UNITED STATESSECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
For the Quarterly Period Ended September 30, 2002
OR
For the Transition Period from ______ to_____
Commission File No. 0-17948
ELECTRONIC ARTS INC.
(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.
TABLE OF CONTENTS
ELECTRONIC ARTS INC. AND SUBSIDIARIES
INDEX
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PART I — FINANCIAL INFORMATION
Item 1. Unaudited Condensed Consolidated Financial Statements
ELECTRONIC ARTS INC. AND SUBSIDIARIESCONDENSED CONSOLIDATED BALANCE SHEETS(Dollars in thousands)(unaudited)
See accompanying Notes to Condensed Consolidated Financial Statements.
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ELECTRONIC ARTS INC. AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(In thousands, except per share data)(unaudited)
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ELECTRONIC ARTS INC. AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(Dollars in thousands)(unaudited)
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ELECTRONIC ARTS INC. AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)(Dollars in thousands)(unaudited)
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ELECTRONIC ARTS INC. AND SUBSIDIARIESNOTES TO CONDENSED 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 2003 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, 2002 as filed with the Securities and Exchange Commission on June 28, 2002.
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 2003 and fiscal 2002 contain 52 weeks. The results of operations for the fiscal quarters ended September 30, 2002 and 2001 contain 13 weeks. For simplicity of presentation, all fiscal periods are treated as ending on a calendar month end.
Note 3. Common Stock
At the Company’s Annual Meeting of Stockholders, held on August 1, 2002, the stockholders elected to amend the 2000 Class A Equity Incentive Plan to increase by 5,500,000 the number of shares of the Company’s Class A common stock reserved for issuance under the Plan.
Note 4. Goodwill and Other Intangible Assets
Effective April 1, 2002, the Company adopted the full provisions of Statement of Financial Accounting Standards (“SFAS”) No. 141,“Business Combinations”, which requires business combinations initiated after June 30, 2001 to be accounted for using the purchase method of accounting and acquired intangible assets meeting certain criteria to be recorded apart from goodwill. The Company evaluated its goodwill and intangibles acquired prior to June 30, 2001 using the criteria of SFAS No. 141, which resulted in $41,462,000 of other intangibles to be recorded separately from goodwill and $4,000,000 of acquired workforce intangibles being subsumed into goodwill at April 1, 2002. In addition, effective April 1, 2002, the Company adopted the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets”. SFAS No. 142 requires that purchased goodwill and certain indefinite-lived intangibles no longer be amortized; rather, goodwill will be subject to at least an annual assessment for impairment by applying a fair-value-based test. SFAS No. 142 also requires, among other things, reassessment
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ELECTRONIC ARTS INC. AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(unaudited)(continued)
of the useful lives of existing recognized intangibles and the testing for impairment of existing goodwill and other indefinite-lived intangibles. The Company evaluated the estimated useful lives of existing recognized intangibles and determined that the estimated useful lives of all such assets were appropriate.
In accordance with SFAS No. 142, the Company has ceased to amortize goodwill (see goodwill information in table below). In lieu of amortization, SFAS No. 142 requires a two-step approach to testing goodwill for impairment for each reporting unit. The first step, required to be completed by September 30, 2002, tests for impairment by applying fair value-based tests at the Company’s reporting unit level. The second step (if necessary), required to be completed by March 31, 2003, measures the amount of impairment by applying fair value-based tests to individual assets and liabilities within each reporting unit. The Company completed the first step of impairment testing during the quarter ended June 30, 2002 and found no indicators of impairment of its recorded goodwill. Accordingly, provided there are no future indicators of impairment, the second testing step is not necessary during fiscal 2003.
The following table presents comparative information showing the effects that non-amortization of goodwill would have had on the Condensed Consolidated Statements of Operations for the three and six months ended September 30, 2001 (in thousands, except per share amounts):
The Company operates in two business segments globally, EA Core and EA.com (see Note 8 of the Notes to Condensed Consolidated Financial Statements). During the quarter ended September 30, 2002, the Company recorded additional goodwill as a result of an acquisition of a software development company. Goodwill information for each business segment is as follows (in thousands):
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Other intangibles consisted of the following (in thousands):
As of September 30, 2002, future intangible asset amortization expense is estimated as follows (in thousands):
Note 5. Prepaid Royalties
Prepaid royalties consist primarily of prepayments for manufacturing royalties, co-publishing and/or distribution affiliates and license fees paid to celebrities, professional sports organizations and other organizations for use of their trade name and content. 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 research and development expense 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 $104,266,000 and $65,484,000 at September 30, 2002 and March 31, 2002, respectively. The long-term portion of prepaid royalties, included in other assets, was $4,379,000 and $1,164,000 at September 30, 2002 and March 31, 2002, respectively.
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Note 6. Inventories
Inventories are stated at the lower of cost or market. Inventories, net, at September 30, 2002 and March 31, 2002 consisted of (in thousands):
Note 7. Accrued and Other Liabilities
Accrued and other liabilities at September 30, 2002 and March 31, 2002 consisted of (in thousands):
Note 8. Segment Information
Statement of Financial Accounting Standards 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.
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The Company operates in two business segments globally:
Please see the discussion regarding segment reporting in the Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A).
Information about the Company’s business segments is presented below for the three and six months ended September 30, 2002 and 2001 (in thousands):
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Information about the Company’s operations in North America and foreign areas for the three and six months ended September 30, 2002 and 2001 is presented below (in thousands):
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Information about the Company’s net revenues by product line for the three and six months ended September 30, 2002 and 2001 is presented below (in thousands):
Note 9. Comprehensive Income (Loss)
The components of comprehensive income (loss), net of tax, for the three and six months ended September 30, 2002 and 2001 were as follows (in thousands):
The currency translation adjustments are not adjusted for income taxes as they relate to indefinite investments in non-U.S. subsidiaries.
