Take-Two Interactive Software Inc (TTWO) 2005 Q3 法說會逐字稿

Greetings, ladies and gentlemen, and welcome to Take-Two Interactive's third quarter 2005 results 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 zero on your telephone keypad.

As a reminder, this conference is being recorded.

It is now my pressure to introduce Ms. Cindi Buckwalter, Executive Vice President of Take-Two Interactive Software.

Thank you.

Ms. Buckwalter, you may begin.

Good afternoon.

Thank you for joining us for Take-Two's third quarter conference call.

Before we would begin, I would first like to quickly review our Safe Harbor statement by reminding everyone that the statements made during this 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 these forward-looking statements based on a variety of factors.

These important factors are described in our filings with the SEC, including our 10-Q for the second quarter ended April 30, 2005, which may be obtained from our website at www.take2games.com, or by contacting the SEC.

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

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

Today, we will give a detailed discussion of our Q3 results, review our expectations for the balance of fiscal 2005, and provide an early look into fiscal 2006.

While the third quarter was an eventful period, we remained focused on our continued efforts to build on Take-Two's strength.

We are proud of our high-quality product lineup that is the most diverse in our history, and that places us in an excellent position to benefit from the installed base of current generation video game hardware and the introduction of new systems.

We also have maintained a solid financial position to support future growth.

Now let's look at the third quarter in more detail.

Results for Q3 were in line with our revised guidance, with net sales of $170 million and a net loss of $0.41 per share.

These results and our revised guidance reflected a reserve for the return of Grand Theft Auto: San Andreas inventory due to the game being rerated by the ESRB.

During the quarter, the SEC investigation was concluded as the Commission accepted our settlement offer in June.

As we previously disclosed, we recorded an expense related to the SEC settlement in Q4 of fiscal 2004.

We also initiated our $25 million stock repurchase program during the third quarter, and completed it shortly after the close of the quarter.

The share repurchase reflects management's and the board of directors' continued confidence in the value of Take-Two as an investment and in the Company's prospects for the future.

Turning to product highlights, our results for Q3, again, demonstrated the strength of our established franchises, the potential of our newer titles and the additional success of our diversification efforts into lead platforms and genres.

Rockstar had a very strong showing during the quarter.

We were very pleased with the launch of Grand Theft Auto: San Andreas for Xbox and PC.

The Xbox version led the NPD charts in June.

Midnight Club 3: DUB Edition, the latest version of another core Rockstar franchise, launched on the PSP handheld for the North American market in late June.

It was the number one PSP title for July according to NPD, and was the only PSP title on the Top 10 list for all platforms.

We're continuing to see strong demand as the PSP hardware base increases.

In July, we shipped Charlie and the Chocolate Factory on five platforms.

The launch coincided with the release of the movie in mid-July, which performed very well at the box office.

The title has been on ELSA’s (ph) Top 10 list since the release, and it is also one of our most successful GameCube and Game Boy Advance titles ever.

The success of this title further demonstrates our ability to deliver products that are appropriate for specific platforms and their target audiences.

2K Games shipped Sid Meier's Pirates for Xbox, our first title in collaboration with renowned developers FIRAXIS in mid-July.

We're extremely pleased with the critical and consumer response to the Xbox version of this game.

We have also continued to build our 2K sports label. announced Shaquille O'Neal as the cover athlete and official spokesperson for NBA 2K6.

To strengthen the appeal of NHL 2K6 in local markets, we Marty Turco from the Dallas Stars as our U.S. cover athlete, with Matt Sundin from the Toronto Maple Leafs as the cover athlete for our Canadian and European Special Edition.

For Top Spin on PS2, we showed -- we chose tennis superstars Roger Federer and Maria Sharapova as cover athletes.

For our World Poker Tour game, we're featuring famous poker venues and real world poker tour professionals like Phil Laak and Antonio Esfandiari.

I'll wrap up my overview by saying that we continue to be extremely excited about our opportunities.

We have powerful core franchises and increasingly diverse lineup of new high-quality titles.

Our marketplace continues to be vital and growing, with a massive install base of current generation hardware, enthusiastic gamer reception to the PSP, and the upcoming launch of the Xbox 360.

And we have the operational and financial resources to take advantage of these opportunities.

Now Karl will review our financial performance in more detail and discuss our guidance, then Paul will talk about our industry outlook and pipeline.

Karl?

Thanks, Cindi, and good afternoon.

Net sales for the third quarter were 169.9 million, an increase of 6% compared to 160.9 million a year ago.

Our net loss for the quarter 28.8 million, or $0.41 per share, compared to a net loss of 14.4 million or $0.21 per share in the third quarter of 2004.

Let's compare our results for the quarter to the revised guidance we provided back in mid-July, when we reduced our guidance to reflect the anticipated returns of Grand Theft Auto: San Andreas, due to the rerating of the title by the ESRB.

Our original Q3 revenue forecast was 205 to 215 million, and on July 20, we revised our revenue guidance to 160 to $170 million.

Our actual Q3 revenue came in at about 170 million.

As of July 31, the reserve for San Andreas returns was approximately $33 million.

Moving on to more detailed Q3 results, sales of Grand Theft Auto: San Andreas for Xbox and PC led our third quarter sales, representing 37% of the quarter's total revenue.

We also realized strong performance from our other major Q3 releases.

Midnight Club 3: DUB Edition for the PSP was about 6% of total revenue.

