UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarterly Period Ended September 30, 2001 OR [_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Transition Period from ______ to_____ Commission File No. 0-17948 ELECTRONIC ARTS INC. (Exact name of registrant as specified in its charter) Delaware 94-2838567 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 209 Redwood Shores Parkway Redwood City, California 94065 (Address of principal executive offices) (Zip Code) (650) 628-1500 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES X NO ------- ------- Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Outstanding at Class of Common Stock Par Value November 5, 2001 --------------------- --------- ---------------- Class A common stock $0.01 137,080,809
ELECTRONIC ARTS INC. AND SUBSIDIARIES <TABLE> <CAPTION> INDEX Part I - Financial Information Page - ------------------------------ ---- <S> <C> Item 1. Consolidated Financial Statements Consolidated Balance Sheets at September 30, 2001 and March 31, 2001 3 Consolidated Statements of Operations for the Three Months Ended September 30, 2001 and 2000 and the Six Months Ended September 30, 2001 and 2000 4 Consolidated Statements of Cash Flows for the Six Months Ended September 30, 2001 and 2000 5 Notes to Consolidated Financial Statements 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 22 Item 3. Quantitative and Qualitative Disclosures About Market Risk 47 Part II - Other Information - --------------------------- Item 1. Legal Proceedings 49 Item 4. Submission of Matters to a Vote of Security Holders 49 Item 6. Exhibits and Reports on Form 8-K 49 Signatures 50 - ---------- </TABLE> 2
PART I - FINANCIAL INFORMATION Item 1. Consolidated Financial Statements ELECTRONIC ARTS INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Dollars in thousands) (unaudited) <TABLE> <CAPTION> September 30, March 31, 2001 2001 ---------------- ------------- <S> <C> <C> ASSETS Current assets: Cash, cash equivalents and short-term investments $ 407,945 $ 466,492 Marketable securities 4,581 10,022 Receivables, less allowances of $69,317 and $89,833, respectively 103,538 174,449 Inventories, net 20,819 15,686 Deferred income taxes 57,670 57,082 Other current assets 148,257 94,996 ----------- ----------- Total current assets 742,810 818,727 Property and equipment, net 337,130 337,199 Long-term investments 8,400 8,400 Investments in affiliates 15,819 19,052 Goodwill and other intangibles, net 124,227 136,764 Long-term deferred income taxes 2,841 2,926 Other assets 62,925 55,850 ----------- ----------- $ 1,294,152 $ 1,378,918 =========== =========== LIABILITIES, MINORITY INTEREST AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 79,689 $ 73,061 Accrued and other liabilities 193,992 266,965 ----------- ----------- Total current liabilities 273,681 340,026 Minority interest in consolidated joint venture 3,918 4,545 Stockholders' equity: Preferred stock, $0.01 par value. Authorized 10,000,000 shares - - Common stock Class A common stock, $0.01 par value. Authorized 400,000,000 shares; issued 136,942,210 and 134,714,464 shares; outstanding 136,782,210 and 134,714,464 shares, respectively 1,370 1,347 Class B common stock, $0.01 par value. Authorized 100,000,000 shares; issued and outstanding 6,225,000 and 6,250,000 shares, respectively 62 63 Paid-in capital 607,285 540,354 Treasury stock, at cost; 160,000 shares at September 30, 2001 (6,824) - Retained earnings 427,208 505,286 Accumulated other comprehensive loss (12,548) (12,703) ----------- ----------- Total stockholders' equity 1,016,553 1,034,347 ----------- ----------- $ 1,294,152 $ 1,378,918 =========== =========== </TABLE> See accompanying notes to consolidated financial statements. 3
ELECTRONIC ARTS INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share data) (unaudited) <TABLE> <CAPTION> Three Months Ended Six Months Ended September 30, September 30, 2001 2000 2001 2000 --------------------------------------------------------- <S> <C> <C> <C> <C> Net revenues $ 240,156 $ 219,900 $ 422,106 $ 374,699 Cost of goods sold 117,760 120,615 206,789 198,567 --------- --------- ---------- --------- Gross profit 122,396 99,285 215,317 176,132 --------- --------- ---------- --------- Operating expenses: Marketing and sales 45,020 38,263 85,824 73,456 General and administrative 25,403 26,292 48,618 48,501 Research and development 97,555 90,168 188,360 169,336 Amortization of intangibles 6,475 4,716 12,950 9,370 --------- --------- ---------- --------- Total operating expenses 174,453 159,439 335,752 300,663 --------- --------- ---------- --------- Operating loss (52,057) (60,154) (120,435) (124,531) Interest and other income, net 4,060 4,102 6,777 7,938 --------- --------- ---------- --------- Loss before benefit from income taxes and minority interest (47,997) (56,052) (113,658) (116,593) Benefit from income taxes (14,879) (17,376) (35,234) (36,144) --------- --------- ---------- --------- Loss before minority interest (33,118) (38,676) (78,424) (80,449) Minority interest in consolidated joint venture 294 (233) 346 (731) --------- --------- ---------- --------- Net loss $ (32,824) $ (38,909) $ (78,078) $ (81,180) ========= ========= ========== ========= Class A common stock: Net loss: Basic $ (27,236) $ (34,860) $ (66,611) $ (73,474) ========= ========= ========== ========= Diluted $( 32,824) $ (38,909) $ (78,078) $ (81,180) ========= ========= ========== ========= Net loss per share: Basic $ (0.20) $ (0.27) $ (0.49) $ (0.57) Diluted $ (0.24) $ (0.30) $ (0.57) $ (0.62) Number of shares used in computation: Basic 136,652 130,691 136,158 129,966 Diluted 137,304 131,343 136,810 130,618 Class B common stock: Net loss, net of retained interest in EA.com $ (5,588) $ (4,049) $ (11,467) $ (7,706) ========= ========= ========== ========= Net loss per share: Basic $ (0.93) $ (0.67) $ (1.90) $ (1.28) Diluted $ (0.93) $ (0.67) $ (1.90) $ (1.28) Number of shares used in computation: Basic 6,022 6,000 6,020 6,000 Diluted 6,022 6,000 6,020 6,000 </TABLE> See accompanying notes to consolidated financial statements. 4
ELECTRONIC ARTS INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands) (unaudited) <TABLE> <CAPTION> Six Months Ended September 30, 2001 2000 --------------------------- <S> <C> <C> Operating activities: Net loss $ (78,078) $ (81,180) Adjustments to reconcile net loss to net cash used in operating activities: Minority interest in consolidated joint venture (346) 731 Equity in net loss of affiliates 160 197 Gain on sale of affiliate (200) - Depreciation and amortization 46,362 31,583 Carriage fee amortization 8,932 - Loss on sale of fixed assets 315 420 Provision for doubtful accounts 2,327 3,014 Tax benefit from exercise of stock options 16,789 - Change in assets and liabilities: Receivables 68,584 82,977 Inventories (5,133) 3,701 Other assets (70,114) (36,332) Accounts payable 6,628 (23,014) Accrued and other liabilities (76,723) (26,047) Deferred income taxes (581) 996 ---------- ---------- Net cash used in operating activities (81,078) (42,954) ---------- ---------- Investing activities: Proceeds from sale of property and equipment 225 3,958 Purchase of marketable securities, net - (2,465) Proceeds from sale of affiliate 570 - Capital expenditures (29,711) (86,861) Investment in affiliates, net 3,018 722 Change in short-term investments, net (81,104) 19,632 ---------- ---------- Net cash used in investing activities (107,002) (65,014) ---------- ---------- Financing activities: Proceeds from sales of Class A shares through employee stock plans and other plans 50,164 47,434 Purchase of treasury shares (6,824) - ---------- ---------- Net cash provided by financing activities 43,340 47,434 ---------- ---------- Translation adjustment 3,733 (5,897) ---------- ---------- Decrease in cash and cash equivalents (141,007) (66,431) Beginning cash and cash equivalents 419,812 246,265 ---------- ---------- Ending cash and cash equivalents 278,805 179,834 Short-term investments 129,140 73,983 ---------- ---------- Ending cash, cash equivalents and short-term investments $ 407,945 $ 253,817 ========== ========== </TABLE> 5
ELECTRONIC ARTS INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (continued) (Dollars in thousands) (unaudited) <TABLE> <CAPTION> Six Months Ended September 30, 2001 2000 ----------------------- <S> <C> <C> Supplemental cash flow information: - ----------------------------------- Cash paid during the year for income taxes $ 6,756 $7,992 ======= ====== Non-cash investing activities: - ------------------------------ Change in unrealized appreciation (depreciation) of investments and marketable securities $(3,781) $9,670 ======= ====== </TABLE> See accompanying notes to consolidated financial statements. 6
ELECTRONIC ARTS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) Note 1. Basis of Presentation The condensed consolidated financial statements are unaudited and reflect all adjustments (consisting only of normal recurring accruals) that, in the opinion of management, are necessary for a fair presentation of the results for the interim periods presented. The results of operations for the current interim period are not necessarily indicative of results to be expected for the current year or any other period. Certain amounts have been reclassified to conform to the fiscal 2002 presentation. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Electronic Arts Inc. (the "Company") Annual Report on Form 10-K for the fiscal year ended March 31, 2001 as filed with the Securities and Exchange Commission ("Commission") on June 29, 2001. Note 2. Fiscal Year and Fiscal Quarter The Company's fiscal year is reported on a 52/53-week period that ends on the Saturday nearest to March 31 in each year. The results of operations for fiscal 2002 will contain 52 weeks. The results of operations for fiscal 2001 contained 53 weeks. Accordingly, the results of operations for the first half of fiscal 2002 and the first half of fiscal 2001 contain 26 weeks and 27 weeks, respectively. The results of operations for the fiscal quarters ended June 30, 2001 and 2000 contain 13 weeks and 14 weeks, respectively. For clarity of presentation, all fiscal periods are treated as ending on a calendar month end. Note 3. Tracking Stock On March 22, 2000, the shareholders of Electronic Arts authorized the issuance of a new series of common stock, designated as Class B common stock ("Tracking Stock"). The Tracking Stock is intended to reflect the performance of Electronic Arts' online and e-Commerce division ("EA.com"). As a result of the approval of the Tracking Stock Proposal, Electronic Arts' existing common stock has been re-classified as Class A common stock and that stock reflects the performance of Electronic Arts' other businesses ("EA Core"). Note 4. Common Stock At the Company's Annual Meeting of Stockholders, held on August 1, 2001, the stockholders elected to amend the 2000 Class A Equity Incentive Plan to increase by 6,000,000 the number of shares of the Company's Class A common stock reserved for issuance under the Plan. 7
ELECTRONIC ARTS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) (continued) Note 5. Treasury Stock In September 2001, the Board of Directors approved a plan to purchase up to two million shares of the Company's Class A common stock. For the three months ended September 30, 2001, the Company repurchased 160,000 shares for approximately $6,824,000 under the program. There were no shares reissued as of September 30, 2001. Note 6. Prepaid Royalties Prepaid royalties consist primarily of prepayments for manufacturing royalties, original equipment manufacturer (OEM) fees and license fees paid to celebrities and professional sports organizations for use of their trade name. Also included in prepaid royalties are prepayments made to independent software developers under development arrangements that have alternative future uses. Prepaid royalties are expensed at the contractual or effective royalty rate as cost of goods sold based on actual net product sales. Management evaluates the future realization of prepaid royalties quarterly and charges to the Statement of Operations any amounts that management deems unlikely to be realized through product sales. Royalty advances are classified as current and non-current assets based upon estimated net product sales for the following year. The current portion of prepaid royalties, included in other current assets, was $78,921,000 and $46,264,000 at September 30, 2001 and March 31, 2001, respectively. The long-term portion of prepaid royalties, included in other assets, was $21,885,000 and $9,664,000 at September 30, 2001 and March 31, 2001, respectively. Note 7. Inventories Inventories are stated at the lower of cost or market. Inventories at September 30, 2001 and March 31, 2001 consisted of (in thousands): <TABLE> <CAPTION> - -------------------------------------------------------------------------------------------- September 30, 2001 March 31, 2001 - -------------------------------------------------------------------------------------------- <S> <C> <C> Raw materials and work in process $ 1,879 $ 976 Finished goods 18,940 14,710 - -------------------------------------------------------------------------------------------- $20,819 $15,686 ============================================================================================ </TABLE> 8
ELECTRONIC ARTS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) (continued) Note 8. Accrued and Other Liabilities Accrued and other liabilities at September 30, 2001 and March 31, 2001 consisted of (in thousands): <TABLE> <CAPTION> - -------------------------------------------------------------------------------------------------------- September 30, 2001 March 31, 2001 - -------------------------------------------------------------------------------------------------------- <S> <C> <C> Accrued compensation and benefits $ 63,702 $ 75,603 Accrued expenses 58,248 67,957 Accrued royalties 48,098 55,997 Deferred revenue 15,636 16,967 Warranty reserve 8,308 8,070 Accrued income taxes - 42,371 - -------------------------------------------------------------------------------------------------------- $193,992 $266,965 ======================================================================================================== </TABLE> Note 9. Segment Information Statement of Financial Accounting Standards ("SFAS") No. 131, "Disclosures About Segments of An Enterprise And Related Information", establishes standards for the reporting by public business enterprises of information about operating segments, product lines, geographic areas and major customers. The method for determining what information to report is based on the way that management organizes the operating segments within the Company for making operational decisions and assessments of financial performance. The Company's chief operating decision maker is considered to be the Company's Chief Executive Officer ("CEO"). The CEO reviews financial information presented on a consolidated basis accompanied by disaggregated information about revenues by geographic region and by product lines for purposes of making operating decisions and assessing financial performance. The Company operates in two principal business segments globally: . EA Core business segment: creation, marketing and distribution of entertainment software. . EA.com business segment: creation, marketing and distribution of entertainment software which can be played or sold online, ongoing management of subscriptions of online games and website advertising. Please see the discussion regarding segment reporting in the MD&A. 9
ELECTRONIC ARTS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) (continued) <TABLE> <CAPTION> Information about the Company's business segments is presented below for the three and six months ended September 30, 2001 and 2000 (in thousands): - --------------------------------------------------------------------------------------------------------------------------- Three Months Ended September 30, 2001 EA Core Adjustments and (excl. EA.com) EA.com Eliminations Electronic Arts - --------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Net revenues from unaffiliated customers $ 224,926 $ 15,230 $ - $ 240,156 Group sales 532 - (532) (a) - - --------------------------------------------------------------------------------------------------------------------------- Total net revenues 225,458 15,230 (532) 240,156 - --------------------------------------------------------------------------------------------------------------------------- Cost of goods sold from unaffiliated customers 115,320 2,440 - 117,760 Group cost of goods sold - 532 (532) (a) - - --------------------------------------------------------------------------------------------------------------------------- Total cost of goods sold 115,320 2,972 (532) 117,760 - --------------------------------------------------------------------------------------------------------------------------- Gross profit 110,138 12,258 - 122,396 Operating expenses: Marketing and sales 34,979 5,575 4,466 (c) 45,020 General and administrative 23,152 2,251 - 25,403 Research and development 63,725 15,664 18,166 (b) 97,555 Network development and support - 15,170 (15,170) (b) - Customer relationship management - 2,996 (2,996) (b) - Carriage fee - 4,466 (4,466) (c) - Amortization of intangibles 3,205 3,270 - 6,475 - --------------------------------------------------------------------------------------------------------------------------- Total operating expenses 125,061 49,392 - 174,453 - --------------------------------------------------------------------------------------------------------------------------- Operating loss (14,923) (37,134) - (52,057) Interest and other income (expense), net 4,179 (119) - 4,060 - --------------------------------------------------------------------------------------------------------------------------- Loss before benefit from income taxes and minority interest (10,744) (37,253) - (47,997) Benefit from income taxes (14,879) - - (14,879) - --------------------------------------------------------------------------------------------------------------------------- Income (loss) before minority interest 4,135 (37,253) - (33,118) Minority interest in consolidated joint venture 294 - - 294 - --------------------------------------------------------------------------------------------------------------------------- Net income (loss) before retained interest in EA.com $ 4,429 $ (37,253) $ - $ (32,824) =========================================================================================================================== Interest income $ 4,300 $ 16 $ - $ 4,316 Depreciation and amortization 13,366 10,107 - 23,473 Identifiable assets 1,097,527 196,625 - 1,294,152 Capital expenditures 11,116 3,565 - 14,681 </TABLE> 10
