美商藝電 (EA) 2007 Q2 法說會逐字稿

Good day everyone and welcome to the Electronic Arts second quarter fiscal 2007 second quarter earnings conference call.

Today's call is being recorded.

For opening remarks and introductions, I would like to turn the call over to Ms. Tricia Gugler.

Please go ahead, ma'am.

Thank you.

Welcome to our second quarter fiscal 2007 earnings call.

Today on the call, we have Larry Probst, Chairman and Chief Executive Officer;

Warren Jenson, Chief Financial Officer; and Frank Gibeau, Executive Vice President and General Manager of North American Publishing.

Before we begin, I would like to remind you that you may find copies of our SEC filings, our earnings release, and a replay of the Webcast on our Web site at investor.EA.com.

Shortly after the call, we will post a copy of Warren's remarks on our Web site.

Throughout this call, we'll present GAAP and non-GAAP financial measures.

Non-GAAP measures exclude charges and amortization of intangibles, certain litigation expenses, restructuring charges, and stock-based compensation.

In addition, the company's non-GAAP results exclude the impact of certain one-time income tax adjustments.

Our earnings release provides a reconciliation of our GAAP to non-GAAP measures.

Information regarding our use of non-GAAP measures will be included with a copy of Warren's remarks on our Web site.

These non-GAAP measures are not intended to be considered in isolation from, a substitute for, or superior to our GAAP results and we encourage investors to consider all measures before making an investment decision.

All comparisons made in the course of this call are against the same periods for the prior year unless otherwise stated.

We have concluded our trailing 12-month platform shares in our 2006 estimated market outlook in a supplemental schedule on our Web site.

We may make forward-looking statements regarding future events and the future financial performance of the company.

We caution that you that actual events and results may differ materially.

We refer you to our most recent form 10-K and 10-Q for a discussion of risk factors that could cause our actual results to differ materially from those we discussed today.

We make these statements as of November 2, 2006, and disclaim any update to update them.

Now I would like to turn the call over to Warren.

Thanks, Tricia, and good afternoon, everyone.

I would like to begin with a few highlights from the quarter.

Our second quarter was strong and exceeded our expectations.

Revenue was a Q2 record, $784 million, up $109 million or 16%.

GAAP diluted earnings per share were $0.07 versus $0.16 and non-GAAP diluted earnings per share were $0.21, an improvement of $0.06 or 40%.

Q2 as usual was all about sports.

Madden NFL '07 had another record year, selling 5 million copies in just five weeks.

Today we estimate sell-through is up 15% year-over-year.

NCAA Football '07 hit an all-time high selling over 2 million copies in the quarter and we estimate current sell-through is up 16%.

FIFA '07 current gen had a strong international launch selling nearly 2 million copies in just one week.

Tiger Woods PGA Tour '07 to date has sold more than 1 million copies.

Tiger will be a PS3 launch title and will ship in our fourth quarter.

NBA live '07 sold over 1 million copies in the quarter and NHL '07 is having its strongest year ever with estimated sell-through up over 25%.

In the quarter, we also moved forward on several strategic fronts.

First, we are pleased to be partnering with Apple on the iPod.

In September, we launched Tetris, Mini Golf and Mahjong.

Second, we have joined with Massive and IGA to introduce dynamic ingame advertising.

We started with Battlefield 2142 a couple of weeks ago and Need for Speed Carbon is now live.

Third, FIFA online in Korea continues to do well.

To date, we have completed over 700,000 microtransactions at an average retail price of approximately $1.45 per item.

FIFA online is currently in the top five online midsession games in Korea.

Fourth, we launched Pogo in the U.K.

And finally, we acquired Phenomic games, a talented RTS developer, we welcome the team to EA.

In summary, an excellent fall season for EA SPORTS, a record Q2 topline performance, and a stronger strategic position.

For the next few minutes, I'll focus my remarks in two areas.

First I'll review our Q2 financial results, second I'll go over our outlook and financial guidance.

And then following my comments, Larry, Frank, and I will open the call to your questions.

net revenue was $784 million, up 16% driven by Madden NFL '07, Godfather, NCAA, FIFA, and continued strength in catalog.

By platform, the revenue increase was driven by Xbox 360 and cellular phones, offset by declines in currency and console.

We released 43 SKUs in the quarter versus 37 a year ago.

During the quarter, we had two titles, Madden and NCAA, that sold in excess of 2 million copies.

Console revenue was $514 million, up 10%.

The increase was driven by Xbox 360, which more than offset the decline in current gen platforms.

During the quarter, 360 revenue was 21% of total revenue, up 6 points from last quarter.

Year-to-date, we are number one on the 360, PS2, Xbox, PSP in both PC in North America and Europe.

Mobility, revenue was $121 million, up $59 million, almost two X that of last year.