Charley and the Chocolate Factory across all platforms was about 8% of total revenue, and Sid Meier's Pirates for Xbox was about 3% of total revenue.

Another top ten title was Midnight Club 3: DUB Edition for PS2 and Xbox, released last quarter, which generated about 7% of total revenue this quarter.

Our top performing titles in Q3 demonstrate the progress we have already made in our diversification efforts across platforms and genres.

With the launch of Midnight Club 3: DUB Edition in PSP, we've successfully begun to expand Rockstar's portfolio into the handheld area; and with Charley and the Chocolate Factory and Sid Meier's Pirates, we've established a track record with high profile licensed properties.

Jack of All Games was impacted by a variety of factors in the quarter.

Jack's top accounts are starting to plan for next-gen products, and accordingly are allocating less shelf space to older platforms.

In addition to lower average selling prices for catalog titles, it also appears that at this point in the console cycle, publishers are increasing going to direct to retailers with their back catalog titles.

This has resulted in reduced volume for Jack in its higher margin, value software and back catalog business.

And while Jack has benefited from the launch of the PSP system, the distribution margins from PSP hardware, accessories and front line software are lower than for value print software for prior gen systems.

Jack is responding to these events by working to secure more exclusive distribution arrangements, creating compelling product bundles of hardware, software, and accessories, and by offering compilations of value software.

We have seen positive results in August from Jack's renewed focus.

Our total gross profit margin for the quarter was approximately 28.1% compared to 26.6% last year.

The primary reason for the increased margin was related to our business mix, as our higher margin publishing sales represented a larger percentage of revenue compared to last year's third quarter.

Our publishing distribution split in the quarter was 75% publishing and 25% distribution, compared to our publishing distribution split of 61% versus 39% last year.

Additionally, we had a larger percentage of higher margin PC products this year.

However, Jack's gross margins came in lower than we have seen recently, in the single digits, due primarily to the higher percentage of hardware and front line software in that business mix, which generates lower margins than value software.

In contrast, the gross margins in our publishing business were in the mid-30s in the quarter.

Royalties increased on a dollar basis and as a percentage of publishing revenue.

The dollar increase was primarily attributable to internal royalty expense associated with our publishing sales.

Additionally, we wrote down prepaid advances for external software development of approximately 1.9 million compared to writedowns of about $200,000 in Q3 last year.

Software development costs increased in dollars and as a percentage of publishing revenue.

The majority of the increase related to amortization and development costs for Midnight Club 3: DUB Edition for PSP and Grand Theft Auto: San Andreas for Xbox and PC, which all shipped in the quarter.

Our operating expenses in the third quarter increased.

Our increase in sales and marketing expenses compared with Q3 last year relates primarily to expanding the advertising and promotional support for our products, led by our advertising campaigns for Grand Theft Auto: San Andreas and Midnight Club 3: DUB Edition.

We also realize incremental expenses for E3 this year, as we had a significantly expanded presence on the show floor, primarily related to the introduction of our 2K games and 2K sports labels, and also due to Rockstar's increased visibility of E3.

General and administrative expenses increased from last year, as we have expanded our corporate infrastructure to support our continued growth.

I was also encouraged significantly by our business and professional fees related Sarbanes-Oxley compliance and legal matters.

And we have incurred higher rent and office expenses compared to Q3 last year, as a result of the development studios we've acquired and the opening of a new office for our 2K games and 2K sports publishing labels.

R&D expenses increased from Q3 last year, due to several development studio acquisitions.

We have also added additional staffing in our studios, reflecting our strategy of bringing more development in-house.

Our head count in R&D has almost doubled from July 2004 to over 1200 people at the end of July 2005.

Also in Q3, we incurred some incentive compensation expenses related to key products that were completed.

Additionally, with the upcoming adoption of FASB 123 in fiscal 2006, which requires us to expense stock options, we have increasingly used restricted stock grants as a form of equity compensation.

Restricted stock is expense as the stock vests over time, so this has a contributor to increased expense year over year across all of our key operating expense line items.

Lastly, depreciation and amortization expenses increased over last year, due principally to the continued global improvements in our software systems, the addition of our new Jack of All Games warehouse, and the buildout of office space earlier this year for 2K games and 2K Sports.

Our tax rate for the quarter was approximately 31%, due primarily to an adjustment in our estimated annual effective tax rate to reflect a change in our geographic mix of business, as we had a significantly higher contribution of earnings from our international operations.

This unexpected shift in geographic mix was primarily due to the reduced sales in North America of Grand Theft Auto: San Andreas as a result of the rerating of the title by the ESRB.

Based on our Q3 results and our projected mix of business for the balance of this year, we now expect our full year tax rate for fiscal 2005 to be about 13%.

We generated cash from operations of approximately 13 million in the third quarter and about 110 million in the first nine months.

We would expect to use cash from operations in Q4 as we gear up for the peak holiday season.

Additionally, since many of our major Q4 releases are planned for release late in the quarter, we won't collect on receivables for these sales until Q1.

At the end of the third quarter, we had 195 million of cash as compared to 155 million at year end, and 210 million at the end of Q2.

During the third quarter, we repurchased approximately 15 million of our stock in our repurchase program.

Shortly after the close of the quarter, we repurchased the remaining 10 million under the $25 million plan.

We repurchased the stock at an average cost of $26.96 per share.

