Take-Two Interactive Software Inc (TTWO) 2002 Q3 法說會逐字稿

Good morning, ladies and gentlemen.

And welcome to the Take-Two Interactive third quarter 2002 earnings conference call.

At this time, all participants are in a listen-only mode.

A brief question and answer session will follow the formal presentation.

If anyone should require operator assistance during the conference, please press star 0 on your telephone keypad.

As a reminder, this conference is being recorded.

I would now like to turn the conference over to your host, Vice President of Finance, Miss Cindy Buckwater.

Thank you, you may begin.

Thank you.

Good morning, ladies and gentlemen.

Welcome to the conference call for Take-Two Interactive third quarter fiscal of 2002 and thank you for joining us this morning.

You should all have a copy of our press release which was distributed earlier this morning.

If you have not received a copy, please call Wolf Axlerod at 212-370-4500 for a copy.

I would first like to quickly review our Safe-Harbor statement by reminding everyone that the statements made during the call that are not historical facts are considered forward-looking statements under federal securities laws.

These forward-looking statements are based on the beliefs of our management as well as assumptions made by and information currently available to us at this time.

Actual operating results may vary significantly from the forward-looking statements based on a variety of factors.

These important factors are described in our filings with the SEC, including our annual report on form 10-K as amended for the fiscal year ended October 31st, 2001 and our form 10-Q for the second quarter ended April 30th, 2002.

We have no obligation to update such forward-looking statements.

Before we begin the call, I would also like to mention that our current relationship with the SEC precludes us from discussing and answering questions regarding the status of the SEC investigation.

Beyond what is disclosed in our SEC filing.

Today's call will consist of a presentation by our management team, followed by a question and answer period.

With us today from Take-Two are Kelly Sumner, our CEO, Paul Eibeler, our President, and Karl Winters, our CFO.

At this time, I'm pleased to introduce Mr. Kelly Sumner.

Thank you, Cindy and thanks for joining us today on Take-Two's third quarter 2002 earnings conference call.

This is our first call from our new headquarters at 622 Broadway in New York.

As for the third quarter performance, I'm delighted to say we've had another strong quarter.

Let me share some of the high points from our perspective.

First, Take-Two's titles continued to enjoy great acceptance in the marketplace.

We've created a very strong catalog of titles and this combined with introduction of new titles has given our business the strength you see today.

Second, we exceeded our guidance for the quarter.

Our revenues have exceeded the guidance of $100 million by 22%.

And our earnings per share guidance of 7 cents was exceeded by 70%.

Later on this call, I will give you future guidance for fiscal '02, Q1 '03 and fiscal '03.

The major contributing factor to our performance is that we own a significant amount of our own IP, which is then developed in our internal studios.

Our stated plan of owning and increasing the amount of our IP and being able to divert these brands internally was a key driver did behind our recently completed acquisition of Barking Dog Studios, which we renamed Rockstar Vancouver.

This studio is currently working on two new PlayStaion2 titles for Rockstar, for which we own the IP.

Also, as you may know, we recently renamed our Take-Two games label Gotham Games.

This change reflects our strategy of clarifying the brand position of each label.

And makes Gotham Games the focal point of our efforts to target the mass market.

Third, we continue to strengthen our balance sheet and I'm pleased to say that for the seventh consecutive quarter, we've been cash flow positive.

Generating approximately $10 million of cash flow in our third quarter.

Fourth, our partner in the titles continues to become more impressive.

With additional titles such as the Warriors, based on the 1970s classic cult film which we recently announced is being developed by our Rockstar Toronto Studio.

Additionally,in August, our Gathering of Developers label released Mafia for the PC.

This title is performing very well at retail and we will be further extending this brand by releasing it on the next generation consoles in fiscal '03.

These are just two examples of the 60-plus front line titles that we currently have in development and they are keeping our momentum strong.

Looking forward, our guidance of fiscal '02 is $755 million in revenue and $1.75 in earnings per share.

Excluding the 2 cent charge in the second quarter related to class action settlement.

Our guidance reflects our strong performance year to date.

And also takes into account the planned international release of Vice City in Q1 '03 .

Based on the outlook for continued favorable industry fundamentals and the strong market performance of our published products, we expect fiscal '03 to be another solid year for Take-Two.

Our revenue guidance for fiscal '03 is $830 million in revenue with earnings per share of $1.95.

We expect a strong start to the year.

Our revenue guidance for the first quarter is $295 million with earnings per share of 94 cents.

Let me conclude my remarks by saying that our team is focused on continuing the positive track record we've demonstrated thus far in fiscal 2002.

Thank you again for joining us and for your continued interest and support for Take-Two.

I will now turn the call over to Karl Winters, our CFO.

Thank you, Kelly and good morning.

Our operations resulted in net sales of $122 million and earnings per share of 12 cents.

Net sales increased over 50% in comparison against net sales of $81 million for the third quarter of last year.

Earnings per share of 12 cents compares to pro forma of 2 cents last year.

The primary reason for the $22 million upside in revenue and 5 cents upside in earnings per share compared to our guidance, is from the continuing strength of Grand Theft Auto 3 for PlayStation 2, which sold at better than expected levels during the quarter.

Our publishing revenue represented 70% of our business.

With our distribution business accounting for 30% of revenue.

Compared to 57% publishing and 43% distribution in the third quarter of last year.

The increase in our publishing business as a percentage of total revenue compared to last year reflects the success of our new products as well as the continued strength of our catalog titles.

Our Grand Theft Auto franchise was the largest contributor of revenue for the quarter.

With 30% of our sales from the PlayStation 2 title and 17% of sales from the PC games.

Our other top products during the quarter were Midnight Club, Smuggler's Run, Max Payne and Age of Wonders 2, which together represented approximately 12% of revenue.