On mobile phones, revenue was an industry-leading $35 million.

We had four of the top ten games in North America and in the U.K.

Since acquiring JAMDAT, 8 of EA's franchises are now available on mobile phones.

As compared to JAMDAT's year ago performance, revenue was up 75%.

On handhelds, revenue was $86 million, up 43% driven by growth on all platforms.

PC revenue was $86 million down 5% primarily due to last year's strength of Battlefield Two.

Copub and distribution revenue was $39 million, up 22% driven by the success of Dead Rising and Half Life 2.

Internet, licensing, and other revenue was $24 million.

Club Pogo subscriptions are up 39% year-over-year to $1.4 million.

This quarter we plan to introduce a gem-based buying service on Pogo.com, which will bring more premium content to our customers through microtransactions.

Geographically, North America revenue was $512 million, up $69 million or 16% driven by Xbox 360, cellular phones, and PSP.

Partially offset by declines in current gen.

We had three top ten titles across all platforms.

Madden NFL and NCAA were number one and two respectively.

International revenue was $272 million, up $40 million or 17%.

Excluding a $10 million positive impact from foreign exchange, international revenue would have been increased 13%.

Europe revenue was $245 million, up $54 million or 28% driven by the Xbox 360, PS2, and PSP partially offset by declines in Xbox.

In Europe, our PS2 business grew 18% due to the strong launch of FIFA '07.

Asia revenue was $27 million, down $14 million.

Xbox 360 revenue did not offset the declines in current gen.

Moving on to the rest of the income statement, gross profit in the quarter was $445 million, up 14%.

Gross margin was 56.8% versus 57.9, down 110 basis points driven by higher licensing costs and lower average selling prices, partially offset by lower sales return charges.

OpEx, at the beginning of the fiscal year we adopted FAS 123R.

In the second quarter, this resulted in stock-based compensation of $33 million.

Marketing and sales: marketing and sales expense was $108 million, relatively flat to last year.

Excluding stock-based compensation, marketing and sales would have decreased by 3% due to lower ad spending.

G&A was $72 million up $20 million primarily due to personnel related costs, including stock-based compensation.

Excluding the impact of stock-based comp and the impact of acquisitions, G&A would have been up $7 million or 13%.

R&D: R&D was $238 million, up $56 million primarily due to the expensing of stock-based compensation, the addition of studio head count, and the impact of our acquisition.

Excluding stock-based comp and the impact of acquisitions, R&D increased approximately 15%.

R&D head count was approximately 5600, up roughly 400 from last quarter and up 17% from a year ago.

The JAMDAT, Mythic and Phenomic acquisitions accounted for 10 points of this increase.

Our GAAP tax rate for the quarter was 42%.

As I mentioned in our last call, you can expect our rate this year to be volatile and potentially fluctuate dramatically quarter to quarter.

GAAP diluted earnings per share were $0.07 versus $0.16 a year ago.

Non-GAAP diluted earnings per share were $0.21 versus $0.15.

The $0.14 difference between GAAP and non-GAAP EPS is principally due to stock-based compensation, $0.09; amortization of intangibles, approximately $0.03; restructuring charges of $0.01; and acquisition charges of roughly $0.01.

Our trailing 12 month cash flow was $571 million versus $592 for the comparable period.

Our return on invested capital on a trailing 12-month basis was 17% versus 39% a year ago.

Now on to the balance sheet.

Cash, short term investments, and marketables were $2.4 billion, down $21 million from last quarter, primarily due to our acquisition of mythic.

Gross accounts receivable were $439 million versus $465 million a year ago, a decrease of 6% due to the timing of our release schedule.

Reserves against outstanding receivables totalled $172 million, up $35 million.

Reserve levels were 14% as a percentage of trailing six-month net revenue, up 1 point.

As a percentage of trailing nine-month net revenue, reserves were 9%, consistent with last year.

Inventory was $67 million, down $7 million from a year ago.

Other than FIFA, no one title represented more than $4 million of net exposure.

We recorded $86 million of intangibles related to our acquisition of Mythic.

Of this amount, $22 million will be amortized to the P&L over three to five years.

Now our outlook and guidance.

Before getting into the numbers, a few observations.

First, while things can change very quickly, the current sales environment appears to be healthy.

The strength of the year-to-date numbers backs this up.

As a result, we have increased our industry software growth estimates for the year.

Second, we are very much looking forward to the holidays.

It's the beginning of prime time for next generation technology and entertainment.

On the Xbox 360, we will have four titles and lots of downloadable content.

On PS3, we'll also have four titles, Madden NFL '07, Need for Speed Carbon, Tiger Woods PGA Tour '07 , and Fight Night Round 3.

On the Wii, both Need for Speed Carbon and Madden NFL will be available at launch.

