動視暴雪 (ATVI) 2006 Q4 法說會逐字稿

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

Good afternoon, and thank you all for joining us today.

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; Thomas Tippl, Chief Financial Officer; and Mike Griffith, President and CEO of Activision Publishing. With regard to our Safe Harbor disclosure, I would 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, sales of the Company's titles during fiscal year 2007; consumer spending trends; the seasonal and cyclical nature of the interactive game market; the Company's ability to predict consumer preferences among competing hardware platforms including next generation hardware; software pricing; products returns and price protection; product delays; retail acceptance of our products; delays in hardware launches; industry competition; rapid changes in technology and industry standards; protection of proprietary rights; lawsuits and maintenance of relationship with key personnel, vendors, and third-party developers; international, economic, and political conditions; and integration of recently-acquired subsidiaries and identification of suitable future acquisition opportunities. These important factors and other factors that potentially could affect the Company's financial results are described in our filings with the SEC including the Company's most annual report on Form 10-K and quarterly report on Form 10-Q. The Company may change its intentions, belief, or expectation at any time and without notice based upon any changes in such factors in 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.

And now I would like to introduce Bobby Kotick, our Chairman and CEO.

Thank you, Kristen.

Net revenues and earnings for the fourth quarter were higher than our outlook, driven by continued success of our titles for the Xbox 360 and generally better than expected performance of our products across other platforms. Net revenues for the fiscal year were the highest in Activision's history marking our 14th consecutive year of growth. We ended the fiscal year as the number two publisher overall with a strong balance sheet to pursue the many opportunities that lie ahead. With almost $1 billion in net cash and short-term investments, and $1.2 billion in shareholders equity, we have the financial strength to capitalize on the market growth likely to occur for many years to come. Over the past five years, our shareholders equity has increased from $181 million to $1.2 billion, a 46% rate compounded annually. We remain focused on building shareholder value.

Towards this objective, this past fiscal year we once again strengthened our industry leadership position. Specifically, we grew the number of multimillion unit sellers in our portfolio; we increased our international revenues by deeper country penetration and territorial expansion; we expanded our hand-held presence with products for PSP, DS, and Game Boy; and we created the number one new IP for a third year in a row. And we achieved market share leadership for the first time on a next-generation platform with the number one title on the Xbox 360, Call of Duty 2. This year, we were successful in growing share and increasing brand awareness, although as we said on our last call, our operating results were significantly impacted by the challenges of the console transition. Overall, we exited fiscal 2006 a substantially improved company.

The barriers to entry in the video game business continue to rise, and today include limited access to intellectual property rights, the ability to successfully create new franchises, owning proprietary development resources, and having broad distribution capabilities. Activision's possession of these difficult to duplicate assets, coupled with its proven ability to leverage them, should lead to continued margin expansion and higher returns on invested capital over time. We remain focused on expanding our balance franchise portfolio, strengthening our next generation development leadership, furthering our initiatives to reduce development expense through organizational efficiencies, and expanding our distribution reach. While increasing production cost and the volatility of transitioning to new devices remains a challenge, there is much to be excited about as the installed base of new platforms grows. The investments we have made over the last 16 years and the disciplined focus on institutionalizing our business, combined with our substantial capital position provides us with a great competitive advantage in the creation of long-term shareholder value.

We continue to evaluate the best uses of our capital and over the last few months we have extended many of our important licenses and secured the rights to some important new properties. True to our commitment towards expanding our collection of proven franchises, we announced the acquisition of the long-term rights to develop and publish games based on the James Bond universe through 2014. To date, approximately 30 million units of video games based on James Bond have been sold. Bond is one of the most successful film franchises in history, having grossed over $3.6 billion, and we have a proven track record of success leveraging movie-supported properties such Spider-Man and Shrek. The Bond brand will be helpful as we continue to expand internationally, as it will be the first franchise in our history likely to generate the majority of its revenue from outside of North America. Consistent with our other licensing arrangements, we have secured these rights with the attributes of ownership that allow for proper franchise planning. We have long-term control, flexibility to use the movie and non-movie universes, an attractive royalty rate, and a partner in MGM that recognizes how valuable video games can be in building equity in an underlying intellectual property. Bond is a great addition to our growing brand portfolio.

The composition of the franchise portfolio is also an important asset for our future. Because each of the new platforms is more distinct than the device differences we saw in prior generations, having properties that can take advantage of the unique attributes of each device will create more opportunities for exploitation than in prior generations. As we attempt to define these differences, development costs will remain higher than usual. However, the differences, whether in the on-line support 360 marketplace provides, the incredibly high production values capable on the PS3, or the unique means for interaction with Nintendo's innovative controller will attract new consumers and expand the market and the opportunities for long-term margin expansion.

For the first time, new sources of margin expansion are starting to materialize. Commercially viable digital download of game add-ons is becoming more feasible. First parties are increasingly validating the opportunities for in-game advertising and sponsorship and new rich media wireless devices should also contribute to profit growth over time. From volatility and uncertainty comes great opportunity. We have never been better prepared to take advantage of the many opportunities that lie ahead.