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Note 10. Net Earnings (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 income (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):
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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 an initial public offering for Class B common stock does not occur. Net income (loss) used for the calculation of Diluted EPS for Class A common stock was $50,234,000 and ($32,824,000) for the three months ended September 30, 2002 and 2001, respectively. Net income (loss) used for the calculation of Diluted EPS for Class A common stock was $57,638,000 and ($78,078,000) for the six months ended September 30, 2002 and 2001, respectively. This net income (loss) includes the remaining interest in EA.com (100% of EA.com losses), 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 an initial public offering for Class B common stock does not occur.
Excluded from the above computation of weighted-average shares for Diluted EPS for Class A common stock were options to purchase 349,000 and 231,000 shares of common stock for the three and six months ended September 30, 2002, respectively, as the options’ exercise price was greater than the average market price of the common shares. For the three and six months ended September 30, 2002, the weighted-average exercise price of these respective options was $63.74 and $63.43 per share, respectively.
Due to the net loss attributable for the three and six months ended September 30, 2001 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 5,784,000 shares would have been added to the calculation of diluted common shares for Class A common stock for the three and six
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months ended September 30, 2001, respectively. Due to the net loss attributable for the three and six months ended September 30, 2002 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, 2002, an additional 226,000 and 422,000 shares would have been added to diluted potential common shares for Class B common stock, respectively. Similarly, an additional 889,000 and 911,000 shares would have been added to diluted potential common shares for Class B common stock for the three and six months ended September 30, 2001, respectively.
Note 11. Restructuring and Asset Impairment Charges
In October 2001, the Company announced a restructuring plan for EA.com. The restructuring initiatives involved strategic decisions to discontinue certain product offerings and focus only on key online priorities that align with its fiscal 2003 operational objectives. The workforce reduction resulted in the termination of approximately 270 positions.
The following table summarizes the activity in the accrued restructuring account for the six months ended September 30, 2002 (in thousands):
The restructuring accrual is included in accrued expenses in Note 7 of the Notes to Condensed Consolidated Financial Statements.
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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 due to such risks. 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 41 to 49, as well as in our Annual Report on Form 10-K for the fiscal year ended March 31, 2002 as filed with the Securities and Exchange Commission (SEC) on June 28, 2002 and other documents filed with the SEC.
CRITICAL ACCOUNTING POLICIES
Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses our consolidated financial statements. Our financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, contingent assets and liabilities, and revenues and expenses during the reporting period. The policies discussed below are considered by management to be critical because they are not only important to the portrayal of our financial condition and results of operations but also because application and interpretation of these policies requires both judgment and estimates of matters that are inherently uncertain and unknown. As a result, actual results may differ materially from our estimates.
Sales allowances and bad debt reservesWe derive revenues from sales of our packaged goods product, subscriptions of online service, sales of packaged goods through our online store and website advertising. Product revenue is recognized net of an allowance for returns. We also have stock-balancing programs for our personal computer products which allow under certain circumstances for the exchange of personal computer products by resellers. We may decide to provide price protection under certain circumstances for both our personal computer and video game system products after we analyze: inventory remaining in the channel, the rate of inventory sell through in the channel, and our remaining inventory on hand. We maintain a policy of exchanging products or giving credits, but do not give cash refunds.
We estimate potential future product returns, price protection and stock-balancing programs related to current period product revenue. We analyze historical returns, current sell through of distributor and retailer inventory of our products, current trends in the video game market and the overall economy, changes in customer demand and acceptance of our products and other related factors when evaluating the adequacy of the sales returns and price protection allowances. In addition, management monitors and manages the volume of our sales to retailers and distributors and their inventories as substantial overstocking in the distribution channel can result in high
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returns or the requirement for substantial price protection in subsequent periods. In the past, actual returns have not generally exceeded our reserves. However, actual returns in any future period are inherently uncertain as unsold products in the distribution channels are exposed to rapid changes in consumer preferences, market conditions or technological obsolescence due to new platforms, product updates or competing products. For example, the risk of product returns for our products on mature platforms may increase as new hardware platforms, such as Xbox, Nintendo GameCube and PlayStation 2, become more popular. While management believes it can make reliable estimates for these matters, if we changed our assumptions and estimates, our returns reserves would change, which would impact the net revenue we report. For example, if actual returns were significantly greater than the reserves we have established, the actual results would decrease our reported revenue. Conversely, if actual returns were significantly less than our reserves, this would increase our reported revenue.
Similarly, significant judgment is required to estimate our allowance for doubtful accounts in any accounting period. Our allowance for doubtful accounts is determined by evaluating customer credit-worthiness in the context of current economic trends. Depending upon the overall economic climate and the financial condition of our customers, the amount and timing of our bad debt expense could change significantly.
We also have no way of accurately forecasting bankruptcy or an inability of any of our customers to meet their financial obligations to us. Therefore, our estimates could differ materially from actual results.
Our gross accounts receivable balance was $264,768,000 and our allowance for product returns, pricing allowances and doubtful accounts was $125,402,000 as of September 30, 2002. As of March 31, 2002, our gross accounts receivable balance was $306,365,000 and our allowance for product returns, pricing allowances and doubtful accounts was $115,870,000.