Our gross profit margin for third quarter was 37.5%.

The same level as our second quarter gross margin, but less than the 39% gross margin we realized in the third quarter of last year.

In comparison to the second quarter, our platform mix in the third quarter included a greater percentage of PC products, primarily due to the introduction of Grand Theft Auto 3 for PC, which carries a higher margin than console titles because there is no hardware royalty.

However, this was offset by several factors.

First, our publishing business as a percentage of total revenue was about 70% in third quarter, compared to 79% of revenue in the second quarter.

In addition, as discussed in the press release, during the third quarter, we settled our outstanding litigation over former European distribution agreement with Red Storm.

The settlement resulted in a $2.2 million charge to cost of goods sold, effectively reducing our gross margin by 180 basis points and a $1.2 million charge to general and administrative expenses during the quarter.

Excluding the impact of the settlement, our gross margin would have been 39.3%.

We also wrote off $3.8 million dollars of pre-paid royalties related to several terminated projects, which also decreased our gross margin by approximately 310 basis points given $122 million net revenue this quarter.

I think it's important to note that the charges did not impact our ability to meet and exceed our guidance for the quarter.

Now for the year-over-year comparison over gross profit margin.

The decrease in gross profit margin from the prior year's third quarter resulted from several factors.

The primary reason for the reduced gross profit margin relates to the $3.8 million write down in pre-paid royalties, and $2.2 million charge cost of goods sold related to the Red Storm settlement.

Which together lowered our gross margin by approximately 490 basis points.

In addition, the platform mix year-over-year has changed significantly.

Beginning earlier this year and continuing into the third quarter, our product mix has shifted in favor of console projects, which carry lower margins than PC products.

In the third quarter of this year, the platform mix for our publishing business was 60% from console software, 37% from PC products and 3% from accessories.

Compared to 36% console software, 56% PC products and 8% accessories in the third quarter of last year.

Total operating expenses increased on a dollar basis year-over-year consistent with our increased sales, but declined on a percentage basis compared to the third quarter of last year.

General and administrative expense increased significantly on both a dollar and percentage basis from last year's third quarter.

Due to our expanded operations and the expenses related to increased professional fees, as well as the $1.2 million charge related to the Red Storm settlement, but decreased from the second quarter of this year.

As we stated on our last two calls, our G&A expenses have been running at an unusually high level this year, due principally to the additional expenses we incurred as a result of our forensic audit, accounting, legal and consulting expenses.

These expenses have been reduced during the third quarter.

In addition, we have also experienced higher expenses related to the expansion of our management team, strengthened internal controls, higher insurance premiums and in the third quarter, expenses related to moving our New York offices.

However, we have realized the net $1.5 million reduction in our G&A expenses in the third quarter in comparison to the second quarter.

Also, if you back out the $1.2 million non-recurring expense related to the Red Storm settlement, our overall G&A expenses decreased by approximately $2.7 million from the second quarter to the third quarter to a base level of about $16 million.

Our selling and marketing expenses decreased as a percentage of revenue, but increased on a dollar basis from last year, due to the growth of our business, and increased level of advertising and promotional support we provided for our new product launches and existing catalog titles.

Our R&D expenses trended back to more normalized levels, after the increase we saw in the second quarter for additional compensation for our development people as a result of the success of Grand Theft Auto 3.

We continued to operate on a cash flow positive basis, generating approximately $10 million in operating cash flow in comparison to positive cash flow of about $1 million during the third quarter of last year.

For the first nine months of the year, we have generated approximately $118 million in operating cash flow.

At the end of the quarter, we had approximately $74 million in cash with no borrowings under our lines of credit, as compared to $15 million in cash and outstanding borrowings of about $70 million at the end of the third quarter last year.

Now I'd like to move on to the balance sheet.

Net accounts receivable at the end of the third quarter were approximately $65 million, compared to $95 million receivables at our fiscal year end.

The third quarter receivables balance is about the same level as the end of the second quarter because of the timing of product shipments.

As you may remember from the last call, in the second quarter, we launched State of Emergency in the first few weeks of the quarter and experienced continued strong demand for Grand Theft Auto 3 and Max Payne early in the quarter.

Asa result we realized about 50% of our revenue during the first months of the second quarter and so we had ample time to collect these receivables by quarter end.

However, in the third quarter, our business was more evenly distributed throughout the quarter.

The relatively even distribution of business throughout the quarter also impacted our DSOs, which was 48 days at the end of the third quarter.

As is customary in the industry, payment terms for the majority of our customers typically are 60 days.

We expect that our DSOs will fluctuate going forward, primarily dependent on the product release schedule.

Our accounts receivable reserve currently stands at about $26 million, representing approximately 29% of total receivables.

Our reserve on an absolute dollar basis and percentage basis stayed about the same as last quarter.

Inventories at the end of the quarter were approximately $50 million, down from $62 million at year end when we were at our seasonal peak, and $55 million at the end of the third quarter last year.

Turning now to our software development costs and pre-paid royalties.

Our long and short-term pre-paid royalties sit at about at $31 million at the end of the third quarter and has been at this level throughout this year.

Our capitalized software was just under $10 million at the end of the third quarter, again, at about the same level throughout this year.

It's important to make a couple of points about the pre-paid royalties and capitalized software numbers.

The balance at July 31st represents about 60-plus products in development.

Approximately 50% of this balance is related to our key brand franchises, including a brand that's not yet been announced, which we will introduce in fiscal 2003.

We expect to ship approximately 10 of the 60 products in development by the fiscal year end 2002, including the products we've already shipped in the quarter.

And about 40 of these products during fiscal 2003.

The remaining products in development are expected ship in fiscal 2004 or beyond.

One other area of note on our balance sheet relates to our intangibles, which have increased by about $29 million from the end of the second quarter.