Later in the call, Mike will share some more details of our plans for the next few fiscal years, but now Thomas will provide a review of our operations during the last quarter and the last fiscal year. Thomas?

Thank you, Bobby.

For the March quarter, net revenues were $188 million. This was higher than anticipated, driven by the Call of Duty franchise and our other previously released Q3 titles. Quarterly revenues were down 16 million versus the prior year as we had no new releases versus two new PSP titles last year. For the quarter, we had a loss per share of $0.03 versus earnings per share of $0.01 in the prior year. Earnings were lower than the prior year due mainly to challenging market conditions, higher product creation, and G&A expenses. In the March quarter, manufacturing and distribution expense was 63% of net revenues down versus 64% in the prior year due to improved mix. Product creation costs for the quarter were 23% of revenues versus 16% in the prior year. We define product creation costs as the sum of cost of sales, software royalties and amortization, cost of sales intellectual property licenses, and product development expense. The increased year-over-year was due mainly to higher next gen development costs. Sales and marketing expense for the quarter was 13% of revenues, down versus 15% in the prior year as we had no new releases. G&A as a percent of revenues was 15%, up from 7% in the prior year driven by higher separation and legal costs. We generated higher investment income for the quarter due to higher cash balances and rising interest rates.

For the fiscal year, revenues reached a record $1.47 billion driven by the multiplatform releases of Call of Duty, Tony Hawk's American Wasteland, Madagascar, Fantastic Four, Ultimate Spider-Man, X-Men Legends II, [inaudible] Shrek, True Time, and QUAKE. Consistent with our stated goals, we were successful in increasing our international publishing revenue 18% versus the prior year. The increase in our international publishing business was driven in part by our successful expansion efforts into new territories and strong affiliate title performance. Our continued focus to improve our hand-held market position resulted in 16% year-over-year publishing revenue growth for the segment. For the year, earnings per share were $0.14, lower than the prior year due mainly to challenging market conditions, higher product creation cost and increased sales and marketing spend. For the fiscal year manufacturing and distribution expense was 50% of net revenues up versus 47% in the prior year due in part to mix shift and price erosion of current gen software. Operating expenses for the fiscal year excluding manufacturing and distribution expense were 49% of net revenues, up significantly versus the prior year due mainly to higher product development expense and marketing costs. Our effective tax rate for the year was 14% versus 30% last year. The reduction is primarily due to tax credits representing a larger portion of pretax income.

Now turning to the balance sheet. On March 31st, we had 925 million in cash and short-term investments, an increase of $104 million versus last year and an increase of 180 million versus the prior quarter due to Q3 receivables collection. The accounts receivable balance was 29 million, down 80 million versus the prior year due in part to lower revenues in the quarter and higher reserves for price protection and returns as a result of difficult market conditions and higher channel inventories. Activision inventories were $61 million, an improvement of 23 million versus last quarter. On March 31st, inventory for the publishing business was $44 million and 17 million for the distribution business. Capitalized software development costs were 61 million, a decrease of 31 million versus last year and up 24 million versus last quarter. The sequential increase reflects more next gen titles going into development for future slates. Capitalized intellectual property costs were 87 million, up 51 million versus the prior year and up slightly versus December 31st. The year-over-year increase was primarily due to the new long term licensing arrangements with Marvel and DreamWorks.

In summary we ended the quarter ahead of plan with a strong cash position and financial base which gives us the flexibility to invest and leverage the many opportunities that the next few years will yield. Before turning to our financial outlook, I would like to begin by saying 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.

Now to Q1. Our first major release is DreamWorks' Over the Hedge, which will hit stores shelves in advance of the May 19th movie opening. We will launch Over the Hedge on PS2, Xbox, GameCube, NDS, GBA, and for PC. This is our fourth DreamWorks movie supported title, and last year's hit, Madagascar, shipped over 3 million units and ranked as the number one children's movie title in 2005. Also launching in May is X-Men: The Official Game in front of the 26 -- May 26 movie premier. X-Men will launch on the PS2, Xbox, GameCube, NDS, GBA, PC and the Xbox 360. X-Men: The Official Game will be our first super hero title to launch on the next gen consoles.

As for our financial outlook for the first quarter, we expect revenues of approximately $145 million and including the impact of adopting FAS 123R, which relates to the expensing of stock options and other share-based payments, we expect a loss per share of approximately $0.11. The Company's loss per share outlook, excluding the impact of FAS 123R, is approximately $0.10. This is down versus prior year due to fewer releases and lower current gen pricing. This year, we have only two major releases in the quarter as compared to last year when we released Doom 3 for the Xbox, Madagascar, and Fantastic Four. In terms of pricing, our two major releases this quarter will launch on the current gen consoles at 39.99 as compared to last year when we launched Doom 3 at 59.99 for the collector's edition and 49.99 for the base SKU, and as you may recall, the collector's edition outsold the base SKU. Fantastic Four also launched at the higher retail price of 49.99 last year.