Prepaid royaltiesPrepaid royalties consist primarily of prepayments for manufacturing royalties, co-publishing and/or distribution affiliates and license fees paid to celebrities, professional sports organizations and other organizations for use of their trade name and content. 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. We evaluate the future realization of prepaid royalties quarterly and charge to research and development expense any amounts that we deem unlikely to be realized through product sales. We rely on forecasted revenue to evaluate the future realization of prepaid royalties. If actual revenues, or revised forecasted sales, fall below the initial forecasted sales, the charge to research and development expense may be larger than anticipated in any given quarter. Once the charge has been taken to research and development expense, that amount will not be expensed in future quarters when the product has shipped. The current portion of prepaid royalties, included in other current assets, was $104,266,000 at September 30, 2002 and $65,484,000 at March 31, 2002. The long-term portion of prepaid royalties, included in other assets, was $4,379,000 at September 30, 2002 and $1,164,000 at March 31, 2002.
Valuation of long-lived assets, including goodwill and other intangible assetsWe evaluate both purchased intangible assets and long-lived assets in order to determine if events or changes in circumstances indicate an other than temporary impairment in value. This evaluation requires us to estimate, among other things, the remaining useful lives along with
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future estimates of cash flows of the business. All require the use of judgment and estimates. Our actual results could differ materially from our current estimates. Please see Risk Factors.
Under current accounting standards, we make judgments about the remaining useful lives of purchased intangible assets and other long-lived assets whenever events or changes in circumstances indicate an other than temporary impairment in the remaining value of the assets recorded on our balance sheet. In order to judge the remaining useful life of an asset, management makes various assumptions about the value of the asset in the future. This may include assumptions about future prospects for the business that the asset relates to and typically involves computations of the estimated future cash flows to be generated by these businesses. Please refer to the Operations by Segment discussion of the Management’s Discussion and Analysis of Financial Condition and Results of Operations for discussions of EA Core and EA.com. For our EA Core division, our future net cash flows are primarily dependent on the sale of products for play on proprietary video game platforms. The success of our products is affected by the ability to accurately predict which platforms and which products we develop will be successful. Also, our revenues and earnings are dependent on our ability to meet our product release schedules. For our EA.com division, the future net cash flows are dependent on the success of online games. Offering games solely for online play is a substantial departure from our traditional business of selling packaged software games. The EA.com business is still in the growing stages, therefore evaluating its business and prospects is more difficult than would be the case for a more mature business. We continue to encounter the risks and difficulties faced with launching a new business, including the launch of new online games, including but not limited to, Earth and Beyond and The Sims Online. Due to these and other factors described in our Risk Factors, we may not realize the future net cash flows necessary to recover our long-lived assets, which may result in an impairment charge recorded in the future.
On April 1, 2002, we adopted Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets”. As a result of adopting this standard, we will continue to amortize finite-lived intangibles, but will no longer amortize certain other intangible assets, most notably goodwill and acquired workforce. In lieu of amortization, SFAS No. 142 requires a two-step approach to testing goodwill for impairment for each reporting unit. The first step, required to be completed by September 30, 2002, tests for impairment by applying fair value-based tests at the Company’s reporting unit level. The second step (if necessary), required to be completed by March 31, 2003, measures the amount of impairment by applying fair value-based tests to individual assets and liabilities within each reporting unit. We completed the first step of impairment testing during the first quarter of fiscal 2003 and found no indicators of impairment of our recorded goodwill. Accordingly, provided there are no future indicators of impairment, the second testing step is not necessary during fiscal 2003. Following adoption of SFAS No. 142, we continue to evaluate whether any event has occurred which might indicate that the carrying value of an intangible asset is not recoverable.
Income taxesAs part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves estimating our current tax exposures in each jurisdiction including the impact, if any, of additional taxes resulting from tax examinations as well as making judgments regarding the recoverability of deferred tax assets. To the extent recovery of deferred tax assets is not likely based on our estimation of future taxable income in each jurisdiction, a valuation allowance is
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established. Tax exposures can involve complex issues and may require an extended period to resolve. To determine the quarterly tax rate, we are required to estimate full-year income and the related income tax expense in each jurisdiction. The estimated effective tax rate is adjusted for the tax related to significant unusual items. Changes in the geographic mix or estimated level of annual pre-tax income can affect the overall effective tax rate.
RESULTS OF OPERATIONS
Revenues
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, Xbox™ and Nintendo GameCube™, and handheld systems such as Game Boy® Advance), 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, 2002 and 2001 is summarized below (in thousands):
North America Net RevenuesThe increase in North America net revenues for the three and six months ended September 30, 2002 compared to the same periods last year was primarily attributable to the following:
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International Net RevenuesThe increase in international net revenues for the three months ended September 30, 2002 compared to the three months ended September 30, 2001 was attributable to the following:
The increase in international net revenues for the six months ended September 30, 2002 compared to the six months ended September 30, 2001 was attributable to the following:
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Information about our worldwide net revenues by product line for the three and six months ended September 30, 2002 and 2001 is presented below (in thousands):
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PlayStation 2 Product Net RevenuesNet revenues increased for the three and six months ended September 30, 2002 primarily due to strong current year sales of the hit title Medal of Honor Frontline. The increase in the three and six months ended September 30, 2002 was also due to the higher installed base of the PlayStation 2 hardware due in part to Sony’s price cut of the hardware in North America in May 2002 and in Europe in August 2002. Major releases for the quarter were Madden NFL 2003and NCAA Football 2003, which generated higher sales in the current quarter and the six months ended September 30, 2002 as compared to prior year releases of these sports franchise titles. We expect revenues from PlayStation 2 products to continue to grow in fiscal 2003, but as revenues for these products increase, we do not expect to maintain these growth rates.