I would like to briefly review some other key balance sheet items.

Net accounts receivable at the end of the third quarter were approximately 62 million, compared to 286 million at year end and 79 million at this time last year.

Our receivables balance was significantly reduced by the $33 million reserve related to anticipated returns of Grand Theft Auto: San Andreas.

Our DSOs in Q3 were 33 days compared to 59 days in the fourth quarter and 45 days in the third quarter last year.

Our business in Q3 was dispersed throughout the quarter, leading to lower than normal DSO levels.

Our accounts receivable reserves stood at about 82 million at the end of the quarter, representing approximately 57% of gross receivables.

Again, the increased reserve level from prior comparable periods is due to the reserve for San Andreas.

If we back out the reserve for returns of San Andreas, our reserves as a percentage of gross receivables would be about 34%.

And again, if we back out the reserve for returns on San Andreas, our Q3 reserves would be approximately 13% of trailing six months' revenue, and about 5% of trailing nine months' revenue, which is in line with Q3 of last year.

Inventories at the end of the quarter were approximately 104 million, a decrease of about 50 million from year end and 12 million from last quarter.

About 65% of our inventory balance relates to our distribution business, with over 85% of the domestic distribution inventory consisting of products with cost of goods below 14.99.

Our software development and license costs totaled about 122 million at the end of the quarter, compared to about 70 million at year end and about 107 million at the end of Q2.

The increase in software development costs since year end relates primarily to the significant ramp-up in new products that we've recently announced for our 2K Games labels, including high profile titles like Oblivion, Civ(ph) IV and Prey.

Additionally, the increase in software development and license costs includes many of the sports titles being developed at our internal studios.

This is in line with the continued execution on our strategy of further expanding our portfolio breadth and depth.

The increase also includes titles that Rockstar is working on internally for near term release, such as The Warriors and Grand Theft Auto Liberty City stories.

We currently have over 140 SKUs in various stages of development, representing over 70 different brands, of which approximately 35 SKUs are planned for the balance of fiscal 2005.

And just a quick balance sheet note: We recently entered into a new $50 million credit line with J.P.

Morgan, replacing our $40 million line with Banc of America and more favorable terms.

Moving on to guidance, we are revising the guidance for full fiscal year 2005 to $1.22 -- $1.22 to 1.27 billion in net sales, and $0.85 and $0.90 in EPS, primarily to reflect the movement of Bully out of fiscal 2005, partially offset by the movement of Sid Meier's Civilization IV into the fiscal year.

Less significantly, but still impacting our fiscal 2005, results we have moved the Japanese launch of Grand Theft Auto: San Andreas out of the fiscal year into Q1.

Today, we are also issuing initial guidance for fiscal 2006.

For the full year, guidance is 1.4 billion to 1.5 billion in net sales, and earnings per share of $1.25 to $1.55.

For Q1, our guidance is 350 million to 400 million in net sales and earnings per share at $0.14 to $0.20.

With the adoption of FASB 123 on November 1, 2005 requiring the expensing of employee stock options, we estimate the impact of this accounting change will result in earnings per share of $1.05 to $1.30 for the fiscal year ending October 31, 2006, and $0.10 to $0.15 for the first quarter ending January 31, 2006.

It is important to note that next year is a period with numerous uncertainties for Take-Two and our industry.

This means our fiscal 2006 numbers may be impacted by a variety of factors, including the launch of two major console platforms -- the Xbox 360 and the Playstation 3 -- as well as the European launch of the PSP.

Additionally, because of our October fiscal year, we are giving guidance today not only for the current holiday period, but for the beginning of holiday 2006.

While we are optimistic about the many opportunities presented to us over the next 12 to 18 months, these market dynamics create uncertainty across many fronts, including the hardware availability, consumer adoption levels and product pricing movements.

We have taken all of these factors into account in determining our initial fiscal 2006 guidance; but we'd note that we will be closely monitoring industry developments as our fiscal year unfolds.

Now let me provide a bit more color and key assumptions underlying our fiscal 2006 guidance.

We expect our publishing business to represent about 65 to 75% of our total revenue on both a quarterly and annual basis, with distribution accounting for the remainder.

Within our publishing business, we expect about 50% of revenue to come from our Rockstar label and about 50% to come from our 2K Games, 2K Sports and Global Star labels.

Of our total publishing revenue from all labels, about 70 to 75% will come from sequels, extensions of proven brands and catalog products, and about 25 to 30% of publishing revenue will come from new brands.

Breaking these numbers down further, we expect our sports business to represent approximately 30% of total publishing, and our Grand Theft Auto franchise to represent about 25% of total publishing revenue.

We've assumed that our top-five titles in fiscal 2006, excluding sports titles, will contribute in the aggregate of about 30% of publishing revenue, ranging by way of individual contributions from 4 to 8%.

In terms of our platform mix, we're assuming the following break down of our publishing revenue by platform: 25 to 30% from PlayStation 2; 25 to 30% from PSP; 15 to 20% from Xbox 360, 10 to 15% from Xbox, about 10% from PC and about 5% from PlayStation 3 and all other platforms.

Lastly, moving on to our tax position, based on our projected geographic mix of business in fiscal 2006, we expect our tax rate to be in the 25% area.