On the quarter, we'll release three titles on the DS, five on the PSP, nine on mobile phones, and one on the iPod.

Third, don't forget about the current gen, particularly the PS2.

This remains the largest platform globally and we are the leading publisher.

Fourth, as a result of our first half performance and can the relative strength in the marketplace, we are taking our numbers up for the year.

That said, we have also made some adjustments to our SKU plan that will move a couple of titles into fiscal 2008, specifically ARMY OF TWO and Crisis.

In summary, the industry appears to be healthy and we are looking forward to having all next gen platforms in the marketplace.

Longer term, we are building a powerful global line up for fiscal 2008 and beyond.

We have some great titles in the works and expect to extend our position of leadership.

I'll now conclude my portion of today's call with our market outlook and financial guidance. 2006 market outlook: as I mentioned earlier, we have revised our software estimates.

We now expect software sales in North America and Europe to be flat to up 5% for calendar 2006.

You can find a summary of our estimates on our Web site.

Now our financial guidance.

Once again I'd like to lead with a few points of caution.

First, transition is not over.

While we are bullish on the long-term, many short-term uncertainties exist.

There could easily be hardware delays and shipment quantities could fall short.

Second demand and/or pricing for current gen platforms and software could fall below that what is in our forecast.

Third, there is always development risk, particularly given the challenges of transition.

It is possible that a title could slip out of any given quarter or the fiscal year.

And finally, it is important that you carefully review and assess the risk factors detailed in our SEC filings.

Now the numbers.

For the quarter ending December 31, we expect revenue to be between $1.2 and $1.3 billion.

GAAP diluted earnings per share to be between $0.33 and $0.43.

Non-GAAP diluted earnings per share to be between $0.50 and $0.60.

Overall, we expect our non-GAAP EPS to be roughly $0.17 better than our GAAP results.

The estimated breakdown of these adjustments is as follows.

Stock-based comp, approximately $0.09; acquisition charges, roughly $0.04 associated with our acquisition of Mythic; amortization of intangibles, roughly $0.03, and restructuring charges, of approximately $0.01 related to our international reorganizaion.

In Q3, we expect to ship 41 SKUs compared to 49 a year ago.

To date, we have released Battlefield 2142 on the PC, which by the way is off to a great start.

Medal of Honour Heroes on the PSP, Need for Speed Carbon on eight platforms, and the Sims II Pets on four platforms.

This title has already gone platinum in just three weeks.

In addition, we expect to release Fight Night round III on the PS3, Madden NFL '07 on the PS3 and Wii, NFL Street on three platforms -- excuse me, NFL Street on two platforms, Superman returns on five platforms, Tiger Woods: PGA Tour on the PS3, the Sims II Pets on two platforms, the Sims II Holiday edition on the PC, the Sims II Happy Holiday on the PC, Crooked '07 on two platforms, Dark Age of Camelot on the PC, Rise of the Witch King on PS3, and replay on the PSP.

Also in the quarter, we'll offer new game content on Xbox live marketplace for Tiger Woods PGA Tour '07, Godfather, and Need for Speed Carbon.

On mobile phones we plan to launch nine games, NBA Live '07, EA Sports Fight Night Round 3, Texas Hold'Em 2, Medal of Honor, NCAA Basketball, Sims Pets, FIFA '07, Dakar 2007, and Scrabble.

On the iPod, we plan to release a game pack which will include both Sodoku and Solitaire.

Now our full year guidance.

For the full year, we expect revenue to be between $2.950 and $3.125 billion.

GAAP diluted earnings per share to be break even to $0.15.

Non-GAAP diluted earnings per share to be between $0.55 and $0.70.

Overall we expect our non-GAAP EPS to be roughly $0.55 better than our GAAP results.

The estimated breakdown of these adjustments is as follows.

Stock-based comp, roughly $0.33; amortization of intangible assets, approximately $0.13; acquisition charges, approximately $0.05 related to our acquisition of Mythic and Digital Illusion; and restructuring charges of roughly $0.04 related to our international reorganization.

Looking ahead, we again ask you to keep in mind that with the introduction of next gen platforms and the global expansion of online gaming, you will see more games delivered with significantly enhanced online game play.

In some situations, this may delay the recognition of revenue.

This, of course, will have no adverse impact on cash flows.

I'll now conclude with a couple of closing thoughts.

First, this is a great time to be in this business.

As traditional media battles technology and the internet, we embrace them.

As I said a few minutes ago, this is beginning to have prime time for interactive entertainment.

Second, our long term priorities are clear.

Next gen leadership, winning in on line, Asia, and mobility, expanding our wholly owned IP portfolio, while at the same time delivering long term value to our share owners.

Of course, these priorities are not without complexity and we will make mistakes along the way.

All that said, EA has the best team in the business to lead us through this changing, challenging, and exciting time.