Xbox Product Net RevenuesWe released five Xbox titles during the six months ended September 30, 2002. Key releases for the quarter included Madden NFL 2003, NCAA Football 2003 andNascar Thunder 2003. Other significant titles on the platform include 2002 FIFA World Cup and James Bond 007 in...Agent Under Fire.
Nintendo GameCube Product Net RevenuesWe released six titles for the six months ended September 30, 2002 for the Nintendo GameCube. Key releases for the quarter included Madden NFL 2003, NCAA Football 2003, Nascar Thunder 2003 and Freekstyle. Other significant titles on the platform include James Bond 007 in...Agent Under Fire and 2002 FIFA World Cup.
Personal Computer Product Net RevenuesThe increase in net revenues of PC products for the three and six months ended September 30, 2002 compared to the same periods last year was due primarily to higher sales of The Sims franchise titles. Current year net revenues includedThe Sims Vacation Expansion Pack, The Sims Unleashed Expansion Pack, The Sims Deluxe and The Sims Hot Date. Prior year releases, including The Sims, The Sims: Livin’ Large and The Sims House Party continued to generate strong sales in the current year. The Sims and its expansion packs have now sold over 18 million units. Due to the strong sales of The Sims products in fiscal 2002, we expect revenues from PC products to only be up slightly in fiscal 2003.
PlayStation Product Net RevenuesThe expected decrease in PlayStation net revenues for the three and six months ended September 30, 2002 compared to the same periods last year was attributable to the transition to next generation console systems. Although our PlayStation products are playable on the PlayStation 2 console, we expect sales of current PlayStation products to continue to decline in fiscal 2003.
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 CDs and DVDs 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.
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Advertising RevenuesNet revenues increased for the three and six months ended September 30, 2002 compared to the same periods last year primarily due to higher advertising revenues generated from AOL and co-branded AOL properties. The increase was partially offset by lower advertising revenues generated from EA.com and Pogo websites. Advertising revenues decreased 17% for the current quarter versus the prior quarter ended June 30, 2002. Due to the current softening of the advertising market, we may experience declines in advertising revenues in future quarters.
Online Subscription Net RevenuesNet revenues increased slightly for the three and six months ended September 30, 2002 compared to the same periods last year primarily attributable to the launch of Motor City Online in October 2001 and Earth & Beyond in September 2002, partially offset by lower subscription revenues from Ultima Online and Platinum and Sports subscription offerings which we discontinued in November 2001. The decrease in Ultima Online was due to strong sales of Ultima Online Third Dawn in the prior year and a slight decrease in the number of paying customers. We recently launched Earth and Beyond and are targeting the launch of The Sims Online in December 2002. Securing and maintaining subscriptions to such products will be critical to the success of EA.com both in the current fiscal year and for the long term.
License, OEM and Other RevenuesThe increase in license, OEM and other net revenues for the three months ended September 30, 2002 was primarily attributable to higher revenues for online packaged goods products. For the six months ended September 30, 2002, license, OEM and other net revenues decreased primarily due to larger license and OEM deals in Europe in the prior year, including a multi-territory license deal in the United Kingdom.
Game Boy Color Product Net RevenuesThe decrease in Game Boy Color net revenues during the three and six months ended September 30, 2002 compared to the same periods last year was primarily due to the release of two hit titles last year, The World is Not Enough and Madden NFL 2002, versus no new titles released in the current periods.
Game Boy Advance Product Net RevenuesWe released two Game Boy Advance titles during the six months ended September 30, 2002, Madden NFL 2003 and Desert Strike Advance. Net revenues were generated primarily in North America and Europe from titles such as Harry Potter and the Sorceror’s Stone and Madden NFL 2003.
Nintendo 64 Product Net RevenuesThe expected decrease in N64 net revenues for the three and six months ended September 30, 2002, compared to the prior fiscal year, was primarily due to the platform transition to next-generation consoles. We do not intend to release any new N64 products in fiscal 2003.
Affiliated Label Product Net RevenuesAL net revenues increased for the three and six months ended September 30, 2002 compared to the same periods last year primarily due to strong sales of hit titles Kingdom Hearts, a distribution deal with Square EA, and Battlefield 1942, a co-publishing deal with Digital Illusions. The increase was also due to products released under new AL distribution deals with LEGO Interactive and Crave Entertainment, Inc. during the current year.
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Operations by Segment
We operate in two business segments globally:
EA.com 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.
Our view of business segments may change due to changes in the underlying business facts and circumstances.
Information about our operations by segment for the three and six months ended September 30, 2002 and 2001 is presented below (in thousands):
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Allocation of retained interest (in thousands):
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Costs and Expenses, Interest and Other Income, Net, Income Taxes and Net Income (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 and other 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. Cost of goods sold for our advertising business consists primarily of ad serving costs.
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 fee (“Carriage Fee”), which began with the launch of EA.com in October 2000. The Carriage Fee is being amortized straight-line over the five-year term of the AOL agreement entered into in November 1999.
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, equipment depreciation, customer relationship management expenses associated with Electronic Arts’ product and online games and write-offs of prepaid royalties. EA.com has research and development expenses incurred by Electronic Arts’ studios consisting of direct development costs and related overhead costs in connection with the development and production of EA.com online games. Research and development also includes network development and support costs directly incurred by EA.com. 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, 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, 2002 as compared to the same periods last year primarily due to:
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Marketing and Sales
Marketing and sales expenses for the three months ended September 30, 2002 increased in absolute dollars by 23%, and increased 41% for the six months ended September 30, 2002 primarily attributed to an increase in titles released compared to the prior year. A significant portion of our marketing and sales expense in the current year related to advertising spending to support key releases in multiple territories including Madden NFL 2003, NCAA Football 2003, Medal of Honor Frontline and 2002 FIFA World Cup.