For the quarter, we expect manufacturing and distribution costs of approximately 55% of net revenues. We expect operating expense including royalties and the impact of FAS 123R of approximately 81%. Projected tax rate of 31% that can be used throughout the fiscal year and basic share count of about 278 million shares. For the quarter, excluding the impact of FAS 123R, we expect operating expenses including royalties of about 78%, all other line items are the same, as I mentioned a moment ago. For modeling purposes, Q2 will also be down versus the prior year, as we have only one new release, QUAKE: Enemy Territory for the PC, versus a number of multiplatform releases last year including Spider-Man and X-Men. Today there's still uncertainty with regard to the market, software pricing and first party hardware plans for current and next gen, but we believe revenues in fiscal '07 will be approximately $1.025 billion and earnings per share including the impact of FAS 123R, I expect it to come in at $0.10. The Company's earnings per share outlook, excluding the impact of FAS 123R is approximately $0.15. For the fiscal year, we expect manufacturing and distribution costs of approximately 49% of net revenues. We expect operating expenses including royalties and the impact of FAS 123R of approximately 49% and a diluted share count of about 302 million shares. For the fiscal year, excluding the impact of FAS 123R, we expect operating expenses including royalties of approximately 47%, all other line items are the same as I just mentioned.

Now, I would like to turn it over to Mike Griffith, President and CEO of Activision Publishing, who will provide his thoughts on the balance of fiscal '07 and fiscal '08.

Thank you, Thomas.

Today my comments will focus on two main areas. First, our market expectations, and second, what we plan to deliver in fiscal 2007 and 2008. Looking at the overall market on March 31st, the installed base of hardware in North America for current and next-generation systems, including hand-held exceeded the 100 million unit mark. We expect the installed base over the next few years will accelerate driven by strong and growing consumer demand for the Xbox 360, Sony PlayStation 3, and Nintendo E, in addition to continued growth in hand-held platforms and lower priced current gen hardware.

With respect to the hardware market, even though we have more information from the first parties than we did at our last call, there is still risk in the short term, primarily surrounding next generation launch dates and quantities and current generation hardware pricing and support. But for now, we still expect the following hardware increases in North America during the calendar year. We're expecting PS2 up 4 to 5 million units which include the impact of the recently announced $129 price point. And we're anticipating approximately 1 million units from PlayStation 3. We expect regular Xbox up 500,000 units while Xbox 360 grows by 4 to 5 million units. We anticipate GameCube up by 800,000 units and we expect less than 1 million units from the launch of Nintendo E. Finally we expect hand-helds, which include GBA, DS, and PSP, will grow by approximately 10 million units.

Moving to software, we define our market to include all major platforms in North America and Europe. For calendar 2006, we expect the combined North American and European software markets for current gen and next general consoles, hand-held, and PCs, will decline by up to 5%. With respect to software pricing, this still remains one of the major risks to our operating plans. We expect that software launch pricing for front-line, current generation console prices will be made on a title-by-title basis between $39 and $49, and that launch pricing for the Xbox 360 and PlayStation 3 will be $59.

Turning now to our fiscal 2007, as we said on our last call, this fiscal year we plan to launch a more focused slate than in fiscal '06, which should align well with the challenging current generation environment and slow ramp-up of the next-generation hardware. The real benefit is that we're able to allocate more development resources against our large and growing fiscal '08 and fiscal '09 lineup when market conditions should be significantly more favorable.

Earlier, Thomas highlighted our product release schedule for the first half of the fiscal year, and I'll review our lineup for the balance of the year. Also, I want to highlight some of the steps we're taking to expand the depth and breath of our franchise portfolio, which, as you know, is our top priority at Activision. Yesterday, we further strengthened our balanced portfolio with the acquisition of the long-term rights to the James Bond license, as Bobby mentioned. This franchise is a perfect fit in our product portfolio for a number of reasons. First it's already a proven video game franchise with over 30 million units sold, and its genre fits well with our development capability. Second, this franchise has a particularly strong built-in European consumer base which will help drive our international expansion efforts. And third, we have a track record of success leveraging mass market movies titles like Spider-Man and Shrek, driven by the release of high quality software. As an organization we're excited by the opportunity this new franchise presents and we look forward to taking it to a whole new level in the years to come. So along with the recently acquired Transformer rights, we've added real depth to our portfolio.

In addition, and in the near term during fiscal '07, we're focused on adding important breadth to three of our largest franchises. Starting with Tony Hawk, our goal is to capture a wider, broader demographic. We'll first target the core Tony Hawk consumer with the release of the new Tony Hawk game. This is our traditional Tony game, completely rebuilt for the next-generation consoles. Next, we'll target a more casual gamer with the launch of Tony Hawk: Downhill Jam, a frenzied, downhill racing game and a new direction for the Tony Hawk franchise.