With that, Larry, Frank, and I will open the call to your questions.

Thank you. [OPERATOR INSTRUCTIONS] We'll hear first from Lowell Singer of Cowen and Company.

Good afternoon, Warren.

I wanted to ask you a couple questions about share and how you guys think about your share by platform.

Obviously your well under index on the PS right now.

What is your long-term goal for the type of software share you think you can have on that platform?

And secondly, though the platform is clearly less important over the long-term, the PS2 sales have held up very well this year and it looks like you may be losing a little bit of share there.

A, do you concur with those numbers?

And B, how much do you really care about that as you look out towards next year?

Thanks.

With regard to the DS platform, year-to-date through September we've got about a 5% market share.

And obviously that's a number that we want to see increase longer term.

We certainly want to see a market share that is double digits and we think we've got a pretty significant lineup of products in the pipeline and we believe we can move that needle in a positive direction longer term.

In terms of the PS2 share, year-to-date in North America, we're trailing our last year's market share on the PS2 just slightly, but we have a fairly robust lineup going into Q3 with still half the business yet to go on an annual basis.

If you look at Europe, we're tracking very well on the PS2.

We feel pretty good about the relative health of the PS2 and our global position.

Going forward, we believe that that's a platform that still has a couple years left in it in terms of business.

And I would add overall in North America, our segment share year-over-year is up a couple of points;

Europe, it's roughly flat.

Okay, thank you.

Now we'll hear from Anthony Gikas of Piper Jaffrey.

Hi, good afternoon, guys.

Great quarter.

Thanks, Tony.

couple of questions, could you give us a quick update on R&D spending.

I'm sure you've seen a lot of the R&D estimates on the Street.

Do you think they're appropriate or have they been moving a little higher than you think they should?

Second question, do you know what the retail takeaway number was for the quarter?

Not only in the U.S., but on a worldwide basis and I have one follow-up.

Let me address the R&D number.

There's a short-term answer, and there's a long-term -- and a couple of things for the long-term, Tony.

In the short-term, we do expect R&D to increase in the back half of the year, looking at the year-over-year comps.

There are a couple things going on .

Obviously we're getting ready for our '08 launch lineup.

The second thing just to note generally because this will affect all of our expense line is we went into the third quarter of last year it became clear that we would not hit our operating plan and as a result we dramatically reduced or planned bonus accrual.

This year as we sit today we expect to meet our operating plan therefore we will have a full bonus accrual and that will increase the overall -- that will increase the expense comps, if you will, year-over-year.

Overall for R&D for the year, I would put it up in the 25 to 30% range given those two issues.

Tony, we aren't clear on your retail takeaway question.

What specifically are you asking for?

What were the -- at the retail level, what were the sales increases during the quarter on a worldwide basis?

We know what the NPD number was, but maybe a little bit more broadly speaking.

The feedback from Europe is that they've been tracking fairly close to the results we've had in North America in terms of current gen and in handhelds, they've had a very robust run on the handheld business.

The 360 business is a little bit stronger in North America than it is in Europe, but in general they're roughly similar.

Okay.

And maybe an update on download transactions through the Xbox 360 and how do you expect them to ramp on the PlayStation 3 over the course of the next year?

Thanks.

The Xbox live service is proving to be a great marketplace for content.

We have a solid position there in terms of what we've produced to date.

In fact, looking forward into Q4, we have a very robust set of pay downloadable content coming from games like Def Jam Icon and NBA Street IV.

I don't anticipate we'll have downloadable content, but going into Q4 is when we'll start making that available.

I would add one thing to Frank's comment.

A lot of this is scattered in various lines of our income statement or various platform categories.

In the quarter, if you look at total, what is called digital revenue, meaning in-game advertising, Pogo, microtransactions, all of that across the board, Xbox live, we had about $28.5 million of revenue and that's up about 40% year-over-year.

So we're on a very nice, healthy run rate in our digital business.

Thanks.

Moving on, we'll hear from John McPeak of Prudential.

Could you give us a sense as to what you're thinking about in terms of the potential of in-game advertising over the longer term?

What percentage of your revenues could that be in, let's say, '08, '09 time frame, fiscal '08, '09?

And what kind of margins do you think that carries?

We're very bullish on dynamic and in-game advertising.

As you know, we've got a couple of deals right now, that are just starting in operation.

We're literally just starting to get the data back on how they're flowing.

I would hesitate to forecast a percentage or talk about the business model too much at this point in time until we get a little bit more time under our belts with Massive and IGA.

Having said that, we're extremely bullish on this segment in our business going forward.

Okay.

Fair enough, thanks.

Now from Lazard Capital Markets, we'll hear from Colin Sebastian.

Thanks and congratulations on the quarter.

A couple of questions.