ELECTRONIC ARTS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) (continued) <TABLE> <CAPTION> - --------------------------------------------------------------------------------------------------------------------------- Three Months Ended September 30, 2000 EA Core Adjustments and (excl. EA.com) EA.com Eliminations Electronic Arts - --------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Net revenues from unaffiliated customers $ 210,563 $ 9,337 $ - $ 219,900 Group sales 683 - (683) (a) - - --------------------------------------------------------------------------------------------------------------------------- Total net revenues 211,246 9,337 (683) 219,900 - --------------------------------------------------------------------------------------------------------------------------- Cost of goods sold from unaffiliated customers 116,085 4,530 - 120,615 Group cost of goods sold - 683 (683) (a) - - --------------------------------------------------------------------------------------------------------------------------- Total cost of goods sold 116,085 5,213 (683) 120,615 - --------------------------------------------------------------------------------------------------------------------------- Gross profit 95,161 4,124 - 99,285 Operating expenses: Marketing and sales 36,752 1,511 - 38,263 General and administrative 24,142 2,150 - 26,292 Research and development 64,195 15,847 10,126 (b) 90,168 Network development and support - 8,018 (8,018) (b) - Customer relationship management - 2,108 (2,108) (b) - Amortization of intangibles 3,221 1,495 - 4,716 - --------------------------------------------------------------------------------------------------------------------------- Total operating expenses 128,310 31,129 - 159,439 - --------------------------------------------------------------------------------------------------------------------------- Operating loss (33,149) (27,005) - (60,154) Interest and other income (expense), net 4,090 12 - 4,102 - --------------------------------------------------------------------------------------------------------------------------- Loss before benefit from income taxes and minority interest (29,059) (26,993) - (56,052) Benefit from income taxes (17,376) - - (17,376) - --------------------------------------------------------------------------------------------------------------------------- Loss before minority interest (11,683) (26,993) - (38,676) Minority interest in consolidated joint venture (233) - - (233) - --------------------------------------------------------------------------------------------------------------------------- Net loss before retained interest in EA.com $ (11,916) $ (26,993) $ - $ (38,909) =========================================================================================================================== Interest income $ 4,082 $ 21 $ - $ 4,103 Depreciation and amortization 11,746 4,813 - 16,559 Identifiable assets 953,087 162,013 - 1,115,100 Capital expenditures 15,120 21,073 - 36,193 </TABLE> 11
ELECTRONIC ARTS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) (continued) <TABLE> <CAPTION> - -------------------------------------------------------------------------------------------------------------------------- Six Months Ended September 30, 2001 EA Core Adjustments and (excl. EA.com) EA.com Eliminations Electronic Arts - ------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Net revenues from unaffiliated customers $390,477 $ 31,629 $ - $ 422,106 Group sales 1,050 - (1,050) (a) - - ------------------------------------------------------------------------------------------------------------------------- Total net revenues 391,527 31,629 (1,050) 422,106 - ------------------------------------------------------------------------------------------------------------------------- Cost of goods sold from unaffiliated customers 201,257 5,532 - 206,789 Group cost of goods sold - 1,050 (1,050) (a) - - ------------------------------------------------------------------------------------------------------------------------- Total cost of goods sold 201,257 6,582 (1,050) 206,789 - ------------------------------------------------------------------------------------------------------------------------- Gross profit 190,270 25,047 - 215,317 Operating expenses: Marketing and sales 65,810 11,082 8,932 (c) 85,824 General and administrative 43,419 5,199 - 48,618 Research and development 119,108 31,297 37,955 (b) 188,360 Network development and support - 32,045 (32,045) (b) - Customer relationship management - 5,910 (5,910) (b) - Carriage fee - 8,932 (8,932) (c) - Amortization of intangibles 6,410 6,540 - 12,950 - ------------------------------------------------------------------------------------------------------------------------- Total operating expenses 234,747 101,005 - 335,752 - ------------------------------------------------------------------------------------------------------------------------- Operating loss (44,477) (75,958) - (120,435) Interest and other income (expense), net 7,268 (491) - 6,777 - ------------------------------------------------------------------------------------------------------------------------- Loss before benefit from income taxes and minority interest (37,209) (76,449) - (113,658) Benefit from income taxes (35,234) - - (35,234) - ------------------------------------------------------------------------------------------------------------------------- Loss before minority interest (1,975) (76,449) - (78,424) Minority interest in consolidated joint venture 346 - - 346 - ------------------------------------------------------------------------------------------------------------------------- Net loss before retained interest in EA.com $ (1,629) $(76,449) $ - $ (78,078) ========================================================================================================================= Interest income $ 9,468 $ 35 $ - $ 9,503 Depreciation and amortization 24,829 21,533 - 46,362 Capital expenditures 18,949 10,762 - 29,711 </TABLE> 12
ELECTRONIC ARTS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) (continued) <TABLE> <CAPTION> - --------------------------------------------------------------------------------------------------------------------------- Six Months Ended September 30, 2000 EA Core Adjustments and (excl. EA.com) EA.com Eliminations Electronic Arts - --------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Net revenues from unaffiliated customers $356,609 $ 18,090 $ - $374,699 Group sales 1,043 - (1,043) (a) - - --------------------------------------------------------------------------------------------------------------------------- Total net revenues 357,652 18,090 (1,043) 374,699 - --------------------------------------------------------------------------------------------------------------------------- Cost of goods sold from unaffiliated customers 192,584 5,983 - 198,567 Group cost of goods sold - 1,043 (1,043) (a) - - --------------------------------------------------------------------------------------------------------------------------- Total cost of goods sold 192,584 7,026 (1,043) 198,567 - --------------------------------------------------------------------------------------------------------------------------- Gross profit 165,068 11,064 - 176,132 Operating expenses: Marketing and sales 70,012 3,444 - 73,456 General and administrative 43,889 4,612 - 48,501 Research and development 117,854 32,339 19,143 (b) 169,336 Network development and support - 15,456 (15,456) (b) - Customer relationship management - 3,687 (3,687) (b) - Amortization of intangibles 6,461 2,909 - 9,370 - --------------------------------------------------------------------------------------------------------------------------- Total operating expenses 238,216 62,447 - 300,663 - --------------------------------------------------------------------------------------------------------------------------- Operating loss (73,148) (51,383) - (124,531) Interest and other income (expense), net 7,931 7 - 7,938 - --------------------------------------------------------------------------------------------------------------------------- Loss before benefit from income taxes and minority interest (65,217) (51,376) - (116,593) Benefit from income taxes (36,144) - - (36,144) - --------------------------------------------------------------------------------------------------------------------------- Loss before minority interest (29,073) (51,376) - (80,449) Minority interest in consolidated joint venture (731) - - (731) - --------------------------------------------------------------------------------------------------------------------------- Net loss before retained interest in EA.com $(29,804) $(51,376) $ - $(81,180) =========================================================================================================================== Interest income $ 8,399 $ 49 $ - $ 8,448 Depreciation and amortization 21,910 9,673 - 31,583 Capital expenditures 29,250 57,611 - 86,861 </TABLE> (a) Represents elimination of intercompany sales of EA Core packaged goods products to EA.com, and represents elimination of royalties paid to EA Core by EA.com for intellectual property rights. (b) Represents reclassification of Network Development and Support and Customer Relationship Management to Research and Development. (c) Represents reclassification of amortization of the Carriage Fee to Marketing and Sales. 13
ELECTRONIC ARTS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) (continued) Information about the Company's operations in the North America and foreign areas for the three and six months ended September 30, 2001 and 2000 is presented below: <TABLE> <CAPTION> ================================================================================================================================ (In thousands) Asia Pacific North (excluding America Europe Japan) Japan Eliminations Total ---------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> Three months ended September 30, 2001 - ------------------------------------- Net revenues from unaffiliated customers $169,555 $ 53,202 $ 8,007 $ 9,392 $ - $ 240,156 Intercompany revenues 816 4,894 2,734 - (8,444) - ---------------------------------------------------------------------------------- Total net revenues 170,371 58,096 10,741 9,392 (8,444) 240,156 ================================================================================== Operating loss (29,987) (20,482) (300) (1,162) (126) (52,057) Interest income 3,649 602 65 - - 4,316 Depreciation and amortization 19,457 3,652 200 164 - 23,473 Identifiable assets 994,577 267,690 18,072 13,813 - 1,294,152 Capital expenditures 9,087 5,211 121 262 - 14,681 Long-lived assets 353,289 164,261 4,083 4,608 - 526,241 Six months ended September 30, 2001 - ----------------------------------- Net revenues from unaffiliated customers $272,617 $113,014 $18,058 $18,417 $ - $ 422,106 Intercompany revenues 2,331 9,446 4,107 - (15,884) - ---------------------------------------------------------------------------------- Total net revenues 274,948 122,460 22,165 18,417 (15,884) 422,106 ================================================================================== Operating loss (95,705) (24,122) (296) (1,002) 690 (120,435) Interest income 8,232 1,138 133 - - 9,503 Depreciation and amortization 39,272 6,412 366 312 - 46,362 Capital expenditures 22,610 6,264 273 564 - 29,711 Three months ended September 30, 2000 - ------------------------------------- Net revenues from unaffiliated customers $152,842 $ 49,949 $ 9,527 $ 7,582 $ - $ 219,900 Intercompany revenues 1,303 4,337 2,539 - (8,179) - ---------------------------------------------------------------------------------- Total net revenues 154,145 54,286 12,066 7,582 (8,179) 219,900 ================================================================================== Operating income (loss) (33,210) (28,343) 454 792 153 (60,154) Interest income 3,115 830 158 - - 4,103 Depreciation and amortization 13,190 3,021 235 113 - 16,559 Identifiable assets 772,853 301,059 21,664 19,524 - 1,115,100 Capital expenditures 31,642 4,056 295 200 - 36,193 Long-lived assets 309,392 156,326 3,950 4,182 - 473,850 Six months ended September 30, 2000 - ----------------------------------- Net revenues from unaffiliated customers $224,598 $101,843 $21,639 $26,619 $ - $ 374,699 Intercompany revenues 5,279 8,818 6,557 - (20,654) - ---------------------------------------------------------------------------------- Total net revenues 229,877 110,661 28,196 26,619 (20,654) 374,699 ================================================================================== Operating income (loss) (79,710) (51,212) 1,871 3,389 1,131 (124,531) Interest income 6,249 1,936 263 - - 8,448 Depreciation and amortization 25,660 5,270 373 280 - 31,583 Capital expenditures 73,435 12,481 671 274 - 86,861 </TABLE> 14
ELECTRONIC ARTS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) (continued) Information about the Company's net revenues by product line for the three and six months ended September 30, 2001 and 2000 is presented below: <TABLE> <CAPTION> ======================================================================================= (In thousands) Three Months Ended Six Months Ended September 30, September 30, 2001 2000 2001 2000 - --------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> PlayStation 2 $ 91,763 $ 2,737 $142,282 $ 13,018 PC 53,888 80,399 123,962 150,756 PlayStation 25,147 65,157 39,189 94,658 Online Subscriptions 7,188 7,145 15,144 15,456 Advertising 7,100 - 14,761 - License, OEM and Other 4,734 7,705 9,024 11,129 N64 6,225 10,161 8,627 10,767 Game Boy Color 4,279 - 4,279 - Affiliated label 39,832 46,596 64,838 78,915 - --------------------------------------------------------------------------------------- $240,156 $219,900 $422,106 $374,699 ======================================================================================= </TABLE> Note 10. Comprehensive Loss The components of comprehensive loss, net of tax, for the three and six months ended September 30, 2001 and 2000 were as follows (in thousands): <TABLE> <CAPTION> ========================================================================================================= Three Months Ended Six Months Ended September 30, September 30, 2001 2000 2001 2000 - --------------------------------------------------------------------------------------------------------- Net loss $(32,824) $(38,909) $(78,078) $ (81,180) - --------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Other comprehensive income (loss): Change in unrealized appreciation (depreciation) of investments, net of tax expense (benefit) of $662, $(78), $78 and $(424) (2,560) 10,864 (3,859) 10,094 Foreign currency translation adjustments 2,546 (2,173) 4,014 (5,743) - --------------------------------------------------------------------------------------------------------- Total other comprehensive income (loss) (14) 8,691 155 4,351 - --------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------- Total comprehensive loss $(32,838) $(30,218) $(77,923) $ (76,829) ========================================================================================================= </TABLE> The currency translation adjustments are not adjusted for income taxes as they relate to indefinite investments in non-U.S. subsidiaries. 15
