美商藝電 (EA) 2009 Q2 法說會逐字稿

Good day, everyone, and welcome to the Electronic Arts second quarter fiscal year 2009 earnings conference call.

Today's conference is being recorded.

Now for opening remarks and introductions I would like to turn the call over to your host, Ms.

Tricia Gugler, Senior Director of Investor Relations.

Please go ahead.

Great.

Thank you.

Welcome to our second quarter fiscal 2009 earnings call.

Today on the call we have John Riccitello, our Chief Executive Officer; Eric Brown, our Chief Financial Officer; and John Pleasants, our Chief Operating Officer.

Before we begin, I'd like to remind that you may finds copies of our SEC filings, our earnings release and a replay of this webcast on our website at Investor.EA.com.

Shortly after the call we will post a copy of our prepared remarks on our website .

Throughout this call we will present both GAAP and non-GAAP financial measures.

Non-GAAP measures exclude the following items: amortization of intangibles, stock-based compensation, acquired in-process technology, restructuring charges, losses on strategic investments, certain abandoned acquisition-related cost and the impact of the change in deferred net revenue related to certain package and digital content.

In addition starting with its fiscal 2009 results, the Company began to apply a fixed long-term projected rate of 28% to determine its non-GAAP results.

Prior to fiscal 2009, the Company's non-GAAP financial results were determined by excluding the specific income tax effects associated with the non-GAAP items, and the impact of certain one time income tax adjustments.

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

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 period for the prior year unless otherwise stated.

Please see our earnings release and the supplemental information on our website for a detailed GAAP to non-GAAP reconciliation and our trailing 12 month segment shares, and a summary of our financial guidance.

During the course of this call, we may make forward-looking statements regarding future events and the future financial performance of the Company.

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

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

We make these statements as of October 30, 2008, and disclaim any duty to update them.

Now I would like to turn the call over

Thanks, Tricia.

Let me update briefly on a few items on our agenda today.

I'm going to start with the review of Q2, talk about our back half of the year, the economy and update on how things are working at EA.

Eric will review our Q2 results in detail, provide our specific guidance for FY '09, he will also discuss our cost reduction initiatives.

John Pleasants will discuss key learnings from Q2, the current retail environment, our holiday slight and our progress in our digital direct to consumer businesses.

Then I'll wrap up with a few closing thoughts and after that Eric, John and I will be happy to take your questions.

Q2 results.

We came in at expected in the top and bottom line.

Our sports franchises especially Madden performed well.

SPORE and Warhammer online met our high expectations, and I want to call out the teams between Madden, Tiger, NHL, FIFA, SPORE, Dead Space, and Warhammer for creating some incredibly innovative high quality titles.

Looking forward, we have an outstanding slate of great titles for the second half of our fiscal year and especially for the crucial holiday quarter.

Despite this strength, we believe it is now prudent to lower our guidance for the balance of the fiscal year.

As you know, we have moved Harry Potter to fiscal '10 with the slip of the movie, which is particularly hard, costing us $0.13 EPS as we have completed an expense of solid game, but won't see revenues until next year.

And in recent weeks we have experienced sharply adverse foreign exchange.

The recent spike up in the dollar compared to where it was when we provided guidance in May and July, if it holds will reduce our earnings per share by approximately $0.12.

Third, we are seeing continued weakness with catalog sales and are starting to see weakness in retail in October.

These factors, balanced against our total set of puts and takes, has us reducing our range by $0.30 EPS both the top and the bottom end.

There are four areas I'd like to address before turning the microphone over to Eric.

First, the broad economic environment.

Second, EA's recent operational performance.

Third, the flow through of topline revenue at EA to bottom line EPS.

And fourth, the reduction in force we announced earlier today and other planned future cost reductions.

In addressing the economic environment, I'll start by telling you what I believe most of you know.

The game industry has been very resilient in past recessions.

History shows us that the technology driver of new consoles has outweighed the negative of a recession.

And this time, we have three strong and well differentiated consoles, each in growth mode.

Having three strong players at one time is unprecedented, and I'm sure you know just how good a value games are to the consumer.

A single $60 game can deliver 50 to 100 hours of play, a far better consumer value than a trip to the movies or a live music or sports event.

We also know just how strong game sales have been thus far this year.

Up 30% in North America and we estimate 22% in Europe.

Retailers, both in North America and Europe, have added space for the game industry.

Still we recognize these times are unprecedented, and so far in October there are indicators that consumers and retailers are being more cautious.

We remain optimistic for our sector longer term, but cautious in the short term.

Turning to EA's operational performance, let me start with some of the negatives.

We experienced a few slips and kills.

Recently we killed Tiberium, a move we made for quality reasons; and Saboteur is moving to FY '10.

And as I mentioned, we are also seeing continued weakness in our catalog sales.

On the positive side, we are seeing across the board improvements in innovation and quality of our games whether on PC, console, mobile phone phones, or in sports we're with a new [ipore] with our IPs.

Overall, our Metacritic scores are up.

This is translated into solid frontline sales for both our sequel titles and new intellectual properties.

On time delivery of games is up in all four of our labels.

And EA Partners continues to perform well in sales and in signing profitable deals.

Now on to the question of how revenue flows through to our margins.

If you look at our growth year-over-year, you will expect--we expect to add over $1 billion in revenue this year with overall operating margins increasing up to 300 basis points.

There are three aspects of this performance that I would like to peal apart for you: our core business, our EAP business, and our investments in digital direct initiatives.

EA's business, excluding co-publishing and distribution, is expected to grow from $3.3 billion in fiscal year '08 to over $4 billion in fiscal year '09.

We're expecting at least 500 basis points of operating leverage year-over-year.

We are not yet where we want to be, but we are expecting--but we expect a doubling in operating margin year-over-year.

We expect to deliver this performance even while making significant upfront online investments.