One, do you -- I know you're not providing guidance for fiscal '08, but how is the development plan shaping up for that year versus this year?

And then secondly, there have been some price reductions on a couple of sports titles.

We were hoping you could provide some background on the catalysts for those changes?

And related to that, how are you feeling more broadly about $59 pricing on the 360 and PS3.

We think we've got a great lineup of titles for fiscal '08.

And to give you a sense of what would be new next year that was not in our plan this year, Warren mentioned that we're moving ARMY OF TWO and Crisis from fiscal '07 to fiscal '08.

Everyone knows about SPORE, we're very excited about that.

We think that has tremendous potential.

There was a Sims title that was being specifically developed for the Wii platform.

There's Command and Conquer Tiberian.

There is a Harry Potter title in conjunction with the movie.

There's a new Road Rash game.

We think we'll be deploying Warhammer that is being developed by mythic.

We've got Simpsons, which is being released in conjunction with a movie.

There will be another Lord of the Rings game next year, there was not one of those in our SKU plan this year.

There's a new skate game to compete with Tony Hawk.

There's a new SimCity game in the pipeline and the next generation version of Black.

Those things alone are all new relative to fiscal '07.

With regards to the $59 price point, we're seeing that that's holding very nicely through this year.

We anticipate that will hold going forward.

When we look at individual pricing moves on a given franchise, that's really a case by case analysis done by the publishing teams to put us in maximum position for holiday.

We've been getting things in position for the November rush and the December finish.

Okay.

Just one last question.

What was the percent of sales from catalog in the quarter?

It was 24%.

Okay.

Thanks a lot, guys.

Evan Wilson with Pacific Crest has our next question.

Thanks for taking the question.

A couple.

First, does your forecast include any meaningful price reductions like the three for two deal you did on sports games last year for the December quarter?

That would be the first question.

The second would be, what are your expectations for an industry-wide on ratio for the PS3 launch?

And can you talk more about the gross margin and separate out that licensed piece, the gross margin was better than your guidance.

Just curious if the licensed portion of that was also better than your expectation?

Thanks.

I'll comment just generally on pricing to say that we compete in the marketplace and it's really the marketplace that will determine what the price is.

Whatever we need to do in that context, we will be competitive.

I don't believe there is a three for two promotion in the works.

In fact, for last year, it really had very minimal economic impact in fact from that promotion.

In terms of the tie rations, the tie ration on the Xbox 360 is a fantastic 5.2 at this point and we definitely see that there is going to be a higher tie ration probably on the PS3 going forward.

We have that as part of our modeling, but I think the 5.2 at this point in the 360's life is fairly impressive and pretty exciting to us.

Can I jump in there real quick, you think the PS3 tie ratio will be higher than the Xbox 360, is that what you mean?

No, I think it will be within range, maybe a little less, but certainly higher than prior cycles.

And to the last question on the license royalty rates, I think it was right in-line with our forecast.

So there was nothing that we really didn't expect in the quarter.

Great, thank you.

Moving on, from Merrill Lynch, we'll hear from Justin Post.

Yes.

As we look back to May, I'm just kind of wondering what has really changed here with your outlook and guidance.

You've been beating numbers for a quarter and it looks like your outlook is good given that you're pushing out a couple of titles.

And part B of that question, it looks sports are up nicely 10% units year-over-year, trending well.

What's really driving the growth for those franchises?

Justin, I would comment as to what changed is I think we have a little more time and certainty under our belt.

As we all know, we are in the midst of transition and things have to shake out.

The net of that is what we've seen is a very healthy marketplace.

Our titles have overall been performing very well.

PS2 sales remain strong and there's a great reception for next generation hardware.

So I think we've got a little more time under our belt, a little more certainty and we are seeing a healthy marketplace.

With regards to the EA SPORTS brand, what we have seen as key drivers to growth is better execution on the launches in terms of retail with the street dating.

That was something we had introduced prior year and it's been taking off with even more momentum.

We've seen product quality up in the EA SPORTS launches with NCAA and Madden year-over-year.

We've got a more robust 360 and PS2 market than anticipated so that's where we're seeing a lot of the growth.

Our relationship with ESPN is also helping us to market in new ways and to market to a broader market.

I think that's opening up new segments for us that traditionally we haven't reached.

And one follow-up.

On the gross margin for next quarter, can you give me some of the positive drivers and some of the negatives for gross margins on a year-over-year basis?

I would say on a year-over-year basis we're going to be roughly in the same sort of scenario as to where we were a year ago.

So kind of put it in a 60 to 62 sort of percent range.

There's always going to be ins and outs depending on the mix of our product.

But it's a fact overall that we have higher licensing costs, in particular on many of our sports products.

And the good news is we have things like Sims II Pets that will be in, which are owned IP.