General and Administrative
General and administrative expenses for the three months ended September 30, 2002 increased in absolute dollars by 8%, and increased 9% for the six months ended September 30, 2002 primarily due to:
Research and Development
Research and development expenses increased slightly for the three and six months ended September 30, 2002 compared to the same periods in the prior year due to additional headcount-related expenses attributable to increased in-house development capacity, net of co-development arrangements.
This was offset by lower EA.com spending due to headcount reductions in the prior fiscal year and lower spending on Majestic and Motor City Online.
Amortization of Intangibles
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For the three and six months ended September 30, 2002, amortization of intangibles relates to amortization of definite-lived identifiable intangible assets from acquisitions of Pogo, Westwood, Dreamworks and Kesmai. For the three and six months ended September 30, 2001, amortization of intangibles relates primarily to amortization of purchased goodwill and intangibles from acquisitions of Westwood, Pogo, Kesmai, Dreamworks, ABC Software and other acquisitions. The decrease in amortization for the three and six months ended September 30, 2002 was due to certain identifiable intangible assets related to Westwood and Dreamworks being fully amortized in fiscal 2002, as well as the result of adopting SFAS No. 142. SFAS No. 142 requires, among other things, the discontinuance of goodwill amortization. As of April 1, 2002, we have ceased to amortize approximately $69,050,000 of goodwill. For the three months ended September 30, 2001, amortization of goodwill totaled $2,931,000. For the six months ended September 30, 2001, amortization of goodwill totaled $5,861,000. In addition, during the three months ended December 31, 2001, we recorded intangible impairment charges of $1,641,000 relating to EA.com’s restructuring.
Interest and Other Income, Net
Interest and other income, net, for the three and six months ended September 30, 2002 decreased from the same periods in the prior year primarily due to a permanent impairment of marketable securities in the current quarter as well as an increase in the cost of utilizing foreign exchange hedge contracts in the current quarter.
Income Taxes
Our effective tax rate was 31% for the three and six months ended September 30, 2002 and 2001.
Net Income (Loss)
In absolute dollars, reported net income (loss) increased for the three and six months ended September 30, 2002 primarily related to higher revenues and gross profits, offset by the increase in expenses compared to the same periods last year. The increase in expenses was primarily due to the increases in marketing and advertising costs to support a higher number of key releases in multiple territories.
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LIQUIDITY AND CAPITAL RESOURCES
EA Core and EA.com
As of September 30, 2002, our working capital was $845,307,000 compared to $699,561,000 at March 31, 2002. Cash, cash equivalents and short-term investments increased by approximately $123,832,000 during the six months ended September 30, 2002. We generated $88,569,000 of cash from operations, $61,282,000 of cash through the sale of equity securities under our stock plans, offset by $23,386,000 of cash used in capital expenditures during the six months ended September 30, 2002.
Reserves for bad debts and sales returns increased from $115,870,000 at March 31, 2002 to $125,402,000 at September 30, 2002. 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 $920,768,000 in cash, cash equivalents and short-term investments and $6,525,000 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 for at least the next 12 months. However, our ability to maintain sufficient liquidity could be affected by various risks and uncertainties, including but not limited to, those related to customer demand and acceptance of titles on new platforms and new title versions on existing platforms, our ability to collect our accounts receivable as they become due, successfully achieving our product release schedules and attaining our forecasted sales objectives, the impact of competition, the economic conditions in the domestic and international markets, seasonality in operating results, risks of product returns and the other risks listed in the “Risk Factors” section.
EA.com
Included in the amounts above is the following for the EA.com business:
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Under the AOL agreement entered into in November 1999, EA.com is required to pay $81,000,000 to AOL over the life of the five-year agreement. Of this amount, $36,000,000 was paid upon signing the agreement with the remainder due in four equal annual installments beginning with the first anniversary of the initial payment. EA.com paid AOL $11,250,000 in both fiscal 2001 and 2002. No payments were made to AOL in the six months ended September 30, 2002.
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.
Other Commitments
Advertising Commitments
We made a commitment to spend $15,000,000 in offline media advertisements promoting our online games, including those on the AOL service, prior to March 31, 2005. As of September 30, 2002, we have spent approximately $3,755,000 against this commitment.
In addition, under an agreement amended on August 30, 2002, we made a commitment to spend $17,000,000 in advertising with News America Corporation and its affiliates through the period ended December 31, 2006. As of September 30, 2002, we have fulfilled approximately $1,388,000 of this commitment.
Lease Commitments
We lease certain of our current facilities and certain equipment under non-cancelable capital and operating lease agreements. We are required to pay property taxes, insurance and normal maintenance costs for certain of our facilities and will be required to pay any increases over the base year of these expenses on the remainder of our facilities.
In February of 1995, we entered into a build-to-suit lease with a financial institution on our headquarters’ facility in Redwood City, California, which was extended in July 2001 and runs through July 2006. We accounted for this arrangement as an operating lease in accordance with SFAS No. 13, “Accounting for Leases”, as amended. Existing campus facilities developed in phase one comprise a total of 350,000 square feet and provide space for sales, marketing, administration and research and development functions. We have an option to purchase the property (land and facilities) for $145,000,000 or, at the end of the lease, to arrange for (1) an additional extension of the lease or (2) sale of the property to a third party with us retaining an obligation to the owner for the difference between the sale price and the guaranteed residual value of up to $128,900,000 if the sales price is less than this amount, subject to certain provisions of the lease.