In looking at our Q1 guidance, and -- in particular, and the dynamics impacting margins in the quarter, it is important to keep in mind our product mix, which is heavily weighted with Xbox 360 titles from 2K Sports and the launch of the Elder Scrolls IV: Oblivion.

We are excited about the prospects for these titles, and we have taken a prudent approach in estimating initial launch quantities on Xbox 360 titles, as the installed base of hardware ramps up.

We would note the majority of these products are licensed titles, which can actually have different economics than products which are internally owned.

Although we are not currently providing 2006 quarterly guidance beyond the first quarter, we would expect the quarterly break down of fiscal 2006 to correlate to our historical trends.

Looking forward, our fiscal 2006 guidance assumes we continue to make significant investments in next generation products and portfolio diversification, two of our most important corporate mandates.

Rockstar is investing significant resources in their fiscal 2007 line up, when Sony's Playstation 3 is expected to be ramping up in North America.

And 2K Sports and 2K Games continue to build their portfolio of sports and licensed products to capture market share in an area that represents a major source of growth for Take-Two.

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

At this point, I'll turn the call over to Paul to cover our product line up and additional corporate developments.

Paul?

Thanks, Karl.

We believe that Take-Two's long-term prospects have never been better.

Our lineup of established and new brands, as well as our top creative talent, growing development teams and solid financial resources, have placed us in a strong competitive position.

We're building on that position by leveraging our publishing and distribution capabilities.

Before I talk about our view of the industry and our product pipeline, I want to comment briefly on the rerating of Grand Theft Auto: San Andreas.

While this was a challenging situation, never seen before in our industry, our Company addressed it with both professionalism and integrity.

We strongly support the ESRB rating system, and strictly follow their guidelines for marketing and advertising our products.

The rating system is the most important tool for parents to make informed entertainment choices for their families.

Responding to the ESRB decision, we took swift and immediate action to comply with the rerating to maintain our good relationships with our retail partners and to protect our intellectual property and brand franchise.

We expect to release M-rated second editions of the Xbox and PC titles next week, with the PS2 shipping later in the quarter.

We do not believe it is appropriate to comment on the FTC inquiry, other than to say we are fully cooperating with it.

But I will tell you I'm proud of how our Company quickly and professionally handled a difficult matter.

Now I'd like to comment on the outlook for the overall business.

As we look at the industry today, we see numerous opportunities for Take-Two.

The installed base of video game hardware is now over 150 million units in North America and Europe alone.

While a lot of attention has been directed towards next-generation hardware, this enormous installed base of current gen hardware will generate continued demand for our products.

Moving to the next gen, we think the positive consumer response in PSP provides a good indication of the strong demand for new hardware.

Sony has shipped approximately 2 million PSPs in the U.S. so far, and it was reported that Sony delivered near the upper end of their projected shipments to Europe last week.

We agree with industry analyst projections that PSP shipments will reach 10 million units worldwide by the end of calendar '05.

The strength of this new handheld platform creates incremental opportunities for Rockstar and 2K products.

The Xbox 360 is planned for launch in November.

We agree with industry estimates of approximately 2 million Xbox 360 units in the U.S., and 3 million units by the end of calendar '05.

We are enthusiastic about our international growth opportunities.

Both Sony and Microsoft are strongly committed to supporting their products in the European market.

All reports from retail over the weekend indicate European PSP hardware and software sales were strong, and initial indications show that the European launch of Midnight Club 3: DUB Edition for the PSP was well received.

We feel very good about the European launch of Grand Theft Auto: Liberty City Stories for PSP later this quarter.

The Grand Theft Auto brand is particularly strong in Europe.

Europe represents a great opportunity for Take-Two, and we continue to build infrastructure and form strategic relationships in all key areas for growth.

Taking these hardware plans into consideration, we believe that the market will continue to grow in fiscal '06.

We are working to expand Take-Two's market share, and we're extremely well positioned for the significant opportunities that will be presented by the favorable industry dynamics.

Our recent positive experience with the release of Midnight Club 3: DUB Edition for PSP in the U.S., which Cindi described earlier, demonstrates the consumers are eager for our products on next gen hardware.

As shown by our release schedule, we are also well positioned for the Xbox 360, with five titles ready at launch: NBA 2K6, NHL 2K6, Top Spin 2 and 3, and the Elder Scrolls IV: Oblivion.

I'll come back to our full pipeline in just a minute.

We're continuing to invest in the expansion of our development capabilities to ensure that we have the best creative talent to maximize our next gen opportunities, including Playstation 3.

Our internal development around the world is now over 1200.

With that overview of the industry's growth prospects and our initiatives to capitalize on this potential, let me turn to our product pipeline.

For the fourth quarter of '05, product highlights will include: Grand Theft Auto: Liberty City Stories for PSP;

Midnight Club 3: DUB Edition for PSP in Europe, which shipped last week;

The much anticipated Rockstar title, The Warriors, for PS2 and Xbox.

We moved Sid Meier's Civilization IV for PC into the fourth quarter.

NBA 2K6 for PS2 and Xbox;

NHL 2K6 for PS2 and Xbox, which is shipping this week;

Top Spin for PS2;

World Poker Tour for Xbox, PS2 and Game Boy Advance;

Conflict Global Terror for PS2, Xbox and PC;

Vietcong 2 for PC;

Serious Sam 2 for PC and Xbox;

Zathura for PS2 and Xbox, based on the Columbia Pictures feature film directed by John Favreau and starring Tim Robbins.

