動視暴雪 (ATVI) 2006 Q1 法說會逐字稿

Good day, everyone, and welcome to this Activision first quarter fiscal 2006 earnings conference. Today's call is being recorded. At this time for opening remarks and introductions, I'd like to turn today's call over to the Vice President of Investor Relations, Kristin Southey. Please go ahead, Kristin.

Good afternoon and thank you all for joining us today for Activision's first quarter 2006 conference call. As always, I will start today's call with a review of our Safe Harbor disclosure, followed by comments from Bobby Kotick, Chairman and CEO, and Ron Doornink, our President. Afterwards we will take your questions. With regard to our Safe Harbor disclosure, I'd like to remind everyone that the statements made during this call that are not historical facts are forward-looking statements. These forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties. The Company cautions that a number of important factors could cause Activision's actual future results to differ materially from those expressed in any such forward-looking statements.

Such factors include, without limitation, product delays, retail acceptance of our products, industry competition, rapid changes in technology and industry standards, protection of propriety rights and maintenance of relationships with personnel, vendors and third-party developers, international, economic and political conditions, integration of recently-acquired subsidiaries and identification of suitable future acquisition opportunities. These important factors and other factors that potentially could effect the Company's financial results are described in our filings with the SEC, including the Company's most recent annual report on Form 10K and quarterly report on Form 10Q. The Company may change its intentions, belief or expectation at any time and without notice based upon any changes in such factors and the Company's assumptions or otherwise. The Company undertakes no obligation to release publicly any revisions to any forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. Now I'd like to introduce Bobby Kotick, our Chairman and CEO.

Thank you, Kristin. We're pleased to share with you our first quarter highlights and revised outlook for the balance of the fiscal year. Revenues reached 241 million, a first quarter record. Our balance sheet and financial position remains strong. We ended the quarter with $786 million of cash and $1.1 billion in shareholders equity. Strategically, we remain focused on our core strengths, branding, product innovation and what we refer to as our go-to market capability. As an organization, we continue to execute against our well-articulated goals and financial objectives. To date, Doom 3, Madagascar and Fantastic Four, our first three releases of the fiscal year, have each exceeded the 1 million unit mark and our lineup for the balance of the fiscal year looks to be the strongest and most profitable in our history.

We're also increasingly excited about overall industry prospects for the long-term. We have more clarity on first party hardware plans, better visibility into the changes required for next generation development and the barriers to entry in our industry continue to rise. The Activision protective moat continues to widen. We continue to make the organizational and infrastructural changes necessary to ensure our long-term industry leadership. In that regard, we recently announced Mike Griffith had joined us as President and CEO of Activision Publishing. Mike is a 24-year veteran of Proctor & Gamble and has a proven record of driving growth and margin expansion through brand equity, product innovation and expansion into new geographies. Mike joined us after a long career of growing and building brands and businesses for P&G. And the fact that he was a software programmer and is a gamer have already proven valuable in integrating him into our Company.

We also continue to improve our development capabilities and capacity. During the quarter, we acquired two high-quality developers, Toys For Bob, the team behind the top-selling Madagascar game, and Beenox, a strong addition to our development resources located in Canada. We continue to expand our portfolio of intellectual properties. During the quarter, we entered into a strategic alliance with Harrah's Entertainment to develop and publish games based on the hugely popular World Series of Poker. These various initiatives and changes should continue to improve shareholder returns. In the shorter term, we remain optimistic with respect to our fiscal '06 plans, but we are mindful of the many variables that can still affect industry fundamentals and our own market performance. For the balance of this fiscal year, we have 10 big propositions planned for launch across more gaming platforms than ever before. Eight of these titles are internally developed games based on our top-selling franchises.

We have one internally developed wholly-owned new, original intellectual property, Gun, which continues to show great promise and market anticipation. In total, nine of our ten exciting titles and big propositions are developed by our own internal studios. We've also announced our very strong lineup for the Xbox 360 and we have more development resources committed to next generation development than ever before. Our success in building and exploiting our exclusive franchises worldwide will remain the main driver in expanding our operating margins and maintaining our high return on invested capital over the long-term. In fiscal '06, operating margin expansion will remain an area of financial concentration and the successful execution of our fiscal '06 operating plan would mark our sixth consecutive year of operating margin expansion.

The key drivers that we've shared with you before remain the key drivers. Those are -- Annualizing and increasing revenues from our franchises; the measured introduction of new, potential Blockbuster franchises; greater international penetration; improved participation in the hand-held market; and the early introduction of high-quality next generation products. Our track record of execution defines our leadership position. As the barriers to entry continue to rise in this business, there are few companies better-positioned than Activision to fully leverage the long-term opportunities afforded by strong industry fundamentals. Ron will now share with you the results of our operations this quarter and provide an update to our fiscal '06 operating plans and increased financial outlook.