These investments include our spending in Star Wars: The Old Republic MMO; developing seven of our franchise in a mid-session games; the infrastructure to self-published microtransaction games in Asia; our nucleus online registration and billing system, and other platform technologies to build direct to consumer business models for our core package goods games.

We think these investments are crucial to EA's long-term success because in the future we see slower growth in the basic package goods business and higher margins, greater growth, and reduced cyclicality with these new direct to consumer businesses.

We are investing approximately $150 million in these activities.

We believe this investment, while compressing near term results, sets us up for success longer term.

Our EAP business is growing very rapidly increasing our co-pub and distribution revenue from approximately $700 million in fiscal year '08 to over $1 billion in fiscal year '09.

Operating margins in this business, while solid, are less than our own business and this year are expected to be single-digit.

The FY '09 negative for the P&L is a result of the recent success we've had in signing new properties from some of the best developers in the world.

Each of these new co-development deals involve some upfront investment and in fiscal year '09 is running about $35 million ahead of fiscal '08 on these investments with no associated revenue.

This development is expensive now with significant returns expected in the future.

If we were to cut short our investments in EAP and digital direct, our operating profit would look much better today with approximately 350 points of more operating margin.

Although this would help in the short term, cutting these investments is not the right answer for the long-term.

Now I'd like to turn to the cost actions we announced today.

Given the uncertain economic environment and the ever present need to drive greater efficiency, earlier today we announced we are reducing headcount.

We are taking cost out both now and as we progress through our fiscal year '10 planning.

We've made the decision to eliminate positions totally approximately 6% of our current workforce and will manage headcount decisions aggressively going forward.

And as we go through our FY '10 planning process, we will continue to focus on cost and efficiencies and eliminate marginal SKUs.

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

Thank you, John, and good afternoon, everyone.

For Q2 we delivered record non-GAAP revenue for the second quarter of $1.125 billion.

Our top and bottom line came in as expected, overall a solid quarter.

A few highlights.

As usual Q2 was a big sports quarter.

Madden NFL '09 was our best selling title in the quarter selling 4.5 million copies.

While units were flat to last year we did this on two fewer platforms.

NCAA Football '09 sold 1.8 million copies, up 5% year-over-year.

Tiger Woods PGA Tour '09 sold 1.5 million copies, and the Wii title is one of the highest rated recently released games.

NHL '09 is our highest rated sports title so far this cycle, with a Metacritic rating of 89 on the XBOX 360 and PS3.

Sell through has been up over 85% year-over-year on these platforms.

Overall our core sports titles delivered as expected in the quarter.

Before leaving sports, I would also like to mention FIFA '09 which is a Q3 title.

It is off to its strongest start in history, with the first three weeks of sell through up an estimated 30% year-over-year.

Q2 was also about new IP.

During the quarter we launched three new games.

SPORE is off to a great start, selling nearly 2 million copies and is number one PC title in North America and is number three in Europe year to date.

Mercenaries 2 sold 1.9 million copies.

And Warhammer Online: Age of Reckoning had a strong debut selling 1.2 million copies.

In addition, for our EA Partners business we shipped Rock Band 2 software exclusively for the XBOX 360.

Combined with original Rock Band, the franchise sold over 1.5 million copies in the quarter.

Calendar year to date, Rock Band is the number one title across all platforms in North America.

And finally during the quarter, we recognized $110 million in digital direct to consumer revenue, up $27 million or 33% year-over-year, and 22% sequentially.

This is the first time this revenue stream has hit the $100 million mark in a quarter.

This growth was fueled by digital downloads, wireless, advertising and POGO subscriptions.

In the quarter, we had $16 million of sales through our EA store, and other third party sites up $12 million from last year.

SPORE alone generated $5 million.

Since the launch of our new EA store last September we've had over 1 million downloads.

We have now up and running in 31 countries.

Our wireless business also experienced strong growth, up $8 million year-over-year, or 21%.

I would now like to spend sometime discussing Q2 in more detail.

Please note that all the following references to second quarter results are non-GAAP unless otherwise stated.

Q2 non-GAAP revenue is $1.126 billion, up 20% year-over-year.

.

Foreign exchange positively impacted the top line by 2%.

As expected, our Q2 revenue was primarily driven by the launches of NFL '09, Madden NFL '09, SPORE, Mercenaries 2, NCAA Football '09, Tiger Woods PGA Tour '09, Warhammer Online and the continued sales of MTV games and Harmonix Rock Band.

By geography, North American non-GAAP revenue was $746 million, up $221 million or 42%, primarily due to the growth in distribution in PC revenue.

International non-GAAP revenue was $380 million, down $31 million or 8%, and down 12% at constant currency rates.

The year-over-year decline traces to a comparison to Q2 fiscal '08, which included approximately $120 million of FIFA.

This year FIFA launched in Q3 '09.

Revenue in the quarter was driven by Rock Band, SPORE, Mercenaries 2 and Warhammer.

Moving to the rest of the income statement, non-GAAP gross profit was $573 million, up 4% year-over-year.

Non-GAAP gross profit margin was 50.9% versus 58.7%, down 7.8 percentage points due to a higher mix of co-publishing and distribution revenue.

Operating expenses--before getting into the details, let me remind you that this year we are recording our bonus expense in a straight line fashion instead of recognizing the expense in proportion to quarterly profitability as we have in the past.

This impacts the quarterly phasing of our bonus expense.

As we said on our last call, this change will negatively impact Q1, Q2, and Q4 '09 and have a corresponding favorable impact on expenses in Q3.

During the quarter, this resulted in an approximate $29 million overall increase to operating expenses year-over-year.

Marketing and sales.

Marketing and sales expense, excluding stock-based compensation, was $192 million, up $33 million primarily due to increased advertising to support our Q2 releases and higher personnel related costs including the bonus phasing.

As a percentage of revenue, marketing sales was 17% of non-GAAP revenue consistent with last year.

General and administrative.

G&A expense, excluding stock-based compensation, was $79 million, up $5 million.