ELECTRONIC ARTS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) (continued) Note 11. Net Loss Per Share The following summarizes the computations of Basic Earnings Per Share ("EPS") and Diluted EPS. Basic EPS is computed as net earnings divided by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur from common shares issuable through stock-based compensation plans including stock options, restricted stock awards, warrants and other convertible securities using the treasury stock method. Net loss per share is computed individually for Class A common stock and Class B common stock. Please see the discussion regarding segment reporting in the MD&A. (in thousands, except per share amounts): <TABLE> <CAPTION> - --------------------------------------------------------------------------------------------------------- Three months ended September 30, 2001 Class A common Class A common Class B stock-Basic stock-Diluted common stock - --------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> Net income (loss) before retained interest in EA.com $ 4,429 $(32,824) $(37,253) Net loss related to retained interest in EA.com (31,665) - 31,665 - --------------------------------------------------------------------------------------------------------- Net loss $(27,236) $(32,824) $ (5,588) - --------------------------------------------------------------------------------------------------------- Shares used to compute net loss per share: Weighted-average common shares 136,652 136,652 6,022 Dilutive stock equivalents - 652 - - --------------------------------------------------------------------------------------------------------- Dilutive potential common shares 136,652 137,304 6,022 ========================================================================================================= - --------------------------------------------------------------------------------------------------------- Net loss per share: Basic $ (0.20) N/A $ (0.93) Diluted N/A $ (0.24) $ (0.93) - --------------------------------------------------------------------------------------------------------- </TABLE> 16
ELECTRONIC ARTS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) (continued) (in thousands, except per share amounts): <TABLE> <CAPTION> - ------------------------------------------------------------------------------------------------------------ Six months ended September 30, 2001 Class A common Class A common Class B stock-Basic stock-Diluted common stock - ------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> Net loss before retained interest in EA.com $(1,629) $(78,078) $(76,449) Net loss related to retained interest in EA.com (64,982) - 64,982 - ------------------------------------------------------------------------------------------------------------ Net loss $(66,611) $(78,078) $(11,467) - ------------------------------------------------------------------------------------------------------------ Shares used to compute net loss per share: Weighted-average common shares 136,158 136,158 6,020 Dilutive stock equivalents - 652 - - ------------------------------------------------------------------------------------------------------------ Dilutive potential common shares 136,158 136,810 6,020 ============================================================================================================ - ------------------------------------------------------------------------------------------------------------ Net loss per share: Basic $ (0.49) N/A $ (1.90) Diluted N/A $ (0.57) $ (1.90) - ------------------------------------------------------------------------------------------------------------ </TABLE> <TABLE> <CAPTION> - ------------------------------------------------------------------------------------------------------------ Three months ended September 30, 2000 Class A common Class A common Class B common stock-Basic stock-Diluted stock - ------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> Net loss before retained interest in EA.com $(11,916) $(38,909) $(26,993) Net loss related to retained interest in EA.com (22,944) - 22,944 - ------------------------------------------------------------------------------------------------------------ Net loss $(34,860) $(38,909) $ (4,049) - ------------------------------------------------------------------------------------------------------------ Shares used to compute net loss per share: Weighted-average common shares 130,691 130,691 6,000 Dilutive stock equivalents - 652 - - ------------------------------------------------------------------------------------------------------------ Dilutive potential common shares 130,691 131,343 6,000 ============================================================================================================ - ------------------------------------------------------------------------------------------------------------ Net loss per share: Basic $ (0.27) N/A $ (0.67) Diluted N/A $ (0.30) $ (0.67) - ------------------------------------------------------------------------------------------------------------ </TABLE> 17
ELECTRONIC ARTS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) (continued) <TABLE> <CAPTION> - ------------------------------------------------------------------------------------------------------------- Six months ended September 30, 2000 Class A common Class A common Class B common stock-Basic stock-Diluted stock - ------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> Net loss before retained interest in EA.com $(29,804) $(81,180) $(51,376) Net loss related to retained interest in EA.com (43,670) - 43,670 - ------------------------------------------------------------------------------------------------------------- Net loss $(73,474) $(81,180) $ (7,706) - ------------------------------------------------------------------------------------------------------------- Shares used to compute net loss per share: Weighted-average common shares 129,966 129,966 6,000 Dilutive stock equivalents - 652 - - ------------------------------------------------------------------------------------------------------------- Dilutive potential common shares 129,966 130,618 6,000 ============================================================================================================= - ------------------------------------------------------------------------------------------------------------- Net loss per share: Basic $ (0.57) N/A $ (1.28) Diluted N/A $ (0.62) $ (1.28) - ------------------------------------------------------------------------------------------------------------- </TABLE> The Diluted EPS calculation for Class A common stock, presented above, includes the potential dilution from the conversion of Class B common stock to Class A common stock in the event that the initial public offering for Class B common stock does not occur. Net loss used for the calculation of Diluted EPS for Class A common stock was $32,824,000 and $38,909,000 for the three months ended September 30, 2001 and 2000, respectively. Net loss used for the calculation of Diluted EPS for Class A common stock was $78,078,000 and $81,180,000 for the six months ended September 30, 2001 and 2000, respectively. This net loss includes the remaining 15% interest in EA.com, which is directly attributable to outstanding Class B shares owned by third parties, which would be included in the Class A common stock EPS calculation in the event that the initial public offering for Class B common stock does not occur. Due to the net loss attributable for the three and six months ended September 30, 2001 and 2000 on a diluted basis to Class A Stockholders, stock options have been excluded from the Diluted EPS calculation as their inclusion would have been antidilutive. Had net income been reported for these periods, an additional 5,443,000 and 6,744,000 shares would have been added to diluted potential common shares for Class A common stock for the three months ended September 30, 2001 and 2000, respectively. Similarly, an additional 5,784,000 and 5,996,000 shares would have been added to diluted potential common shares for Class A common stock for the six months ended September 30, 2001 and 2000, respectively. Due to the net loss attributable for the three and six months ended September 30, 2001 and 2000 on a diluted basis to Class B Stockholders, stock options have been excluded from the Diluted EPS calculation as their inclusion would have been antidilutive. Had net income been reported for the three and six months ended September 30, 2001, an additional 889,000 and 18
ELECTRONIC ARTS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) (continued) 911,000 shares would have been added to diluted potential common shares for Class B common stock, respectively. For the three and six months ended September 30, 2000, no additional shares would have been added to diluted potential common shares for Class B common stock. Note 12. Impact of Recently Issued Accounting Standards In June 1998, the Financial Accounting Standards Board ("FASB") issued SFAS 133 "Accounting for Derivative Instruments and Hedging Activities", as amended by SFAS 137 "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133 - an Amendment of FASB Statement No. 133" and SFAS 138 "Accounting for Certain Derivative Instruments and Certain Hedging Activities - an Amendment of FASB Statement No. 133" which establishes accounting and reporting standards for derivative instruments and hedging activities. The terms of SFAS 133 and SFAS 138 are effective as of the beginning of the first quarter of the fiscal year beginning after June 15, 2000. SFAS 133, as amended, requires that all derivative instruments be recorded on the balance sheet at their fair value. Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of a hedge transaction and, if it is, the type of hedge transaction. The Company utilizes fair value foreign exchange contracts to hedge foreign currency exposures of underlying assets and liabilities, primarily certain intercompany receivables that are denominated in foreign currencies. The Company adopted SFAS 133 on April 1, 2001. The adoption of SFAS 133 did not have a material impact on the Company's consolidated financial position or results of operations. In April 2001, the Emerging Issues Task Force issued No. 00-25 ("EITF 00-25"), "Accounting for Consideration from a Vendor to a Retailer in Connection with the Purchase or Promotion of the Vendor's Products", which states that consideration from a vendor to a reseller of the vendor's products is presumed to be a reduction of the selling prices of the vendor's products and, therefore, should be characterized as a reduction of revenue when recognized in the vendor's income statement. That presumption is overcome and the consideration can be categorized as a cost incurred if, and to the extent that, a benefit is or will be received from the recipient of the consideration. That benefit must meet certain conditions described in EITF 00-25. The consensus should be applied no later than in annual or interim financial statements for periods beginning after December 15, 2001. The Company is currently evaluating the impact of this consensus on its Statements of Operations. In June 2001, the FASB issued SFAS 141 "Business Combinations", which addresses financial accounting and reporting for business combinations and supersedes Accounting Principles Board Opinion No. 16 ("APB 16"), "Business Combinations", and SFAS 38, "Accounting for Preacquisition Contingencies of Purchased Enterprises". All business combinations in the scope of SFAS 141 are to be accounted for using one method, the purchase method. This Statement requires that intangible assets be recognized as assets apart from goodwill if they meet one of two criteria--the contractual-legal criterion or the separability criterion. SFAS 141 19
ELECTRONIC ARTS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) (continued) also requires disclosure of the primary reasons for a business combination and the allocation of the purchase price paid to the assets acquired and liabilities assumed by major balance sheet caption. This Statement does not change many of the provisions of APB 16 and SFAS 38 related to the application of the purchase method. Also, SFAS 141 does not change the requirement to write off certain research and development assets acquired in a business combination as required by FASB Interpretation No. 4, "Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method". The provisions of SFAS 141 apply to all business combinations initiated after June 30, 2001 and applies to all business combinations accounted for using the purchase method for which the date of acquisition is July 1, 2001, or later. In June 2001, the FASB issued SFAS 142, "Goodwill and Other Intangible Assets", which supersedes APB 17, "Intangible Assets". SFAS 142 addresses the accounting treatment for goodwill and other intangible assets acquired individually or with a group of other assets upon their acquisition, but not acquired in a business combination. This statement also addresses how goodwill and other intangible assets should be accounted for after they have been initially recognized in the financial statements. With the adoption of SFAS 142, goodwill is no longer subject to amortization over its estimated useful life; rather, goodwill will be subject to at least an annual assessment for impairment by applying a fair-value-based test. Also, if the benefit of an intangible asset is obtained through contractual or other legal rights, or if the intangible asset can be sold, transferred, licensed, rented or exchanged, an acquired intangible asset should be separately recognized. The terms of SFAS 142 are effective as of the beginning of the first quarter of the fiscal year beginning after December 15, 2001. Certain provisions of SFAS 142 shall be applied to goodwill and other acquired intangible assets for which the acquisition date is after June 30, 2001. The Company is currently determining the effect of SFAS 142 on its financial statements. In June 2001, the FASB issued SFAS 143 "Accounting for Asset Retirement Obligations". SFAS 143 addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. This Statement applies to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development or normal use of the asset. As used in this Statement, a legal obligation results from existing law, statute, ordinance, written or oral contract, or by legal construction of a contract under the doctrine of promissory estoppel. SFAS 143 is effective for fiscal years beginning after June 15, 2002. We do not expect the adoption of SFAS 143 to have a material impact on our financial position or results of operations. In October 2001, the FASB issued SFAS 144 "Accounting for the Impairment or Disposal of Long-Lived Assets" which addresses financial accounting and reporting for the impairment or disposal of long-lived assets. SFAS 144 supersedes FASB Statement No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of", and also supersedes the accounting and reporting provisions of APB Opinion No. 30, "Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions", for the disposal 20
ELECTRONIC ARTS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) (continued) of a segment of a business. SFAS 144 is effective for fiscal years beginning after December 15, 2001 and interim periods within those fiscal years. The Company is in the process of determining the impact of this new accounting standard. Note 13. Subsequent Events On October 23, 2001, the Company announced cost controls within its online unit, EA.com, through a workforce reduction of approximately 36% of EA.com's approximately 700 employees. In addition, EA.com plans to consolidate various offices and incur impairment charges for abandoned leaseholds and assets that have yet to be determined. EA.com expects to complete the restructuring plan by December 31, 2001. 21
ITEM 2: Management's Discussion and Analysis Of Financial Condition and Results Of Operations This Quarterly Report, on Form 10-Q and, in particular, the following "Management's Discussion and Analysis of Financial Condition and Results of Operations" contains forward-looking statements about circumstances that have not yet occurred. All statements, trend analysis and other information contained below relating to markets, our products and trends in revenue, as well as other statements including words such as "anticipate", "believe" or "expect" and statements in the future tense are forward-looking statements. These forward-looking statements are subject to business and economic risks and actual events or our actual future results could differ materially from those set forth in the forward-looking statements due to such risks and uncertainties. We will not necessarily update information if any forward-looking statement later turns out to be inaccurate. Risks and uncertainties that may affect our future results and performance include, but are not limited to, those discussed under the heading "Risk Factors" at pages 39 to 46, as well as in our Annual Report on Form 10-K for the fiscal year ended March 31, 2001 as filed with the Securities and Exchange Commission on June 29, 2001 and other documents filed with the Commission. We derive revenues primarily from shipments of entertainment software, which includes EA Studio products for dedicated entertainment systems (that we call video game systems or consoles such as PlayStation, PlayStation 2 and Nintendo 64), EA Studio personal computer products (or PC), Co-Publishing products that are co-published and distributed by us, and Affiliated Label (or AL) products that are published by third parties and distributed by us. We also derive revenues from licensing of EA Studio products and AL products through hardware companies (or OEM), selling subscriptions on our online gaming service, selling advertisements on our online web pages and selling our packaged goods through our online store. Information about our net revenues for North America and foreign areas for the three and six months ended September 30, 2001 and 2000 is summarized below (in thousands): <TABLE> <CAPTION> September 30, September 30, Increase/ 2001 2000 (Decrease) % change ------------------------------------------------------- <S> <C> <C> <C> <C> Net Revenues for the Three Months Ended: North America $169,555 $152,842 $ 16,713 10.9% ------------------------------------------------------ Europe 53,202 49,949 3,253 6.5% Asia Pacific 8,007 9,527 (1,520) (16.0%) Japan 9,392 7,582 1,810 23.9% ------------------------------------------------------ International 70,601 67,058 3,543 5.3% ------------------------------------------------------ Consolidated Net Revenues $240,156 $219,900 $ 20,256 9.2% ====================================================== </TABLE> 22