Thank you, Bobby. For the quarter ending June 30, net revenues were $241 million, a 14% increase over the prior year. We had a loss of $0.02 per share, better than our prior outlook and, as expected, down versus earnings per share of $0.06 last year. Our first quarter revenue performance was driven by our three major releases, Doom 3 for the Xbox, which launched in early April and quickly became our first title to surpass the million unit mark. The Doom 3 collectors edition, which retailed at $59.99, was the number one selling title in the U.S. for April, proving that quality products can command premium pricing. In addition, we had two movie-supported releases, DreamWorks' Madagascar, which was the number two title overall in the month of June. And Marvel's Fantastic Four, which shipped very late in June for the July U.S. theatrical release.

As of today, both titles have already surpassed the million unit mark. In Europe, our affiliate business performed ahead of expectation, driven by the launch of "Star Wars" Episode 3, the game based on the last movie in the series. Turning to the financial results. In the June quarter, our manufacturing and distribution expense was 57% of net revenues, up versus 42% in the prior year, due mainly to the success of Episode 3, which, because it is a -- in our affiliate label program, carries a significantly higher product cost than our own titles. The quarter was also impacted by reduced catalog pricing and a $10 price difference between Madagascar and last year's Shrek. Operating expenses for the quarter, excluding manufacturing and distribution expense, were about 49% of net revenues, relatively flat versus the prior year. Our effective tax rate was 41.2% in the quarter versus 33% in the prior year, primarily due to a one-time international tax benefit.

Looking ahead to the balance of the year, our performance will be driven by focusing our time, energy and capital on our broad portfolio of big propositions driven by the largest sales and marketing investment in our history. In fiscal '05, we were successful in growing the number of million unit sellers to an all-time record and this year we plan to grow that number once again. Our commitment to next gen development and our intent to have a high quality presence at the launch of each new platform is on track. During E3, we announced our strongest next gen launch lineup ever for the XBox 360 and to date Tony Hawk's American Wasteland, Gun, Quake 4 and Call of Duty 2 are all on schedule and looking great. Our financial position remains strong and clearly we have one of the strongest balance sheets in the industry, a major competitive advantage.

On June 30, we had $786 million in cash and short-term investments, an increase of $247 million versus last year and down $55 million versus last quarter, due to the seasonality and the timing of payments and expenses. As of June 30, we had $916 million of working capital, an increase of 211 million or 30% versus last year. The accounts receivable balance on June 30 was $95 million, that's down 28 million versus last year. The AR reserve of $77 million was up $8 million versus the prior quarter and as a percent of gross receivables is 45%. DSOs were 36 days. Inventories on June 30 were $45 million, down 3 million versus March 31. Inventory for the publishing business was $26 million, down 6 million versus March 31.

Capitalized software development costs on June 30 were $108 million, up $16 million versus last quarter and up 10 million versus last year, reflecting the growth of our product slate. Capitalized intellectual property costs were $35 million, flat versus last quarter and up 2 million versus last year. Now I'd like to share our thoughts on the overall market, beginning with our hardware estimates. On June 30, the install base in North America for current generation systems, including hand-held, was 81 million units. The outlook for the hardware market is positive. The addressable installed base of hardware for current gen systems is large and growing.

The next gen installed base will be driven by the new hand-helds and the much anticipated launch of the Xbox 360, which is just around the corner. For the calendar year, our U.S. hardware forecast assumes the following increases -- The PlayStation 2 up 4.5 million units; The Xbox and the Xbox 360 combined up 3 to 3.5 million units; The GameCube, 1.5 million units up; Hand-helds, which include the GBA, the DS and the PSP will grow an estimated 12 -- 13 million units. Moving to software. We define our market to include all major platforms in North America and Europe. For calendar 2005, we expect that a combined North American and European software markets for current gen and next gen consoles, hand-held and PC could grow as much as 5%. Looking at the market segments in calendar '05, we're projecting that the total current gen and next gen console market, which is defined as software for the PlayStation2, Xbox, the Xbox 360 and the GameCube, will be flat to down 5%.

We expect a hand-held market to grow, driven by the two new hardware introductions. We project the combined software growth rate for the console market and the hand-held market will be a positive 3 to 5%. We expect the PC market to come in flat to down 5% with a combined growth for console, hand-held and PC video game software to grow in the range of 0 to 5%. With respect to software pricing, with the exception of children's titles, we expect launch tiding for AAA titles to hold and we're planning that this will continue through the holidays. Our reserves protect against continued gradual price erosion, but if launch pricing for AAA titles drops abruptly market wide before the holidays, then we have exposure. Before turning to our current financial outlook, I'd like to reiterate that our outlook represents our views as of today and there are a number of internal and external factors that could cause our actual results to differ materially. I refer you to our financial filings with the SEC for a full review of our risk factors.