This increase relates almost entirely to the purchase of the Max Payne brand franchise, which we acquired in May for $10 million in cash and approximately a million shares in common stock.

Intangibles in capitalized software were also impacted by reclassification we did in the third quarter.

We reclassified about $2.2 million from capitalized software to intangibles.

This reclassification related to intellectual property for products and technology that we acquired.

The benefit from this reclassification is that now capitalized software relates to products or technologies developed internally, rather than those that are acquired.

This reclassification was applied to the October 31, 2001 balance sheet, which is also included in today's press release.

I'd like to speak briefly about some of the other events that have occurred since we talked to you.

In late August, we established a new line of credit to replace our existing line, which is due to expire in early December.

Our new, three-year $40 million line is with a group of lenders led by Banc of America, the lead bank in our prior line.

As I mentioned on the last call, in the second quarter, we brought in DeLoitte and Touche as consultants to further review and assess the financial and operating procedures throughout our domestic organization.

They've completed a comprehensive massing of our accounting processes and provided recommendations where operating efficiencies can be made.

Recently, we completed the merger of the Jack of All Games accounting personnel into our New York City office from the previous location in Queens.

We expect that this will also add to our operating efficiencies and further improve our internal control environment.

We're also working to bring in an outside team to provide an internal audit function, which should be in place by November 1st, the start of our 2003 fiscal year.

Moving on to guidance.

Our guidance for fiscal 2002 has been increased to $755 million in net revenue and $1.75 in earnings per share, excluding the 2 cent charge related to the class action settlement incurred in the second quarter.

For fiscal year 2003, our guidance is $830 million in net revenue and $1.95 in earnings per share.

Our Q1 2003 guidance is $295 million in net revenue and 94 cents in EPS.

In looking at our guidance for Q1 of fiscal 2003 and comparing that to the results we reported for Q1 of fiscal 2002, it is important to remember that as a result of a revision of our cut-off policy for revenue recognition last year, approximately $17 million in net sales and 11 cents in earnings per share, was moved from Q4 of fiscal 2001 to Q1 of fiscal 2002 to reflect products that were shipped in October but not received by customers until November last year.

I'd like to provide some additional insight into the general trends we expect to see in fiscal 2003.

Coming off a strong performance so far this year, we're pleased to provide guidance for next year that provides meaningful growth.

We believe we can modestly increase our gross profit margins beyond the 37% level we've achieved year to date thus far.

Second, we expect our operating expenses to range from just under 20% and a high sales volume period to approximately 30% during the seasonally slowest months of the year and average out in the low 20's for the entire year.

Within our operating expenses, G&A expense should show minimal growth.

For sales and marketing, we expect to support our current portfolio and invest in supporting new launches at levels modestly higher than fiscal 2002.

R&D expense will increase, giving the acquisition the Barking Dog Developing Studio on August 1st and 50 new employees we have in that studio already during this fourth quarter.

Lastly, we expect our corporate tax rate to remain at the current levels of about 41%.

In summary, we're pleased with the operating results this quarter and our current financial position as well as the continuing improvements in our organization.

We look forward to speaking with you again in December when we report our fourth quarter and year-end results.

At this point, I'd like to turn the call over to Paul Eibeler, our President, who will review Take-Two's business for the quarter in more detail.

Paul?

Thank you, Karl.

I'd like to first review the product highlights of our strong Q3 and recap the drivers for Q4 and fiscal 2003.

Our Q3 was driven by the strength of our Grand Theft Auto grand franchise from our Rockstar label.

Grand Theft Auto 3 for PC shipped in May, and we experienced better than anticipated sales.

Grand Theft Auto 3 for PlayStation 2 represented the majority of our Q3 revenue upside.

Based on its continued strong retail sales, Grand Theft Auto 3 for PlayStaion2 remains a top title for most major retailers.

This achievement, 10 months after launch, shows the unprecedented strength of this franchise.

The introduction of our brands, Midnight Club and Smuggler's Run to the PlayStaion2 Greatest Hits program, also have enjoyed strong retail sales.

We anticipate that these catalog sales will represent an additional revenue driver for Take-Two as we enter the holiday selling season.

Our PC business had two releases.

Age of Wonders 2 and Tropico Mucho Macho product extensions supporting the existing brands.

In Q3, we continue to support our strategy of building low risk, high volume PlayStation value product with shipments of the Italian Job and Big Bass Fishing.

Moving to Q4 and August shipments was the much anticipated game, Mafia, for PC.

Mafia brings a 1930s underworld to life with its startling graphics and compelling story line.

Smuggler's Run War Zone for GameCube shipped in August and is a good example of our strategy to expand our IP by extending our brands to other platforms.

Duke Nike 'Em advanced, color Game Boy advanced, also shipped in August.

Stronghold Crusader for PC, an extension to the successful Stronghold brand is set for shipment in September.

Also in Q4, we will ship two additional PlayStation value titles, Austin Powers Pinball and Spec Ops Airborne Assault.

In late September, we will ship the timely title, Conflict Desert Storm on multiple platforms, PlayStaion2, PC and XBox.

Conflict Desert Storm allows gamers to play as part of an elite special forces squad on missions behind enemy lines during the Gulf War.

Realistic game play has been fine-tuned under the direction of a special forces SAF veteran who consulted in this product development.

Grand Theft Auto Vice City is currently one of the most anticipated games at retail.

Previews are now hitting the gamers with front cover stories in the key gaming publications like Game Informer, PSM, PlayStation Magazine 2 and Official PlayStaion2 Magazine.

The previews describe the feature list, which include more and new weapons, new vehicles, including motorcycles, boats and helicopters, nine hours of audio, enhanced game play and graphics, set in an even bigger tropical urban environment.