<TABLE> <CAPTION> September 30, September 30, Increase/ 2001 2000 (Decrease) % change ---------------------------------------------------------- <S> <C> <C> <C> <C> Net Revenues for the Six Months Ended: North America $272,617 $224,598 $ 48,019 21.4% ---------------------------------------------------------- Europe 113,014 101,843 11,171 11.0% Asia Pacific 18,058 21,639 (3,581) (16.5%) Japan 18,417 26,619 (8,202) (30.8%) ---------------------------------------------------------- International 149,489 150,101 (612) (0.4%) ---------------------------------------------------------- Consolidated Net Revenues $422,106 $374,699 $ 47,407 12.7% ========================================================== </TABLE> North America Net Revenues The increase in North America net revenues for the three and six months ended September 30, 2001 compared to the same period last year was primarily attributable to: . PlayStation 2 revenues of $83,307,000 for the quarter and $119,061,000 for the six months ended September 30, 2001 from titles such as Madden NFL 2002, NCAA Football 2002, NBA Street, and NHL 2002. . Advertising revenues of $7,100,000 were generated for the quarter and $14,761,000 for the six months ended September 30, 2001. We commenced generating advertising revenues immediately following the launch of our gamesite on the world wide web in October 2000. In addition, advertising revenues were generated from Pogo Corporation's ("Pogo") websites subsequent to the February 2001 acquisition. . These increases were partially offset by an expected decrease in Sony PlayStation revenue, which had fewer titles shipping compared to the same period in the prior year and due to a declining market. In addition, PC sales in the prior year were higher due to the strong sales of The Sims and The Sims Livin' Large. International Net Revenues The increase in international net revenues for the three months ended September 30, 2001 compared to the three months ended September 30, 2000 was attributable to the following: . Europe's net revenues increased 7% compared to the prior year primarily due to higher AL sales and PlayStation 2 sales, offset by lower PC revenues and the expected decrease of revenues from PlayStation. . Japan's net revenues increased 24% compared to the prior year in spite of an unfavorable exchange rate comparison of about 13%. The increase is primarily due to higher AL sales. . Offset by a decrease in Asia Pacific's net revenues compared to the prior year primarily due to the expected decrease in PC sales, an unfavorable exchange rate comparison and the later emergence of the PlayStation 2 in this market resulting in fewer units in the area. Additionally, Asia Pacific did not benefit from our primary PlayStation 2 releases during the three months ended September 30, 2001 which have more appeal to the North American market. The slight decrease in international net revenues for the six months ended September 30, 2001 compared to the six months ended September 30, 2000 was attributable to the following: . Japan's net revenues decreased 31% compared to the prior year primarily due to the strong sales of our first PlayStation 2 title FIFA Soccer World Championship in the prior year, as 23
well as a significant decrease in PlayStation revenues due to the console transition, no new products for the PlayStation and weakness in the Yen currency. Japan did not benefit from our primary PlayStation 2 releases during the six months ended September 30, 2001, which have more appeal to the North American market. . Asia Pacific's net revenues decreased 17% compared to the prior year primarily due to the expected decrease in PC and Sony PlayStation sales, an unfavorable exchange rate comparison and the later emergence of the PlayStation 2 in this market resulting in fewer units in the area. Additionally, Asia Pacific did not benefit from our primary PlayStation 2 releases during the six months ended September 30, 2001 which have more appeal to the North American market. . Offset by Europe's increase in net revenues by 11% compared to the prior year primarily due to higher PlayStation 2 and AL sales, offset by lower PC revenues and the expected decrease of revenues from PlayStation. Information about our worldwide net revenues by product line for the three and six months ended September 30, 2001 and 2000 is presented below (in thousands): <TABLE> <CAPTION> September 30, September 30, Increase/ 2001 2000 (Decrease) % change --------------------------------------------------------- <S> <C> <C> <C> <C> Net Revenues for the Three Months Ended: EA Studio: - --------- PlayStation 2 $ 91,763 $ 2,737 $ 89,026 N/A PC 53,888 80,399 (26,511) (33.0%) PlayStation 25,147 65,157 (40,010) (61.4%) Online Subscriptions 7,188 7,145 43 0.6% Advertising 7,100 -- 7,100 N/A N64 6,225 10,161 (3,936) (38.7%) Game Boy Color 4,279 -- 4,279 N/A License, OEM and Other 4,734 7,705 (2,971) (38.6%) ----------------------------------------------------- 200,324 173,304 27,020 15.6% Affiliated Label: 39,832 46,596 (6,764) (14.5%) - ----------------- ----------------------------------------------------- Consolidated Net Revenues $ 240,156 $ 219,900 $ 20,256 9.2% ===================================================== <CAPTION> September 30, September 30, Increase/ 2001 2000 (Decrease) % change --------------------------------------------------------- <S> <C> <C> <C> <C> Net Revenues for the Six Months Ended: EA Studio: - --------- PlayStation 2 $ 142,282 $ 13,018 $ 129,264 N/A PC 123,962 150,756 (26,794) (17.8%) PlayStation 39,189 94,658 (55,469) (58.6%) Online Subscriptions 15,144 15,456 (312) (2.0%) Advertising 14,761 -- 14,761 N/A N64 8,627 10,767 (2,140) (19.9%) Game Boy Color 4,279 -- 4,279 N/A License, OEM and Other 9,024 11,129 (2,105) (18.9%) ----------------------------------------------------- 357,268 295,784 61,484 20.8% Affiliated Label: 64,838 78,915 (14,077) (17.8%) - ----------------- ----------------------------------------------------- Consolidated Net Revenues $ 422,106 $ 374,699 $ 47,407 12.7% ===================================================== </TABLE> 24
PlayStation 2 Product Net Revenues We released four titles in the second quarter of fiscal 2002 compared to one title released only in Japan for the same period last year for the PlayStation 2. We released six titles in the six months ended September 30, 2001 compared to two titles released only in Japan for the same period last year. Major releases for the quarter were Madden NFL 2002, NCAA Football 2002 and NHL 2002. Revenues increased for the three and six months ended September 30, 2001 due to the higher number of new and catalogue titles shipping worldwide in the current period compared to a couple of titles shipping in Japan in the same period last year. We expect revenues from PlayStation 2 products to continue to grow in fiscal 2002. Personal Computer Product Net Revenues The decrease in sales of PC products for the three and six months ended September 30, 2001 compared to the same period last year was primarily due to the strong sales of major hits including The Sims, SimCity 3000 Unlimited and The Sims: Livin' Large in the prior year. We released four PC titles in both the second quarter of the current and prior fiscal year. We released five PC titles in the six months ended September 30, 2001 compared to eight in the same period last year. Due to the strong sales of The Sims in fiscal 2001, we expect revenues from PC products to be flat or lower in fiscal 2002. PlayStation Product Net Revenues We released one title for the PlayStation console during the second quarter of fiscal 2002 compared to five titles released in the second quarter of fiscal 2001. We released one PlayStation title in the six months ended September 30, 2001 compared to six titles in the same period last year. As expected, PlayStation sales decreased for the three and six months ended September 30, 2001 compared to the prior year primarily attributable to the transition to next generation console systems and fewer titles released for the product during the current year. Sony released the PlayStation 2 worldwide in the prior year. Although our PlayStation products are playable on the PlayStation 2 console, we expect sales of current PlayStation products to continue to decline significantly in fiscal 2002. We expect to ship significantly fewer products for the PlayStation than in the prior year. Under the terms of a licensing agreement entered into with Sony Computer Entertainment of America in July 1994 (the "Sony Agreement"), as amended, we are authorized to develop and distribute CD-based software products compatible with the PlayStation. Furthermore, under the terms of an additional licensing agreement entered into with Sony Computer Entertainment of America as of April 2000 (the "PlayStation 2 Agreement"), as amended, we are authorized to develop and distribute DVD-based software products compatible with the PlayStation 2. Pursuant to these agreements, we engage Sony to supply its PlayStation and PlayStation 2 CD's and DVD's for distribution by us. Accordingly, we have limited ability to control our supply of PlayStation and PlayStation 2 CD and DVD products or the timing of their delivery. Online Subscription Net Revenues The increase in online revenues for the three months ended September 30, 2001 and decrease in online revenues for the six months ended September 30, 2001 as compared to the same 25
period last year was due to: . An increase in the number of paying customers for Ultima Online to 211,000 as of September 30, 2001 as compared to 168,000 as of September 30, 2000. . This was offset by a decrease in subscription revenues for Kesmai and Worldplay online games (most of which were transferred to our free service when the EA/AOL site went live in October of 2001) for the three and six months ended September 30, 2001. Advertising Revenues We commenced generating advertising revenues in the third quarter of the prior fiscal year following the launch of our gamesite on the world wide web and the AOL Games Channel in October 2000. We also generated advertising revenues from Pogo's websites subsequent to the February 2001 acquisition. Nintendo 64 Product Net Revenues We released one N64 title in the three and six months ended September 30, 2001 and 2000. The expected decrease in N64 revenues for the three and six months ended September 30, 2001 compared to the same period last year was primarily due to the declining market for N64 products. We expect revenues from N64 products to decline significantly in fiscal 2002. Under the terms of the N64 Agreement, we engage Nintendo to manufacture our N64 cartridges for distribution by us. Accordingly, we have little ability to control our supply of N64 cartridges or the timing of their delivery. A shortage of microchips or other factors outside our control could impair our ability to obtain an adequate supply of cartridges. License, OEM and Other Revenues The decrease in license, OEM and other revenues for the three and six months ended September 30, 2001 was primarily a result of higher licensing revenues in the prior year from Europe. Affiliated Label Product Net Revenues AL product sales decreased for the three and six months ended September 30, 2001 compared to the same periods last year primarily due to a decrease in the number of titles and revenues generated from the distribution of titles by Square EA and fewer overall titles released in the current year as compared to the same period last year. Operations by Segment The series of common stock designated as Class B (see Note 3) was approved to reflect the performance of EA.com. Accordingly, management considers EA.com to be a separate reportable segment. We operate in two principal business segments globally: . Electronic Arts Core ("EA Core") business segment: creation, marketing and distribution of entertainment software. . EA.com business segment: creation, marketing and distribution of entertainment software which can be played or sold online, ongoing management of subscriptions of online games and website advertising. 26
EA.com, a division of Electronic Arts Inc., represents Electronic Arts' online and e-Commerce businesses. EA.com's business includes subscription revenues collected for Internet game play on our websites, website advertising, sales of packaged goods for Internet-only based games and sales of Electronic Arts games sold through the EA.com web store. The Consolidated Statements of Operations includes all revenues and costs directly attributable to EA.com, including charges for shared facilities, functions and services used by EA.com and provided by EA Core. Certain costs and expenses have been allocated based on management's estimates of the cost of services provided to EA.com by EA Core. Information about our operations by segment for the three and six months ended September 30, 2001 and 2000 is presented below (in thousands): <TABLE> <CAPTION> - --------------------------------------------------------------------------------------------------------------------------- Three Months Ended September 30, 2001 EA Core Adjustments and (excl. EA.com) EA.com Eliminations Electronic Arts - --------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Net revenues from unaffiliated customers $ 224,926 $ 15,230 $ - $240,156 Group sales 532 - (532) (a) - - --------------------------------------------------------------------------------------------------------------------------- Total net revenues 225,458 15,230 (532) 240,156 - --------------------------------------------------------------------------------------------------------------------------- Cost of goods sold from unaffiliated customers 115,320 2,440 - 117,760 Group cost of goods sold - 532 (532) (a) - - --------------------------------------------------------------------------------------------------------------------------- Total cost of goods sold 115,320 2,972 (532) 117,760 - --------------------------------------------------------------------------------------------------------------------------- Gross profit 110,138 12,258 - 122,396 Operating expenses: Marketing and sales 34,979 5,575 4,466 (c) 45,020 General and administrative 23,152 2,251 - 25,403 Research and development 63,725 15,664 18,166 (b) 97,555 Network development and support - 15,170 (15,170) (b) - Customer relationship management - 2,996 (2,996) (b) - Carriage fee - 4,466 (4,466) (c) - Amortization of intangibles 3,205 3,270 - 6,475 - --------------------------------------------------------------------------------------------------------------------------- Total operating expenses 125,061 49,392 - 174,453 - --------------------------------------------------------------------------------------------------------------------------- Operating loss (14,923) (37,134) - (52,057) Interest and other income (expense), net 4,179 (119) - 4,060 - --------------------------------------------------------------------------------------------------------------------------- Loss before benefit from income taxes and minority interest (10,744) (37,253) - (47,997) Benefit from income taxes (14,879) - - (14,879) - --------------------------------------------------------------------------------------------------------------------------- Loss before minority interest 4,135 (37,253) - (33,118) Minority interest in consolidated joint venture 294 - - 294 - --------------------------------------------------------------------------------------------------------------------------- Net income (loss) before retained interest in EA.com $ 4,429 $ (37,253) $ - $ (32,824) =========================================================================================================================== </TABLE> Allocation of retained interest (in thousands): <TABLE> <CAPTION> - --------------------------------------------------------------------------------------------------------------------------- Three Months Ended September 30, 2001 EA Core Adjustments and (excl. EA.com) EA.com Eliminations Electronic Arts - --------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Net income (loss) before retained interest in EA.com $ 4,429 $(37,253) $ - $(32,824) Net loss related to retained interest in EA.com (31,665) 31,665 - - - --------------------------------------------------------------------------------------------------------------------------- Net loss $ (27,236) $ (5,588) $ - $(32,824) =========================================================================================================================== </TABLE> 27