There'll be a lot of ins and outs, probably some higher licensing costs, some lower product costs, too, given the health that's in the channel.

But overall we would expect to have it be somewhere in that 60 to 62% range.

Thank you.

Thank you.

Next up is Heath Terry with Credit Suisse.

Great, thank you.

I was wondering if you could talk to us about how your strategy in Asia is progressing, both from a ultimate revenue generating standpoint in that market, but also as you start to explore some of the cost saving opportunities and outsourcing in those markets?

I will -- Heath, I'll take a swing at that and then my partners here can jump in.

I think the most encouraging thing that we have seen this past year in Asia has been the success of FIFA Online so far.

To date, it's not making a huge revenue contribution, but the fact that it's one of the top five online midsession games in Asia is great.

The fact that we're over 700,000 microtransactions is great.

It's very positive learnings for us in how to do that in the market -- in the Asian marketplace.

The trick for us going forward is to take that success that we've had in Korea and replicate in Taiwan, replicate in China, and in other Asian countries in order to build a long-term more powerful revenue base.

The second key to building is to take other titles like NBA Street for example, and do the same thing in Korea times Taiwan times China and other marketplaces.

So over the course of the coming years, that is exactly what you're going to see us do.

That's step number one in terms of progress.

I think step number two is that we now have roughly 100 people or so on the ground in Shanghai doing game development.

And one of the things that I think we all feel will help us tremendously is having actual developers, EA developers on the ground in Asia where you really become part of the marketplace to build better and more applicable local content and to better understand the complexities of those marketplaces.

That's not a revenue-driving opportunity for us today, but it's something that we do believe will result in long-term revenues and hopefully long-term success in the overall marketplace.

With respect to the cost side, candidly our first priority is really all about local content development and about quality.

So our first effort is going to be to go develop content that we believe will be applicable in whatever the local markets might be, like China and/or Korea and Taiwan or India for that matter.

So our focus right now is not on the cost side.

We think development in those parts of the world over the long-term will be an advantage in the near term.

It's really all about building our capacity and also building local content.

Great, thank you.

Thank you, Heath.

Now we'll hear from Elizabeth Osur with Citigroup.

I had two questions.

One is a follow-up on Asia.

Can you talk about what kind of uh outsourcing you will be doing in lower cost countries and how long it will be before you think about using the Chinese studios to develop western games?

And sec question, I see you've now finished some of the upcoming PS3 games.

Can you give us an update on next gen development costs?

What you've learned now that you're further into the process.

And I may have missed this earlier, but can you reiterate what the R&D target might be next year as a percentage of sales?

Liz, I'll try to take at least a couple parts to the question.

First on the outsourcing side, I think you have to recognize that in our business across EA, outsourcing has always been a part of our business.

It's fundamentally nothing new.

We work with a lot of outside vendors in every area of the company.

The second thing that -- and coming back to Heath's question, the number one rule for us, it has to be about quality.

Because you can save $2 in development and if you blow $100 in revenue, it is just not worth it.

So for us, the entire -- our entire move has to be about product quality first and then slowly working your way into taking advantage of new, lower cost development options.

Where we are doing offshoring today is we are moving some of our transaction processing to India.

That's ongoing, as a matter of fact this quarter, that transition.

Secondly, our mobile business is very active in a very high quality -- with the high quality development organization in both Romania and in India and in fact we're significantly increasing the size of those two development organizations this year.

And we have a lot of content or art that is being done today in our core games business in a place in Korea, as an example.

So over time, we like the overall entertainment business and other software will become increasingly global in every respect.

Whether it's our top line and/or whether it's development.

But it has to be a process where the first focus is quality and you take your time to ensure that we're doing everything we can to make sure our products are the best and most locally relevant.

With regard to development costs on PS3 games, clearly these next generation titles both on Xbox 360 and Playstation 3 are going to cost more than the previous generation.

I think it's probably too early in the game to speak specifically about how much more.

As we get further into the development process, I think we'll become more knowledgeable about that and can share that information with you.

Regard to R&D, this year it's going to end up around 30% of revenue and our goal would be to bring that down over the next few fiscal years as we get further into the next generation cycle and we can start to leverage some of the investment we've done the last couple of years.

That's great.

Thanks, guys.

Thank you.

Now we'll hear from Arvind Bhatia with Sterne Agee.

Good afternoon, guys.

My question, first one is more long-term.

Wondering if you can comment on what do you think is a reasonable operating margin goal sort of towards the peak versus your 26.5% that you did in the last cycle.

Maybe just in general, what are the factors that would cause potential margins to be higher or lower than what you achieved in the past?

What are the new, different dynamics?

For example, the new revenue stream obviously has some impact.

That's the first long-term question.

And then if you can provide some color on your best guess in terms of the launch quantities or maybe the launch quantities are different than what you expect, a little bit lower, how should we think in terms of the delta and the impact to your bottom line?