The increase was driven primarily by the bonus phasing.

Research and development.

R&D, excluding stock-based compensation, was $337 million, up $100 million.

Of the $100 million, $29 million is related to the acquisition of VGH, $32 million in contracted services due to a greater number of projects under development and EAP advances, and $20 million related to bonus phasing.

R&D headcount ended the quarter at roughly 7,400, up 7% year-over-year adjusted for M&A.

Below the operating income line, other income and expense was $7 million, down $25 million from a year ago due to decline in interest income and foreign exchange losses.

Income taxes.

On a GAAP basis we recorded $81 million of tax benefit.

On a non-GAAP basis we recorded taxes at 28%.

GAAP diluted loss per share was $0.97 versus diluted loss per share of $0.62 a year ago.

This quarter, our GAAP loss included $21 million of pre-tax acquisition related charges associated with the abandonment of the Take Two transaction.

Non-GAAP diluted loss per share was $0.06 versus diluted earnings per share of $0.27 a year ago.

Our trailing twelve-month operating cash flow was $219 million, versus $145 million for the prior period.

We are expecting to generate significant positive cash flows for the remainder of the year.

Turning to the balance sheet.

Cash and short term investments were $1.825 billion at quarter end, down $122 million from last quarter due to cash used in operations.

With respect to our cash and our short term investment portfolio, we managed to navigate the downturn in the capital markets relatively well; and for the quarter, we realized only a small net gain and incurred no impairment charges on the portfolio.

Marketable equity securities and other investments were $648 million, down $104 million from last quarter due to declines in the market value of our strategic investments.

During the quarter we recognized a pre-tax loss of $34 million in the P&L related to our investment in Neowiz .

At quarter end, after the write down, we had a net unrealized gain of $438 million comprised of a $441 million unrealized gain on UB Soft, and a $3 million unrealized loss on the nine.

Gross accounts receivable were $715 million versus $609 million a year ago, an increase of 17% primarily due to the growth in non-GAAP revenue.

Reserves against outstanding receivables totaled $168 million, down $17 million from a year ago.

Reserve levels were 10% of trailing six month non-GAAP revenue, down four points.

As a percentage of trailing nine-month non-GAAP revenue, reserves were 6%, down three points.

The decrease year-over-year is related to A., a higher mix of our revenue coming from our distribution business for which we have less return risk, and lower channel exposure in Europe.

Inventory was $328 million, up $105 million sequentially.

Only a small portion of this increase is for our own titles where we carry full inventory risk.

Any deferred net revenues from package goods and digital content was $424 million, up $232 million sequentially primarily due to a build of deferred net revenue related to our Q2 releases.

Now to our outlook.

Let's start with the industry.

We continue to expect software sales to grow 20% or more this year combined from North America and Europe.

Keep in mind that year-over-year comparables will get more difficult in the holiday quarter given the robust growth experienced year ago.

Now to our guidance.

Before I get into the numbers, I would like to provide some detail on our recently announced cost reduction plan.

Beginning in our third fiscal quarter, we expect to reduce our worldwide staff by approximately 6% across the labels, publishing, and corporate divisions.

We expect to incur cash charges of approximately $10 million, the majority of which will be incurred in our fiscal third quarter.

We expect this action to result in annual operating cost savings of approximately $50 million.

As part of this cost reduction initiative, we expect to reduce hiring and continue to expand in lower cost location.

At the end of FY '09, we expect to have fewer employees in high cost locations versus the end of last year.

Also, as we enter our planning process for fiscal '10, we expect to carefully scrutinize all operating expense budgets and optimize the Company's SKU plan.

Now for the GAAP guidance.

For the full year, we expect GAAP revenue to be between 4.9 and $5.15 billion.

GAAP EPS to be between a diluted loss per share of $0.21 to a diluted earnings per share of $0.07.

GAAP gross margin to be between 54% and 55%.

Diluted share count to be approximately 325 million shares.

We expect to end the year with roughly $500 million in deferred net revenue related to online enabled packaged goods.

Now our non-GAAP guidance.

As John indicated, we are lowering our full year EPS guidance by about $0.30 on both the top and bottom end of the range for various items including the shift of Harry Potter which is $0.13 of EPS; foreign exchange impact, which is $0.12 of EPS; catalog weakness, and other factors including the slipped Saboteur.

For the full year we now expect non-GAAP revenue to be between 5 and $5.3 billion, non-GAAP EPS to be between $1.00 and $1.40 per share, non-GAAP gross margin to be between 55.5% and 56.5%, diluted share count to be approximately 325 million shares.

Please see our press release for the difference between our expected GAAP and non-GAAP guidance.

Let me provide some additional details.

FX assumptions.

Foreign exchange rates have been volatile in the last few weeks and for purposes of guidance, we are taking into account current spot rates.

To the extent the U.S.

dollar continues to strengthen against the euro and the British pound, we may have downside EPS exposure.

On non-GAAP expenses, R&D.

Given our headcount reduction, more focus on head count additions through the back half of the year and the weaker Canadian dollar, we now expect non-GAAP R&D will increase roughly 25% to 27% year-over-year.

Core R&D expenses are expected to grow at a high single-digit percentage year-over-year.

We expect sales and marketing to be flat as a percentage of revenue versus last year, and we expect G&A to be down 1 to 1.5 points as a percentage of revenue versus last year.

On non-GAAP operating margins, we expect a non-GAAP operating margin of 8.5% to 11.25% for FY '09, or an increase of 50 to 325 basis points from fiscal '08.

Below the operating income line, we expect that non-GAAP other income and expense will be roughly $35 million this year; down from our last estimate, and down significantly from last year as a result of steep declines in interest rates and foreign exchange losses.

Income taxes.

We expect our non-GAAP tax rate for FY '09 to be 28%.

You can also use this 28% rate to model the quarters.

On a GAAP basis, we expect 35 to $70 million of tax expense.

