that specifically at least G&A. It will be down as a small amount as a percent of net sales from the kind of this year’s 5.8% to something a little bit lower next year with the growth in dollars slower than our projected growth in sales. In terms of the tax rate, for next fiscal year, we’re talking about 37%.

Tony Gikas

Okay. Thank you guys. Have a good night.

Colin Slade

Thank you.

Julie MacMedan

Thanks. I think we have time for one more question, one more caller.

Operator

Okay. Your final question comes from the line of Ben Schachter with UBS.

Ben Schachter

Hey guys, I apologize if I missed this because I jumped on late. In wrestling and the mixed marshal arts, do you expect there to be new brands from competitors in mixed marshal arts beyond just UFC?

Brian Farrell

As you probably know, Ben, there are other competing leagues, so other competitors may try and sign up some of those leagues because MMA, mixed marshal arts is a big category right now. But, the UFC really is the dominant player, so we’re delighted to be working with the industry leader. I wouldn’t rule out competition over the longer term, but we’re glad we’re partnered with the biggest and the best.

Ben Schachter

But do you have any idea in terms of timing when something else might come? Would you expect to be a first to market, I guess, is the question?

Brian Farrell

We haven’t heard anything announced yet, and given what we’re putting into this game, we believe we’ll be first to market, but most importantly is to be best to market.

Ben Schachter

And then also, Brian, you mentioned before really conservative guidance for the year, particularly on the bottom line. Just wondering how important it is for Saints and Red Faction to work in order to get to the guidance that you’re talking about?

Colin Slade

In terms of unit volumes?

Ben Schachter

Correct.

Colin Slade

Yeah, Ben as you know, we don’t get into unit volumes on the call. Both brands as you probably know have multi-million unit histories. We’ve tried to model them conservatively. But again, as I mentioned in the prepared remarks and in an answer to another question, the idea here is to drive the upside to the extent we can.

Ben Schachter

And just a last question, if memory serves me right I believe our friends over the old company acclaim that the legends of wrestling game out. I think you guys were competing with them back then. I'm wondering if you remember the history from then was more cannibalistic towards the WWE or was it not a problem for you then?

Brian Farrell

We look at these legends of WrestleMania as a totally unique extension. What it's going to feature is a lot of the older wrestlers that have retired and part of the history in legacy of wrestling and we think the WWE fan, our research shows there are very avid fans, and this is a new experience as we roll it out, you will see it's a lot more Arcadian play, very different feel to it, so we think it's additive to the brand. We don’t think it puts up the same numbers as SmackDown versus Raw, but that it will reach a core part of that audience that buy a second game.

Ben Schachter

Okay. Good luck on the year.

Colin Slade

Thank you, sir.

Julie MacMedan

Well, thank you for joining us today. That concludes our fourth quarter call. Okay, thank you.

Operator

Thank you. And that does conclude today’s teleconference. You may disconnect at this time.

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