Our proprietary Grand Theft Auto, go where you want, when you want engine, will take gamers to the next step and certainly take this brand franchise to the next level.

Domestically, Grand Theft Auto Vice City will be in stores on October 29th for our Q4.

And in international retail stores for the first week of November for our Q1, fiscal 2003.

Now to the Jack of All Games business, which remains a predictable component of our balanced revenue model.

In the past year, Jack of All Games has successfully grown it's customer base to include all channels of retail.

This varied base of customers support the three components of its product offering.

Value opportunity software, front line software and the three hardware players, Nintendo, XBox and Sony.

In Q3, distribution business from Jack of All Games was 30% of our overall business and year to date, 29%.

This positions us to more than achieve our goal of 60/40.

Publishing more than 60% and distribution less than 40% of our overall business.

In managing the Jack of All Games business, we remain more focused on the bottom line performance as we move into the key holiday selling season.

As we look to fiscal 2003, we have tremendous opportunities to expand our brand franchises for Midnight Club, Smuggler's Run, Max Payne, Oney, Grand Theft Auto, Serious Sam, Hidden and Dangerous and Railroad Tycoon.

MTV's Celebrity Death Match will be a multi-platform launch in 2003.

The benefit of our leading market share position for PlayStation 2 allows for two additional revenue drivers.

First, we can continue to expand our brands to other platforms and secondly, the Greatest Hits program extends the product life with very inviting margin opportunities.

In the past year, we have shown that Take-Two has the ability to establish and build brand franchises.

We anticipate continuing this when we announce several new products to our release schedule in 2003.

At the recent ECTS, the European equivalent to E-3, Take-Two received seven awards for our Grand Theft Auto and Max Payne brand franchises.

Given that there are only 13 game-related awards at the show, we're very proud with this endorsement of our products.

I recently visited 3-D Realms.

The creators and developers of the Duke Nuke 'Em franchise.

I'm pleased to say that the 20-plus person team is working extremely hard on the much anticipated game, Duke Nuke 'Em Forever.

We remain confident in this project but we have not included it in our guidance.

We will continue to update you as we gain increased visibility.

Going forward, Take-Two will continue to build on our exciting pipeline of brands, our leading market share on next generation of product and strengthening financial position.

Now we are ready to respond to any questions.

Due to the large number of participants, and in effort to respond to all of you, we request you all limit your questions to one.

Thank you very much.

Thank you.

Ladies and gentlemen, at this time we will be conducting the question and answer session.

If you would like to ask a question, please press star one on your telephone keypad.

To remove your question from the queue, please press star two.

If you're using speaker equipment it may be necessary to pick up your handset before pressing the star keys.

I will pause while we wait for our first question.

I think we're experiencing some difficulty in connecting.

We're still waiting for our first question.

Thank you.

Our first question from Mr. Arvin Batia with SW Securities.

Sir, please state your question.

Good morning, guys.

Hi, Arvin.

Fabulous quarter.

Thank you.

However, I'm a little perplexed with the guidance for next year, because as I look at this quarter I know you reported 12 cents, but as I back out all the one-time charges, it seems to me there could have been another 10 cents in operating EPS, which would then put your number for this year somewhere close to $1.85 and you got to $1.95 and that, like, seems to be extremely conservative.

I'm just wondering if you can talk maybe or speak to the expectations on Grand Theft Auto Vice City, which you built for next year, relative to how that franchise performed in '02.

Well, as you know, we've just come off -- just coming off the year where the company has grown something like 70%.

And, you know, we're very, very confident of our strong pipeline with products like Vice City, Conflict Desert Storm, Celebrity Death Match and Midnight Club 2.

What we're trying to do is put a solid guidance number out there.

We've said this is our initial guidance number.

And as the year progresses, we will continue to review that, obviously Grand Theft Auto 3 was a very large part of fiscal 2002.

We have extremely high hopes for Vice City but, I think we need to see a little bit more visibility about how the trade and customers react to that and then we can give you more guidance.

Okay.

And just a quick one on the Red Storm litigation.

Can you remind us what the whole issue was maybe just in 30 seconds?

And what, you know, what caused it to settle in this quarter?

The issue relates to a distribution agreement that we had with Red Storm some, I think, two years ago.

And we decided to settle in this quarter because, obviously, we were coming up to a trial and we believed it was in the best of both parties, including Red Storm's, to settle now, rather than to have a protracted lawsuit which would have distracted our management over the year's major selling season.

Got it.

Thank you and again, very impressive quarter.

Thank you very much.

Our next question comes from Mr. Paul Kauf with Dougherty and Company.

Sir please state your question.

Good morning.

Good morning, Paul.

One quick question, can you talk about the distribution of revenue EPS for fiscal '03?

I know you gave Q1 guidance and full year guidance, but how about the rest of the year?

You know, obviously we have a strong Q1 that we are anticipating, you know, we expect to see some growth, obviously, throughout the remainder of the year and you've obviously taken in mind, seasonally the summertime is slow for us.

I think that's probably about as much as we can offer this morning.

As Kelly mentioned, we expect a solid year in the content of our performance.

We will have to see how things are.

So, essentially, start thinking about it in terms of seasonality and how things have progressed over the last couple of years?

I would say particularly over the last year since the business is dramatically changed and shifted away a little bit from the distribution business and more toward the console product driven business.

OK.

Any margin expectations you can share with us?

Gross margin that is?

I think as I mentioned, we expect our gross margin to improve modestly over our year to date level, about 37%.

And that's, again, because we're driven with console product.

Okay, thanks.

Thanks, Paul.

Our next question comes from Mr. Heath Terry with Credit Suisse First Boston.

Please state your question.

I wondered if you can talk -- obviously we're seeing a couple of products shift and the international release of your biggest product shift out of Q4, but your guidance is staying exactly the same as what it was back when the products were in the quarter.