Please note that our GAAP tax rate can be particularly volatile at lower levels of pre-tax income as a relatively small change can produce a big swing in our annual effective tax rate.

A few things you need to keep in mind for the quarters.

Given the change in mix of our revenue, we expect our non-GAAP gross profit margin to be in the mid 50s for Q3 and low 60s for Q4.

On bonus phasing, we expect to incur 35 to $40 million in bonus expense in each quarter given the straight line accounting.

Relative to last year, this will result in less bonus expense in Q3 '09 versus Q3 '08.

Last year the bulk of the full year bonus expense was booked in Q3 '08.

Now our Q3 title slate.

We have 21 titles and 56 SKUs slated for Q3 versus 10 titles and 38 SKUs a year ago.

Please see the supplemental deck on our website for the complete listing.

We made the decision to launch Lord of the Rings: Conquest in a better ship window, Jan '09.

From EA Partners we expect to ship 13 SKUs including Left for Dead and Rock Band: Track Packs.

From EA Mobile we plan to release 12 games including Need for Speed, FIFA and Trivial Pursuit.

That concludes our guidance and outlook commentary.

I would now like to turn the call over to John Pleasants

Thank you, Eric, and good afternoon, everybody.

I would like to cover a few topics.

First, go a bit deeper on Q2 and discuss some of our learnings and observations.

Second, discuss what we are seeing at retail and key titles that we have for the upcoming holiday quarter.

And third, wrap up with what we are doing in our digital direct to consumer businesses.

As John and Eric indicated, Q2 came in as expected but we wanted to share a few observations.

First in sports, we raised the question on the July earnings call as to whether quality and innovation would trump soft pre-orders.

We now have the answer: it does.

Every one of our sports simulation titles was up in quality this year; and our sales trend has turned positive.

Second.

SPORE met our initial expectations as a packaged goods PC product and we are pleased to report it's the most successful North American new IP launch on PC; beating both The SIMS and World of Warcraft.

So we are off to a great start.

What is also interesting is the strong user engagement we are seeing.

Over 40 million creations have been shared online; and on YouTube, 150,000 videos have been uploaded and viewed over 30 million times.

That makes us very confident that we can build SPORE into a platform for years to come.

We have two expansion packs coming over the next six months with much more on the way.

Third, we are also making great progress with non-traditional forms of marketing.

This is an important initiative for us as we look to drive efficiencies in our cost of customer acquisition.

We continue to experiment with viral and online marketing and are thrilled with the response from our Tiger Woods and Mercenaries campaigns in particular.

If you haven't already done so you should check out the Tiger Woods Walk On Water YouTube video, which has received over 2.3 million viewings so far.

Now let me shift to the retail environment and our holiday slate.

As you know well, the overall retail environment is tough.

Foot traffic is soft, consumer spend is down, and total retail forecast for the holidays are down.

However, in our category, retailers are betting on the video game sector this holiday.

Major retailers are continuing to add space to the sector particularly Wal-Mart and Best Buy in North America, and Asda and Tesco in Europe.

Specialty retailers continue to add hundreds of stores.

Although these are positive indicators, the overall economic environment is leading retailers to be more conservative with their open to buys and general inventory management.

Based on what we have seen in October, retailers are being cautious, particularly in North America.

In addition, we are seeing weakness in catalog, particularly in games with limited online connectivity.

This is something we are addressing directly with post-launch content such as on NBA Live where the game is refreshed daily.

You will see more of this in our upcoming launches.

For EA, we've got an incredibly strong slate of titles that we believe positions us well this holiday.

We've got tent pull games: Need For Speed Undercover, FIFA, NBA Live and My Sims.

We have got new innovative IP including the critically acclaimed, Mirrors Edge and Dead Space.

We've got our casual lineup including Littlest Pet Shop, Nerf N Strike from Hasbro.

We are thrilled to be expanding into this important genre.

And finally we've got a broad slate of Nintendo games.

We've released 10 SKUs, and have 30 coming including Nerf N Strike, Skate It and My Sims Kingdom.

Now let me switch gears and talk about a key long-term strategic initiative for EA, our digital direct to consumer businesses.

We are back in the MMO business with the launch of Warhammer Online.

Currently 800,000 people are playing online worldwide.

In North America, we have 250,000 subscribers in less than two weeks, and are seeing conversions of over 70%.

Although it is still early days, we like what we are seeing.

In addition, we announced we have Star Wars: The Old Republic MMO underdevelopment in EA's bioware studio in partnership with Lucas Arts.

We are making good progress in Asia with our midsession games.

Today we have nine instances of our FIFA and NBA Street franchises in closed beta in various countries cross Asia; and we expect to be generating revenue on all of them by year end.

That compares to just one game last year.

We are starting to make progress on premium downloadable content.

Burn Out Paradise was our first full download game on the PlayStation network with over 20,000 downloads in a three week period.

In Tiger Woods PGA Tour '09, consumers have purchased 90,000 pieces of content in over--in just over five weeks, driving microtransaction revenue up 5X that of last year.

On the PC side, we just launched The Sims 2 store, and so far we have regenerating $14.50 per paying user in microtransactions.

Although the dollars are all relatively small, the growth is significant.

Our wireless business is also delivering, with revenue up 25% for the first six months.

This business is on track to generate over $185 million in revenue this year, consistent with our previous guidance.

With that, I'll turn it back to John.

Thanks, John.

Before we take your questions, I want to emphasize a few thoughts.

First, reducing our guidance is a big deal and we take it seriously.

We're proactively making cost adjustments now and will continues to do so as we plan the next fiscal year.

Second, we are in a fast growing industry driven by innovation and technology.

Third, we are making significant progress in the business and have the right long term strategy and are driving towards our F '11 targets.

In summary, while we are very bullish long-term we are more cautious in the short term.

With that we would be happy to take your questions.

Thank you.

(OPERATOR INSTRUCTIONS)

We'll take our first question from Doug Creutz with Cowen & Company.