Strategically and financially, our performance in fiscal '06 will be driven by focusing our time, energy and capital on the global execution of our big propositions. Our strong fiscal '06 lineup has more depth and breath than any slate in our history and our worldwide selling and marketing capabilities continue to expand, putting us in a position to realize even greater returns on our product investments. In fiscal '06, it's our goal to have 12 titles sell in excess of 1 million units, with five to six reaching multimillion unit status. And as we've already mentioned, our first three releases of the fiscal year have all exceeded the million unit mark. The introduction of the next generation consoles and hand-held hardware are providing significant opportunity. Our portfolio of annualizable franchises gives us a clear advantage in resource allocation and planning for the next generation. Our fiscal '06 slate combines our most proven, predictable brands with the very best product development resources we control.

As we see it, there are a number of risks in the marketplace, but from an Activision perspective, we have never been better prepared to execute. For the remainder of fiscal '06, we plan to launch 10 propositions across more gaming platforms than ever before. Nine of the ten propositions are internally developed, eight of which are new versions of our proven top-selling franchises, Tony Hawk, Spider Man, Shrek, True Crime, X-Men, Quake and Call of Duty. Complimenting these proven video game franchises are the movies on the PC and our own new IP, Gun. A multiplatform title in development by our own Neversoft team. We recently revealed more information on this exciting new property and it is getting significant mind share of the gaming and retail communities.

As we have said, we plan to invest heavily against this title to maximize its potential to become a top-selling franchise. In fiscal '06, we have more propositions than last year and our SKU count will rise as we add the two new hand-helds and the Xbox 360 to our multiplatform strategy. For fiscal '06, we are increasing our financial outlook and expect revenues to reach $1.470 billion which, if achieved, would mark our 14th consecutive year of revenue growth. We also expect earnings per share of $0.69, translating into about a 14% operating margin which would be our sixth consecutive year of margin expansion. For fiscal '06, we expect manufacturing and distribution costs of 45% of net revenues with operating expenses, including royalties, of 41.3%. Operating expenses are expected to be higher than in fiscal '05, primarily due to increased selling and marketing expense.

However, product creation costs, which include developer and intellectual property royalties and product development expense, are not expected to increase as a percentage of net revenue as compared to the prior year and are projected to stay in line with the annual percentage for the previous five years of about 20% of net revenues. For the year, we expect interest income of about 2% and a tax rate of 34.3%. Our tax rate is up versus the prior year, mainly because of lower R&D credits and no prior year true-ups. We expect to fully diluted share count of 221.4 million. For the second quarter of fiscal '06, we expect revenues of $200 million and a loss per share of $0.10. Driving the quarter will be the late September U.S. only launches of Ultimate Spider-Man and now X-Men: Legends 2.

Previously, we had planned to ship Ultimate Spider-Man to Europe in the quarter, but that will now occur in Q3, along with the European launch of X-Men: Legends 2. In Europe, we will launch Tony Hawk's Underground 2 remix and Spider-Man 2 for the PSP launch in September. Additionally, we will release World Series of Poker, worldwide, on multiple platforms. For the quarter, we expect manufacturing and distribution costs of 50% of net revenues with operating expenses, including royalties, of 68%. We project interest income of 3%, a tax rate of 34.5% and a basic share count of 204.3 million. For the third quarter, we expect revenues of $790 million and earnings per share of $0.69. We expect manufacturing and distribution costs of 40% of net revenues with operating expenses, including royalties, of 31%.

We project interest income of 0.9%, a tax rate of 34.5% and a diluted share count of 222.7 million. In the third quarter, we plan to release our strongest and most diverse lineup ever, including the New Tony Hawk's American Wasteland, Call of Duty 2, Call of Duty 2 Big Red One, True Crime: New York City, Quake 4 and Shrek SuperSlam. In addition, we plan to release our two new intellectual properties, The Movies and Gun. In total, we will launch eight major propositions in Q3 versus only four in the prior year, two of which were relatively small propositions. In summary, our Q3 program is shaping up to be nothing short of a massive drive for profitable growth. Moving to the fourth quarter, we expect revenues of $240 million and earnings per share of $0.09.

In summary, fiscal '06 represents another year of opportunity for Activision, driven by our very promising slate, more platforms in the marketplace than ever before, more direct sales capability in European countries than ever before, our marketing excellence, our strong balance sheet and our incredible people and their ability to consistently excel. Looking to the future, our strategy for growth is tied directly to the continued investment and annualization of our existing franchises, selective but heavily supported launches of new concepts and continued expansion of our international publishing operation. We thank you for the opportunity to share our continued success and initiatives for the future. And now we'll open the call up to your questions. Operator, please?

