UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
þ | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the Quarterly Period Ended December 31, 2011
OR
¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the Transition Period from to
Commission File No. 000-17948
ELECTRONIC ARTS INC.
(Exact name of registrant as specified in its charter)
Delaware | 94-2838567 | |
(State or other jurisdiction of incorporation or organization) |
(I.R.S. Employer Identification No.) | |
209 Redwood Shores Parkway Redwood City, California |
94065 | |
(Address of principal executive offices) | (Zip Code) |
(650) 628-1500
(Registrants telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES þ NO ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). YES þ NO ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act.
Large accelerated filer þ | Accelerated filer ¨ | |||||||
Non-accelerated filer ¨ | Smaller reporting company ¨ | |||||||
(Do not check if a smaller reporting company) |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES ¨ NO þ
As of February 2, 2012, there were 331,388,311 shares of the Registrants Common Stock, par value $0.01 per share, outstanding.
FORM 10-Q
FOR THE PERIOD ENDED DECEMBER 31, 2011
Table of Contents
Page | ||||||
Item 1. |
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Condensed Consolidated Balance Sheets as of December 31, 2011 and March 31, 2011 |
3 | |||||
4 | ||||||
Condensed Consolidated Statements of Cash Flows for the Nine Months Ended December 31, 2011 and 2010 |
5 | |||||
Notes to Condensed Consolidated Financial Statements (Unaudited) |
6 | |||||
33 | ||||||
Item 2. |
Managements Discussion and Analysis of Financial Condition and Results of Operations |
34 | ||||
Item 3. |
59 | |||||
Item 4. |
62 | |||||
Item 1. |
63 | |||||
Item 1A. |
63 | |||||
Item 2. |
74 | |||||
Item 3. |
74 | |||||
Item 6. |
74 | |||||
75 | ||||||
76 |
2
PART I FINANCIAL INFORMATION
Item 1. | Condensed Consolidated Financial Statements (Unaudited) |
ELECTRONIC ARTS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited) (In millions, except par value data) |
December 31, 2011 |
March 31, 2011 (a) |
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ASSETS |
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Current assets: |
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Cash and cash equivalents |
$ | 1,242 | $ | 1,579 | ||||
Short-term investments |
406 | 497 | ||||||
Marketable equity securities |
143 | 161 | ||||||
Receivables, net of allowances of $295 and $304, respectively |
526 | 335 | ||||||
Inventories |
69 | 77 | ||||||
Deferred income taxes, net |
92 | 56 | ||||||
Other current assets |
328 | 327 | ||||||
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Total current assets |
2,806 | 3,032 | ||||||
Property and equipment, net |
547 | 513 | ||||||
Goodwill |
1,716 | 1,110 | ||||||
Acquisition-related intangibles, net |
402 | 144 | ||||||
Deferred income taxes, net |
44 | 49 | ||||||
Other assets |
181 | 80 | ||||||
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TOTAL ASSETS |
$ | 5,696 | $ | 4,928 | ||||
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LIABILITIES AND STOCKHOLDERS EQUITY |
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Current liabilities: |
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Accounts payable |
$ | 112 | $ | 228 | ||||
Accrued and other current liabilities |
846 | 768 | ||||||
Deferred net revenue (packaged goods and digital content) |
1,439 | 1,005 | ||||||
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Total current liabilities |
2,397 | 2,001 | ||||||
0.75% convertible senior notes due 2016, net |
534 | | ||||||
Income tax obligations |
183 | 192 | ||||||
Deferred income taxes, net |
82 | 37 | ||||||
Other liabilities |
235 | 134 | ||||||
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Total liabilities |
3,431 | 2,364 | ||||||
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Commitments and contingencies (See Note 13) |
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Stockholders equity: |
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Preferred stock, $0.01 par value. 10 shares authorized |
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Common stock, $0.01 par value. 1,000 shares authorized; 332 and 333 shares issued and outstanding, respectively |
3 | 3 | ||||||
Paid-in capital |
2,549 | 2,495 | ||||||
Accumulated deficit |
(477 | ) | (153 | ) | ||||
Accumulated other comprehensive income |
190 | 219 | ||||||
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Total stockholders equity |
2,265 | 2,564 | ||||||
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TOTAL LIABILITIES AND STOCKHOLDERS EQUITY |
$ | 5,696 | $ | 4,928 | ||||
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See accompanying Notes to Condensed Consolidated Financial Statements (unaudited).