Also, Dora the Explorer and Code Name Kids Next Door for console.

For fiscal '06, our expectations are for top line growth of 15 to 18%, and EPS growth of over 40%.

At this early date, products currently planned for fiscal '06 include: Rockstar will introduce extensions of its Grand Theft Auto franchise, a sequel to an existing Rockstar brand, two additional PSP titles, an Xbox 360 title based on a new brand, along with Bully for PS2 and Xbox in the second quarter.

Bully was moved out of the Rockstar Q4 lineup to provide more development time.

While product movement is disappointing in the short-term, releasing the game in early '06 is absolutely the right decision to ensure Bully meets the standards fans have come to expect from Rockstar titles.

Grand Theft Auto: San Andreas for the Japanese market was moved to Q1.

Looking forward, Rockstar is supporting next generation platforms, with commitments of key franchises for holiday '06 and beyond.

For fiscal '06 from 2K, we have the following titles: For Xbox 360, we have NBA 2K6, NHL 2K6, College Hoops 2K6, Top Spin 2, The Elder Scrolls IV: Oblivion, and Amp 3.

Top Spin 2 will also be on DS and GBA, and the Elder Scrolls IV: Oblivion on PC. 2K also has 24: The Game for PS2 in North America;

Prey for PC and Xbox 360;

MLB 2K6 on multiple platforms, including Xbox 360, and NBA 2K7 on multiple platforms, including Xbox 360.

Of the titles that will ship from now through the end of fiscal '06, we have over 12 with the potential of selling one million-plus units.

These potential top-selling units include Grand Theft Auto: Liberty City Stories, The Warriors, Bully, Sid Meier's Civ IV, NBA 2K6 and 2K7, Elder Scrolls IV: Oblivion, Prey, and MLB Baseball 2K6.

Looking forward, we are confident about our position in the industry and marketplace.

Our business is entering a new cycle of hardware innovation and growth while enjoying an enormous installed base of current generation hardware.

Take-Two is entering this cycle with the most extensive and diverse product line in our history, including AAA products from Rockstar and a popular and growing portfolio of Sports and the high quality games from 2K.

We continue to have a strong balance sheet to support our growth, with 195 million in cash and no debt.

In summary, I want to reiterate that our industry is extremely robust, and that Take-Two's long term prospects have never been better.

Now, we'd like to open up the call to question and answers.

Thank you. [OPERATOR INSTRUCTIONS].

Our first question is coming from Edward Williams with Harris Nesbitt Gerard.

Hi, couple of -- couple of questions for you.

The R&D headcount, can you break it down between 2K and Rockstar at this point?

Edward, it's probably -- it's about 3/4s Rockstar, 1/4 2K.

Okay, and how do you expect the headcount to change over the course of the balance of this fiscal year into 2006?

I think we -- we've certainly shown, you know, in the past the history of getting involved with, you know, games and franchises, and from time to time we bring those on internally.

We have also grown the studios internally, as we -- for instance, with Rockstar, we have gone with hand-held launches and products like that.

So a difficult question, but we certainly are open to acquisition of things that fit within our, you know, strategic outlook, and as we need to bring on resources to develop things for more and more platforms as we move into the future, we'll do that as well.

With that said, Ed, we were very fortunate last year with the 2K acquisitions that went all very, very smoothly, with Visual Concepts, Kush and Indie Built.

It really continues to support the great effort they are doing in the sports games with real high-quality product.

And our Rockstar guys, you know, are very much focused on continuing to build compelling product and really utilizing the tools and technologies, the resources that they have been given for next gen, as they approach this transition.

Okay, and just a follow-up on the buyback, with your new line of credit, can you still buy back stock at this point?

No, we have not announced any further program with regard to buyback, and we've completed the program that was announced.

Okay, and then the last question.

Paul, you had mentioned 12 titles that could surpass one million units in sell through; are you assuming that all of them will?

Are we assuming?

We -- when we look at the projections, we have a -- you know, a balanced mix on there, and we have identified over 12 that we think are million unit sellers -- some, you know, are more than million unit sellers, so it kind of balances out.

And Edward, you know, we gave some ranges on the platforms, which certainly, you know, shows we try to run some level of sensitivity in terms of, you know, what the mix can be, so yes.

And different from the past, when we entered the last transition, you know, with the PlayStation 2, we were heavily focused on PlayStation 2.

What you are seeing today is a much more balanced portfolio supporting, you know, the different consoles in the marketplace.

So we will have titles next year that, you know, support three or more consoles.

Okay, thank you.

Our next question is coming from Tony Gikas with Piper Jaffray.

Hi, good afternoon, guys.

Couple of questions.

It looks -- you know, looking at the guidance you have provided for 2006, it looks like margins are coming under pressure somewhat there, and looking at sales of about 1.4 or 5 and EPS $1.25 to $1.55.

Where in the mix there are the margins coming under pressure, why, and are there any software products that moved out of 2006 potentially?

Second question, could you just clarify for us -- you talked about the 33 million in reserve for the hot coffee issues as it related to.

Is that where the reserve stands today, or is that what you reserved for the quarter?

Could you just clarify that for us?

Tony, you know, the margins for next year, you know, certainly range from the high -- we'll call them the internally owned and developed products -- and as you know, those perform handsomely for us.

And then more modestly, when we get into -- we'll call it the 2K end of the business, because they're typically licensed or third party developed products, and then the Jack of All Games business.