Thanks.

If I could drill down on the guidance a little bit, you mentioned currency issue, presumably depressed revenue, you've got some title push backs, which depressed revenue but you are leaving your non-GAAP revenue guidance, I believe, unchanged for the year.

So presumably there's something offsetting that which is doing better than you expected; and I guess could you just explain how that all fits together?

Thanks.

Thanks for the question.

This is Eric.

We are leaving the top end of the range unchanged at 5.0 to $5.3 billion and what we have is a mix change we are doing better than we expected last quarter in terms of our distribution business.

The discrete previously announced title slip of Harry Potter is a high margin title, that is pushed out into fiscal '10.

So all in, there are puts and takes on the revenue line.

Specifically in regards to the change in the EPS, we called out Harry Potter as previously announced, that's $0.13.

Foreign exchange is $0.12 with all of our profitability ahead of us in the back half of the fiscal year; and so those would be the primary drivers on the reduction of the guidance for EPS.

This is John, a little color on the top line is Rock Band, in particular, is doing better.

FIFA looks like it's doing better, Dead Space has got off to a good start and Sports is performing well.

On the offset you've got catalog Saboteur and a few other items, so hence the lack of change in the top line guidance.

And we'll move next to Leo Choi with Pacific Growth Equities.

Hi, thanks for taking my question.

Got a question in Sports, since last year you guys mentioned a slower start for the Sports label and with some of the numbers coming out for Madden, etc., I was wondering if that puts you back on track in terms of your target.

This is John.

I believe you are referring to last year or last call, actually, where we had suggested that we had very weak preorders on our key titles.

And as John Pleasants had mentioned during his commentary, the question that we had raised, or Peter Moore had raised during the last call, was something we were very concerned about at the time which is we had low preorders, we had the expectation for higher quality and innovation, and we were unsure which was going to be the more important factor in determining how many units we would sell or how many dollar revenue we would generate.

And as we mentioned, the revenues have come in as expected with each of our titles collectively adding up to year-over-year growth in line with our expectations.

So by and by I think we learned that quality wins.

(OPERATOR INSTRUCTIONS)

We'll move next to John Taylor with Arcadia Investments.

Hi.

You've got a pretty big range in terms of the operating margin for the year, and I wonder other than revenue operating leverage, I wonder what factors you might call out in terms of operating cost lines or specific products that might account for that variability.

And I'm going to sneak in a second one if you can, could you give us an update on the high/low percentages, high/low cost locations?

Thanks.

Okay, so one of the factors we considered in setting the guidance range, the top and the bottom end is, of course, product mix.

We've talked about it before.

We are heading into peak season.

We still have the bulk of revenue and more than 100% of our EPS in front of us.

And so that in and of itself can be--will be the most important swing factor in terms of how our bottom line plays out.

We are bringing in the cost line items and OpEx either fairly consistent with what we discussed last time, G&A is the same, marketing and sales up a point and expectations for R&D actually down a little bit.

So we feel we have a pretty good handle on OpEx so this boils down to product mix.

I think, J.T., contributing to the widespread really is early reports in North America suggesting retail is quite slow, a little better in Europe.

But it makes it a little hard to see through, so keeping the range wide is frankly a better judgment at this point given lack of visibility of how the consumer is going to react between now and the holidays.

Your headcount question, we are expecting to finish the year with approximately 19% of our headcount in low cost locations versus 13% at the beginning of the year.

And one other point that I would identify here is we expect year-over-year to finish this fiscal year with fewer actual heads in high cost locations than we started the year.

Something that leads us as far back as my memory goes, which is mid-90s, that's not happened.

So it's a strong ship, a consequence of our moves into low cost locations and it's happening in a year when we are generating more than $1 billion in top line growth.

So it's the right thing to be doing for our business.

We'll move next to Brent Thill with Citi.

Thanks, and John, just on operating margins, your goal for fiscal '11 is to get to 25%.

Should we now assume that's going to be way more backend loaded based on the actions that you are taking today?

And I guess just as a follow-up on the margins, is there anything near term you can really turn to really amp the margins up here?

Well, I'm going to start by telling you we are not giving updated guidance for FY '11, that our focus at the present time is on the balance of FY '09 executing well through a significant cost reduction, making sure that we set up F '10 by being tougher on heads and projects and SKUs so that we can get our operating margins where we want them to be.

In terms of understanding the complexion of F'11, I would point you back to a few of the comments that I've made.

This year we are carrying $150 million net investment in online and then incremental to just even last year, $35 million in EAP.

Those types of things are investments today and profits tomorrow.

So they reverse themselves out and then some.

So one of the reasons I think you're seeing--if you're asking for what discontinuous or what would signal a shift, it's getting through the investment period of creating the right online set of business models for us; and that's certainly is planned to take place prior to this start of F'11 in a big way and continue from there.

We'll move next to Mike Hickey with Janco Partners.

Hi, guys, thanks for taking my question.

Given the considerable, at least, it looks like considerable weakness we're seeing from the consumer, what gives you guys confidence that you will be able to hold pricing into the holiday?

Certainly, if you bring out a calculator, you can definitely justify the value proposition, but $60 much less, $200 is still a fairly large purchase.

Look, I think our industry, historic--I've been through this before in prior cycles.

What determines the sustainability of retail pricing on frontline games has a great deal more to do with associated hardware pricing.

So by and large you saw frontline pricing hold on the PlayStation 2 until we were down below $149 for the hardware.

What that was about is you're bringing a different consumer in the marketplace, expanded breadth, if you will.

You are getting to a mass market and it takes lower pricing to entice that consumer to buy the software that goes with it.

They initially would wait and buy catalog, but breaking price was a profitable decision to make.

Once we got down and to those low price points on the PS2.

As you can see, frontline pricing on all three consoles is well above that level right now.

So we are seeing compression.

We are seeing weaker catalog.

We are seeing some faster moves to brakes, but we are not seeing anything to suggest that there is a broad based need to move frontline pricing down.