This dual launch strategy is similar to the approach we used this past year with Call of Duty 2 and Call of Duty: Big Red One, which gave us tremendous leverage with respect to our marketing dollars and was without a doubt our most successful franchise in fiscal '06. Second, we'll capitalize further on the success of Call of Duty 2. In addition to releasing an all-new Call of Duty title, we'll offer 7 downloadable multiplayer maps for a fee on the Xbox 360 that will feature exciting new World War II locations. This way of continuing to add breadth to our Call of Duty franchise is our first step in exploiting the revenue potential of online and extending the shelf live of our games.

Third, we'll broaden our superhero slate and category leadership with the release of Marvel: Ultimate Alliance, an all-new RPG game where one can play as 20 different superhero characters, including Spider-Man and Captain America. So in total, with these three franchises and the balance of our portfolio, we remain committed to maintaining the leadership position on next generation hardware in fiscal '07, and will release 5 PSP titles, 4 Xbox 360 titles, 3 PlayStation 3 launch titles, and 3 Nintendo E launch titles.

While we're committed to driving high-quality next generation titles, we're also committed to driving product development efficiencies over time. As expected, in absolute dollars, product development expenses for next generation hardware are rising. In anticipating this, we're pursuing a number of strategies that will help us leverage key learning and development costs across our global organization. In fiscal 2007, all of our next generation titles will utilize a number of proprietary tools that enable our artists to utilize character rendering and shading techniques across multiple platforms and more easily simulate a variety of game effects. In addition to shared technologies, we're increasing our development schedules to facilitate longer pre production phase and more predictable work flow times that produce a double benefit of higher quality output and more efficient use of manpower. And finally, we're outsourcing areas of game development like artwork to other parts of the world such as Asia. These are just a few of the things that we're currently working on that, in addition to leveraging the next generation learning curve, will help bring product creation costs in line with our historical levels over the course of the cycle.

Fiscal 2007 will be a year of caution and investment as we manage through the remainder of the transition and focus resources to prepare for accelerated growth in the next few years. In fiscal '08, we'll begin to reap the benefits of leveraging next generation development, a larger installed base of hardware, and a growing deeper and broader franchise portfolio. We'll start the first quarter of the year with two of our strongest movie supported franchises, Spider-Man 3 and Shrek 3. The prequels of these two movies generated $1.7 billion in worldwide box office sales and collectively the franchises have sold in excess of 33 million game units to date. There's also an added benefit to releasing well-known movie-supported franchises early in the year, as you get additional revenue opportunities during the holiday season. Also, anchoring our slate will be strong new titles from a number of our largest franchises. Tony Hawk, Call of Duty, and X-Men. And we'll release new movie-supported properties based on DreamWorks Bee Movie and the Transformers movie, which are both scheduled to launch early in our fiscal year.

Our core fiscal year '08 lineup is one of our strongest ever, and we'll share with you the specifics of our full lineup on future calls. But as of today, we expect that fiscal '08 revenues will preliminarily exceed $1.6 billion. Our growth in fiscal 2008 will be driven by double-digit market growth, our expanding balanced franchise portfolio, greater international publishing realization, benefits of a more efficient cost structure, and continued successful focus on winning big with winning customers.

Well, we thank for your time and the opportunity to share our initiatives for the future with you, and I'll now open up the call for your questions. Thank you.

[OPERATOR INSTRUCTIONS]. Mike Wallace, UBS.

Hi. A couple questions. Let me -- since what happened EA last night -- start with the cost issue. If you look at this cycle compared to the last one with R&D costs higher, is it going to be a slower ramp up in terms of your operating margins, or looking at the jump in sales in '07, do you think it follows a similar pattern? In other words, is the pay off on the margin side going to be a couple years out further than it would have because the R&D costs are so high?

Let me first say that margin expansion continues to be a key focus area for the Company, and while near term margins will remain under pressure as we navigate through the console transition, we are focused on balancing short-term cost control with the investments necessary to drive significant growth in '08 and beyond when market conditions should improve. So the drivers behind the long-term margin expansion that we see really remain unchanged from what we've seen so far, and that is, as Mike described, building the depth and breadth of the franchise portfolio and leverage that against market growth and international expansion, than participating in the growth of the margin enhancing business models that are emerging, such as [online wireless] and in-game advertising, and then obviously continuing to optimize our cost structure. So '08, while that's still early in the cycle, we still feel that as we hit certain revenue milestones we can grow operating margins to the 15 to 18% range over the next couple of years that we talked about previously.

And one of the things that EA talked about was the online market. Do you have any plans in the multiplayer genre? Is that something you're working on or exploring for subscription-type games?