I'll take a swing at the launch quantity question.

I suspect you're asking about Playstation III and Nintendo Wii.

We're thinking that on the Playstation 3 in North America, the range is probably 500,000 to 800,000.

And if you take the middle of that range, that's approximately what Microsoft sold last year on the Xbox 360.

So I think from a consumer standpoint, it's probably going to be as challenging to find a Playstation 3 this year as it was to get an Xbox 360 last year.

On the Nintendo Wii, we're ranging from 900,000 to 1.4 million units in North America, and in Europe, we've got a pretty broad range there on the Nintendo Wii from anywhere from 200,000 to 900,000.

Somewhere probably in the middle of that range.

And on the margin question, the factors are going to be the likely list of suspects.

First is going to be how much larger is the next cycle than the current one?

Secondly is, how will price hold?

Third, our success in building new and more wholly owned intellectual properties.

Next will be our success in building larger, high-margin revenue streams from things like online, mobile, Asia, microtransactions, in-game advertising, digital distribution, and the like.

And then on the cost side, it's really a matter of keeping fixed costs fixed and what we can do to leverage our fixed infrastructure in order to scale our overall operating expense base on all the lines, not just R&D.

So once you put all of this together, is it fair to say that you could still do the peak operating margins in the next cycle as you did in the last one?

We're going to leave it just the way I left it.

Okay.

Just a clarification.

The launch quantity that you mentioned, those are I presume for the end of the year, not at launch?

Those are through the end of the calendar year, yes.

Okay, great.

Thanks, guys.

Thank you.

Moving on, we'll now hear from Mike Hickey of Janco Partners.

Just a follow-up to Tony's question on the R&D year-over-year, you said 25 to 30%.

Is that with option expense or without?

That is non-GAAP.

So without.

Okay.

So we're looking at a number that all-in could be over $1 billion for the fiscal year?

Again, you can do the math, but it could be with option expense, yes.

Okay.

And, we haven't talked about Ubisoft for a while.

Can you remind us why you initially took your investment into Ubisoft, and update us about took your investment into Ubisoft, and update us about how you feel about that investment to date.

And perhaps characterize your conversations with management today versus what they were like a year ago.

I would say we feel great about our investment and are very happy to be long-term shareholders.

We own roughly 20% of the company, we think the world of the management team, we think they've just done a great job in building some excellent titles and have strong position in next gen and on the handhelds and we're prepared to be great long-term shareholders.

And I would characterize our conversations with management as cor gal and professional.

And SPORE.

How is that progressing?

And can you confirm or deny whether you have a Sims 3 in development at this time?

The development on SPORE is doing great.

It's an extremely ambitious and innovative game.

Will and the team in Emeryville are making strong progress, and we're excited about that, shipping in the next fiscal year.

Yes, there's a Sims 3 in development and it's likely to be a fiscal '09 title.

Thanks, guys.

Thank you.

Next up is Edward Williams with BMO Capital Markets.

Good afternoon.

Just a quick question for you.

Taking a look at your digital revenue streams you were alluded to, Warren, how should we look at that $28.5 million.

How does it break down between the in-game ads or some of the digital download content, microtransactions?

Secondly, what are the margins like there relative to the traditional business?

And what are the principal near-term drivers we should see in that, that could affect that 40% growth rate that we saw in that this past quarter?

Just let me try to give you a general breakdown.

Right now -- and also you have to think about what will happen with some of the products like Warhammer that we have in development.

I would put today over half of the revenue associated with subscription, and that's coming principally from Club Pogo and then also our various online products that we have both through Ultima Online and also through Dark H at Mythic.

And obviously we have so far great about what's going on with the development of warhammer as well.

The advertising pieces and microtransactions -- advertising would be the next largest followed by microtransactions.

And our objectives on each of those fronts is continue to build them and make them larger as we go forward.

Just to build on that, with regards to advertising as we expand the list of titles that are supporting dynamic in-game advertising, that number is going to lift dramatically as well as looking at the amount of content that we start to provide through our system, like episodic content, downloadable levels and maps.

Not only on the Xbox live, but also on the PC, PS3, and a lot of the other connected systems.

And just to be clear, the IGA relationship and the Massive relationship, do those contribute much in the quarter, or is that something that should be incremental going forward?

That will be going forward.

Okay. and if you could touch upon the margin -- the approximate margin contribution of these revenues, just collectively relative to the traditional shrink wrap business?

It's going to vary.

And you also have to get into different royalty rates you might have with the platform guys, but you can basically figure our overall margins after development are going to be in the 70% range.

Okay.

And just a quick question, more housekeeping.

Can you give us an idea, Warren, I know this is a challenging question.

But the tax rate for the December quarter, how that should shake out relative to the --

I would put the GAAP rate again at around 40%.