(a) Derived from audited consolidated financial statements.
3
ELECTRONIC ARTS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited) | Three Months Ended December 31, |
Nine Months Ended December 31, |
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(In millions, except per share data) | 2011 | 2010 | 2011 | 2010 | ||||||||||||
Net revenue |
$ | 1,061 | $ | 1,053 | $ | 2,775 | $ | 2,499 | ||||||||
Cost of goods sold |
552 | 586 | 1,224 | 1,171 | ||||||||||||
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Gross profit |
509 | 467 | 1,551 | 1,328 | ||||||||||||
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Operating expenses: |
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Marketing and sales |
269 | 253 | 631 | 553 | ||||||||||||
General and administrative |
98 | 75 | 260 | 226 | ||||||||||||
Research and development |
325 | 273 | 928 | 825 | ||||||||||||
Amortization of intangibles |
11 | 14 | 37 | 44 | ||||||||||||
Acquisition-related contingent consideration |
(11 | ) | 1 | 8 | (25 | ) | ||||||||||
Restructuring and other charges |
| 154 | 17 | 162 | ||||||||||||
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Total operating expenses |
692 | 770 | 1,881 | 1,785 | ||||||||||||
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Operating loss |
(183 | ) | (303 | ) | (330 | ) | (457 | ) | ||||||||
Gain on strategic investments, net |
| | | 23 | ||||||||||||
Interest and other income (expense), net |
(10 | ) | | (13 | ) | 6 | ||||||||||
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Loss before provision for (benefit from) income taxes |
(193 | ) | (303 | ) | (343 | ) | (428 | ) | ||||||||
Provision for (benefit from) income taxes |
12 | 19 | (19 | ) | (1 | ) | ||||||||||
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Net loss |
$ | (205 | ) | $ | (322 | ) | $ | (324 | ) | $ | (427 | ) | ||||
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Net loss per share: |
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Basic and Diluted |
$ | (0.62 | ) | $ | (0.97 | ) | $ | (0.98 | ) | $ | (1.29 | ) | ||||
Number of shares used in computation: |
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Basic and Diluted |
332 | 332 | 331 | 330 |
See accompanying Notes to Condensed Consolidated Financial Statements (unaudited).
4
ELECTRONIC ARTS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited) | Nine Months Ended December 31, |
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(In millions) | 2011 | 2010 | ||||||
OPERATING ACTIVITIES |
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Net loss |
$ | (324 | ) | $ | (427 | ) | ||
Adjustments to reconcile net loss to net cash provided by (used in) operating activities: |
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Depreciation, amortization and accretion, net |
148 | 138 | ||||||
Stock-based compensation |
129 | 138 | ||||||
Acquisition-related contingent consideration |
8 | (25 | ) | |||||
Non-cash restructuring charges |
(3 | ) | 1 | |||||
Net gains on investments and sale of property and equipment |
(12 | ) | (24 | ) | ||||
Change in assets and liabilities: |
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Receivables, net |
(176 | ) | (180 | ) | ||||
Inventories |
11 | (4 | ) | |||||
Other assets |
(81 | ) | (9 | ) | ||||
Accounts payable |
(150 | ) | 59 | |||||
Accrued and other liabilities |
50 | 34 | ||||||
Deferred income taxes, net |
(44 | ) | 32 | |||||
Deferred net revenue (packaged goods and digital content) |
434 | 334 | ||||||
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Net cash provided by (used in) operating activities |
(10 | ) | 67 | |||||
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INVESTING ACTIVITIES |
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Capital expenditures |
(128 | ) | (38 | ) | ||||
Proceeds from sale of property and equipment |
26 | | ||||||
Proceeds from sale of marketable equity securities |
| 132 | ||||||
Proceeds from maturities and sales of short-term investments |
463 | 282 | ||||||
Purchase of short-term investments |
(374 | ) | (367 | ) | ||||
Acquisition of subsidiaries, net of cash acquired |
(676 | ) | (16 | ) | ||||
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Net cash used in investing activities |
(689 | ) | (7 | ) | ||||
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FINANCING ACTIVITIES |
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Proceeds from issuance of common stock |
39 | 17 | ||||||
Proceeds from borrowings on convertible senior notes, net of issuance costs |
617 | | ||||||
Proceeds from issuance of warrants |
65 | | ||||||