Yes, in fact, we -- little known fact, we have the largest online game in the industry in QUAKE, so we've had a fair number of -- a lot of experience with this in the past. But in terms of generating revenue online and microtransactions, we're pretty bullish on this as an area for revenue expansion and margin expansion over time, although we think that it's obviously a gradually ramp-up with the capabilities of next-generation hardware and installed base. But we're learning and committed to taking a leadership position on that. We're going to make available, beginning with E3, 7 new maps available via live on Xbox 360 for our Call of Duty franchise. And these will retail between 5 and $11 in a margin accretive way. So while the revenue will be quite small, we think it's an important test, and we're very interested in learning about the area.

But as far as like the massively multiplayer/persisted state product, Mike, with its subscription revenue model that's not something we're investing in presently.

Okay. And then just one more question with what Nintendo's doing with the controller. Are you going to do more Nintendo-supported games this time around than you did for GameCube, and are you going to do more exclusive titles that are only on their platform?

We haven't commented on what would be exclusive and what wouldn't. We're really excited about the platform. I think it is a really well-differentiated product. It'll appeal to that younger consumer, to the more casual consumer, and you'll get to see it in full force next week, but there'll be some unique opportunities on the platform. We're very committed to it, and I think you'll see a level of support that is more than what we did with GameCube.

Okay. Thank you.

Tony Gikas, Piper Jaffray.

Hi. Good afternoon, guys. Couple questions. Do you know, is it -- just kind of going back to the product development expense, is it clear at this point if you'll actually be able to port from the PlayStation 3 to the 360, or vice versa? Second question, could you characterize the marker opportunity a little bit more for in-game advertising and these console downloads? Can they reach maybe together 10% of the market over the next three to five years, and maybe you could just touch on what they -- what the revenue model looks on the downloads, the transactions you were referring to on Call of Duty? And I have a follow-up as well.

That's a lot of questions for a follow-up, too. But let me -- let me start with the product development question that you asked. I think, no surprise, we're seeing costs increase with the new generation of hardware, and you're right, that there are differences between platforms, PlayStation 3 and Xbox 360. And we're climbing the learning curve on it. And I think while early in the platform transition, porting between the platforms is more challenging than we've seen on the previous platforms. This is an area that we're learning day-by-day and getting more efficient. We're building engines and tools and developing assets and experience, all of which are going to help us develop more efficiently and port more efficiently across platforms. So we're -- we think we're about where we would expect to be at this stage of the platform, and we think we're going to be able to develop much more efficiently over time and get to that area of cross-platform porting, as you say, as we've experienced with this transition.

As far as the in-game advertising, Tony, we're seeing a level of interest and commitment on the part of the first parties that we've always said is critical to the establishment of standards in pricing and in measurement. And you're not going to see it move the dial this fiscal year, probably not even next fiscal year, but it's starting to get traction. You have a lot interest on the part of advertisers, and I think once you do see a decent-sized installed base of next generation hardware some serious opportunities will emerge. As far as digital downloads, again, it's early days. I think this is a good experiment for us. You're going to need a much bigger installed base for it to be meaningful. Could it eventually be 10% of revenues? We like to look at the PC model, and you look at our more successful PC franchises, where we have add-on packs. In the console -- in our history of console exploitation, the add-on pack has not really been economically feasible for a variety of reasons. But I think this is going to be that supplement. So we've had add-on packs that have sold in excess of 25 or 30% of the installed base of the PC product. And I think that the opportunity exists to do that on the consoles.

I think you see this with the way the Xbox Live downloads work. It ends up being a margin accretive part of the business model.

Do you know what those downloads are going to cost? I mean, are these 1.99 transactions or 9.99 transactions?

Well, they're -- they're between 5 and $11 per transaction.

Okay. And then last question's, can you comment on how long you've had development kits for the PS 3, and what are the games looking like at this point in the development process?

We obviously can't say when we receive development systems, but we've been working on them for a long time. And the multiprocessor architecture and all the graphics capability of the hardware's spectacular. The throughput is beyond what I think we would have expected in terms of original design. It's a great product, and it really is a meaningful difference, generation over generation.

Okay. Good job. Thanks, guys.

Thank you.

Ed Williams, Harris Nesbitt.

Good afternoon. Just a couple quick questions for you. Looking first of all at your studios, can you just remind us what you did in fiscal '06 and your revenues from internal studios, and where that number has been in the recent past and what your target is as far as getting into the -- the heart of the next generation cycle?

It was very consistent with prior years. We were about two-thirds of the revenue -- of publishing revenue generated from internal studios and we don't expect that to change materially for fiscal '07, either.

Okay. And -- but looking into -- do you have a goal that you can kind of elaborate as to where you hope to get that number getting into the rest of the platform cycle, or is two-thirds where you're comfortable?

Generally speaking, Ed, I think one of the things you're finding is as production expense is increasing and the requirement for using centralized tools and technologies is getting greater, it becomes more difficult for us to use third parties because they just don't have the capabilities that we'll need for the next generation. But I would say when you look at the non-strategic platforms like Game Boy or some of other things that we're using outside developers for, that number is not likely to change this fiscal year and maybe it increases slightly in favor of internal development in fiscal '08.