In December 2000, we entered into a second build-to-suit lease with a financial institution for a five year term from December 2000 to expand our headquarters’ facilities and develop adjacent property adding approximately 310,000 square feet to our campus. Construction was completed in June 2002. We accounted for this arrangement as an operating lease in accordance with SFAS No. 13, as amended. The facilities will provide space for marketing, sales and research and development. We have an option to purchase the property for $127,000,000 or, at the end of the lease, to arrange for (1) an extension of the lease or (2) sale of the property to a third party with
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us retaining an obligation to the owner for the difference between the sale price and the guaranteed residual value of up to $118,800,000 if the sales price is less than this amount, subject to certain provisions of the lease.
Lease rates are based upon the Commercial Paper Rate. The two lease agreements described above require us to maintain certain financial covenants, all of which we were in compliance with as of September 30, 2002.
Letters of Credit
In connection with our purchases of Nintendo GameCube optical disks for distribution in North America, Nintendo requires us to provide irrevocable letters of credit prior to Nintendo’s acceptance of purchase orders from us for purchases of these optical disks. For purchases of Nintendo GameCube optical disks for distribution in Japan and Europe, Nintendo requires us to make cash deposits.
Development, Celebrity, League and Content Licenses: Payments and Commitments
The products published by EA Studios are designed and created by our in-house designers and artists and by independent software developers (“independent artists”). We typically pay the independent artists royalties based on the sales of the specific products, as defined in the related independent artist agreements. Advance payments on these royalties are paid to independent artists upon meeting deliverables as detailed in the contractual agreement. In addition, certain celebrity, league and content license contracts contain minimum guarantee payments and marketing commitments that are not dependent on any deliverables. Celebrities and organizations with whom we have contracts include: FIFA, NASCAR, John Madden, National Basketball Association, PGA TOUR, Tiger Woods, National Hockey League, Warner Bros. (Harry Potter), MGM/Danjaq (James Bond), The Saul Zaentz Company d/b/a Tolkien Enterprises (The Lord of The Rings) and National Football League. These minimum guarantee payments and marketing commitments are included in the table below.
Summary of minimum contractual obligations and commercial commitments as of September 30, 2002 (in thousands):
Transactions with Related Parties
Square EAIn May 1998, we entered into a joint venture with Square Co., Ltd. (“Square”), a leading developer and publisher of entertainment software in Japan. In North America, the companies
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formed Square Electronic Arts, LLC (“Square EA”), which has exclusive publishing rights in North America for future interactive entertainment titles created by Square. Additionally, we have the exclusive right to distribute in North America products published by this joint venture. Either party may terminate the existence of Square EA and the distribution agreement effective March 31, 2003. We own a 30% minority interest in this joint venture while Square owns 70%. This joint venture is accounted for under the equity method.
We generated $27,320,000 and $33,606,000 in net revenues from sales of Square EA products during the three and six months ended September 30, 2002. We generated $7,691,000 and $15,102,000 in net revenues from sales of Square EA products during the three and six months ended September 30, 2001.
Indebtedness of ManagementAs of September 30, 2002, we had loans outstanding to executive officers in the amount of $4,988,900. All loans were in effect prior to the enactment of the Sarbanes-Oxley Act of 2002.
News America Corporation ExchangeOn February 7, 2000, we acquired Kesmai from News America Corporation (“News Corp”) in exchange for $22,500,000 in cash and approximately 206,000 shares of our existing common stock valued at $8,650,000. Under the original agreements, we agreed to spend $12,500,000 through the period ended June 1, 2002 in advertising with News Corp or any of its affiliates. In addition, under these agreements if certain conditions were met, including that a qualified public offering of Class B common stock did not occur within twenty-four months of News Corp’s purchase of such shares and all of the Class B outstanding shares had been converted to Class A common stock, then (1) News Corp would have the right to (i) exchange Class B common stock for approximately 206,000 shares of Class A common stock, and (ii) receive cash from Electronic Arts in the amount of $9,650,000, and (2) we would agree to spend an additional $11,675,000 in advertising with News Corp and its affiliates.
On August 30, 2002, we entered into a new agreement with News Corp under which (i) News Corp exchanged its 2,000,000 shares of Class B common stock for 206,454 shares of Class A common stock and (ii) the Company paid News Corp $1,000,000 in cash and committed to spend an additional $17,000,000 in advertising with News Corp and its affiliates through the period ended December 31, 2006. All other obligations of the Company to News Corp under the original agreements were terminated.
Impact of Recently Issued Accounting Standards
In June 2001, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 143, “Accounting for Asset Retirement Obligations”. SFAS No. 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. SFAS No. 143 is effective for fiscal years beginning after June 15, 2002. We do not expect the adoption of SFAS No.143 to have a material impact on our consolidated financial position or results of operations.
In April 2002, the FASB issued SFAS No. 145,“Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections”. SFAS No. 145 rescinds SFAS No. 4, “Reporting Gains and Losses from Extinguishment of Debt”, as amended by SFAS
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No. 64, “Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements”. We do not expect the adoption of SFAS No. 145 to have a material impact on our consolidated financial statements.
In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities”. SFAS No. 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring)”. We do not expect the adoption of SFAS No. 146 to have a material impact on our consolidated financial statements.
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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
New Video Game Platforms Create Additional Technical and Business Model Uncertainties
A majority of our revenues are derived from the sale of products for play on proprietary video game platforms such as the Sony PlayStation 2. 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 did not develop 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 with development for new technologies. For example, EMPEROR: Battle for Dunefor 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, James Bond 007 in...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, DVD and proprietary optical format disk 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. Failure to meet anticipated production schedules may adversely impact our revenues and profitability and cause our actual results to be materially different than any financial guidance given by the Company.