Is that -- is that a suggestion of the strength of your other products that you're expecting from here on out?

Or something that you've already seen up to this point in the quarter so in the month of August, the first week in September?

There is a couple of things, actually, Heath, one is the strength of the -- the continued strength of our catalog.

Certainly Grand Theft Auto, Max Payne and Midnight Club and Smuggler's Run and the Greatest Hits have been strong and they continue to be very strong.

It looks like they're going to have a very good Christmas selling season.

And the reaction to the trade for Vice City, Midnight Club and Conflict Desert Storm, you know, has been very good.

As I said to a previous call, you know, what we wanted to do is put out there a solid guidance number and as the Christmas selling season and the year unfolds, we will obviously update you as soon as we can.

We're very confident of the catalog, products such as Midnight Club.

We think are going to be significant products for us and everything looks very impressive for next year.

Great.

Can you talk a little bit -- can you give us one just numbers question.

How many development professionals do you have at this point?

How many employees total do you have at this point?

And, I guess, where do you see that, you know, the development professional number being, say, this time next year?

The total number of people in the company is about 750 people and we have approaching 300 people in development.

We don't see any major expansion on that number of people.

There will be some key rows that we still would like to bring into executives to strengthen our management team and we're continuing to do that.

The only significant increase would be if we were to go through a transaction like the Barking Dog Studios and buy another development.

I guess that's kind of what I was getting at.

What -- what's your appetite for doing those type of of acquisitions, you know, do you have a target number of -- of studios that you would like to acquire over say the next 12 months given the new-found cash on the balance sheet?

And then, also, if you could just talk, of that 750 employees, 300 are in development.

How many of them are in the distribution business?

Okay, I think what -- it's -- it's not a question -- it's a targeted number of people.

It's, you know, finding the right people at the right time.

We've been -- with the transactions that we've carried out, people like PopTop and DNA and ART in Canada, which have all been studios of ours for a number of years, we've obviously found very good talent and are working with them very, very well.

We believe that's what we found in Barking Dog.

We continue to look at opportunities out there, but it has to be the right people, rather than a numbers game, I believe.

But it is important for us to ensure that our IP and our technology is utilized in-house and we control it totally.

At the moment, we feel comfortable with the number of studios we have but if there is an opportunity to acquire a creative team that we think would be a good fit for our IP and technology, then we will certainly do that.

As far as the number of people in distribution, I think it is approximately 200 people.

Okay, and so then the remaining 250 are within kind of the corporate office?

The corporate office.

We obviously have all the subsidiaries out there in Australia, France, Germany, Italy, U.K., Scandinavia, Canada, et cetera.

Sales and marketing support.

Yeah, you know what?

That wraps it up.

Heath, please remember that the people in distribution are generally at a lower salary level.

Sure.

There is a lot of temporary people that come on during the key selling season.

Our goal is to always to try to maintain at least a million dollars per employee which we're looking at.

Great, thanks.

Our next question from Mr. Edward Williams with Gerard Klauer Madison.

Sir, please state your question.

Good morning.

Just to get it started, what was catalog as a percentage of revenues in the July quarter?

Ed, we typically don't get into those types of numbers.

We did get into the Grand Theft Auto, which, together with PC, was approximately 47%.

We named a number of our other top titles that did about 12% of our business.

Of which Max Payne was the leader, followed by Midnight Club.

Okay, and any plans at this point with regards to the Halo Engine, when we might see games utilizing that?

We -- the Halo Engine is being looked at by our new label, Gotham Games and they're looking at design documents and designs at the moment.

But it's a question of finding the right design that will better utilize the engine.

At present, we haven't got anything in development, we haven't got anything in the guidance using that engine.

Okay.

And one question for you, Karl, at the end of this fiscal year, what are you targeting with regards to inventory levels?

I think it's, you know, fair to say it will be representative of about where we were last year, but we, you know, obviously we have a number of our key products that are scheduled for late October, early November time frame.

We will have to be mindful of that.

I don't expect any major deviation from where we last year.

Ed, we feel very good with our inventories, particularly the distribution inventory, which, you know, we feel is very, very manageable and we've made a number of smart buys, particularly in the opportunity value area.

Okay, and one last question, cap software, target for the end of the year.

Where is that number?

You know, the spending levels and, you know, what we're doing on the projects, we're not talking about a large number to begin with.

We have 9, $10 million on the balance sheet currently and our focus is to stay very productive with the products we have internally that we're working on.

I don't expect to see major deviation of that number, as well.

Great, thank you.

Our next question is from Mr. Robert Dulene with Morgan Keegan.

Sir, please state your question.

Hey, guys, from my recollection, you canceled two projects in the second quarter and now you've canceled some projects here in third quarter.

Can you tell us how many projects did you cancel?

And should we look at that as an ongoing part of the business or is it a one-time issue?

How do you look at that?

Well, you know, the business has shifted in the recent past more as a console, you know, game business away from the distribution business.

So, I think it's fair to say that we will have this from time to time.

We've walked away from a number of projects this year and my recollection as well is that we did about two projects last quarter and several this quarter.

We have 60 plus, you know, projects in the pipeline and aggregate, we have about $40 million in our pre-paids and capitalized software numbers.

When you look at that on an averaging basis, you will realize we don't concentrate a lot of money into one given project.

It would be hard-pressed to find more than a couple million dollars on any project in our balance sheet.

So, you know, we do expect to see some of this from time to time.

A little larger this quarter, but we're taking a very careful hard look at things each quarter and making sure we're happy with the economics of what we can see into the future and then we make decisions accordingly.

I think it's fair to say that the expectations from our customers and the end users has raised dramatically over the year with the delivery of products such as Grand Theft Auto, Max Payne, et cetera and we do feel it is very, very important to review this stringently every quarter.