Okay. And then can you just elaborate a little bit about the steps that you guys have taken to gain some leverage on the cost of developing games? You mentioned, Mike, I think you mentioned that you're outsourcing more in terms of the artwork and the like. Could you elaborate a little bit more on that?

Sure. Well, as I said, we're not surprised to see the cost pressure increase at this stage of the development cycle, and as we talk about our product development costs or product creation costs, we include intellectual property in there, and traditionally it's been about 20% of net revenue. And as Thomas mentioned in fiscal '06, we saw that climb to 23%. We think it will stay about there in fiscal '07. But we have a clear priority to improve our efficiency in the product creation costs process, and we're finding efficiencies and plans for efficiencies broadly, without sacrificing game quality or innovation. And it's really on the development and application of tools that can be developed and used and applied centrally to build efficiencies across platforms, across studios. We're reconfiguring our quality assurance program to move more resources upstream into our studio process, where we've got a double benefit of being more efficient and more effective. And as I mentioned before, we're sourcing more of our art development offshore. So, again, not particularly unexpected for this stage of the cycle, but we're confident we've got the right program in place to drive back to our historical levels of cost on a -- percent of net revenue overt time.

Hey, Ed, one other area of specifics is the movement of quality assurance to India. And it's something that we've been experimenting with, and we've had some pretty good success in our first phase of testing. So when you look at QA, both upstreaming some of the production testing to the studios themselves and moving offshore on things like Indian testing has really actually been something that we think is going to pay dividends for the next couple years.

Okay. And then -- it's last question. As you look towards the next platform cycle, where do you expect most of the growth to be coming from? Is it through -- is it in the North American market, or is it in the European market? And do you envision the household penetration of game consoles to expand, or do you expect MMO games to have an impact on the market as a whole and possibly negatively affecting the consoles games?

Well, I -- first of all, we're seeing market growth potential in both North America and Europe, so we've got an expectation over the course of the cycle that will be helped by market growth broadly. If you look at where our business is today, it's between North America and Europe. We've got more upside potential in Europe just because we're less developed there. We've spent less time building the business than in North America, and so that continues to be a major focus for growth. And in terms of console penetration or game platform penetration, yed, we think it's going to go up, but we're also seeing more multiplatform ownership in homes, which provides -- which is providing additional revenue opportunities.

The other thing I would say, Ed, is when you look at the next generation devices and you look at things like Blu-Ray, the first hi-def DVD devices that will be in the marketplace are going to be the PlayStation 3. I think you're going to see a lot of mass market consumer interest in PlayStation 3 as a video player. I think when you look at how compelling it is to play online with a multiplayer in a multiplayer experience, with tournaments and ladders and organized competition and the benefit of integrated instant messaging and audio with a headset on the 360. And then the really unique characteristics of the Nintendo, which is absolutely going to appeal to much broader audiences than we've seen in prior generations hardware, but I think what you'll see is there will be a broadening of the audience for the console here and in international markets, and while the MMOPG business is an interesting one, it's likely to remain a much more of a niche business focused on the PC until you have a much larger installed base of more capable next generation hardware out there. So we're going to stay focused on the retail distribution of our products at the primarily means of distribution, and we definitely think that you're going to see a broader audience emerge.

Okay. Great. Thank you.

Lowell Singer, Cowen & Co.

Thanks. Good afternoon. Just a couple questions. Bobby, can you help out on this whole question of game development costs by offering, for a generic title, some perspective on would what it costs you to develop games for essentially four platforms back in 2002 for the last cycle, and where you all think that comparable game development cost will be for three consoles and three hand-held platforms in 2007? So essentially what's the delta where you sit today before you start building in all the efficiencies? And second, Thomas, a question for you. Can you provide some -- some of the assumptions that underlie the 1.6 billion forecast in fiscal '08, what some of your -- hardware and software categories assumptions are and sort of your specific company title assumptions? Thanks.

Okay. So I really can't give you the specifics on title development, but we now have five next generation 360 products under our belt. There have been wide ranges in production expense. We've also been developing these cross-platforming tools and our centralized technology group has increased considerably, and it is still early days on PlayStation 3 and on the Nintendo. So I don't think we have a really good handle, but our guess overall is that -- I mean, when you step back and you think about the cost increases we've seen in prior generations, typically what we saw in the first couple of years is about a 25 to 30% cycle-on-cycle increase in production expense. In some cases that's been higher now, but I think ultimately we'll get -- remember, we're actually operating today with a $10 higher wholesale price, which has been a pretty good offset to some of the increased production expense, but we're going to need to get through the balance of this fiscal year and get products out on PlayStation 3 and the new Nintendo to really know exactly which tools are going to be effective for us and how much control we can have over production expense. But I would say there are a couple of other things that we're doing that are giving us more control. Our studios are bonused and rewarded on their ability to achieve operating margin targets. And one of the things that we're finding is that we're improving the allocation process by putting things like production testing into the studios. They have more control over testing as an expense. We're really empowering our studio executives to get deeper into the details of their production budgets and reward performance in the reduction of those -- of production budgets. And so there are a lot of systemic things that we're doing as well, but we really won't have a great handle on the differences in the costs until we get through this fiscal year.