So we certainly have, I think, in front of us the proof of the diversification already showing up in the business currently; and ahead of us, you know, for 2006 when we talk about a balanced portfolio of 50% coming from 2K and 50% coming from Rockstar.

So when you lay that all into the math, you'll see some margins -- you know, we always would like to see high margins, but margins that make sense to us with that product mix.

Having said that, I'm not aware of anything that we really moved out of 2006 into the beyond when we really sat down and have been working this over the, you know, recent past.

With regard to the $33 million reserve, that was the reserve as of the end of July that we felt was warranted to address products that could be returned for San Andreas.

So is it your take that there are further returns coming in?

Will the reserves be sufficient?

Or are you perhaps, you know, overreserved?

And then a follow-up to the first part of that.

Do you expect that the SKU count next year could come down?

I mean, do you guys -- do you plan to start weeding out some of these, you know, games that aren't, you know, having large sell through?

I mean, do you really need to publish Outlaw and Tennis, for example.

I think with regard -- let me finish the reserve.

The $33 million is on an accrual basis.

We feel that's the appropriate amount to handle this issue.

And you know, you understand that the return activity can, you know, vary, that that doesn't have to do with the accrual accounting as the product comes in from retailers; but we feel $33 million is the right number to address this issue.

And with regard to the SKU count for the future, Paul?

Two comments.

As we build out the sports and build out our 2K Games group, because of the product mix -- and we have seen in sports there are a lot of pressure on the margin with the various, you know, licensing from the leagues.

But as we complement that with other products that either we own or we have lower margins, you know, we believe that there's a big opportunity to expand that margin.

Regarding what you said in terms of lesser products, we believe that we're in a pretty dynamic marketplace right now, and we have the Global Star label, It's a smaller label and they've really focused on a lot of value products.

And what I believe that we will see in the next year and two years is that not every product is going to go out the door at AAA-type pricing or even A-type pricing.

But there will be titles that will have a spot in the market, but they will be at lower pricing, more value-oriented.

And when we take on some titles that don't have high profiles, we'll manage them separately.

We'll -- there's a whole different culture and there's a whole different group that will manage that to maximize to try to, you know, make money with quantities that are not, you know, AAA.

We do that for two reasons: one, because we have good relationships at retail, and also it's a natural feed into our distribution business.

Okay.

Thanks.

Our next question is coming from Mike Wallace with UBS.

Hi, couple of things.

Back to the charge, 33 million -- and I'm assuming it's about 800,000 units if it's 40 bucks a pop.

Is that the level of inventory?

That seems kind of high for what would be out there for all of the GTA products?

And along those lines, if at some point that level doesn't get returned, do you reserve -- reverse that reserve in a quarter or two?

Or how long do you keep it out there?

Mike, I can't fault you necessarily on the math -- we won’t get right into the last unit.

We certainly did have the ability to estimate the number of units that we felt, you know, would be subject to return.

We're comfortable with that level of reserve.

You know, as -- as with any estimate, it is subject to an estimation process.

But we do have good information that backs that process up.

And if there's any final true up, I certainly would not expect that to be of any significant nature.

Remember that that also was the U.S., Canada and Australia, and included Xbox, Playstation 2 and PC; and the vast majority of retailers, I guess due to the somewhat of the publicity around this, opted to return the product.

Okay.

Second question about the distribution business, which seemed very weak.

I think you said that more publishers are going direct at this point in the cycle, and I just know in the past, usually at the end of a cycle, more publishers are going through distributors because there's a lot of product out there that ends up not selling at the end of a cycle.

Well, what happened this summer was we were up against a lot of promotions from last summer, that in the transition retailers were very much focused on inventory.

They were, you know, cutting back shelf space on some -- or maintaining their inventory, or driving their inventory down.

We think that that will open up some opportunities going into the back half of this year and going forward, where real retailers will see the opportunity for value priced software -- someone like Jack with their sales organization, can manage it for them.

But we saw a little bit of a shift this summer that we don't believe is long term and, you know, we're reacting to it.

Our guys have done a good job in locking up promotions.

August was a strong month for us and we see the opportunity to move that product mix back into the more of the value priced stuff that we make the better margin on.

So just looking at the numbers, it looks like there is growth for distribution in '06.

Should we assume the margins are similar to where they are now, or up or down in '06 for distribution?

We think it will skew a little bit towards a hardware mix, Mike, so you know, just a little lighter than perhaps in recent years.

But again, the opportunities, we think, are ahead of us for our holiday season.

Also remember, retailers were very concerned this summer about controlling or maintaining their inventory mix with some of the uncertainty of ship dates of next gen hardware, quantities of next gen hardware, so we had a slightly unusual summer for the value business.

Yes.

Okay, and then last question, with your guidance for '06 for the end of October, what kind of 360 install base are you assuming, and do you have the PS3 shipping in your fiscal '06?

We have very, very small exposure to PS3 shipments in late '06, and we assume, you know, some modest increases over the launch quantities that we discussed on the call -- you know, continued flow of product from Microsoft.

Okay.

All right.

Thank you.

Thanks, Mike.

Our next question is coming from Heath Terry from Credit Suisse First Boston.

Thank you.

Can you clarify a little bit more -- you talked a little bit about plans for the GTA franchise, and obviously that's going to have a big impact on '06 extensions and such.