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, these seasonal trends were magnified by general industry factors, including the platform transition, the fall 2001 launches of the Xbox and Nintendo GameCube in North America and the economic slowdown in the United States and other territories. 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
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slow at a faster rate than sales of new platforms. There can be no guarantee that the current platform cycle will mirror past cycles in length or in terms of consumer behavior.
Our Business is Intensely Competitive and Increasingly “Hit” Driven
Competition in our industry is intense in all areas. We are regularly facing strong competition by our competitors on a product by product and brand by brand basis, particularly in the sports product line. If our competitors develop more successful products, or if we do not continue to develop consistently high quality products, our revenues will be adversely affected.
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, online distribution may become a more significant channel for distribution of our products in the future. How online distribution ultimately affects the more traditional retail distribution, at which we have historically had success, and over what time period, is uncertain. We also 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 of Content, Consumer Privacy and Online Delivery 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.
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 is still in an early stage business. 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 current fiscal year. We expect EA.com to continue to incur losses at least through the current fiscal year as it builds 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.
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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 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 revenue models, including subscription fees, “pay to play fees” and advertising. We have limited experience with developing optimal pricing strategies for online games. For example, our product Majestic and our Platinumoffering, which contained certain browser-based entertainment games, were launched with a monthly subscription pricing model and obtained only limited commercial success. Accordingly, we did not realize our projected cash flows and discontinued these offerings.
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 goods games. Players frequently are not 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. It is difficult to monitor 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 have become a serious problem for online sites, and significant hacking and spamming could seriously interfere with online game play. The success ofEarth and Beyond and The Sims Online are critical to the success of EA.com in the short-term. The products provide unique customer experiences and we cannot be assured of broad acceptance. 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.
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. Electronic Arts has agreed to provide a limited amount of funding to EA.com, but this financing alone may not be sufficient. Any additional funding that is obtained from Electronic Arts may either be treated as a debt arrangement or alternatively may increase Electronic Arts’ 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 incremental interest payments and debt-related restrictions. To date, nearly all funding (except warrants and cash from revenues) has been provided by Electronic Arts. We cannot provide assurance that Electronic Arts will be able to recover its investment in EA.com.
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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:
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:
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 New Content. This Is Inherently Risky and Expensive.
EA.com’s success depends on our ability to develop new products and services for the EA.com site. Our agreement with AOL requires us to develop new games for the EA.com site. We cannot assure you that products will be developed on time, in a cost effective manner, or that they will be commercially successful. Currently, the release of The Sims Online for which we expect to generate subscription revenue, has been delayed due to longer than anticipated development schedules. Similarly, the online product Majestic achieved only limited commercial success due in part to the length of time it took to download the online software component. Accordingly, we discontinued Majesticon May 1, 2002.
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. 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.
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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 subscription 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 competing products could cause revenues 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 Continue to Invest in Research and Development and Network Technology and Operations for EA.com, and We Cannot Be Assured That We Will Achieve Revenues That Support This Level of Spending
We have invested heavily, and expect to continue to invest, in research and development and network technology and operations for our website and online games. While we have reduced the overall level of spending for EA.com, we will continue to invest in the technologies, tools and network infrastructure that are necessary for us to launch and support our key products, The Sims Online and Earth & Beyond. Accordingly, there are no assurances that the revenues from these products will exceed the associated costs in order for EA.com to achieve profitability. If we cannot increase revenues to profitable levels, the value of EA.com will be impaired. In order to develop the game offerings that we envision for our online operations it will continue to be necessary to engage in significant developmental efforts both to adapt existing Electronic Arts 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.
We Derive a Significant Portion Of Our Revenue From Advertisements and Advertising Services, Which Revenues Tend to be Cyclical and Dependent on the Economic Prospects Of Advertisers and Direct Marketers and the Economy in General. A Continued Decrease in Expenditures By Advertisers and Direct Marketers Or a Continued Downturn in the Economy Could Cause Our Revenues to Decline Significantly in any Given Period.
We derive, and expect to continue to derive for the foreseeable future, a portion of our revenue from products and services we provide to advertisers, direct marketers and agencies, advertising sold through our agreement with AOL and from advertisements we deliver to Web sites. Expenditures by advertisers tend to be cyclical, reflecting overall economic conditions as well as budgeting and buying patterns. The overall market for advertising, including Internet advertising, has been characterized in recent quarters by increasing softness of demand, lower prices for advertisements, the reduction or cancellation of advertising contracts, an increased risk of uncollectible receivables from customers and the reduction of marketing and advertising budgets, especially for online advertising and by Internet-related companies. As a result of these reductions, advertising spending across traditional media, as well as the Internet, has decreased. We have seen a sequential decline in our advertising revenues in the current quarter compared to the previous quarter. Further declines may occur.
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The advertising revenue outlook for EA.com may be adversely affected by an environment where the supply of advertising inventory exceeds advertisers’ demand. Under these circumstances, Web publishers tend to remove ad space from their Web sites in an effort to correct the supply-demand imbalance; other publishers may cut back on their Web presence or go out of business. Faced with smaller budgets, advertisers and ad agencies purchase less advertising inventory and tend not to experiment with newer advertising media, like the Internet. Consequently, the number of ad impressions delivered by EA.com may decline or fail to grow, which would adversely affect our revenues.
We cannot assure you that further reductions in advertising spending will not occur. We also cannot assure you that if economic conditions improve, marketing budgets and advertising spending will increase from current levels. A continued decline in the economic prospects of advertisers or the economy in general could alter current or prospective advertisers’ spending priorities or increase the time it takes to close a sale with a customer. As a result, our revenues from advertisements and advertising services may decline significantly in any given period.