It is much better to write a product off a quarter way or halfway or even three-quarters way through the development than to try and make it something it is really not.

And obviously then incur marketing costs and production costs, et cetera.

So we're taking a very, very hard look every quarter as we see the market developing and the quality of titles increasing by not only ourselves, but also by our competitors.

And to clarify with Karl, he says there's been a shift in the business, more console.

From that, I would guess we would assume there's been some PC projects that were canceled?

No, don't read anything into that.

I was just pointing out more over the last several years, that you may not have seen this earlier in the company's development cycle because it was principally a distribution business.

So for instance last year in the third quarter, we had no write-offs, but there weren't a lot of large sellers like we have today at that point in time.

Karl, with respect to modeling, you mentioned $16 million as the base level for G&A.

Is that the number we should use with some creep upward going forward in our modeling?

I chose my words carefully there.

Yes, $16 million, in that range, roughly is about where we see the business.

You know, we expect to see the minimal growth throughout 2003.

And a final question.

I think you mentioned it was 12% of sales, I think it was talked about twice it came from Max Payne, Midnight Club and what else?

Smuggler's Run and Age of Wonders 2.

All right, thanks.

Bob that, was the initial shipment on the Greatest Hits of Smuggler's Run and Midnight Club.

And one final thing.

Are we talking about the 47% GTA and 12% these other products.

Is that total revenue or just publishing?

That's total revenue.

Our next question is from Mr. Shawn Milne with SoundView Technology Group.

Sir, please state your question.

Thank you, just a quick question, Karl, just going through the July quarter --

Shawn, can you speak up, it's very faint.

Surely, can you hear me?

Yes, go ahead.

Okay, great, thanks.

In the July quarter of Grand Theft Auto, the franchise was about I guess, 65 to 70% of publishing revenue.

In terms of the fourth quarter guidance, can you give me a ballpark on what you think that mix will be and, Paul, maybe you can chime in, what's your pricing strategy as you go forward here and ship Vice City, it will be sold for $50 retail.

What's your thought process in terms of going forward with GTA 3 and the holiday period and as you roll out into the first quarter of next year?

Thank you.

And the answer with regard to the fourth quarter expectation, obviously, GTA 3 has continued to perform very well.

We also expect it still in the fourth quarter to be a significant contributor.

I don't want to get percentage-specific, but certainly in that direction is where we expect it to be in the fall.

And GTA 3 for the PlayStaion2 represented that upside, the majority of the upside in the quarter that we experienced.

On GTA 3, because of its unprecedented strength and we've also talked to several key retailers, we don't see a price change on GTA 3 when we introduce Vice City.

We see Vice City coming out as a full-price title.

Think GTA 3 will benefit from the sales and promotion and advertising that we will spend to drive the Vice City sales.

Shawn, it's very difficult to -- we've done a lot of calculations and looked at a lot of data to try to understand were the pricing should be on something like GTA 3.

It's very fair to say it's never been a product like GTA 3, selling is still something in North America, something like 200,000 units a month through -- and that's in the slow summer period.

We're expecting 6 to 8 million new PlayStaion 2 owners who are a targeted audience for us, not only for Grand Theft Auto 3, but for Vice City, as well.

We would like keep the trump card up our sleeve, which is the Greatest Hits.

So, probably sometime next year.

We believe it is quite possible to sell a good number of Grand Theft Auto 3 through Christmas at full price.

Certainly, that's what the indication is from our retailers, as well.

So, the Greatest Hits, you would --putting GTA 3 in the Greatest Hits, we should think about maybe next year at some point.

Paul, have you looked at any bundling programs?

No.

And then, lastly, just a housekeeping -- Karl, it looks like you've added some people in terms of overhead relative to the finance department.

Can you just give us an update on the JDA implementation?

It seems like you're making the necessary infrastructure additions, but you also sound like there's not much movement upwards in the G&A line.

Well, the G&A line we have increased somewhat significantly over prior year levels and we have added, you know, a number of people.

However, it's not necessarily quantity versus quality in terms of, you know, that assessment.

I think we've been successful in sort of upgrading the middle tier of our financial management team and, you know, we added Nick Ashford as the press release indicated this period, which is more towards an operating eye.

So, I think, you know, commensurate with the size of the organization and the growth we experienced, we're making the right investments.

We want to be prudent about how we spend our G&A money because that's in the fixed arena and as you build, it's more difficult to pare.

Nonetheless, we're in good shape and added a number of folks to assist in the financial reporting functions.

As I mentioned, we expect to bring on a few, a little bit more spending in terms with of an internal audit function.

The recent merger of our accounting department out of Queens into the New York City offices here will benefit us in a number of areas.

One, the tightness of, you know, reporting here domestically.

The efficiencies with which we do that.

The timeliness with which we can get our information put together internally and all which then leads to a better operating environment.

And just on the system front?

Oh, and on the systems front, JD Edwards is performing well for us.

We continue to do some additional training and implementation procedures and we're adding some additional modules with regard to warehousing and pricing functions out of our Ohio warehouse.

But we're very pleased where we stand at this point.

Thanks a lot.

Thank you.

Our next question is from Mr. Richard Zimmerman with Commerce Capital Markets.

Sir, state your question.

Congratulations on the nice quarter.

Thank you very much.

Can you talk about, first off on the third quarter, due to the success of your catalog products, whether there was a shifting intentionally of a product you were going to release in third quarter to the fourth quarter?

Yes, we moved three products from the third quarter, third quarter to the fourth quarter.

The first was the Game Boy advanced Duke Nuke 'Em, which is shipped domestically, recently shipped domestically and is shipping in Europe in September.

We didn't release it in August because August is a pretty dead month for Europe as they're all on their vacations.