Can you talk a little bit more about what you mean by that and what we should be thinking about as far as time line and thought process, particularly given the hardware transition around the next kind of key GTA release?

And then if you could also talk a little bit about the increase that we saw on G&A.

I know -- you know, obviously, Sarbanes-Oxley and the recall had a lot to do with that.

How much of that should we expect to carry forward into future quarters?

Okay.

Regarding Grand Theft Auto, we believe that when we get the product San Andreas back in the market we'll see some reaction to the pent-up demand that that product has not been on the shelves now for a period of time.

We are very excited about Liberty City Stories and extending that brand to PSP.

We think that, you know, we have the opportunity with a brand as big as Grand Theft Auto to continue to do things like that, and we've shown in the past that we can be fairly innovative in taking that brand.

You know, we own that brand we control that brand.

The brand is really all about, you know, compelling content, great story line; and we have the ability to expand it in a number of different ways.

So we will continue to capitalize on that, you know, all during '06.

And just to -- Heath to your question about G&A, you are right; we certainly experienced significantly increased professional fees related to Sarbanes-Oxley, as well as some of the other legal matters that we have been dealing with in the past quarter.

I would also say that some of the investments that we're making in terms of building out the 2K Sports and 2K Games label into the building infrastructure a little bit more for them here in New York has added to some of the G&A.

As well as some of the studios that we brought on in the past year have also increased our overhead.

Going forward, though, I think we would expect to kind of see that you know, G&A to level out, kind of the mid-to you know, high 30s per quarter in the fiscal '06 period.

Okay.

Thank you.

Our next question is coming from John Taylor with Arcadia.

Hi, I got a couple of questions.

The first one, Karl, could you walk us through the accounting of how you dealt with the San Andreas recall?

You know, I think you said you did about 37% of revenue from that.

So I'm wondering is, did you book a gross amount which included the 33 and then take that off to report the net number of the roughly 62, and just kind of -- how did you treat that, because -- you know, in terms of accounting -- because it all took place in the quarter?

And the other thing is, I wonder if you could talk about whether you are going to get any relief from Microsoft/Sony on the royalty for replacing the product that you had to destroy or had to take back, basically?

And I’ve got another question after that, thanks.

J.T., with regard to the, you know, accounting during the quarter, yes, we launched the PC and the Xbox titles earlier in the quarter; and the simple answer to the question is, you know, near the end of the quarter, we booked a return reserve provision to deal with what we thought was the estimated exposure for product that would come back.

And as Paul mentioned, you know, a large, large majority of retailers opted to remove the product from the shelf, and have taken actions to send it back to us.

So would I be wrong then in thinking about the gross amount that was originally shipped in, to take the GTA contribution of revenue and add the 33 on top of it to come up with a gross selling number?

I think you would have to mindful of the fact we had three SKUs in the marketplace, and only two of which were launched during the quarter.

So I'd make that adjustment, okay, great.

And then any -- any sense of whether you are going to get relief on the royalty side on the bill of goods?

I think with regard to the relaunch of the product, you know, we have a variety of plans in place and at this point, you know, I think we should deal with that as we go rather than get ahead of ourselves.

So -- but from a cost standpoint, would you expect there to be much margin difference between what you reship in and what you originally shipped in?

I would suspect there shouldn't be that much difference.

Okay, all right.

And then -- I think you mentioned having five 360 titles available at launch of that platform.

So what sense do you get of the role that Microsoft is going to play as gatekeeper in terms of not flooding the market with too many SKUs so that those that are out there are -- you know, can have a chance to make a little bit of money and to space things out as we go through the -- say the first six months of the launch?

J.T., is that your last best question?

That will be my last one, yes.

We're trying not to enforce the one-question policy too tightly.

Okay, go ahead.

J.T., we feel they are acting as a good gatekeeper, but the -- you know, just producing quality product and getting it done on time has been the biggest factor that will limit a flood of products.

And we have experienced a very good relationship with Microsoft, and you see the list of titles that we have supporting 360.

They're the type of titles that they want on the platform.

So I -- you know, I feel good about it.

So -- so are you thinking -- are those available basically on launch date or are those pretty much spread out for a little while?

Well, our goal on those five is to get, you know, very close to launch, and then we have, you know, titles that ship after, and then we'll have more titles throughout the year; but those five in particular we believe -- and some of them on sports, you know, strategically it's important to have them near or -- you know, near or at launch.

Yes.

Okay.

Thank you.

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

Hey, guys, couple of questions.

Is there another Grand Theft Auto on the consoles in your fiscal year '06 plan?

That's my first question.

We haven't announced that yet, Gary.

What we feel good about is the PSP gain that is getting some real great press from the publications who have had a feel and touch of the product, so we haven't made any announcements beyond that.

Okay.

Second question.

I think there was a statement in there about fiscal year '06 quarterly guidance mirroring what it has been in the past.

And I think what it has been in the past is there's a gain in EPS in Q1 and Q4 and a loss in Q2 and Q3.

Do you expect that pattern to hold?

And if it does, it looks like your Q4 is going to be a pretty good EPS number.

Do I have that about right?

Gary, yes, we did mention that, you know, we expect seasonally to sort of follow where we have been in the past.

And, you know, those are holiday oriented quarters, Q1 and Q4, and the other quarters are somewhat lighter; having said that, we do have some plans for having good products in the marketplace during the middle of the year as well.