Certainly. [ OPERATOR INSTRUCTIONS ] We will take our first question from Mike Wallace of UBS.

Hi. A couple questions. First, Ron, the -- the second quarter, 200 million sales and loss of $0.10, I mean it looks like expenses are really high. Could you explain why the OpEx is so high relative to sales in Q2? Second question, what are your expectations for supply for the Xbox 360 for the U.S. and Europe in terms of hardware production? And the third, are you doing anything for the Game Boy Micro?

On the first question, the second quarter OpEx, they are high in part because we see significant expenditures on the marketing side in preparation for the Christmas season. That's one of the major reasons. We're also, on the product side, finishing a lot of product and late in the process, meaning the development process, lots of people working on the games. So, those are the main drivers. It's just the sort of ramp-up to the Christmas season. On the Xbox 360, we are, you know, planning on pretty modest hardware availability, the sort of order of magnitude of the PlayStation2 launch is the basis for our planning. There might be upside to that, we obviously don't know that yet. And at this point, the Game Boy Micro, we are still looking at what our, you know, opportunities are there. We don't have any firm plans to announce.

Thank you.

Thank you.

We'll take our next question from Brian Pitz with Morgan Stanley.

Hi, guys, just a broad question, can you talk through your development expectations for the next generation console? Obviously there's been a lot of talk about increased cost for both of these platforms, Xbox and PS3. Can you talk about how you think about those as well as when you would expect that costs to ramp down, is it near the end of fiscal '07? Then I've got a follow-up.

Yes, on product development costs related to the next cycle, we've talked about it some in prior calls. First let me clarify that whatever we talk about, we like to talk about that in the context of what we call total product creation cost, that includes the cost of software and IP royalties as well as our own product development costs. Those costs, as a percent of net revenues, have been pretty steady in the last few years, around 20%. We expect that to continue to be the case this year and are cautiously optimistic that that will also be the case in future years. The reason that those costs have been pretty steady, even though clearly on an absolute basis, the costs of making video games has gone up.

The reason that as a percentage of net revenues, we've been able to keep that steady is we've been deploying strategies to offset the rising cost of game development. Strategies like focusing more on big brands in our portfolio, developing more brands internally, aggressively exploiting brands across all platforms, expanding our international sales and marketing capabilities. And as we look at those strategies, we think there's still plenty of room left for continued leverage and that makes us cautiously optimistic that we can offset the rising costs of game creation on the next gen hardware.

Great. And just a quick question on in-game advertising. Maybe you could talk about how that business is progressing? And when do you expect the big inflection point for that business? Is it two to three years out and any color would be great.

We said in our last called and will maintain is that we're in the midst of developing rate card and measurement systems and once we have more clarity and detail on the measurement system and the rate card, I think that will give you a better perspective on the size of the opportunity, but I think it's reasonable to expect that nothing significant will impact our business for another couple of years.

Great, thanks.

Sure.

Our next question will come from Jeetil Patel with Deutsche Bank.

Yes, a couple of questions. Can you just talk about -- as you look at your fiscal second quarter lineup, relative to your previous assumptions, what's kind of gotten shifted around, just want to figure out what products got moved around? And second, as you look kind of longer term, or just over the course of this upcoming cycle, do you think that the biggest kind of challenge that you find out there is the cost of development or actually the -- the time required for development as you look at the next gen market, especially in consideration of some of the launches that you planned here in the short-term.

The answer to your first question is we pulled X-Men: Legends 2 into the quarter, for the U.S. only. At the same time, Ultimate Spider-Man moved out of the quarter for Europe only. So, those are the two major changes and they ended up more or less canceling each other out. Jeetil, I'm sorry, the second question you had?

I'm just trying to figure out, do you think that -- as you go through this upcoming cycle, the bigger challenge is going to be just managing product development schedules in terms of how long it takes to develop? Or do you think it's more of a -- a-- I mean obviously cost is pretty important here, but which one do you think is going to be the tougher one as you look at the up cycle over the next two years, to manage?

I would say going by our experience on the 360, you know, we've really been able to identify some smart development strategies, some synergies with our PC development programs that have made developments for the 360 fairly efficient and we're pleased with that. It's still too early to comment on the PlayStation 3, but we're looking for similarly smart strategies to optimize the schedules and keep the cost in check.

Thanks.

Our next question comes from Heath Terry with Credit Suisse.

Great. Just wondering if you could talk to us about the software line on the balance sheet. Obviously we seeing an increase as you put more and more product in development and we get ahead of the, not only the holiday season, but also the Xbox 360 launch. At what point do you think that that number will start kind of coming down as -- as products start to hit? Should we expect a similar kind of pattern to what we saw last cycle this cycle as well?