And with regard to your question, how the 1.6 builds up, I think we've -- at the last call talked about some of the slates, so I'm going to go back into that for a minute. A lot of our big sellers are going to be on the slate in '08. We're going to start very strongly with movie-supported titles of Spider-Man the movie 3 and Shrek 3, two of our best performing titles ever, and a lot of our proven franchises are back on the slate. Call of Duty will be there, Tony will be there. We have about -- if you add it all up -- we haven't announced all the titles, but from an SKU point of view we're going to be about 50% above fiscal '07. Then apart from the slate, we expect the market to come back significantly in '08. We expect double-digit market growth, as Mike mentioned early on in his comments. We continue to make good progress internationally, and that leads to higher realization, higher penetration of international markets. Some of those we're already in, but we expanding our percentage of business that we sell direct to. And at the end of the day, there will be some contribution from the new markets and business models that are starting to emerge, although it's not going to be huge at that stage.

Okay. Thanks a lot.

Sure.

Ralph Schackart, William Blair.

Good afternoon. Good to see you're standing by the long-term guidance. Can you sort of walk us through your fiscal '08 guidance and sort of help us understand how it may be actually a little higher than what you put out there, and what could potentially be the biggest risk to that? And additionally, two, can you just give us an update -- have you seen any uptick in sales especially on back catalogs since the PS2 price cut has taken place? Thanks.

I think first of all we've given '08 revenue guidance earlier than we would usually do, and at this stage we are not yet providing earnings per share guidance for '08. So with regard to how the revenues build up, I think I've just been -- just gone through that. So I don't know, not much to add from that perspective. And sorry, what was your second question?

The PlayStation 2 price cut. I know it's early, but have you seen any uptick in sales, especially on some of the catalog titles?

Well, it's -- it's really too early to see an increase in sales based on the PlayStation price cuts. The 129 price point is really just now being reflected at retail in North America, and as you know, they've not made a similar move yet in Europe. So it's really just getting established. We have built that expectation into our plans -- in the fiscal '07 plans and guidance that we've already provided, but I will say that given that price point on the PlayStation and the robust slate we put into the market in fiscal '06 and the continued growth in the Xbox 360 penetration, we do expect our catalog business, as a percent of revenue, to be up slightly in '07 compared to '06.

And we did see the catalog in the fourth quarter perform better than we expected.

Great. Thank you.

Okay.

Evan Wilson, Pacific Crest Securities.

Hi there. Thanks for taking the question. Three -- I've got three. The first, when should we expect to see first Bond game? The second, on the new Call of Duty you've announced for this Christmas what SKUs should we expect there? Is that just a PC title or it will roll across all the consoles as well? And then the third, and probably the hardest, owned intellectual property versus licenses. These new licenses you've been signing are definitely helping to smooth out the transition, but a company -- you're definitely a company that's traditionally focused more than others on owned IP. Any sense on what owned IP versus outside IP will represent fiscal 2007 and if you have any sense on fiscal 2008, that'd be helpful, too. Thanks.

All right. Well, first of all, let me answer your Bond question. We're in the early days, obviously, of working with MGM and understanding the movie slate that they have in mind. And talking about various scenarios, so we've not made any decisions and certainly not any announcements about when the first Bond game will come into the market. This is, as Bobby mentioned, a very important long term franchise for us, so it's very important that we do it right, and that's what we're focused on doing on Bond. For Call of Duty, this year it's a broad-based title, and we think it's going to be a very successful follow-up on Call of Duty 2. It will launch in our third quarter.

But it's not a PC product, it's a console product and it's all next gen.

Right. And in terms of your intellectual property question, we are focused on a balanced portfolio of -- across different genres, different platforms, and across owned and licensed intellectual property. There's a lot of good reasons to be pursuing both licensed and wholly owned, and we have a combination of that, and we think that our split is going to stay pretty constant in the near term, and in '07, our major wholly owned property is Call of Duty.

Could you give us any sense in the previous fiscal year what owned versus external was?

Yes, it was -- internally, it -- about a third of our revenues are owned versus licensed.

Thanks.

Justin Post, Merrill Lynch.

Hi. This is [Hannen Fahn] in for Justin. I just was wondering if you could discuss a little bit how you're going to use the 1 billion in cash. You said it's a good opportunity to invest. Are you looking more aggressively at mobile or online gaming? And also could you review your acquisition strategy?

Yes, we've had some great success in the last few months in extending our intellectual property agreements for very long terms, so that's been one good use of our capital. We had good success last year in the acquisition of development resources, and that will continue to be a focus of our capital usage, and so I would say those would be the two things over the last six months to a year that we've gotten the benefit of that capital.