In fact, one of the things you could argue if you look at the data, is we are getting more of our sales in the first month than we've ever seen on new title introductions.

Of course that means there's less catalog, but it also means that the consumer is quite willing to be in the store on day one and buy the titles they want and they are relatively price [in-elastic] at that point.

We'll move next to Mark Wienkes with Goldman Sachs.

Great, thank you.

Just wondering what do you think the $1.00 to $1.40 in EPS target translates to in terms of free cash flow per share?

And then just a clarification, when you say retail is slower in early October, are you referencing EA retail, video game retail overall, or just in general retail?

Okay, this is Eric, I'll take the first half of the question.

We are not providing specific operating or free cash flow guidance for the full year, but we do expect to turn significantly operating and free cash flow positive in the second half of this year.

We also expect to significantly grow cash flow year-over-year FY '09 compared to FY '08.

This is John Pleasants.

On the retail side, the comments that I was making were about retail overall aS a category; and as it relates to our specific sector, we have seen just in even recent weeks, a bit of a constriction of people's appetite to be as aggressive with things like open to buys.

So it's just sort of a--it's a prepositioning that makes us a little nervous in terms of how they are looking at the holiday.

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We will move next to Daniel Ernst with Hudson Square.

Yes, good evening.

Thanks for taking my call.

My question is on Warhammer.

Can you just clarify the stat you made on the 70% conversion, does that refer to the 800,000 versus people who have bought the game so far?

And then can you talk about what that conversion looks like at the end of the 30 day initial trial that you get with the game?

And then related to that, can you talk a little bit about the profitability of the title given the start-up cost and having to maintain the servers, and where you see that tracking?

Where do you have to take this in terms of subcount before this thing starts to contribute to operating margins that we see in line with corporate overall?

Thanks.

The way we measure this, and we may followup in more detail is the consumer gets 30 days on the game from the day they initially install the title and register.

And so when we are talking about 70%, what we are talking about is we are just shy of two weeks from the first tranch of consumers hitting their 30 day point.

And for those consumers 70% that have made the--come to their 30 day point and made the decision to continue their subscription to the title.

70% is a very high statistic.

We would not expect it to sustain itself, but then again it's not surprising that the first buyers of a title are sort of the most loyal to the intellectual property, and you would get a higher conversion rate to full subscription.

You could expect that to drift down some from here.

In terms of our servers we manage them ourselves in North America.

We work with a partner in Europe that's been previously announced.

We have not managed our roll-out in Asia yet, that's the next step.

We are also not at the point of conversion in Europe.

So there is more in front of us than behind us.

The things that we need to manage and pay at lot of attention to as we look forward, is driving unit volumes up and we push more aggressively across Europe, Asia, continued sales in North America in terms of putting the top of the funnel.

And then maintaining both the conversion rate and managing attrition to drive this business to be--first get to a major milestone like 300,000 or 400,000 ongoing subscribers and from there up to whatever level we can achieve.

So far, it's meeting and exceeding our expectations.

We'll move next to Tony Gikas with Piper Jaffray.

Good afternoon, guys.

A couple once real quick.

How about the--could you just talk about key changes to execution at retail over the holidays given the change in the macro environment in terms of like add spending, any bundling, co-op spend, etc.

And then Eric, could you please repeat the gross margin guidance by quarter?

Sure, Tony, this is John again.

We are very focused on retail execution right now.

Again, I would say somewhat pridefully that I think it's probably one of the strongest organizations we have at EA.

Our publishing organization, particularly in our western markets, where most of this activity is going on.

We have been very carefully managing discounts and bundling right now.

There's been a lot of that activity going on; and again, you can rest assured that we will sort of manage that carefully.

In regards to your question on guidance, to recap what we had, for the third quarter we are expecting non-GAAP gross profit margins to be in the mid-50s; and for the fourth quarter we are expecting non-GAAP gross profit margins to be in the low 60s.

Last thing I would say Tony too, this is John.

My hat's off to Eric there, was just we put a particular focus on our marketing mix over the course of the year on retail.

I think that this year we are significantly up on our retail spend versus other media outlets that we focus on; and in particular on actual infrastructure, primarily led by our sports franchises.

We've put a lot of new units into Best Buy, and we are spending a lot more than we have in the past on things like circulars and in retail advertising.

So we've got a lot of merchandising, a lot of POP and a lot of foot space out there, if you will, so again that's something that we feel pretty strongly about this coming holiday.

We'll move next to Eric Handler with Barclays Capital.

Hi.

Thanks for taking my question.

Just a clarification on FX, you talked about a $0.12 impact to the bottom line, but you generally mention FX as a top line impact.

Am I missing something there or was--can you just clarify that issue?

That's correct, we quantified FX impact for EPS only for the full year.

The revenue range, again, we made the comment that mix is kind of an important component of that outcome.

Overall, we are expecting some depression of revenue as a result of the FX changes.

But we feel that we can maintain the overall top line range.

Just a little detail inside of that.

So we obviously have puts and takes on our guidance going forward, Saboteur slip is a take, FIFA upside is a put, and these are offsetting Rock Band upside.

One of the downsides is FX, which is approximately $150 million of our top line, but we had enough on the positive side to offset that.

Unfortunately, too much of that is low margin business hence the shift in guidance on the bottom line.

Okay, so it's--a lot of what we are seeing then is really the EA Partners business, that's the distribution?

Yes, we have a sharp increase there.

Okay.

Thanks.

We'll move next to Ben Schachter with UBS.

You mentioned you have a lot of confidence in Rock Band 2 and it's off to a good start, but given everything that's going on with retail, what really gives you the confidence to bank on this going forward particularly with the price points?

And then John, also you mentioned that seven franchises are slated to become mid-session games.

Can you give us a high level view of how you view margins from more of these online and subscription type products particularly through the consoles and how they're work with the first parties?

Thanks.