Heath, I would say that the curve or the sort of relative increase is definitely coming down. If you look back at years 2002, 2003, you know, the -- the relative increase on this item on the balance sheet was a lot larger. We're still expecting a bit of an increase this year but it's in the $10 to $15 million range, that's beginning of the fiscal to the end of the fiscal.

Yes.

And that's simply a reflection of the fact that we are building out our slate. We're putting out more SKUs.

Sure.

And fortunately, you know, a lot of the -- well, the vast majority of the balance that's on the balance sheet all relates to products that have not been released yet.

Great and could you talk a little bit more about the hand-held business, just now that we've got a few quarters of PlayStation portable under our belt and the European launch ahead of us as well as a few quarters of Nintendo DS, has there been any change since you talked about this last quarter, at E3, in terms of how you're positioning your development assets towards the different platforms? Are you seeing more toward hand-held or we still kind of same place?

More or less in the same place. We are excited about that part of the business. We think that the DS and the PSP offer opportunities for us to continue to grow our share of the hand-held business. We've got a solid slate for both the PSP and the DS. We're looking forward to the Christmas season, we think that will be a very strong season for the hand-held market.

Great, thank you very much.

Thank you.

Next from Citigroup, we will hear from Elizabeth Osur.

Thanks, I just had a couple of quick ones. First, could you give us some idea of what your plans are for development headcount this year?

Yes, we, through some acquisitions and some organic increases, have already added about 100 people on the studio side, we're looking to add another two, maybe even 300 this year.

And that would be organically, not through acquisitions?

Well, I -- I would never comment on our acquisition plans, but that's our goal in the absolute.

Okay, thanks. You made a comment about a one-time tax benefit, I'm not sure if this was in the release and I just didn't see it. Can you tell us how much that was?

It wasn't that much, but because it was in the first quarter, the percentage was, you know, a little bigger than the actual amount. It's like $0.5 million.

Less than $0.5 million.

Okay. Thanks. And then finally, can you just give us a sense of how much of your sales forecast for the year is coming out of catalog product?

25 to 30% of consolidated net revenues is our catalog estimate.

Great, thanks.

You're welcome.

Our next question will come from Edward Williams with Harris Nesbitt.

Good afternoon. A couple of questions for you. Can you just remind us as to the timing of the four Xbox 360 releases by quarter, first of all? And also, did you add any direct sales offices in Europe during the quarter?

The Xbox releases, the four that we have in our plan, that's Tony Hawk's American Wasteland, Call of Duty 2, Quake 4 and Gun are all aimed to go out in Q3, with a launch of the platform. That's our goal. As far as new European offices, we did not open any new offices during the quarter in Europe.

What are your expectations, this is kind of going out a longer term, as far as international revenues for your publishing business as a percent of the publishing sales? Say in the current fiscal year, but looking into the next cycle, do you see more growth in Europe as a whole than coming out of North America?

We see it as a, you know, a great opportunity for the Company. We have talked about it in the past. There's a number of countries where we are planning to put direct sales capability and marketing capabilities on the ground. And for that reason, we expect Europe to, you know, all other things being equal, outgrow the U.S. market.

Okay. And then just a final question, what was the revenue from the affiliated label percentage of your sales in the quarter?

For competitive reasons, we don't give that out on a quarterly basis, but I can tell you on sort of a trailing 12-month basis, it's in the low to mid-single digits.

Okay, great, thank you very much.

You're welcome.

Our next question will come from Tony Gikas with Piper Jaffray.

Good afternoon, this is Steph for Tony. Just a couple of housekeeping questions. What is your planned SKU count for fiscal '06 in total? And then second in a follow-up to Liz's question, what was the catalog as a percent of total in the quarter? And third, can you comment a bit on your mobile gaming initiatives for this fiscal year?

Sure. The total SKU count for fiscal '06 is 55. The catalog percentage for the quarter was 20? 11%, sorry. And then our mobile game plans for this year, we have on tap about seven or eight games for this year, typically they're tied to our big propositions such as Tony Hawk and The Movies and so forth.

Okay, thank you.

You're welcome.

Our next question will come from Arvind Bhatia with Southwest Securities.

Good afternoon, guys.

Hi, Arvind.

A couple of clarifications. First of all on the Fantastic Four numbers, the million unit sales, is that sell through or sell in? I guess that applies to the others, as well, Madagascar and Doom, we're talking about selling or sell through numbers, that's one. And then secondly, the SKU count, I can you said 55. Last quarter you said 50. Have you added front line titles or is that just more value so the numbers last quarter were just front line? Those two clarifications, then I just have a follow-up.

Okay, the sell -- the numbers that we quote when we talk about a million units of support, those are all sell-in.

Sell-in, okay.

Okay? The SKU count did go up a little bit versus the last quarter. We added some smaller items, I think a couple of hand-held titles and a couple of PC titles that are based on our big propositions. We did not add another big proposition.