And looking forward, are you looking to be more aggressive in other areas?

We're still -- remain opportunistic but focused on what has worked well for us in the last few years.

Great. Thank you.

Yes, and I think, if you look at the financial discipline that we've exercised in our acquisition process, we've stayed true to, generally speaking, deals that are coming with some proprietary technology or franchise, a history of profitable operations, they are margin accretive for the long term, generally non-dilutive, and come with good management. And so when they meet all of those requirements we usually get interested.

All right. Thank you.

Colin Sebastian, Lazard Capital Markets.

Okay. Hi, Colin. Go ahead.

Want to go to the next question?

Operator?

[Azene Ebrahem], Deutsche Bank.

Hi. Thanks for taking my questions. When you guys look at when you launch your games in the sort of first quarter, second quarter, third quarter, fourth quarter, looking out into the next cycle, typically you've sort of had your movie release games coming out in the first quarter, Third quarter's always been the sort of big quarter for pushing out a bunch of titles. When you look into the next cycle, do you think that it may be more prudent to, say, launch games throughout all the four quarters, or do you think we're still going to kind of see the third quarter be the big weighted quarter? And I ask that question in the context of there's been some sort of -- there's been some claims that perhaps games may cannibalize or compete against each other when they're dumped into the third quarter. That's the first question. And then second question, could you just pretty simply sort of characterize your discussions with MGM over the James Bond franchise? Do you think it was a sort of discussion based on you won it on a quality issue, or it was a price issue, or maybe MGM were sort of looking to just refresh the whole franchise, especially given that the movie itself is undergoing a bit of a refreshment right now? Could you sort of give a characterization of why you think you were able to get that franchise? Thank you.

Well, let me start by addressing your quarter-by-quarter launch strategy question. Clearly, for movie supported titles, we need to launch the games concurrent with the movie. That is the way to maximize revenues. And for those movies that launch outside of the holiday window in Q1, let's say, those are important opportunities, because they give us then a chance to double dip again during the holidays as often not just seasonality but the DVD releases. So movie supported titles will really be driven by the release schedule of the movies. Beyond that, I think we'll continue to see the third quarter -- the October-December quarter be the most important just in terms of overall consumer demand. We have seen our slate vary as a percent of the year released in that quarter over time, and I think we'll continue to see that based on a number of factors. But clearly from a seasonality view that's going to continue to be the most important quarter. In terms of the Bond, I've got to tell you, we -- we're delighted with MGM. We've had many very productive discussions. I think we are seeing this franchise alike and very similarly. It's fitting well into our strategic priorities and I really can't comment much beyond that.

Okay. Thank you.

Daniel Ernst, Hudson Square Research.

Yes, thanks, [inaudible], and thanks for taking the call. Just I think -- two hopefully quick ones. One, on your plans for the PS3 launch, are you planning to launch those just sort of day and date or within the near term of the launch of the console in November? And then secondly, maybe a different cut at the cost of putting out your title, not necessarily the development cost, but the marketing costs? What do you think the sales and marketing costs as a percent of revenue are going to trend to? They've obviously been up significantly over the last few years as a percent of revenue. Do you see it stabilizing here or is it going to creep up a little further here in a competitive and hits-driven environment? Thanks.

Well, I think, first of all, on the PlayStation 3 launch, as we said, we're committed to supporting that launch. We've got three launch titles that will come out in very near proximity to the hardware launch. In terms of the variable -- or the sales and marking expenses, as I said, we've -- we increased our sales and marketing expenses quite considerably in fiscal '06. We tried to offset weaker market conditions. We found that it didn't work as well as we expected. So we've gone back and analyzed line by line what's working and what's not working as well from our marketing expenses. We are committed to returning to proven historical levels of marketing support. We know how to do that. It's pretty straightforward, and we're on path to do that over the next one and two years.

And then just maybe as a follow-up to that, is there an opportunity to create some synergies on your multiplatform concept, i.e. like can market Tony Hawk for the PS3 and the PSP at same time, that day and day kind of synergy? Is that an opportunity or do you have to market them separately?

No, it's absolutely an opportunity. In fact, if I can take you back to the year we've just closed, we think one of our most successful programs was the simultaneous launch of Call of Duty 2 and Call of Duty: Big Red One, which were on different platforms, and we realized significant marketing efficiencies across that. So it was a very successful program, and we'll reapply that learning on the Tony Hawk franchise this year and more beyond.

Great. Thanks. Look forward to seeing you next week as well.

All right. Thanks very much.

And at this time that concludes today's question and answer session. I would like to turn the conference back over Ms. Southey for any additional or closing remarks.

Okay. Thank you on behalf of everyone at Activision. We thank you for your time and consideration, and we hope to see you all at next week's E3. Thank you.

And that does conclude today's teleconference. We'd like to thank you for your participation, and have a great afternoon. You may now disconnect.