Purchase of convertible note hedge |
(107 | ) | | |||||
Excess tax benefit from stock-based compensation |
4 | | ||||||
Repurchase and retirement of common stock |
(230 | ) | | |||||
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Net cash provided by financing activities |
388 | 17 | ||||||
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Effect of foreign exchange on cash and cash equivalents |
(26 | ) | 3 | |||||
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Increase (decrease) in cash and cash equivalents |
(337 | ) | 80 | |||||
Beginning cash and cash equivalents |
1,579 | 1,273 | ||||||
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Ending cash and cash equivalents |
$ | 1,242 | $ | 1,353 | ||||
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Supplemental cash flow information: |
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Cash paid (refunded) during the period for income taxes, net |
$ | (4 | ) | $ | 11 | |||
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Non-cash investing activities: |
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Change in unrealized gains on available-for-sale securities, net of taxes |
$ | (16 | ) | $ | 23 | |||
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Equity issued in connection with acquisition |
$ | 87 | $ | | ||||
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See accompanying Notes to Condensed Consolidated Financial Statements (unaudited).
5
ELECTRONIC ARTS INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(1) DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION
We develop, market, publish and distribute game software and content that can be played by consumers on a variety of platforms, including video game consoles (such as the Sony PLAYSTATION 3, Microsoft Xbox 360, and Nintendo Wii), personal computers, mobile phones (such as the Apple iPhone and Google Android compatible phones), tablets and electronic readers (such as the Apple iPad and Amazon Kindle), the Internet, and handheld game players (such as the Sony PlayStation Portable (PSP) and the Nintendo DS and 3DS). Some of our games are based on content that we license from others (e.g., FIFA, Madden NFL, STAR WARS, Harry Potter, and Hasbros toy and game intellectual properties), and some of our games are based on our own wholly-owned intellectual property (e.g., The Sims, Need for Speed, Battlefield, Mass Effect, and Dead Space). Our goal is to publish titles with global mass-market appeal, which often means translating and localizing them for sale in non-English speaking countries. In addition, we also attempt to create software game franchises that allow us to publish new titles on a recurring basis that are based on the same property. Examples of this franchise approach are the annual iterations of our sports-based products (e.g., FIFA, Madden NFL, and NCAA Football), wholly-owned properties that can be successfully sequeled (e.g., The Sims, Need for Speed, Battlefield, Mass Effect, and Dead Space) and titles based on long-lived literary and/or movie properties (e.g., Harry Potter and STAR WARS).
Our fiscal year is reported on a 52- or 53-week period that ends on the Saturday nearest March 31. Our results of operations for the fiscal years ending or ended, as the case may be, March 31, 2012 and 2011 contain 52 weeks each, and ends or ended, as the case may be, on March 31, 2012 and April 2, 2011, respectively. Our results of operations for the three months ended December 31, 2011 and 2010 contained 13 weeks each, and ended on December 31, 2011 and January 1, 2011, respectively. Our results of operations for the nine months ended December 31, 2011 and 2010 contained 39 weeks each, and ended on December 31, 2011 and January 1, 2011, respectively. For simplicity of disclosure, all fiscal periods are referred to as ending on a calendar month end.
The Condensed Consolidated Financial Statements are unaudited and reflect all adjustments (consisting only of normal recurring accruals unless otherwise indicated) that, in the opinion of management, are necessary for a fair presentation of the results for the interim periods presented. The preparation of these Condensed Consolidated Financial Statements requires management to make estimates and assumptions that affect the amounts reported in these Condensed Consolidated Financial Statements and accompanying notes. Actual results could differ materially from those estimates. The results of operations for the current interim periods are not necessarily indicative of results to be expected for the current year or any other period.