Got it. And then as far as the sell-through is concerned for those titles, particularly Fantastic Four, how is that tracking versus what you would have expected at this point in time? And in general, if you could comment on the industry conditions at retail? You know, the inventory for other -- you know, your competitors. Indirectly trying to understand, you know, is this a normal slow summer or slower than normal? Just your comments on the conditions right now.

Yes, we're -- first of all, to your first question, we're pleased with the performance of Fantastic Four, of course. It's still to be launched in Europe, so, there is a big part of the program still on hold. People have really liked the movie. That has had a beneficial effect on the game. So, we're pleased with the program. In terms of the second part of your question, market commentary. I'd say, first of all, generally I see people that are happy with the fact that the software market posted double-digit growth, both domestically and in Europe during the first half of this calendar year. That was, I would say, above expectation. Having said that, at this very moment there is a fair amount of focus on channel inventory and unproductive SKUs and a fair amount of discussion about that. I'd say that's understandable if you consider that the number of SKUs in the channel at the moment is huge, about 2100 SKUs were logged by MPD during the month of June as having sales.

That's up about 600 SKUs from last year. So, quite a bit more product and understandably therefore more discussion about that product, especially the slow-moving product. And those tend to be smaller propositions. And we're fortunate that our active catalog includes almost all big proposition-based titles like Tony Hawk, Call of Duty and Spider-Man. I'd say a couple of other things. You know, we're obviously in the midst of a seasonally slow period and you get the sense that people are eager to get to the fall when the business revitalizes behind new titles coming out. And I will add to that, as we're showing our fall titles to retailers, as we did a couple of weeks ago here in the U.S. and last week in Europe, we're getting lots of positive feedback. I think it's fair to say, based on the feedback that we're getting, that we have an incredibly promising second half slate this year.

Let me ask you just a philosophical question, you've done great with your million unit sellers and yet you continue to drive more of those. What are you doing different now to be able to get more and more million unit sellers? Is that simple as it's better product, better marketing? What are you doing different that you all of a sudden have continually, you know, increasing number of million unit sellers?

I'm not going to give you all our trade secrets, but I will give you a couple of examples because they're visible in the marketplace. We're kind of super sizing the big propositions. We're doing things like collector's editions on some of the big propositions where that makes sense. For example, on Ultimate Spider-Man, there is a very exciting collector's edition coming out at a premium price, $59.99, that we think has excellent potential. We're obviously taking the big propositions to platforms this year that we couldn't last year because the platforms weren't out, the DS, the PSP, the Xbox 360. That's how we're growing the business.

Internationally, we're expanding our presence in countries where we have had a presence for some time, building out the organization and the infrastructure there, taking more business direct. In countries where we have relatively recently established ourselves, we are busy taking more accounts direct than we have had in the past. And then, of course as we've talked in the past, there are a number of new territories that we're targeting to move into over the next 12 months.

One of your goals is to get to the top five for the year, which product or brand do you think has the best chance of getting in the top five this year?

That's a trick question, I'm not going to answer it!

As we told you in the past, Arvind, we expect to have 11 of the top 10 titles.

That's right. I guess last two quick ones, if I can. The revenue upside this quarter was significant, it was 40 million above what you were guiding. The EPS was only $0.01 above. Maybe just if you can answer what caused the upside to be less than expected with that kind of revenue upside? And last question is on PlayStation 3. I think you mentioned a little bit, but would you still expect -- or what's your expectation of the timing at this point, your best guess?

Let me ask the first question, the -- in the quarter, you said okay, significant revenue performance only $0.01. The reason -- a primary reason for that is that we saw a lot of overperformance over in Europe within the affiliate label program driven by the success of the Star Wars 3 title. And, of course, the affiliate label program has a gross margin characteristics that are much like our distribution business, so, low margin revenue. There were some other secondary items like we mentioned the fact that Shrek last year went out at $10 more than Madagascar did this year and also we had Doom 3 on the Xbox, that's a fairly low margin item because of the relationship with ids. And there also were some pricing actions on our catalog, all of that kind of makes for a lower margin revenue. Got it. And PS3, your guesstimate on the timing? We really have no information that would -- that you don't already have on that. So, no new news.

Got it. Thanks, guys.

Thank you.

We will take our next question from Glen Reid with Bear Stearns.

Hi, good afternoon. A couple of quick questions. First one just on hardware price cuts this fall. Just maybe your thoughts on the PS2 and the PSP? And then secondly, maybe a longer term question. There was a couple questions about wireless and in-game ads. But maybe if you could talk about, you know, as we try to think about peak earnings in the next cycle, you know, how big all of these could contribute to earnings collectively, wireless, Asia, micro transactions and then perhaps maybe rank them in order of contribution. So that would be helpful. Thanks.