<TABLE> <CAPTION> - --------------------------------------------------------------------------------------------------------------------------- Three Months Ended September 30, 2000 EA Core Adjustments and (excl. EA.com) EA.com Eliminations Electronic Arts - --------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Net revenues from unaffiliated customers $ 210,563 $ 9,337 $ - $ 219,900 Group sales 683 - (683) (a) - - --------------------------------------------------------------------------------------------------------------------------- Total net revenues 211,246 9,337 (683) 219,900 - --------------------------------------------------------------------------------------------------------------------------- Cost of goods sold from unaffiliated customers 116,085 4,530 - 120,615 Group cost of goods sold - 683 (683) (a) - - --------------------------------------------------------------------------------------------------------------------------- Total cost of goods sold 116,085 5,213 (683) 120,615 - --------------------------------------------------------------------------------------------------------------------------- Gross profit 95,161 4,124 - 99,285 Operating expenses: Marketing and sales 36,752 1,511 - 38,263 General and administrative 24,142 2,150 - 26,292 Research and development 64,195 15,847 10,126 (b) 90,168 Network development and support - 8,018 (8,018) (b) - Customer relationship management - 2,108 (2,108) (b) - Amortization of intangibles 3,221 1,495 - 4,716 - --------------------------------------------------------------------------------------------------------------------------- Total operating expenses 128,310 31,129 - 159,439 - --------------------------------------------------------------------------------------------------------------------------- Operating loss (33,149) (27,005) - (60,154) Interest and other income (expense), net 4,090 12 - 4,102 - --------------------------------------------------------------------------------------------------------------------------- Loss before benefit from income taxes and minority interest (29,059) (26,993) - (56,052) Benefit from income taxes (17,376) - - (17,376) - --------------------------------------------------------------------------------------------------------------------------- Loss before minority interest (11,683) (26,993) - (38,676) Minority interest in consolidated joint venture (233) - - (233) - --------------------------------------------------------------------------------------------------------------------------- Net loss before retained interest in EA.com $ (11,916) $(26,993) $ - $ (38,909) =========================================================================================================================== </TABLE> Allocation of retained interest (in thousands): <TABLE> <CAPTION> - --------------------------------------------------------------------------------------------------------------------------- Three Months Ended September 30, 2000 EA Core Adjustments and (excl. EA.com) EA.com Eliminations Electronic Arts - --------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Net loss before retained interest in EA.com $ (11,916) $(26,993) $ - $ (38,909) Net loss related to retained interest in EA.com (22,944) 22,944 - - - --------------------------------------------------------------------------------------------------------------------------- Net loss $ (34,860) $ (4,049) $ - $ (38,909) =========================================================================================================================== </TABLE> 28
<TABLE> <CAPTION> - --------------------------------------------------------------------------------------------------------------------------- Six Months Ended September 30, 2001 EA Core Adjustments and (excl. EA.com) EA.com Eliminations Electronic Arts - --------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Net revenues from unaffiliated customers $ 390,477 $ 31,629 $ - $ 422,106 Group sales 1,050 - (1,050) (a) - - --------------------------------------------------------------------------------------------------------------------------- Total net revenues 391,527 31,629 (1,050) 422,106 - --------------------------------------------------------------------------------------------------------------------------- Cost of goods sold from unaffiliated customers 201,257 5,532 - 206,789 Group cost of goods sold - 1,050 (1,050) (a) - - --------------------------------------------------------------------------------------------------------------------------- Total cost of goods sold 201,257 6,582 (1,050) 206,789 - --------------------------------------------------------------------------------------------------------------------------- Gross profit 190,270 25,047 - 215,317 Operating expenses: Marketing and sales 65,810 11,082 8,932 (c) 85,824 General and administrative 43,419 5,199 - 48,618 Research and development 119,108 31,297 37,955 (b) 188,360 Network development and support - 32,045 (32,045) (b) - Customer relationship management - 5,910 (5,910) (b) - Carriage fee - 8,932 (8,932) (c) - Amortization of intangibles 6,410 6,540 - 12,950 - --------------------------------------------------------------------------------------------------------------------------- Total operating expenses 234,747 101,005 - 335,752 - --------------------------------------------------------------------------------------------------------------------------- Operating loss (44,477) (75,958) - (120,435) Interest and other income (expense), net 7,268 (491) - 6,777 - --------------------------------------------------------------------------------------------------------------------------- Loss before benefit from income taxes and minority interest (37,209) (76,449) - (113,658) Benefit from income taxes (35,234) - - (35,234) - --------------------------------------------------------------------------------------------------------------------------- Loss before minority interest (1,975) (76,449) - (78,424) Minority interest in consolidated joint venture 346 - - 346 - --------------------------------------------------------------------------------------------------------------------------- Net loss before retained interest in EA.com $ (1,629) $(76,449) $ - $ (78,078) =========================================================================================================================== <CAPTION> Allocation of retained interest (in thousands): - --------------------------------------------------------------------------------------------------------------------------- Six Months Ended September 30, 2001 EA Core Adjustments and (excl. EA.com) EA.com Eliminations Electronic Arts - --------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Net loss before retained interest in EA.com $ (1,629) $(76,449) $ - $ (78,078) Net loss related to retained interest in EA.com (64,982) 64,982 - - - --------------------------------------------------------------------------------------------------------------------------- Net loss $ (66,611) $(11,467) $ - $ (78,078) =========================================================================================================================== </TABLE> 29
<TABLE> <CAPTION> - --------------------------------------------------------------------------------------------------------------------------- Six Months Ended September 30, 2000 EA Core Adjustments and (excl. EA.com) EA.com Eliminations Electronic Arts - --------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Net revenues from unaffiliated customers $ 356,609 $ 18,090 $ - $ 374,699 Group sales 1,043 - (1,043) (a) - - --------------------------------------------------------------------------------------------------------------------------- Total net revenues 357,652 18,090 (1,043) 374,699 - --------------------------------------------------------------------------------------------------------------------------- Cost of goods sold from unaffiliated customers 192,584 5,983 - 198,567 Group cost of goods sold - 1,043 (1,043) (a) - - --------------------------------------------------------------------------------------------------------------------------- Total cost of goods sold 192,584 7,026 (1,043) 198,567 - --------------------------------------------------------------------------------------------------------------------------- Gross profit 165,068 11,064 - 176,132 Operating expenses: Marketing and sales 70,012 3,444 - 73,456 General and administrative 43,889 4,612 - 48,501 Research and development 117,854 32,339 19,143 (b) 169,336 Network development and support - 15,456 (15,456) (b) - Customer relationship management - 3,687 (3,687) (b) - Amortization of intangibles 6,461 2,909 - 9,370 - --------------------------------------------------------------------------------------------------------------------------- Total operating expenses 238,216 62,447 - 300,663 - --------------------------------------------------------------------------------------------------------------------------- Operating loss (73,148) (51,383) - (124,531) Interest and other income (expense), net 7,931 7 - 7,938 - --------------------------------------------------------------------------------------------------------------------------- Loss before benefit from income taxes and minority interest (65,217) (51,376) - (116,593) Benefit from income taxes (36,144) - - (36,144) - --------------------------------------------------------------------------------------------------------------------------- Loss before minority interest (29,073) (51,376) - (80,449) Minority interest in consolidated joint venture (731) - - (731) - --------------------------------------------------------------------------------------------------------------------------- Net loss before retained interest in EA.com $ (29,804) $(51,376) $ - $ (81,180) =========================================================================================================================== </TABLE> Allocation of retained interest (in thousands): <TABLE> <CAPTION> - --------------------------------------------------------------------------------------------------------------------------- Six Months Ended September 30, 2000 EA Core Adjustments and (excl. EA.com) EA.com Eliminations Electronic Arts - --------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Net loss before retained interest in EA.com $ (29,804) $(51,376) $ - $ (81,180) Net loss related to retained interest in EA.com (43,670) 43,670 - - - --------------------------------------------------------------------------------------------------------------------------- Net loss $ (73,474) $ (7,706) $ - $ (81,180) =========================================================================================================================== </TABLE> (a) Represents elimination of intercompany sales of EA Core packaged goods products to EA.com, and represents elimination of royalties paid to EA Core by EA.com for intellectual property rights. (b) Represents reclassification of Network Development and Support and Customer Relationship Management to Research and Development. (c) Represents reclassification of amortization of the Carriage Fee to Marketing and Sales. 30
The following table presents pro-forma results of operations allocating taxes between EA Core and EA.com. Consolidated taxes have been allocated to EA Core and EA.com on a pro rata basis based on the consolidated effective tax rates, thereby giving EA.com the tax benefit of its losses which is utilized by the consolidated group. Such tax benefit could not be recognized by EA.com on a stand-alone basis. The sum of tax expense and tax benefit for EA Core and EA.com is the same as consolidated tax expense and tax benefit. This presentation represents how management analyzes each segment of the business (in thousands): <TABLE> <CAPTION> - --------------------------------------------------------------------------------------------------------------------------- Three Months Ended September 30, 2001 EA Core Adjustments (excl. and Electronic EA.com) EA.com Eliminations Arts - --------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Loss before benefit from income taxes and minority interest $(10,744) $(37,253) $- $ (47,997) Benefit from income taxes (3,331) (11,548) - (14,879) - --------------------------------------------------------------------------------------------------------------------------- Loss before minority interest (7,413) (25,705) - (33,118) Minority interest in consolidated joint venture 294 - - 294 - --------------------------------------------------------------------------------------------------------------------------- Net loss $ (7,119) $(25,705) $- $ (32,824) =========================================================================================================================== </TABLE> <TABLE> <CAPTION> - --------------------------------------------------------------------------------------------------------------------------- Three Months Ended September 30, 2000 EA Core Adjustments (excl. and Electronic EA.com) EA.com Eliminations Arts - --------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Loss before benefit from income taxes and minority interest $(29,059) $(26,993) $- $ (56,052) Benefit from income taxes (9,008) (8,368) - (17,376) - --------------------------------------------------------------------------------------------------------------------------- Loss before minority interest (20,051) (18,625) - (38,676) Minority interest in consolidated joint venture (233) - - (233) - --------------------------------------------------------------------------------------------------------------------------- Net loss $(20,284) $(18,625) $- $ (38,909) =========================================================================================================================== </TABLE> <TABLE> <CAPTION> - --------------------------------------------------------------------------------------------------------------------------- Six Months Ended September 30, 2001 EA Core Adjustments (excl. and Electronic EA.com) EA.com Eliminations Arts - --------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Loss before benefit from income taxes and minority interest $(37,209) $(76,449) $- $(113,658) Benefit from income taxes (11,535) (23,699) - (35,234) - --------------------------------------------------------------------------------------------------------------------------- Loss before minority interest (25,674) (52,750) - (78,424) Minority interest in consolidated joint venture 346 - - 346 - --------------------------------------------------------------------------------------------------------------------------- Net loss $(25,328) $(52,750) $- $ (78,078) =========================================================================================================================== </TABLE> <TABLE> <CAPTION> - --------------------------------------------------------------------------------------------------------------------------- Six Months Ended September 30, 2000 EA Core Adjustments (excl. and Electronic EA.com) EA.com Eliminations Arts - --------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Loss before benefit from income taxes and minority interest $(65,217) $(51,376) $- $(116,593) Benefit from income taxes (20,217) (15,927) - (36,144) - --------------------------------------------------------------------------------------------------------------------------- Loss before minority interest (45,000) (35,449) - (80,449) Minority interest in consolidated joint venture (731) - - (731) - --------------------------------------------------------------------------------------------------------------------------- Net loss $(45,731) $(35,449) $- $ (81,180) =========================================================================================================================== </TABLE> 31