Smuggler's Run War Zone was exactly the same.

We shipped that now and will be shipping soon international.

And lastly, as we come around, Mafia has shipped domestically and will be in the stores internationally tomorrow.

So, with three products, we moved from 3 to 4.

And that obviously allowed us the benefit of moving Grand Theft Auto 3, I'm sorry, Grand Theft Auto Vice City from 4 to 1.

Which we think is a better place for it to be in, quite frankly.

Looking full circle, the success of your products is giving you a lot of flexibility.

Can you talk about that, how it's enhanced your visibility and your ability to forecast?

Clearly our catalog is becoming a much more important part of the whole forecasting as we go forward.

We've all commented on the strength of the Grand Theft Auto, Max Payne, Smuggler's Run, Midnight Club, et cetera.

And that will continue to be so for the foreseeable future.

I think the most important thing that this has given us is the ability to actually finish off the products correctly in a timely basis to make the best possible product we could for market, rather than be pressurized as we may have done a couple of years ago to get a product out for the quarter.

I think one of the biggest benefits with that will be Midnight Club 2, which we launch in the Christmas season.

We've decided because of the flexibility we had, to give it like an extra six months of development time.

We believe that it could, you know, be one of the sleepers of the industry.

It is absolutely looking superb and will benefit from every extra day that we can give it.

Great.

Richard, just a note on that, Midnight Club 1, when we moved it to the Greatest Hits program, showed, you know, tremendous strength at retail.

That brand is an extremely strong brand and we feel, you know, as Kelly said, very good about Midnight Club 2.

In terms of planning our business, the catalog business, we remain very cautious going forward, but it's given us tremendous flexibility to move products around which is one of our strengths going forward.

I went through the list of products that we have the ability to extend in 2003, we feel very, very good about that.

Just related to that, Paul, when you talked a little bit about Duke Nuke 'Em, what's going on there, as far as the increased flexibility, is that one reason you're not talking about it for next year so much?

Or is it that the uncertainty about getting it shipped because of the development time, it is still there?

Well, as I said, I recently went down there and visited 3-D Realms, they have 20-plus people working extremely hard on the project.

We feel very, very good about the project because of the size of the brand and what they're putting into the game as far as game play, graphics, feature, the size.

So, we feel good but because of the past history on the product with us, we decided not put it in our guidance.

And when we feel 110% sure we will then share that with the marketplace.

We do feel from a marketing standpoint that that gain, because it is such a big brand and there is such demand for it, that it won't limit us, it will help us, this anticipation, the gamers waiting for Duke Nuke 'Em.

We should be able to guide you a quarter ahead of the release of Duke Nuke 'Em.

It won't be -- it will be something that you will be able to model for everybody.

I want to reiterate that this flexibility that the success for us has generated is only going to increase in the success of the future and perhaps gain us even more flexibility.

We've put together the guidance which we think is very strong given that we've grown 70% over the past year and we would expect to -- we would hope to guide you going forward next year.

And two housekeeping questions for Karl.

Karl, where do you expect your cash flow from operations to be at the end of the October?

And maybe at the end of January, given the timing of when you receive cash?

I think the fourth quarter has its own unique working capital requirement.

So, while we've had a number of consecutive quarters here that have been operating cash flow positive, and we'd love to repeat that during the fourth quarter, I don't think that's likely.

Having said that, I don't expect us to have any difficulty, obviously, financing the bills that we need for the seasonal business.

With regard to the first quarter, obviously, you know, the holiday selling season at some point we bring the money in.

We've been very successful in managing the amount of time it takes to collect our receivables and expect to have a very good first quarter.

Quantity, can you give us any kind of range or...

I think it's a little early for that, given, you know, the product release in the quarter.

Okay, and just, can you tell us, based on your projections for 2003, the sales mix, publishing, distribution and the platform mix?

I will answer this one, then we need another question from another caller.

We expect that to be, again, in the 60/40 or better range.

Okay, thank you.

Thank you, Richard.

Our next question is from Mr. Gary Cooper with Banc of America Securities.

Sir, please state your question.

Hi, a couple of questions.

I think, Paul, you mentioned the -- that the price on the GTA 3 is still the same.

I've seen where it's been bundled with Smuggler's Run.

Is that something the retailers are doing?

Is that what you guys are encouraging them to do?

It's strictly driven by retail.

Okay.

And I wanted to know if you could comment on whether you think the margins for GTA Vice will be meaningfully different from GTA 3 given the fact that you talked about your relationship with Sony and so forth on the last call?

The margins because of the success of quarter three, they are slightly increased bonuses and plans given that we have the tremendous success with Vice that we had with 3 for the development teams.

But that's the only thing that would differ.

There weren't -- nothing differs as far as the Sony relationship.

It is the same discounts we worked with Grand Theft Auto 3.

Okay.

I wanted to ask a couple of questions.

You've obviously had some personnel in your development team and your development costs were actually down $2 million from the prior quarter.

Can you talk about what's causing that to be down?

And maybe kind of give us an idea of how much you expect it to be up, if any, going forward.

And lastly, can you put an early number on the pre-orders of Vice City?

Thank you.

I think with the -- the R&D folks, we brought on the Barking Dog Studio in early August, which added about 50 people.

Our run rate going forward we expect to be higher than approximately $2 million, where we are right now.

Last quarter was significantly higher than that because we did have some added compensation expense with regard to discretionary bonuses paid to employees for the success related to Grand Theft Auto 3.

We're obviously very pleased with the efforts of our development folks and would like to keep them happy and motivated and moving forward.

That was behind the expense last quarter.

And, you know, as Kelly mentioned, we'll opportunistically look but we've been very successful in adding development people in low-rent and low-cost neighborhoods.

We will have to see what the future holds.

And year second question, Gary was?