I will take the first one. The hardware pricing expectations for the PlayStation 2 and the PSP, in our model we've assumed a modest price reduction on the PlayStation 2 to $129, which could either happen through a list price reduction or promotional activity. That looks like a reasonable assumption to us. On the PSP we've assumed that the price stays where it's at. If it were to come down and stimulate movement, that will be a little bit of upside.

As far as the, you know, new areas of opportunity like in-game advertising, wireless or micro transactions, we haven't provided any outlook for fiscal '07 or beyond. We view all of those things as very promising, all have the potential to expand operating margin but our real focus right now is on the things that we know, business models that we can see, clearer pathways for operating margin expansion, like annualization of our franchises, building our penetrations in more territories and geographies, higher price realization on things like collector's editions and next generation software. And those are things that are really tangible that we can easily identify as ways for us to expand their operating margins. And while wireless and micro transaction in Asia all offer promise, there's a lot more low-hanging fruit doing the things that we're focused on right now.

So, maybe these sort of ancillary opportunities you'd characterize maybe as more incremental than as -- I now we're talking qualitative terms here, but then sort of significant opportunities towards, you know, these are sort of peak earnings, you know, potential?

It depends a lot, Glen, on your time horizon. But, you know, over the next few years, yes, there would be incremental opportunities.

Okay, thanks.

Sure.

Our next question will come from Evan Wilson with Pacific Crest Securities.

Hi, thanks for taking the questions. Two and then a follow-up. The first is what was the impact of foreign exchange on the quarter and did your full year guidance take into account any changes in foreign exchange going forward? And then also on the PSP launch in Europe in September, could you gauge what you think the selling opportunity is of those two PSP games relative to what you did last March in the United States?

On the effects of the quarter it was a little less than $5 million on the net revenue line and what, $300 million or so in operating income.

$300,000.

$300,000, I'm sorry. As far as our outlook is concerned, you know, there's a lot of things that go into our outlook and we try not to comment on any single element like FX. Clearly, things have changed in that area, but that's been taken into account in the outlook that we've provided. And we will update that as we go through the year. And as far as the PSP expectations are concerned, you know, we're looking forward to the launch in Europe. We're hearing some pretty good numbers in terms of hardware availability. So, we're expecting that our two titles, which performed pretty well at the launch here in the U.S., will also do well in Europe. But we will not give out specific numbers of that.

All right. And the follow-up I'd like to rephrase Arvind's question on the PS3 in another fashion. Given that, you know, we know that there's development kits out there for the PS3 and given that we know you will have four titles ready for the Xbox 360 this holiday season, if the PS3 were to come out, let's say, a year from today, do you think it would be possible for you guys to have four titles ready for the PS3 upon launch?

We're not prepared to answer that today. We're going to talk about the PlayStation 3, obviously, in future calls, but for today we're passing.

All right. I understand. Thanks.

Thank you.

Our next question comes will from Colin Sebastian with Thomas Weisel.

Good afternoon, guys. I was hoping you could talk a little bit more specifically about the promotional plans for the back half of the year. Perhaps how sales and marketing might ramp up on a year-over-year basis. And then secondly, Gun is clearly getting positive feedback from retailers and they're expecting good sales. Was hoping you could quantify that as well. Do you expect it to be as big as Tony Hawk? Or where should we think about that relative to your holiday lineup? Thanks.

The promotional and marketing ramp-up, we've talked about it. On this whole year basis we expect year-over-year marketing spending to be up a couple of points and, of course, most of that takes place in the next six months, Christmas season. So, with the concentration of big propositions between September and November, a lot of that marketing spending will occur, beginning in the late second quarter, all the way through the end of the third quarter. As far as expectations for Gun, we've said that we've expected -- that we expect to grow the number of million units selling titles for the year. Gun is definitely in the family of titles that's been targeted to help us achieve that goal, but that's as far as we will go in terms of getting specific in terms of the expectations for Gun.

Okay, thank you very much.

Thank you.

Our next question comes from John Taylor with Arcadia.

Hi. I've got a couple of questions. So, this year, unlike last year, we've got a number of new releases coming from all the publishers that you know and everybody wants to grow. I'm wondering if -- how confident you guys are that Sony, in particular, has the manufacturing capacity on the disc side for PS2 and PSP in case one or two of your titles start to run. Anticipate any trouble in turn around at getting enough product in store by holiday?

To your first question, John, we did a little exercise. We looked at ourselves (inaudible), Take 2 and THQ and what their latest expectation are for Q3. When you add those numbers up, you have an aggregate expectation of about a $3.2 billion revenue level during that quarter. That's up 6% versus last year, not that big of an increase. And actually two of the four publishers, us not included, are expecting lower revenues in Q3 than they did last year. So, we think that the aggregate expectations between those four companies, at least, look pretty reasonable and not out of whack. Also, I should point out that as a percent of total revenue for the fiscal -- their fiscal years, that number, that 3.2 billion equals about 46% of total fiscal expectations. Last year, for perspective, it was 45%. So, also from that angle, it doesn't look like, you know, the sort of aggregate expectations are out of whack.