Costs and Expenses, Interest and Other Income, Net, Income Taxes and Net Loss - ----------------------------------------------------------------------------- for both EA Core and EA.com Segments - ------------------------------------ Cost of Goods Sold. Cost of goods sold for our packaged goods business consists of actual product costs, royalties expense for celebrities, professional sports organizations and independent software developers, manufacturing royalties, expense for defective products and operations expense. Cost of goods sold for our subscription business consists primarily of data center and bandwidth costs associated with hosting our websites, credit card fees and royalties for use of EA and third party properties. Marketing and Sales. Marketing and sales expenses consist of personnel related costs, advertising and marketing and promotional expenses. In addition, marketing and sales includes the amortization of the AOL carriage and revenue share fees ("Carriage Fee"), which began with the launch of EA.com in October 2000. The Carriage Fee is being amortized straight line over the term of the AOL agreement. General and Administrative. General and administrative expenses consist of personnel and related expenses of executive and administrative staff, fees for professional services such as legal and accounting and allowances for bad debts. Research and Development. Research and development expenses consist of personnel related costs, consulting and equipment depreciation, and customer relationship management expenses associated with Electronic Arts' product and online games. EA.com has research and development expenses incurred by Electronic Arts' studios consisting of direct development costs and related overhead costs (facilities, network and development management and supervision) in connection with the development and production of EA.com online games. Network Development and Support. Network development and support costs consist of expenses associated with development of web content, depreciation on server equipment to support online games, network infrastructure direct expenses and depreciation, software licenses and maintenance, and network and management overhead. Cost of Goods Sold. Cost of goods sold as a percentage of revenues decreased for the three and six months ended September 30, 2001 as compared to the same period last year primarily due to: . An increase, as a percentage of revenues, of higher margin PlayStation 2 products as compared to the prior year. . High margin advertising revenues for the three and six months ended September 30, 2001. . Offset by lower revenues and margins on the PlayStation products. . Offset by lower revenues on PC products compared to the prior year due to the strong sales of major hits including The Sims, SimCity 3000 Unlimited and The Sims: Livin' Large in the prior year. 32
Marketing and Sales. Marketing and sales expenses for the three months ended September 30, 2001 increased in absolute dollars by 18%, and increased 17% for the six months ended September 30, 2001 primarily attributed to: . The amortization of the AOL carriage fee which began with the launch of EA.com in October 2000. . Higher EA.com marketing and sales expenses due to increased staff required to support the live game sites, increased advertising campaigns promoting the Games Channel, and marketing and sales related headcount and expenditures associated with Pogo. . Offset by lower marketing and advertising in Japan and Europe, due to large programs in the prior year for FIFA Soccer World Championship and Euro 2000 and delays in several promotional programs for F1 2001 and NHL 2002. General and Administrative. General and administrative expenses decreased for the three months ended September 30, 2001 in absolute dollars by 3%, primarily due to a decrease in bad debt due to a write off of a receivable as a result of a default of payment from a customer in Europe in the prior year. General and administrative expenses remained relatively flat in absolute dollars for the six months ended September 30, 2001 primarily due to: . Additional staff and administrative related costs associated with the acquisition of Pogo in February 2001. . Increase in payroll and occupancy costs to support the increased growth in North America. . Offset by a decrease in bad debt expense due to a write off of a receivable as a result of a default of payment from a customer in Europe in the prior year. Research and Development (excluding Network Development and Support and Customer Relationship Management). Research and development expenses (excluding network development and support and customer relationship management) remained relatively flat for the three and six months ended September 30, 2001 compared to the same period in the prior year due to a slight increase in development spending for next generation console products including development for the PlayStation 2, Xbox and Nintendo GameCube, offset by a slight decrease in write-offs of royalty advances as compared to the same period in the prior fiscal year. Network Development and Support. Network development and support expenses increased for the three months ended September 30, 2001 in absolute dollars by 89%, and by 107% for the six months ended September 30, 2001, primarily due to: . Capitalization of costs prior to the EA.com gamesite launch in the prior year as required under Statement of Position 98-1. . Depreciation related to both hardware and internally developed software that began when the site went live in October 2001. . Increased headcount and capital spending on our network infrastructure to support the growth of our live gamesites and related depreciation. . Increased headcount and network-related costs associated with Pogo. 33
Customer Relationship Management. Customer relationship management expenses increased for the three months ended September 30, 2001 by 42% and 60% for the six months ended September 30, 2001, primarily due to increased headcount to support the growth in the Ultima Online subscriber base, launch of Majestic, and the increase in the number of free games and subscription offerings. Amortization of Intangibles. The amortization of intangibles results primarily from the acquisitions of Westwood, Pogo, Kesmai, DreamWorks Interactive, ABC Software and other acquisitions. The increase for the three and six months ended September 30, 2001 for EA.com, compared to the same period in the prior year, was due to the acquisition of Pogo in March 2000. Interest and Other Income, Net. Interest and other income, net, for the three months ended September 30, 2001 remained relatively consistent with the same period in the prior year. For the six months ended September 30, 2001, interest and other income, net, decreased in absolute dollars primarily due to a write-off of an investment in an affiliate in the current year. Income Taxes. Our effective tax rate was 31% for the three and six months ended September 30, 2001 and 2000. Net Loss. In absolute dollars, reported net loss for the three and six months ended September 30, 2001 decreased primarily related to higher revenues and gross profits as compared to the same period last year. This was partially offset by an increase in expenses due to the investment in EA.com, including amortization of carriage fee, higher network development and support costs for new online products, and our game site and the Games Channel on the AOL service. Excluding goodwill and non-cash charges in the amount of $4,783,000, net of taxes, for the three months ended September 30, 2001 net loss would have been $28,041,000. Excluding goodwill and non-cash charges in the amount of $3,951,000, net of taxes, for the three months ended September 30, 2000, net loss would have been $34,958,000. Excluding goodwill and non-cash charges in the amount of $9,732,000, net of taxes, for the six months ended September 30, 2001 net loss would have been $68,346,000. Excluding goodwill and non-cash charges in the amount of $7,549,000, net of taxes, for the six months ended September 30, 2000, net loss would have been $73,631,000. 34
LIQUIDITY AND CAPITAL RESOURCES - -------------------------------------------------------------------------------- As of September 30, 2001, our working capital was $469,129,000 compared to $478,701,000 at March 31, 2001. Cash, cash equivalents and short-term investments decreased by approximately $58,547,000 during the six months ended September 30, 2001. We used $81,078,000 of cash from operations, $81,104,000 for short-term investments, $29,711,000 of cash in capital expenditures, offset by $50,164,000 of cash generated through the sale of equity securities under our stock plans during the six months ended September 30, 2001. Reserves for bad debts and sales returns decreased from $89,833,000 at March 31, 2001 to $69,317,000 at September 30, 2001. Reserves have been charged for returns of product and price protection credits issued for products sold in prior periods. Management believes these reserves are adequate based on historical experience and its current estimate of potential returns and allowances. Our principal source of liquidity is $407,945,000 in cash, cash equivalents and short-term investments and $4,581,000 in marketable securities. Management believes the existing cash, cash equivalents, short-term investments, marketable securities and cash generated from operations will be sufficient to meet cash and investment requirements on both a short-term and long-term basis. Included in the amounts above is the following for the EA.com business: . With the exception of the proceeds from the sale of stock and warrant to AOL in fiscal 2000 in the amount of $20,000,000, to date, EA.com has been funded solely by Electronic Arts. This funding has been accounted for as capital contributions from Electronic Arts. Excess cash generated from operations is transferred to Electronic Arts, and has been accounted for as a return of capital. We anticipate these funding procedures will continue in the near-term. However, Electronic Arts may, at its discretion, provide funds to EA.com under a debt arrangement, instead of treating such funding as a capital contribution. . During the six months ended September 30, 2001, EA.com used $54,370,000 of cash in operations, $10,762,000 in capital expenditures for computer equipment, network infrastructure, internal use software and related third party software, offset by $65,781,000 provided through the capital contributions from Electronic Arts. As a result of the net operating loss generated, we realized a tax benefit of approximately $23,699,000. . During the six months ended September 30, 2000, EA.com used $53,417,000 of cash in operations, $57,611,000 in capital expenditures for computer equipment, network infrastructure and related software (including $28,281,000 of consulting hardware, software and direct payroll and payroll-related costs associated with the implementation of customized internal-use software), offset by $111,066,000 provided through the capital contributions from Electronic Arts. As a result of the net operating loss generated, we realized a tax benefit of approximately $15,927,000. Under the AOL agreement entered into in November 1999, EA.com is required to pay $50,000,000 to AOL as a carriage fee and $31,000,000 as a minimum guaranteed revenue share for revenues generated by subscriptions and other certain commercial transactions on the EA.com site. Of these amounts, $25,000,000 in carriage fee and $11,000,000 in revenue share 35
were paid upon signing the agreement with the remainder of the respective items due in four equal annual installments beginning with the first anniversary of the initial payments. EA.com paid AOL the first annual carriage payment of $6,250,000 and the first annual revenue share payment of $5,000,000 in fiscal 2001. No payments were made to AOL in the six months ended September 30, 2001. EA.com also made a commitment to spend $15,000,000 in offline media advertisements promoting our online games, including those on the AOL service, during the term of the AOL agreement. Future liquidity needs of EA.com will be met by Electronic Arts as Electronic Arts intends to continue to fund the cash requirements of EA.com for the foreseeable future. Impact of Recently Issued Accounting Standards In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 133 ("SFAS 133") "Accounting for Derivative Instruments and Hedging Activities", as amended by SFAS 137 "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133 - an Amendment of FASB Statement No. 133" and SFAS 138 "Accounting for Certain Derivative Instruments and Certain Hedging Activities - an Amendment of FASB Statement No. 133" which establishes accounting and reporting standards for derivative instruments and hedging activities. The terms of SFAS 133 and SFAS 138 are effective as of the beginning of the first quarter of the fiscal year beginning after June 15, 2000. SFAS 133, as amended, requires that all derivative instruments be recorded on the balance sheet at their fair value. Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of a hedge transaction and, if it is, the type of hedge transaction. The Company utilizes fair value foreign exchange contracts to hedge foreign currency exposures of underlying assets and liabilities, primarily certain intercompany receivables that are denominated in foreign currencies. The Company adopted SFAS 133 on April 1, 2001. The adoption of SFAS 133 did not have a material impact on the Company's consolidated financial position or results of operations. In April 2001, the Emerging Issues Task Force issued No. 00-25 ("EITF 00-25"), "Accounting for Consideration from a Vendor to a Retailer in Connection with the Purchase or Promotion of the Vendor's Products", which states that consideration from a vendor to a reseller of the vendor's products is presumed to be a reduction of the selling prices of the vendor's products and, therefore, should be characterized as a reduction of revenue when recognized in the vendor's income statement. That presumption is overcome and the consideration can be categorized as a cost incurred if, and to the extent that, a benefit is or will be received from the recipient of the consideration. That benefit must meet certain conditions described in EITF 00-25. The consensus should be applied no later than in annual or interim financial statements for periods beginning after December 15, 2001. The Company is currently evaluating the impact of this consensus on its Statements of Operations. In June 2001, the FASB issued SFAS 141 "Business Combinations", which addresses financial accounting and reporting for business combinations and supersedes Accounting Principles Board Opinion No. 16 ("APB 16"), "Business Combinations", and SFAS 38, "Accounting for 36
Preacquisition Contingencies of Purchased Enterprises". All business combinations in the scope of SFAS 141 are to be accounted for using one method, the purchase method. This Statement requires that intangible assets be recognized as assets apart from goodwill if they meet one of two criteria--the contractual-legal criterion or the separability criterion. SFAS 141 also requires disclosure of the primary reasons for a business combination and the allocation of the purchase price paid to the assets acquired and liabilities assumed by major balance sheet caption. This Statement does not change many of the provisions of APB 16 and SFAS 38 related to the application of the purchase method. Also, SFAS 141 does not change the requirement to write off certain research and development assets acquired in a business combination as required by FASB Interpretation No. 4, "Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method". The provisions of SFAS 141 apply to all business combinations initiated after June 30, 2001 and applies to all business combinations accounted for using the purchase method for which the date of acquisition is July 1, 2001, or later. In June 2001, the FASB issued SFAS 142, "Goodwill and Other Intangible Assets", which supersedes APB 17, "Intangible Assets". SFAS 142 addresses the accounting treatment for goodwill and other intangible assets acquired individually or with a group of other assets upon their acquisition, but not acquired in a business combination. This statement also addresses how goodwill and other intangible assets should be accounted for after they have been initially recognized in the financial statements. With the adoption of SFAS 142, goodwill is no longer subject to amortization over its estimated useful life; rather, goodwill will be subject to at least an annual assessment for impairment by applying a fair-value-based test. Also, if the benefit of an intangible asset is obtained through contractual or other legal rights, or if the intangible asset can be sold, transferred, licensed, rented or exchanged, an acquired intangible asset should be separately recognized. The terms of SFAS 142 are effective as of the beginning of the first quarter of the fiscal year beginning after December 15, 2001. Certain provisions of SFAS 142 shall be applied to goodwill and other acquired intangible assets for which the acquisition date is after June 30, 2001. The Company is currently determining the effect of SFAS 142 on its financial statements. In June 2001, the FASB issued SFAS 143 "Accounting for Asset Retirement Obligations". SFAS 143 addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. This Statement applies to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development or normal use of the asset. As used in this Statement, a legal obligation results from existing law, statute, ordinance, written or oral contract, or by legal construction of a contract under the doctrine of promissory estoppel. SFAS 143 is effective for fiscal years beginning after June 15, 2002. We do not expect the adoption of SFAS 143 to have a material impact on our financial position or results of operations. In October 2001, the FASB issued SFAS 144 "Accounting for the Impairment or Disposal of Long-Lived Assets" which addresses financial accounting and reporting for the impairment or disposal of long-lived assets. SFAS 144 supersedes FASB Statement No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of", and also supersedes the accounting and reporting provisions of APB Opinion No. 30, "Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions", for the disposal 37