These Condensed Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and Notes thereto included in our Annual Report on Form 10-K for the fiscal year ended March 31, 2011, as filed with the United States Securities and Exchange Commission (SEC) on May 24, 2011.
(2) SIGNIFICANT ACCOUNTING POLICIES
Revenue Recognition
We evaluate revenue recognition based on the criteria set forth in Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 985-605, Software: Revenue Recognition, and Staff Accounting Bulletin (SAB) No. 101, Revenue Recognition in Financial Statements, as revised by SAB No. 104, Revenue Recognition. We evaluate and recognize revenue when all four of the following criteria are met:
| Evidence of an arrangement. Evidence of an agreement with the customer that reflects the terms and conditions to deliver products must be present. |
| Delivery. Delivery is considered to occur when a product is shipped and the risk of loss and rewards of ownership have been transferred to the customer. For online game services, delivery is considered to occur as the service is provided. For digital downloads that do not have an online service component, delivery is generally considered to occur when the download is made available. |
| Fixed or determinable fee. If a portion of the arrangement fee is not fixed or determinable, we recognize revenue as the amount becomes fixed or determinable. |
6
| Collection is deemed probable. We conduct a credit review of each customer involved in a significant transaction to determine the creditworthiness of the customer. Collection is deemed probable if we expect the customer to be able to pay amounts under the arrangement as those amounts become due. If we determine that collection is not probable, we recognize revenue when collection becomes probable (generally upon cash collection). |
Determining whether and when some of these criteria have been satisfied often involves assumptions and management judgments that can have a significant impact on the timing and amount of revenue we report in each period. For example, for our multiple element software arrangements, we must make assumptions and judgments in order to (1) determine whether and when each element has been delivered, (2) determine whether undelivered products or services are essential to the functionality of the delivered products and services, (3) determine whether vendor specific objective evidence of fair value (VSOE) exists for each undelivered element, and (4) allocate the total price among the various elements we must deliver. Changes to any of these assumptions or management judgments, or changes to the elements in a software arrangement, could cause a material increase or decrease in the amount of revenue that we report in a particular period.
Depending on the type of product, we may offer an online service that permits consumers to play against others via the Internet and/or receive additional updates or content from us. For those games that consumers can play via the Internet, we may provide a matchmaking service that permits consumers to connect with other consumers to play against each other online. In those situations where we do not require an additional fee for this online service, we account for the sale of the software product and the online service as a bundled sale, or multiple element arrangement, in which we sell both the software product and the online service for one combined price. We defer net revenue from sales of these games for which we do not have VSOE for the online service that we provided in connection with the sale, and recognize the revenue from these games over the estimated online service period, which is generally estimated to be six months beginning in the month after shipment.
In addition, for some software products we also provide updates or additional content (digital content) to be delivered via the Internet that can be used with the original software product. In many cases we separately sell digital content for an additional fee; however, some purchased digital content can only be accessed via the Internet (i.e., the consumer never takes possession of the digital content). We account for online transactions in which the consumer does not take possession of the digital content as a service transaction, and accordingly, we recognize the associated revenue over the estimated service period. In other transactions, at the date we sell the software product we have an obligation to provide incremental unspecified digital content in the future without an additional fee. In these cases, we account for the sale of the software product as a multiple element arrangement and recognize the revenue on a straight-line basis over the estimated period of game play.
Determining whether a transaction constitutes an online service transaction or a digital content download of a product requires judgment and can be difficult. The accounting for these transactions is significantly different. Revenue from product downloads is generally recognized when the download is made available (assuming all other recognition criteria are met). Revenue from an online game service is recognized as the service is rendered. If the service period is not defined, we recognize the revenue over the estimated service period. Determining the estimated service period is inherently subjective and is subject to regular revision based on historical online usage. In addition, determining whether we have an implicit obligation to provide incremental unspecified future digital content without an additional fee can be difficult.
Product Revenue. Product revenue, including sales to resellers and distributors (channel partners), is recognized when the above criteria are met. We reduce product revenue for estimated future returns, price protection, and other offerings, which may occur with our customers and channel partners.
Shipping and Handling. We recognize amounts billed to customers for shipping and handling as revenue. Additionally, shipping and handling costs incurred by us are included in cost of goods sold.