Sure, I will take the second piece while John focuses on the first.

On the MSGs these are actually businesses with very, very different economic models than our packaged goods business.

And when you look at it as a system basis using FIFA online in Korea, you will see that we generate more absolute revenue than we did with our prior packaged goods business on the microtransaction model.

But in this case, we split that revenue with a local parter Neowiz.

On a consolidated basis, it's both a higher absolute margin once it gets to scale and it's a higher revenue in that one marketplace.

One of the reasons we are doing as many tests as we are, John had mentioned the nine instances with both NBA Street and FIFA roaming across Asia, is to give us enough data to be able to answer your question definitively.

And at this point in time, what we have is models to show how aggressive or how successful these can be with principle titles like the one we've announced: Battlefield Heroes which is going global late in our fiscal year.

The simple answer to your question is we intend to run them directly in most markets, hence, we will capture all the revenue.

If the revenue is substantial, this business is margin accretive to Electronic Arts, but it starts with a fixed cost of establishing servers, customer support, and all of the intelligence behind it.

So again, the principle issue is how much consumer uptake there is.

Our models show this being a more attractive business for us by a fairly wide margin.

We now need to deliver on those visions and it's really early.

We've really got only substantive experience from one title in one country.

We note, though, that our competitors in Asia that have been doing this model more broadly and for the longer periods of time, have and often do generate pre-tax margins north of 50%.

So, of course, they are running at scale.

Our goal is to do the same.

Okay.

Back to the Rock--this is John on the Rock Band 2 question.

So quite a few things that give us confidence there.

The first and most important obviously is just the quality of the product.

Rock Band 2 is a 93 Metacritic product, I think there's only been two products launched the entire year that have a score above that--that being GTA and and Mario Super Smash Brothers.

Those products speak for themselves.

So we have an absolutely fantastic product is the first starting point.

The second thing is Rock Band 2 is an unbundled product.

So you don't have to buy the big box at the same high ASP that did you for Rock Band 1.

So in an unbundled presentation there's a lot more flexibility for consumers just to buy whatever component they want.

They do not need to, therefore, buy all the hardware as they did the first time.

And that price point we think, again, given this economy is going to be particularly attractive.

Third, it's launching obviously in this Q3 holiday season.

We think it's going to be a fantastic gifting item in a category that continues to boom, which is the family and music category and social categories.

And then finally long-term, MTV has done a fantastic job in their business development and obviously the signing and announcing of The Beatles is fantastic for this franchise long term.

So we see nothing but bright lights for Rock Band 2.

We'll go next to Jess Lubert from Banc of America Securities.

Good afternoon.

Wii related revenue is down more than $20 million year-over-year despite strong sales of the console.

Can you walk us through what you need to do better to gain share in the Wii?

And perhaps offer what insights you can into the break down of retail trends amongst hardcore versus casual gamers?

So the principle issue on our Wii revenues, and I don't have a subtotal in front of me right now, I will have someone try to bring it to me; but the real easy gap for is last year, our number one Wii title was Harry Potter, and this year it's not because we don't have Harry Potter; and that's a big year-over-year miss.

Of course, we have it next year.

The biggest issue for us in driving our Wii business is really starting now.

Downstairs is a line in our lobby for our own store to buy the Nerf N Strike product, which is going to be very strong on the Wii.

And so we are really just moving into our strength; and, frankly, given the nature of this particular consumer it would not surprise me to see relatively weak sales through the next couple of weeks until we get right in front of the Thanksgiving holiday where the gift consumer goes into the store and picks up titles like a second look at titles we released earlier this year like Boom Blox, what we have coming now and through the holidays with our titles like Hasbro and Monopoly and family game night, etc.

And then, also pick up titles, that extra title for dad like Tiger on the Wii, which is a fantastic piece of software.

So I think on Wii year-over-year big issue, Harry Potter, no Harry Potter.

The Fall is coming really starting today, and what we are going to be looking at very carefully is what happens in the week running up to Thanksgiving, and the first two weeks after because that's where this consumer usually shows up.

I would also note, this is Eric, that the last year in Q2 we had a FIFA Wii SKU, and this year we are launching FIFA in Q3.

So that's a change in term of the year-over-year SKU plan comp.

We'll go next to Colin Sebastian with Lazard Capital.

Thanks for taking my question.

John, I don't want to beat a dead horse, but back to your comment on retailers lowering their open to buy.

Is that across the board?

And then would you characterize this as a reaction to slower sell through, or are they preparing for the possibility?

And so related to that, then what gives you the confidence in reaffirming the 20% industry growth forecast?

Okay, so what it primarily is, is that when you sort of get underneath the covers of that a little bit, what retailers have seen is that, first of all, their foot traffic is down.

And secondly in our category, the things that are really moving are the big titles and they are getting a lot of movement on discount product so when things are all the way down into the value consumer.

It's the sort of middle tier product of which obviously as we all know there's a lot of product in the marketplace from all the different publishers, it's that middle tier product that has slowed down.

So what they are doing is they're focusing more on the bigger frontline titles.

They are being a lot more cautious with catalog ordering, in particular, and especially in that kind of mid-zone.

So that does affect, I think, all publishers not just EA obviously; but it's something that we are seeing, we are feeling and we are working through and obviously trying to optimize results for.

The second question again was, second part of your question was.

I've got the answer for you, 20% industry growth.

It takes roughly 8% for the last three months of the year for us to finish at 20% even.

That seems like a reasonable estimate based on what we are seeing so far.

We are seeing a bit of a split with Europe doing a little bit better that North America.

And one of the things that (inaudible), I can point to one good reason why Europe overall as a sector is outperforming North America, it's FIFA.

So one of the things it sort of tells you there's a pulse in the industry is when titles are what drives movement and right now Europe is outperforming North America in one of the most important titles in that marketplace is the main reason for it.

And it's nice that we are the beneficiaries of that.

We'll move next to Justin Post with Merrill Lynch.