of a segment of a business. SFAS 144 is effective for fiscal years beginning after December 15, 2001 and interim periods within those fiscal years. The Company is in the process of determining the impact of this new accounting standard. 38
RISK FACTORS - -------------------------------------------------------------------------------- Electronic Arts' business is subject to many risks and uncertainties which may affect our future financial performance. Some of those important risks and uncertainties which may cause our operating results to vary or which may materially and adversely affect our operating results are as follows: Risk Factors Relating to Our Core Business Platform Transitions Such as the One Now Occurring Typically Depress the Market for Video Game Software Until New Platforms Achieve a Wide Market Acceptance When new video game platforms are announced or introduced into the market, consumers typically reduce their purchases of video games for current platforms in anticipation of new platforms being available. During that period, sales of our video game products can be expected to slow or even decline until new platforms have achieved a wide market and consumer acceptance. We are currently in such a transition. Sony shipped its PlayStation 2 product in Japan, North America and Europe in calendar year 2000. Nintendo launched its new console system, Nintendo GameCube, in Japan in September 2001 and announced subsequent releases in November 2001 in North America and in calendar year 2002 in Europe. Microsoft announced that its new console system, Xbox, will be initially released in November 2001 in North America, followed by releases in Japan and Europe. Delays in the launch or shortages of these platforms could also adversely affect our sales of products for these platforms. Current sales of our products for the existing PlayStation and Nintendo 64 platforms have been adversely affected (by the introduction of the PlayStation 2 and the pending introduction of new platforms). We expect this trend to continue until one or more of these new consoles achieve a wide installed base of consumers. New Video Game Platforms Create Additional Technical and Business Model Uncertainties Large portions of our revenues are derived from the sale of products for play on proprietary video game platforms such as the Sony PlayStation. The success of our products is significantly affected by acceptance of the new video game hardware systems and the life span of older hardware platforms and our ability to accurately predict which platforms will be most successful. Sometimes we will spend development and marketing resources on products designed for new video game systems that have not yet achieved large installed bases or will continue product development for older hardware platforms that may have shorter life cycles than we expected. Conversely, if we do not develop for a platform that achieves significant market acceptance, or discontinue development for a platform that has a longer life cycle than expected, our revenue growth may be adversely affected. For example, the Sega Dreamcast console launched in Japan in early 1999 and in the United States in September of 1999. We have developed no products for this platform. Had this platform achieved wide market acceptance, our revenue growth would have been adversely affected. Similarly, we are developing products for the Xbox and Nintendo GameCube. If these platforms do not achieve wide commercial acceptance, our revenue growth will be adversely impacted. Product Development Schedules Are Frequently Unreliable and Make Predicting Quarterly Results Difficult Product development schedules, particularly for new hardware platforms and high-end multimedia personal computers, or PCs, are difficult to predict because they involve creative processes, use of new development tools for new platforms and the learning process, research and experimentation associated 39
with development for new technologies. For example, EMPEROR: Battle for Dune for the PC, which was expected to ship in fiscal 2001 was not released until the first quarter of fiscal 2002 due to development delays. Also, Agent Under Fire for the PS2, which was expected to ship in fiscal 2001, released in October of fiscal 2002 due to development delays. Additionally, development risks for CD-ROM and DVD products can cause particular difficulties in predicting quarterly results because brief manufacturing lead times allow finalizing products and projected release dates late in a quarter. Our revenues and earnings are dependent on our ability to meet our product release schedules, and our failure to meet those schedules could result in revenues and earnings which fall short of analysts' expectations for any individual quarter and the fiscal year. Our Business Is Both Seasonal and Cyclical Our business is highly seasonal with a significant percentage of our revenues occurring in the December quarter. In fiscal 2002, we expect these seasonal trends to be magnified by general industry factors, including the current platform transition, anticipated fall launches of the Xbox and Nintendo GameCube in North America and the economic slowdown in the United States and other territories. In addition, we are continuing to invest significantly in our online operation, EA.com. Our business is also cyclical; video game platforms have historically had a life cycle of four to six years, and decline as more advanced platforms are being introduced. As one group of platforms is reaching the end of its cycle and new platforms are emerging, buying patterns may change. Purchases of products for older platforms may slow at a faster rate than sales of new platforms. We are currently in such a platform transition. Sony shipped its PlayStation 2 console in Japan, North America and Europe in calendar year 2000. Nintendo launched its new console system, Nintendo GameCube, in Japan in September 2001 and announced subsequent releases in November 2001 in North America and in calendar year 2002 in Europe. Microsoft announced that its new console system, Xbox, will be released in November 2001 in North America and will be followed by releases in Japan and Europe. Sales of our current products for the current Nintendo and Sony platforms have already been adversely affected, and we expect this trend to continue. The Impact of e-Commerce and Online Games on Our Business Is Not Known While we do not currently derive significant revenues from online sales of our packaged products, we believe that such form of distribution will become a more significant factor in our business in the future. E-Commerce is becoming an increasingly popular method for conducting business with consumers. How that form of distribution will affect the more traditional retail distribution, at which we have historically had success, and over what time period, is uncertain. In addition, we expect the number and popularity of online games to increase and become a significant factor in the interactive games business generally. We do not know how that increase generally, or the emerging business of EA.com specifically, will affect the sales of packaged goods. Our Business, Our Products, and Our Distribution Are Subject to Increasing Regulation in Key Territories Legislation is increasingly introduced which may affect the content of our products and their distribution. For example, privacy rules in the United States and Europe impose various restrictions on our web sites. Those rules vary by territory while of course the Internet recognizes no geographical boundaries. Other countries such as Germany have adopted laws regulating content transmitted over the Internet that are stricter than current United States laws. In the United States, in response to recent events, the federal and several state governments are considering content restrictions on products such as those made by us as well as restrictions on distribution of such products. Any one or more of these factors could harm our business. 40
Our Platform Licensors Are Our Chief Competitors and Frequently Control the Manufacturing of Our Video Game Products Our agreements with hardware licensors, which are also our chief competitors, typically give significant control to the licensor over the approval and manufacturing of our products. This fact could, in certain circumstances, leave us unable to get our products approved, manufactured and shipped to customers. In most events, control of the approval and manufacturing process by the platform licensors increases both our manufacturing lead times and costs as compared to those we can achieve independently. For example, in prior years, we experienced delays in obtaining approvals for and manufacturing of PlayStation products which caused delays in shipping those products. The potential for additional delay or refusal to approve or manufacture our products continues with our platform licensors. Such occurrences would harm our business and adversely affect our financial performance. Additionally, we have not negotiated a final publishing agreement with Nintendo for the Nintendo GameCube platform and we do not know whether the final terms of this agreement will be favorable. Proliferation and Assertion of Patents Poses Serious Risks to our Business Many patents have been issued that may apply to widely used game technologies. Additionally, many recently issued patents are now being asserted against Internet implementations of existing games. Several such patents have been asserted against us. Such claims can harm our business. We will incur substantial expenses in evaluating and defending against such claims, regardless of the merits of the claims. In the event that there is a determination that we have infringed a third party patent, we could incur significant monetary liability and be prevented from using the rights in the future. Risk Factors Relating to Our Online Business Because of EA.com's Limited Operating History, It Will Be Difficult To Evaluate its Business and Prospects EA.com's business is still in the developing stages, so evaluating its business and prospects will be more difficult than would be the case for a more mature business. We will continue to encounter the risks and difficulties faced in launching a new business, and we may not achieve our goals or may be compelled to change the manner in which we seek to develop the business. These uncertainties as to the future operations of EA.com will increase the difficulty we face in completing and pursuing the essential plans for the development of the business and will also make it more difficult for our stockholders and securities analysts to predict the operating results of this business. EA.com Has a History of Losses and Expects To Continue To Incur Losses and May Never Achieve Profitability EA.com has incurred substantial losses to date, including the first and second quarters of fiscal year 2002. We expect EA.com to continue to incur losses as it develops its business. EA.com will be required to maintain the significant support, service and product enhancement demands of online users, and we cannot be certain that EA.com will produce sufficient revenues from its operations to support these costs. Even if profitability is achieved, EA.com may not be able to sustain it over a period of time. 41
Our Agreements with America Online May Not Prove Successful to the Development of EA.com's Business We have a series of agreements with America Online ("AOL") for the offering of our games for online play. These agreements require that we make substantial guaranteed payments to AOL and that we commit our resources to the pursuit of the online game opportunity. We cannot be assured that the substantial costs associated with the AOL agreements will be justified by the revenues generated from that relationship. In addition, restrictions included in the AOL agreements limiting other channels we may develop for offering online games may limit our ability to diversify our online distribution strategies. The success for us of the AOL agreements will also be a result of AOL's performance under the agreements, a factor over which we will have very little control. We Have Very Limited Experience with Online Games and May Not Be Able To Operate This Business Effectively Offering games solely for online play is a substantial departure from our traditional business of selling packaged software games. We have employed various pricing models, including subscription fees, "pay to play fees" and advertising. We have very little experience with developing optimal pricing strategies for online games and no experience in "pay to play" pricing or in securing advertising revenues for online services. For example, our product Majestic and our Sports package, each of which launched with a monthly subscription pricing model , have obtained only limited commercial success to date. Similarly, we are inexperienced in predicting usage patterns for our games. Because of our inexperience in this area, we may not be effective in achieving success that may otherwise be attainable from offering our games online. Online Games Have Risks That Are Not Associated with Our Traditional Business Online games, particularly multiplayer games, pose risks to player enjoyment that do not generally apply to packaged game sales. Players frequently would not be acquainted with other players, which may adversely affect the playing experience. Social issues raised by a player's conduct may impact the experience for other players. We have not determined whether or how we might monitor or proctor player behavior that impairs the game experience. In addition, there are substantial technical challenges to be met both in the introduction of our games online and in maintaining an effective game playing environment over time. Also, hacking and spamming has become a serious problem for online sites, and significant hacking and spamming could seriously interfere with online game play. If these risks are not successfully controlled and technical challenges resolved, potential customers for our games may be unwilling to play in sufficient volume to allow us to attain or sustain profitability. Proliferation and Assertion of Patents Poses Serious Risks to the Business of EA.com Many patents have been issued that may apply to widely used Internet technologies. Additionally, many recently issued patents are now being asserted against Internet implementations of older technologies. Several such patents have been asserted against us. Such claims can harm our business. We will incur substantial expenses in evaluating and defending against such claims, regardless of the merits of the claims. In the event that there is a determination that we have infringed a third party patent, we could incur significant monetary liability and be prevented from using the rights in the future. Development of EA.com's Business Will Require Significant Capital, and We Cannot Be Assured That It Will Be Available EA.com will not be successful if it does not continue to receive substantial financing that is required to develop its business. Electronic Arts has agreed to provide a limited amount of funding to EA.com, 42
but this financing alone may not be sufficient for the development of EA.com's business. Any additional funding that is obtained from EA may either be treated as a revolving credit advance or would increase EA's retained interest in EA.com and correspondingly decrease the interest of the holders of outstanding shares of Class B common stock. The attraction of additional equity or debt financing for EA.com from third parties may not be possible or may only be possible on terms that result in significant dilution to Class A and Class B common stockholders or interest or other costs and debt-related restrictions on the operation of the business. To date, nearly all funding (except warrants and cash from revenues) has been provided by EA. If Use of the Internet Does Not Continue To Develop and Reliably Support the Demands Placed on It by Electronic Commerce, EA.com's Business Will Be Harmed EA.com's success depends upon growth in the use of the Internet as a medium for playing games. The use of the Internet for sophisticated games like ours is relatively new. Our business would be seriously harmed if: . use of the Internet does not continue to increase or increases more slowly than expected, . the infrastructure for the Internet does not effectively support online game play, . concerns over the secure transmission of confidential information over public networks inhibit the growth of the Internet as a means of conducting commercial transactions, or . government regulations regarding Internet content, privacy or other conditions impede the effectiveness of the Internet to users. Capacity Restraints May Restrict the Use of the Internet as a Forum for Game Play, Resulting in Decreased Demand for Our Products The Internet infrastructure may not be able to support the demands placed on it by increased usage or the limited capacity of networks to transmit large amounts of data. Other risks associated with commercial use of the Internet could slow its growth, including: . outages and other delays resulting from the inadequate reliability of the network infrastructure, . slow development of enabling technologies and complementary products, and . limited availability of cost-effective, high speed access. Delays in the development or adoption of new equipment standards or protocols required to handle increased levels of Internet activity, or increased governmental regulation, would cause the Internet to fail to gain, or lose, viability as a means of game playing. If these or any other factors cause use of the Internet for commerce to slow or decline, the Internet may not prove viable as a commercial marketplace. This, in turn, would result in decreased demand for EA.com's products and services. To Become and Remain Competitive, EA.com Must Continually Develop and Expand New Content. This Is Inherently Risky and Expensive. EA.com's success depends on our ability to develop products and services for the EA.com site and our ability to continually expand the content on that site. Our agreement with AOL requires us to develop new games under our relationship with AOL. We cannot assure you that products will be developed on time, in a cost effective manner, or that they will be successful. Currently, the release of 43