Okay. Great. And then could you talk a little bit about pricing dynamics with all the SKUs out there and sort of taking up shelf space, what's happening in terms of retailer tolerance for rapid erosion rates on new game releases and what are you seeing in terms of the pressure you're getting from them or the pressure they're exerting on retailers -- I don't want to blame this on you, necessarily, but the pressure they might be putting on folks to start to mark stuff down faster? Are you seeing any increase in that?

I would say that was not unexpected. That's in part a function of the stage of the cycle that we're in. I talked during the prepared remarks a little bit about the fact that, you know, there are a lot of SKUs out there. There's about 5, 600 SKUs out there today that weren't out there last year in total. On the console side of the business more than 2,000 SKUs, you know, as measured by MPD, forcing some level of sales. So, there's a lot to manage for the retailers. They also have new platforms to integrate into their shelf sets. That adds extra pressure on the system, if you will, in terms of managing SKUs. Again, key is, for us, is to not get caught in that by focusing on big propositions and that's a lesson that we've learned and our program is exactly that, it's focused on big propositions and those tend to hold up better at the beginning when they launch and all the way through the end of their life cycle.

The feedback that we've been getting from retailers is that the strategy that we're employing, really focusing big resources on a small number of titles that are across multiple platforms is consistent with what all of the best-run retailers are looking for from publishers.

Okay. Great. And then last question has to do with margin on distribution revenue versus publishing. I don't know if you want to give us specifics on that, but could you tell us -- it sounds like the publishing margin was lower because of the lower price point on Madagascar, for instance. Was there much difference -- I mean is that correct? And was the distribution margin lower, as well, versus last year?

Yes, no, in fact, the publishing margin was not lower, it was the fact that we had distribution account for such a significant portion of the overall -- well, affiliate publishing accounting for such a significant portion of the revenue increase that drove the margin.

Yes, okay. Thank you.

Sure.

Next we will hear from P.J. McNealy with American Tech Research.

Two questions. The first is with respect to the ESRB are you changing anything you're doing so you guys avoid having any hot coffee and true crimes?

We strongly support the ESRB rating system and we will continue to follow the guidelines regarding game content. We will be complying with the ESRB's new policy to disclose all disabled content in our games. We -- our intention remains to release Gun, True Crime as well as Quake 4 as M-rated games and we'll comply with ESRB regulations in order to secure an M-rating for those three titles.

Does your internal policy and procedures change at all after the last two weeks?

No, but we did sort of make sure that everybody, you know, was reminded of the policy.

And the second question, Ron, earlier you talked about a scenario, you know, about having exposure if AAA pricing drops to 49.99, what are some of those reasonable scenarios or factors that you're looking at? Because, for example one of them I would assume would be hardware pricing, you already said that the PS2 could take a haircut this holiday. So what else has you worried on that front?

That scenario, I think, is mostly dependent on competitive activity. In other words, if big competitors on AAA product start dropping their price points well before the holidays that would be not expected in a model. We don't expect that and, in fact, we fully intend to continue with premium pricing on our AAA products. We're seeing good results with that, we feel they are worth it and we think that the consumer is willing to pay that. So, that's the basis for our planning.

And if you look at our experience this past quarter with the collector's edition on Doom for Xbox, we definitely are seeing validation on both the product consumer and the retailer that higher price points for in-demand premium products can be sustained.

Great, all right. Thank you very much.

Thank you.

And it looks like we have time for one more question. Our final question will come from Garrett Edson with Monarch Research.

Hi, guys, good afternoon. Just a couple of quick questions. Number one, just wanted to check to see if there are still plans for X-Men: Legends 2 hand-held game for the third quarter on the PSP.

Yes.

And just regarding Gun, in terms of marketing, what television outlets are you looking to possibly put advertising on for Gun?

You know, we have different programming for all of our titles and to be honest with you, I don't know the exact answer to your question, so I'm going to have to pass.

I will say this, though, that when you look at our media spending and our overall variable selling marketing budget for the launch of Gun, it will be among the biggest in the video game industry's history and we are very focused on establishing Gun as an important intellectual property for the Company.

Okay, great, thanks a lot, guys.

And with that, we are out of time for questions. Miss Southey, I'l turn the conference back to you.

Thank you. And on behalf of everyone at Activision, we thank you for your time and consideration today. If anyone should have any follow-up questions, please contact me directly.

That does conclude our conference. Thank you all for your participation. We hope you enjoy the rest of your day.