And on the non-GAAP, I'd stay right around the 30% range.

Okay.

And same thing for the March quarter?

March quarter, given the guidance, could be one of those weird quarters, just given where breakeven may be on a GAAP basis.

Which as you know it can do some crazy things with the tax rate.

So in that rate, I may assume a GAAP rate that's sort of mid-20s and a non-GAAP rate that can even be down like we had in Q1 in the teens.

Now that's -- we'll update you on that rate as we move into Q4, because there are a lot of -- there's a lot of volatility potentially -- or there is volatility in the tax rate this year.

Okay.

We'll take one more question.

Thank you.

Our last question will come from John Taylor of Arcadia Investment.

Hi.

I've got a couple of questions.

On the -- I wonder if you could talk a little bit about revenue per unit applications now that the direct digital download, the microtransaction, the advertising components are starting to kick in.

Can you give us any sense of how you think that's going to ramp in a year, two years, three years down the road?

That's the first question.

The second question is with platform dynamics, I noticed on your sell-through numbers, there's some numbers up and some numbers down and stuff.

Could you talk a little bit about the SKU implications that you're planning for '08.

What platforms are going up and down, magnitude wise?

And the third thing was, as you book the advertising stuff or some of these -- the nonpublishing revenues, I wonder how you're thinking about percentage breakdown between maybe what gets deferred, goes on the balance sheet, what actually runs through, kind of give us a sense of the mix of timing of when those things are going to hit the P&L as they get announced down the road, just to get us thinking about that.

Thanks.

I'll take the question on our SKU plan for fiscal '08.

It's premature to give you specific numbers, but what I would say that you can expect a similar number of titles on the Playstation 3 and Xbox 360.

We're working very hard to increase the number of SKUs that we will publish next year on the Nintendo Wii and NDS, and the number on the PC will be similar to what we have done in the past.

In terms of looking at the average revenue per user goals, it's clearly a goal inside our management team to grow that number, what we've seen in our Battlefield and Sims business has led us to believe we can do that over the next cycles fairly comfortably.

I don't have hard numbers can I give you at this point in time in terms of what we're shooting for, but it's a management goal.

Before you go in, can I follow-up on that.

So when Massive was doing their PR outreach, they used to talk in term of a $1, $2 per unit type of thing.

It seems like those numbers ought to be relatively easy to achieve given the concentrated nature of the audience and that sort of thing.

Would you agree or disagree with that comment?

I believe that we will be able to raise average revenue per user.

One component will be dynamic ingame advertising.

The rates you call out aren't necessarily outside the realm of possibility.

You have to look at other things, which include paid downloadable content and other sources.

Okay.

J.T., I'll take the last question, which the answer is going to be -- it depends upon the content.

And to try to someplace -- it depends upon the content in the product.

So, for example, there are two things that will determine over the period, over the period which revenue is recognized.

The first thing is whether you can have -- whether you can determine specific evidence of value of the online service, or called software rev rec.

The second thing is to determine really the estimated life of that service you're going to provide.

So what can revenue deferrals be?

Revenue deferrals could be if there's three-month usage, it could be three months.

If it's six months usage, it could be up to six months.

If there's specific evidence of value, that would be the dollar value of deferral.

On microtransactions, as an example on Club Pogo, we have transactions today that are being deferred over three months over three -- over a year.

And the reason for that is that transaction lives on for the estimated life of the customer.

In fact, we have a couple of pieces of revenue in Pogo that are being deferred by as much as three years -- or amortized over a three-year period.

The good news is is that builds is the cash comes in, it doesn't affect cash flows.

The second good piece of news is once you get through the transitionary period, things start to equal out as you build revenue and get good year-over-year comps.

So this is a matter of just understanding that which is coming in, the cash is cash, some will go on the balance sheet, but as we work our way through whatever sort of transitionary period may occur, all things in the long-term will equal out.

So there's no kind of back of the envelope one-third, two-thirds, any wild guess in terms of what that mix might look like over a 12-month period two or three years down the road?

I'm not in a position that I can really estimate that today.

There's still a lot of defining that has to do relative to the service we will provide and the determination as to what, again, what vendor-specific evidence of value truly is.

Great.

Let me follow-up on one thing, if I could.

The $28 million in direct digital kind of stuff.

I think you gave us a $4 million number in that June quarter, which probably did not include subscription.

So I wonder if you take the basket that you gave us today, and what was the June equivalent of that?

The June equivalent would have been roughly $28 million.

So sequentially, relatively flat, but up in both quarters year-over-year about 40%.

Okay, great.

Thank you very much.

Great.

Thank you.

And gentleman, do you have any further comments?

No.

Just, thanks, everyone, for joining us.

Thank you, that does conclude today's conference and we do thank you for your participation.