Hi, thanks for taking my question.

John when you think about the hit titles or the top titles you had in the quarter, are these sequelable, do you find any issues; and did you guys have to take any extra reserves for these titles?

I know you give us the ship in numbers as you went through the month of October.

How's your reserve situation?

When you're thinking about principal titles in terms of hits and whether they're sequelable, I presume you're thinking about titles of Dead Space and Mirrors Edge, which are actually Q3 titles as opposed to Q2 and/or SPORE.

John's answered the question on SPORE.

We feel very much that there's a franchise there.

We've got expansion packs coming, new business models coming so, yes, it's a franchise.

Titles like Dead Space and Mirrors Edge, I think you can absolutely expect those titles to come back in one way, shape or form; but they are not likely to be annual sequels.

Warhammer Online is a subscription game, another important IP for us that's going to be monthly; and Mercenaries 2, there will be a Mercenaries 3.

And if I can have anything to do with it, there will be a Mercenaries 10.

In terms of reserves, Eric, any update?

Yes.

We've taken a close look at--talked a bit about the catalog trend versus frontline title.

We've assessed that carefully.

We believe we're appropriately reserved.

We'll go next to Jeetil Patel with Deutsche Bank.

Great, a couple of questions.

If I just take the midpoint of your guidance for this year, which is about a little over $500 million in profit and about $5.15 billion in revenue; and I then compare against fiscal '11 which is $6 billion and $1.5 billion profit.

That implies revenues grow $850 million and profits grow almost $1 billion.

So I'm just trying to figure out how to reconcile that in terms of cost reduction as you look at the next several years.

I'm just trying to look at the progression as you look forward in the next couple of years around what you stated already.

And then second, just on retail, I guess, has there been any change or are you just are more concerned at this point in terms of the open to buys?

Or is it too early to tell kind of where this is all going to shake out in terms of, I guess, initial orders and what's going to play out on release dates and what have you?

So this is Eric.

Kind of three different questions there, I will try to take them in order.

Yes, you asked about the $6 billion in revenue target.

To clarify, when we talked about FY '11, we talked about $6+ billion in revenue.

And a lot of people have backed into a fixed 25% percentage in terms of the overall outcome.

We were very clear in stating that $6+ billion in revenue.

So the percentage isn't necessarily what one should focus on.

In terms of the progression too, to get to those targets, we touched upon a little bit of this today.

Because we expense R&D and external developer advances, we have kind of discontinuous events that cross from one fiscal period to the next.

And so we could spend 18 months or more developing a game or an MMO have pure dilutive R&D OpEx in the P&L, and then it will be shipped as a product or when we turn the MMO on live and start generating subscription revenue, it comes at a significantly higher margin.

In the case where we're in our EAP business, where we are undertaking development with outside parties, we have pure expense for a period of time and then we ship a game and have all margin associated with that particular distribution business.

So we did note that, for example, we've stepped up investment in EAP advances.

We quantified that earlier.

That's part of this.

And we are also making significant operating expense investment in FY '09 for online for ratable subscription based titles such as MSGs in Asia and other regions.

And finally your third question about what can one expect in terms of the open to buy behavior.

What we are seeing is more caution, smaller order sizes but greater frequency; and you look at that, and it's not unreasonable to think that there may be some kind of working capital management or optimization occurring in retailers as well, so that may be part of the pattern that we are seeing here.

To build on Eric's point on retail.

I want to be clear, we are not saying the sky is falling.

In fact, I'm not going to give you the specifics, we have some individual retailers, those are disclosed to us confidentially, but I've already mentioned FIFA is doing exceptionally well across Europe.

We've had strong opens for new titles like Warhammer and Dead Space and others.

And frontline is holding up almost as if there isn't an economic turn down; and in a lot of ways that should almost surprise us.

We pointed you specifically to areas of weakness: catalog, and more specifically in North America to a less robust performance than Europe at least so far.

There's a lot of reasons to believe the sector will hold up better than most, if not almost all others, as were we move through a recession.

What we are bringing to the table is caution, a recognition that catalog is weaker and a commitment to managing our cost, both because it's the right thing to do for business efficiency, and it's the right thing to do with the spector of a significant recession over our shoulder.

So you will come in at this, I think, with a balanced view; and we think it's appropriate for to us take these types of cost actions especially given the broader economic environment.

I think we've probably go time for one more question.

Thank you.

We will take our final question today from Arvind Bhatia with Sterne Agee.

Thank you.

My question was can you tell us what catalog sales were during the quarter?

And then Sports, if you can tell us at this point what you are expecting that to be this year in percentage terms up or down?

And kind of the performance of Sports on the Wii console?

So this is Eric.

I'll take the first half of that question.

Catalog sales as a percent of overall revenue Q2 FY '09 actuals were 17%, and that compares to 19% in Q2 last fiscal year.

In terms of our Sports business on the Wii, we generally don't disclose quarterly numbers by label.

I would offer--you'd also ask about the Wii, I would tell you that there's two things for us to look at there.

Overall Sports is meeting expectations on revenue right now.

That's a very good thing given where we were in terms of certainty or lack thereof a quarter ago.

In terms of Wii, in particular, we've seen some of the highest Metacritic scores on the entirety of The wii platform being turned in by EA Sports particularly with titles like Tiger and NHL, really strong scores.

So the question becomes, when does the consumer show up and how many of them show up in that crowd?

We've got enough to believe that we are going to get a significant bump from prior year.

I don't know if it feels like it crosses through to the critical mass, but the experience, the entertainment value, and the quality is there to justify it.

But this is a consumer that shows up in November and December, it's not a consumer that shows up on launch day.

So we've got the products.

We've got the programs.

We've got the circular, John mentioned them.

And we just need to close the bargain with the consumer over the course of the next four to five weeks.

Okay.

Thanks, everyone, for joining us today.

We look forward to updating you on our progress.

That does conclude today's program.

We thank you for attending and have a great day