There's a lot of talk about Grand Theft Auto Vice.

You sold over 7 million copies of GTA 3.

What are the pre-orders are and whether you think GTA Vice will outsell?

Obviously I can't give you the -- there are a number of retailers running pre-order campaigns at the moment where they're asking people to reserve copies of Vice City for when it is available.

I think it's quite possible that Grand Theft Auto Vice City could be the largest pre-ordered, at store level product in the history of American video games.

It will be our intention to keep the product tight as we did last year.

Maybe not quite as tight as last year because we were taking somewhat by surprise and we have some track record to base it on now, but the expectation internally is, yes, that Grand Theft Auto Vice City will be as good if not bigger than Grand Theft Auto 3.

I've got to say that's not the way we're modeling it, though, we're taking a very cautious approach and as we said in the press release, Gary, this is our initial guidance.

As we see more visibility, we will keep on guiding you.

Can we take the last call, please?

Our last question is from Mr. John Taylor with Arcadia Investments.

Sir, please state your question.

Hi, good morning.

I've got a couple of questions.

Karl, I don't know where you are in the process of breaking out publishing from distribution.

Is that some information you can give us about the third quarter?

And kind of, you know, as it relates to inventory, accounts receivable, operating margin contribution.

That kind of thing?

No, in other words I think we're comfortable with the level of information we give out with regard to distribution and publishing.

You know, we've had, as Paul mentioned, I think a keen eye in the distribution business with regard to more operating production off the bottom line, perhaps than a top line orientation in the past.

And we're seeing the fruits of that and we're very pleased with the profits we're making.

Particularly in the budget title type categories.

Okay.

Is -- as you get all the systems integrated and so on, is that something you will be willing to talk about down the road?

We've put out a little bit of additional information today and we try to be forthcoming, you know, about what we consider to be useful information so people can understand the business appropriately.

At some point it becomes clutter versus useful.

But if you have things specifically that are troubling you, perhaps you can talk to myself or Cindy afterwards and we can always take it into further consideration.

Okay.

All right.

Professional expense has been up for all the obvious reasons.

Can you give us a sense of how Q3 specifically compared to Q3?

And how you expect next fiscal year to compare to this year?

And I guess what I'm asking for a little bit of a sense of what we on the outside might call discretionary or sort of one-time nature, once you get the internal teams in place, the -- you know, the -- the excessive chunk of this starts to go away.

Can you quantify that for us at all?

I think what happened already during the third quarter is we had some abatement in our professional fees.

I can't tell you where we have in terms of a run rate, but we've perhaps been spending a little bit additionally as we mentioned on infrastructure, insurance premiums have certainly gotten a lot more expensive in this environment for general business and, you know, some of the improvements to our internal control environment have, perhaps, substituted for some of the spending earlier this year.

So, we do expect, as I mentioned, to have a G&A spend rate in the $16 million plus range going into next year.

We will have to see how it goes.

Any chance you can give us a sense of what the delta is, the dollar delta in your assumption for next year versus what it is going to be this year for outside professional?

You know, putting aside the -- the spending earlier this year, you know, we typically don't breakdown that type of item and I think that's probably not useful for our discussion here this morning, but we expect to have less professional fees, obviously, throughout fiscal year '03 than we incurred for instance in doing the forensic audits that were done late last year, early this year.

Okay.

The 60/40 split between publishing and distribution does that hold as your basic breakdown for next year's guidance as well?

That's generally been our target.

We've obviously been overachieving that target if you want to think of it as increased contribution from the publishing business.

So, we wouldn't expect to see anything, you know, beyond the 60/40 relationship.

It's entirely possible to do even better than that.

Okay.

And I think you mentioned that 40 SKUs are going to ship next year.

Can you give us a sense of how many of those 40 relate to IP that we know about, maybe other properties you may have signed and announced and how much are brand-new properties that we've never heard of before.

I think the only hints we've given this morning is in my comments, that we have at least one major brand that we probably expect to say something more about with regard to next year.

Beyond that, we indicated that a large number that supports our existing franchises was approximately 50% and beyond that, we will just have to see, you know, when the sales and marketing folks and Kelly and Company are comfortable in talking about our products for next year.

Okay.

And let's see, the DMA team, I gathered Vice City is being done by the old DMA team.

When they come off of that project, can you give us a hint of what their next assignment will look like?

Well, it is actually a number of teams at Rockstar North in Scotland, which was from the DMA.

And not surprisingly, they are or will continue to look at the Grand Theft Auto franchise and obviously depending on the success of Vice City and Grand Theft Auto 3, it would depend on when we release the next version of that franchise.

Obviously at Christmas, we will have two full-priced products out there.

Even next year we could even have three.

But we're -- they're working on Grand Theft Auto 3 franchise and they're working on a IP that Karl mentioned that we haven't disclosed to anybody, but as we get nearer the finalzation of that project, we will -- it is something we think is unique, it is something we really don't want to give anyone or our competitors prior knowledge of.

We're very, very excited about that.

Okay.

And then last question, Paul, this is probably for you, any initial read on Mafia sell-through?

We're pleased with the sales so far.

We got good distribution on it.

It was a good launch and we have a good feel from some of the key guys that it looks like it will be a good title.

I will say that our expectation just to conclude on Mafia, is that it's going to be a significantly larger title internationally, particularly in Germany than it will be in North America.

But we are pleased with the initial rollouts and the sell-through so far.

Great, thank you very much.

We'd like to close the call.

Cindy, myself and Don will be around for additional questions to call in.

For most of you, we're speaking at the Credit Suisse First Boston conference.

We appreciate you getting up early with us on this call.

We look forward to our fourth quarter and year-end results which we will announce in September.

Thank you very much.

Thank you.

This concludes today's conference.

Thank you for your participation.