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, 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. Our online product currently under development,The Sims Online (“TSO”), has experienced development delays and will be released later than planned. While we are targeting the launch of TSO in December 2002, it may be delayed further. Our revenues and operating costs are dependent on our ability to meet our product “go live” schedules, including forTSO, and our failure to meet those schedules could result in revenues falling short of analysts’ expectations, resulting in increased operating losses for EA.com. If TSO does not launch in December 2002, or if it is not successful, our fourth quarter of fiscal year 2003 may not meet analysts’ expectations.
We Are Heavily Dependent on a Few Internet Infrastructure Service Providers to Host and Manage Our Servers at Co-Location Facilities and Our Operating Results May Be Adversely Affected if We Must Change Service Providers
We are dependent on a few third party internet infrastructure service providers to host and manage the majority of our servers that support our online games. The performance of these service providers are outside of our control. Many of the service providers in the internet infrastructure space require substantial financial resources to build, maintain and manage co-location facilities. Many of these service providers have experienced significant financial difficulties during the recent economic downturn. To the extent that industry, economic, financial or competitive factors influence the level of performance that we expect from service providers we currently use for co-location space (bandwidth and rack), we may need to re-locate our servers to another co-location facility which would increase our expenses and may result in delays or reduced shipments of our online products, thereby adversely impacting our operating results.
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General Risk Factors
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 our products and management of our businesses is extremely competitive. In the last fiscal year, notwithstanding the downturn of the economy generally, competitive recruiting efforts aimed at Electronic Arts’ employees and executives continued. Electronic Arts’ leading position within the interactive entertainment industry makes us a prime target for recruiting of executives and key creative talent. In addition, the cost of real estate in the San Francisco Bay area — the location of our headquarters and one of our largest studios — 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.
Our Platform Licensors Are Our Chief Competitors and Frequently Control the Manufacturing of and/or Access To 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 although we are currently operating under an understanding with Nintendo, we cannot be assured that the final terms of the formal agreement will be favorable.
In addition, as online capabilities for videogame platforms emerge, our platform licensors will control our ability to provide online game capabilities for our console platform products. Currently, both Microsoft and Sony provide, or have announced plans to provide, online capabilities for Xbox and PlayStation 2 products respectively. In each case, compatibility code and the consent of the licensor are required for us to include online capabilities in our products. In addition, the business model for Microsoft’s and Sony’s online businesses for their videogame products may compete with our EA.com business. As these capabilities become more significant, the failure or refusal of our licensors to approve our products, or the successful deployment by these licensors of services competitive to EA.com, may harm our business.
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. For example, in June of 2002 we were sued for alleged infringement of a patent which the plaintiff claims generally describes the distribution of a software program on CD-ROMs to users containing a link capability (e.g., hyperlinks) to additional information stored on a remote server. 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.
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Foreign Sales and Currency Fluctuations
For the six months ended September 30, 2002, international net revenues comprised 38% of total consolidated net revenues. For the fiscal year ended March 31, 2002, 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.
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 do not ship the number of units planned for the Xbox and Nintendo GameCube, our sales of these products may be adversely affected in fiscal 2003.
The Current Legislative and Regulatory Environment Affecting Accounting Principles Generally Accepted in the United States of America is Uncertain and Volatile, and Significant Changes in Current Principles Could Affect Our Financial Statements Going Forward
Recent actions and public comments from the SEC have focused on the integrity of financial reporting generally. Similarly, Congress has considered a variety of bills that could affect certain accounting principles. In addition, the FASB and other regulatory accounting agencies have recently introduced several new or proposed accounting standards, such as accounting for stock options, some of which represent a significant change from current industry practices. While we believe that our financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America, we cannot predict the impact of the adoption of any such proposals on our financial statements going forward.
Fluctuations in Stock Price
Industry and Financial Analysts provide investors with estimates of our future production and financial performance. We also give guidance as to our expectations for future performance. We may not meet those expectations. This may create an immediate and significant adverse effect on the trading price of our common stock. 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. 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, 2002, the price per share of our Class A common stock ranged from $42.40 to $66.01 and $53.38 to $67.73 during the six months ended September 30, 2002.
World Events
The terrorist attacks of September 11, 2001 in the United States, the subsequent US military action, and the continuing concerns over potential additional terrorist attacks against US interests and citizens
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pose serious uncertainties in our business. Consumer spending, consumer preferences in entertainment, and the securities markets and the economy 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.
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Item 3. Quantitative and Qualitative Disclosures About Market Risk
MARKET RISKWe 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. Our foreign exchange contracts are accounted for as derivatives whereby the gains and losses on these contracts are reflected in the Consolidated Statement of Operations. Gains and losses on open contracts at the end of each accounting period resulting from changes in the forward rate are recognized in earnings and are designed to offset gains and losses on the underlying foreign currency denominated assets and liabilities. At September 30, 2002, we had foreign exchange contracts, all with maturities of less than one month to purchase and sell approximately $124,553,000 in foreign currencies, primarily British Pounds, 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, 2002. 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.
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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, 2002, our cash equivalents and short-term investments included debt securities of $721,802,000. 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, 2002:
Maturity dates for short-term investments range from 15 months to 35 months with call dates ranging from 0 months to 11 months.
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Item 4. Controls and Procedures
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PART II — OTHER INFORMATION
Item 1. Legal Proceedings
Item 4. Submission of Matters to a Vote of Security Holders
Item 6. Exhibits and Reports on Form 8-K
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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.
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CERTIFICATIONS
I, Lawrence F. Probst III, certify that:
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I, Warren C. Jenson, certify that:
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