several products such as The Sims Online and Earth and Beyond for which we expect subscription revenue, have been delayed due to slipping development schedules. Similarly, the online product Majestic has thus far achieved only limited commercial success due in part to the difficulties of delivering the product online. We May Not Be Able To Respond to Rapid Technological Change The market for Internet products and services is characterized by rapid technological change and evolving industry standards. Both in completing the design and implementation of our network infrastructure and thereafter, we will be required to continually improve performance, features, reliability and capacity of our network infrastructure. We cannot assure you that we will be successful in responding rapidly or in a cost effective manner to such developments. Increasing Governmental Regulation of the Internet Could Limit the Market for Our Products As Internet commerce continues to evolve, we expect that federal, state and foreign governments will adopt laws and regulations covering issues such as user privacy, taxation of goods and services provided over the Internet, pricing, content and quality of products and services. It is possible that legislation could expose companies involved in electronic commerce to liability, taxation or other increased costs, any of which could limit the growth of electronic commerce generally. Legislation could dampen the growth in Internet usage and decrease its acceptance as a communications and commercial medium. If enacted, these laws and regulations could limit the market for EA.com's products. Our Revenues Have Been Heavily Dependent on a Single Product and Would Be Adversely Affected if That Product's Popularity Were To Decline In the near term, EA.com's revenues to date have consisted primarily of revenues from sales of our online product Ultima Online, and we would be adversely affected if revenues from that product were to decline for any reason and not be replaced. We expect the online game market to become increasingly competitive, and it is possible that other producer's current or future games could cause our revenue from Ultima Online to decline. In addition, popularity of Ultima Online could decline over time simply because of consumer preference for new game experiences. We Invest Very Heavily in Research and Development and Network Technology and Operations for EA.com, and We Cannot Be Assured That We Will Achieve Revenues That Validate This Level of Spending We have invested, and expect to continue to invest, very heavily in research and development and network technology and operations for our website and online games. We will need to expand EA.com's revenues substantially for it to achieve profitability with these levels of expenditure being required, and we may not be able to do so. If we cannot increase revenues to profitable levels, the value of EA.com will be impaired. In order to develop the broad game offerings that we envision for our online operations it will be necessary to engage in significant developmental efforts both to adapt existing EA games to the online format and to create new online games. Our agreements with AOL require us to maintain a substantial commitment to online game development and we cannot be assured that we will realize acceptable returns from this investment. Online Product Development Schedules Are Unreliable and Make Predicting Quarterly Results Difficult Online product development schedules, particularly for Internet based games are difficult to predict because they involve creative processes, use of new development tools, Internet latency issues, 44
a learning process to better understand Internet based game mechanics, and research and experimentation associated with development for new online technologies. Additionally, development risks for Internet based products can cause particular difficulties in predicting quarterly results because of the challenges associated with game testing, live Beta testing, integration into network servers and integration on to the Games web site and may impact the release ("go live") dates of products during a particular quarter. Several online products currently under development such as The Sims Online and Earth and Beyond have experienced development delays and will be released later than planned. Our revenues and operating costs are dependent on our ability to meet our product "go live" schedules, and our failure to meet those schedules could result in revenues falling short of analysts' expectations, with no corresponding decrease in expenses, resulting in increased operating losses for EA.com. General Risk Factors Because of the Competition for Qualified Technical, Creative, Marketing and Other Personnel, We May Not Be Able To Attract and Retain the Personnel Necessary for our Businesses The market for technical, creative, marketing and other personnel essential to the development of online businesses and management of our online and core businesses continues to be competitive, although current market conditions have made it less difficult to attract and retain the employees we need. In addition, the cost of real estate in the San Francisco Bay area - the location of our headquarters and largest studio remains relatively high, and has made recruiting from other areas and relocating employees to our headquarters more difficult. If we cannot successfully recruit and retain the employees we need, our ability to develop and manage our businesses will be impaired. Foreign Sales and Currency Fluctuations For the six months ended September 30, 2001 international net revenues comprised 35% of total consolidated net revenues. For the fiscal year ended March 31, 2001, international net revenues comprised 37% of total consolidated net revenues. We expect foreign sales to continue to account for a significant and growing portion of our revenues. Such sales are subject to unexpected regulatory requirements, tariffs and other barriers. Additionally, foreign sales are primarily made in local currencies which may fluctuate. While we hedge against foreign currency fluctuations, we cannot control translation issues. For example, our Japan and Asia Pacific revenues in the first half of fiscal 2002 were adversely impacted by a devaluation of the Yen and Australian Dollar as compared to the prior year. The devaluation had an adverse effect for the quarter and six months ended September 30, 2001 on our sales and net income. Any of these factors may significantly harm our business. Increased Difficulties in Forecasting Results During platform transition periods, where the success of our products is significantly impacted by the changing market for our products, forecasting our revenues and earnings is more difficult than in more stable or rising product markets. The demand for our products may decline during a transition faster than we anticipate, negatively impacting both revenues and earnings. At launch, Sony shipped only half of the number of PlayStation 2 units to retail in North America than it had originally planned, and it shipped significantly fewer units than planned at launch in Europe as well. Shortages were announced as being caused by shortages of components for manufacturing. Due to these shortages, our results of operations for fiscal 2001 were adversely affected. Consequently, if Microsoft or Nintendo does not ship the number of units planned for the Xbox and Nintendo Gamecube, our sales of these products may be adversely affected in fiscal 2002. 45
We cannot predict the impact of recent actions and comments by the Securities and Exchange Commission (SEC) and FASB Recent actions and comments from the SEC have focused on the integrity of financial reporting. In addition, the FASB and other regulatory accounting agencies have recently introduced several new or proposed accounting standards, some of which represent a significant change from current industry practices. Fluctuations in Stock Price Due to analysts' expectations of continued growth and other factors, any shortfall in earnings could have an immediate and significant adverse effect on the trading price of our common stock in any given period. As a result of the factors discussed in this report and other factors that may arise in the future, the market price of our common stock historically has been, and we expect will continue to be, subject to significant fluctuations over a short period of time. These fluctuations may be due to factors specific to us, to changes in analysts' earnings estimates, or to factors affecting the computer, software, Internet, entertainment, media or electronics businesses. In addition, fluctuations may be due to uncertainties in the securities markets in general. For example, during the fiscal year ended March 31, 2001, the price per share of our Class A common stock ranged from $26.59 to $56.13 and $44.50 to $63.04 during the six months ended September 30, 2001. World Events The terrorist attacks of September 11, 2001 in the Unites States, the subsequent US military action, and the continuing concerns over potential additional terrorist attacks against US interests and citizens pose serious uncertainties in our business. Consumer spending, consumer preferences in entertainment, and the securities markets generally may be affected on an ongoing and unpredictable basis by these events, all of which may make prediction of our results more difficult. Because of these and other factors affecting our operating results and financial condition, past financial performance should not be considered a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods. 46
Item 3: Quantitative and Qualitative Disclosures About Market Risk MARKET RISK - ----------- We are exposed to various market risks, including the changes in foreign currency exchange rates and interest rates. Market risk is the potential loss arising from changes in market rates and prices. Foreign exchange contracts used to hedge foreign currency exposures and short-term investments are subject to market risk. We do not consider our cash and cash equivalents to be subject to interest rate risk due to their short maturities. We do not enter into derivatives or other financial instruments for trading or speculative purposes. Foreign Currency Exchange Rate Risk We utilize foreign exchange contracts to hedge foreign currency exposures of underlying assets and liabilities, primarily certain intercompany receivables that are denominated in foreign currencies, thereby, limiting our risk. Gains and losses on foreign exchange contracts are reflected in the income statement. At September 30, 2001, we had foreign exchange contracts, all with maturities of less than six months to purchase and sell approximately $155,862,000 in foreign currencies, primarily British Pounds, Canadian Dollars, European Currency Units ("Euros"), Japanese Yen and other currencies. Fair value represents the difference in value of the contracts at the spot rate and the forward rate. The counterparties to these contracts are substantial and creditworthy multinational commercial banks. The risks of counterparty nonperformance associated with these contracts are not considered to be material. Notwithstanding our efforts to manage foreign exchange risks, there can be no assurances that our hedging activities will adequately protect us against the risks associated with foreign currency fluctuations. The following table below provides information about our foreign currency forward exchange contracts at September 30, 2001. The information is provided in U.S. dollar equivalents and presents the notional amount (forward amount), the weighted average contractual foreign currency exchange rates and fair value. <TABLE> <CAPTION> =================================================================================================================== Weighted- Average Contract Amount Contract Rate Fair Value - ------------------------------------------------------------------------------------------------------------------- (In thousands) (In thousands) <S> <C> <C> <C> Foreign currency to be sold under contract: British Pound $100,728 1.4556 $ (793) Canadian Dollar 17,602 1.5339 523 Euro 12,192 0.8709 (542) Japanese Yen 7,297 116.9100 67 South African Rand 4,156 0.1123 85 Swedish Krona 2,594 10.7940 (27) Norwegian Krone 1,140 8.7706 16 Danish Krone 1,360 8.0890 13 Australian Dollar 424 0.5300 30 - -------------------------------------------------------------------------------------------------------------- Total $147,493 $ (628) - -------------------------------------------------------------------------------------------------------------- Foreign currency to be purchased under contract: British Pound $ 8,369 1.4706 $ 73 - -------------------------------------------------------------------------------------------------------------- Total $ 8,369 $ 73 - -------------------------------------------------------------------------------------------------------------- - -------------------------------------------------------------------------------------------------------------- Grand total $155,862 $ (555) - -------------------------------------------------------------------------------------------------------------- </TABLE> 47
While the contract amounts provide one measurement of the volume of these transactions, they do not represent the amount of our exposure to credit risk. The amounts (arising from the possible inabilities of counterparties to meet the terms of their contracts) are generally limited to the amounts, if any, by which the counterparties' obligations exceed our obligations as these contracts can be settled on a net basis at our option. We control credit risk through credit approvals, limits and monitoring procedures. Interest Rate Risk Our exposure to market rate risk for changes in interest rates relates primarily to our investment portfolio. We do not use derivative financial instruments in our investment portfolio. We manage our interest rate risk by maintaining an investment portfolio primarily consisting of debt instruments of high credit quality and relatively short average maturities. We also manage our interest rate risk by maintaining sufficient cash and cash equivalent balances such that we are typically able to hold our investments to maturity. At September 30, 2001, our cash equivalents, short-term and long-term investments included debt securities of $339,288,000. Notwithstanding our efforts to manage interest rate risks, there can be no assurances that we will be adequately protected against the risks associated with interest rate fluctuations. The table below presents the amounts and related weighted average interest rates of our investment portfolio at September 30, 2001: <TABLE> <CAPTION> ============================================================================ Average Interest Rate Cost Fair Value - ---------------------------------------------------------------------------- (Dollars in thousands) <S> <C> <C> <C> Cash equivalents Fixed rate 0.00% $ - $ - Variable rate 2.18% $201,748 $201,748 Short-term investments Fixed rate 4.10% $122,582 $124,078 Variable rate 4.10% $ 5,000 $ 5,062 Long-term investments Fixed rate 0.00% $ - $ - Variable rate 6.35% $ 8,400 $ 8,778 - ------------------------------------------------------------------------- </TABLE> Maturity and call dates for short-term investments range from 3 months to 12 months. 48
PART II - OTHER INFORMATION Item 1. Legal Proceedings The Company is subject to pending claims and litigation. Management, after review and consultation with counsel, considers that any liability from the disposition of such lawsuits in the aggregate would not have a material adverse effect upon the consolidated financial position or results of operations of the Company. Item 4. Submission of Matters to a Vote of Security Holders None. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits: None (b) Reports on Form 8-K: None 49
SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. ELECTRONIC ARTS INC. (Registrant) /s/ E. STANTON MCKEE -------------------- DATED: E. STANTON MCKEE November 14, 2001 Executive Vice President and Chief Financial and Administrative Officer 50