So -- but I don't think you're drawing conclusions that are off the beam.

Okay.

Last issue here.

So let's think about this PSP guidance, I think you said 25 to 30% revenue.

I back into it -- depending on what you price your products at, whether it's $40 or something less -- it's somewhere in the neighborhood of 7 or 8 million PSP units that you will -- or that you're planning to ship in your fiscal year '06 guidance.

So depending again on what the install base is, that looks like 20% market share or somewhere in the neighborhood on the PSP platform.

Can you give us some idea, since you plan to take a pretty meaningful amount of share on this platform, what kind of games we're talking about here?

Is this shipments(ph) of the extension of Grand Theft Auto?

Is that a -- is that another extension of the PSP?

Well, we had two games that will follow or roll into '06; particularly, we believe that the Grand Theft Auto PSP Liberty City Stories has the potential to be a hardware driver.

We also have two other Rockstar titles that for PSP that will fall in '06.

And on top of that, we have a number of titles that you could assume would be under the 2K group that would extend a lot of their brands.

So we feel based on the development decisions we have been making in the past year that we have a real opportunity on the PSP, and we're pretty excited about it.

And given the fact that we have the October fiscal year, we're able to really benefit from both this holiday season as well as the beginning of next holiday season with sales of the PSP and as the hardware continues to ramp-up.

Okay.

Thanks.

Our next question is coming from Elizabeth Osur with Citigroup.

Thanks.

I have two questions.

One, I was hoping maybe you could comment on the profitability of the sports business, I guess where you expect to end up this fiscal year, whether it's still supposed to be kind of a break even prospect; and then two, what you'd expect for next year?

Well, the -- we -- we definitely expect enhanced profitability from the 2K business overall, you know, coming up in '06 versus '05. '05 was sort of an entry year for much of the ability of the sports lineup or the business overall, as we've put together a team there.

And they certainly have shown a lot of success in the earliest of quarters.

As we move into this holiday season, you know, we have a variety of pricing strategies in mind, and we're going to choose to be fairly close to the vest about that, given the fact it is a competitive marketplace and we have significant competitors who work in that space.

But, you know, we've certainly been on record saying that we believe, you know, as we get into the next gen, that quality sports products can be full price and premium price by nature, and we're not backing off of that.

Just to clarify that, does that mean the sports business is possible for fiscal ‘06 in your expectations?

We prefer to make a profit.

Okay.

And this last question, I was hoping you guys could be a little more specific on your cost expectations for next fiscal year and where you think gross margin will come out.

You know, I think our gross margins generally, you know, we would expect to range in the 30s.

You know, it depends on which quarter we're looking at and the contribution, again, of -- we'll call it Rockstar -- versus 2K business, and the distribution business.

So there's no neat way to generalize that for you at this point early on when we are staring at two holiday seasons in advance.

But we try to give some clues in the mix of the business, the divisions, the platforms and I think that's probably the best we can do at this point for you.

Okay, thanks.

Our next question is coming from Mike Hickey with Janco Partners.

Hi, thank you.

If you could just clarify on the roughly 800,000 units that have been returned or reserved to be returned, and I guess are AO rated.

How do you -- what are you -- what is your intent on the redistribution of that product?

There is no intent to redistribute that product.

So, what are you going to do with it?

We would presumably destroy it.

And then on 360 pricing, it looks like Microsoft -- I mean, initial indications is like a $60 price point.

It looks like Microsoft has opted to go for a $50 price point.

How do you think third party publishers will respond to that?

Do you think that we're going to be averaging around $50 price points for next generation software, and what kind of pressure do you think that will put on that current generation pricing?

Well, at this point, we feel that, you know, next gen will either be $50 or $60 retails -- 49 or 59 -- and we think we have some products that definitely convey at the higher end of that.

And I believe that we're all pretty excited that the existing generation of hardware, the pricing has held up very -- you know, nicely or very strongly, but there will be some pressure down, potentially as hardware pricing comes down, on the existing gen.

And just to add to that, I think we've had the experience seeing first party publishers sometimes try different -- use different price points for first party titles, and in the past we've still been able to hold pricing at higher levels -- again, also based on the quality of the titles.

Operator, we'll take one more question.

Our next question is coming from Arvind Bhatia with Southwest Securities.

Good afternoon.

First question is just if you could explain the GTA Japan movement.

I think you've talked about Bully but what the reason was for GTA shifting, and if you could give us a catalog sales number for this quarter?

Arvind, just to jump in on the last question, catalogs was about 10% of total publishing.

Okay.

The GTA movement is just us working within the Japanese market in that culture, and you know, we're developing and building our relationship with CapCon(ph).

We also have a relationship with Sega, and just -- the cultural issues of how to get that product out.

And then one last one, if I could.

Since you are launching five products on the 360, can you tell us what your experience has been so far in terms of development costs and how they compare to say PS2 or Xbox?

Each one is different, because of a number of those titles, or some of them were PC The costs are higher.

We're really pushing our studios to operate within the different studios to have more of a synergy in how they approach the business.

But the costs are higher, but they vary by the type of game.

Okay.

I don't have a great answer for you on that, Arvind.

Okay, thanks.

Thank you all for joining us today.

We look forward to speaking with you on our call in December.

Bye.

Thank you.

This concludes today's conference.

You may disconnect your lines at this time.