Online Subscription Revenue. Online subscription revenue is derived principally from subscription revenue collected from customers for online play related to our massively multiplayer online games and Pogo-branded online games services. These customers generally pay on an annual basis or a month-to-month basis and prepaid subscription revenue is recognized ratably over the period for which the services are provided.
Software Licenses. We license software rights to original equipment manufacturers (OEMs) of products in related industries (for example, makers of personal computers or computer accessories) to include certain of our products with the manufacturers product, or offer our products to consumers who have purchased the manufacturers product. We call these combined products OEM bundles. These OEM bundles generally require the customer to pay us an upfront nonrefundable fee, which represents the guaranteed minimum royalty amount. Revenue is generally recognized upon delivery of the product master or the first copy. Per-copy royalties on sales that exceed the minimum guarantee are recognized as earned.
7
Adoption of ASU 2009-13 and ASU 2009-14
On April 3, 2011, we adopted FASB Accounting Standards Update (ASU) 2009-13, Revenue Recognition (Topic 605): Multiple-Deliverable Revenue Arrangements and ASU 2009-14, Software (Topic 985): Certain Revenue Arrangements that Include Software Elements. The new accounting principles establish a selling price hierarchy for determining the selling price of a deliverable and require the application of the relative selling price method to allocate the arrangement consideration to each deliverable in a multiple element arrangement that includes tangible products. In some of our multiple element arrangements, we sell tangible products with software and/or online services. These tangible products are generally either peripherals or ancillary collectors items. Prior to April 3, 2011, because either the software or other elements sold with the tangible products were essential to the functionality of the tangible product and/or we did not have VSOE for the tangible product, we did not separately account for the tangible product.
For our multiple element arrangements that include tangible products entered into after April 2, 2011, revenue is allocated to each separate unit of accounting for each deliverable using the relative selling prices of each deliverable in the arrangement based on the selling price hierarchy described below. If the arrangement contains more than one software deliverable, the arrangement consideration is allocated to the software deliverables as a group and then allocated to each software deliverable in accordance with ASC 985-605.
We determine the selling price for a tangible product deliverable based on the following selling price hierarchy: VSOE (i.e., the price we charge when the tangible product is sold separately) if available, third-party evidence (TPE) of fair value (i.e., the price charged by others for similar tangible products) if VSOE is not available, or our best estimate of selling price (BESP) if neither VSOE nor TPE is available. Determining the BESP is a subjective process that is based on multiple factors including, but not limited to, recent selling prices and related discounts, market conditions, customer classes, sales channels and other factors.
As the result of the adoption of these standards, for the three and nine months ended December 31, 2011, we recognized $15 million more revenue than would have been recognized under previous accounting standards.
(3) FAIR VALUE MEASUREMENTS
Fair value is the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining fair value, we consider the principal or most advantageous market in which we would transact and consider assumptions that market participants would use when pricing the asset or liability. We measure certain financial and nonfinancial assets and liabilities at fair value on a recurring and nonrecurring basis.
Fair Value Hierarchy
The three levels of inputs that may be used to measure fair value are as follows:
| Level 1. Quoted prices in active markets for identical assets or liabilities. |
| Level 2. Observable inputs other than quoted prices included within Level 1, such as quoted prices for similar assets or liabilities, quoted prices in markets with insufficient volume or infrequent transactions (less active markets), or model-derived valuations in which all significant inputs are observable or can be derived principally from or corroborated with observable market data for substantially the full term of the assets or liabilities. |
| Level 3. Unobservable inputs to the valuation methodology that are significant to the measurement of the fair value of assets or liabilities. |
8
Assets and Liabilities Measured at Fair Value on a Recurring Basis
As of December 31, 2011 and March 31, 2011, our assets and liabilities that were measured and recorded at fair value on a recurring basis were as follows (in millions):
Fair Value Measurements at Reporting Date Using | ||||||||||||||||||
Quoted Prices in Active Markets for Identical Financial Instruments |
Significant Other Observable Inputs |
Significant Unobservable Inputs |
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As of December 31, 2011 |
(Level 1) | (Level 2) | (Level 3) |
Balance Sheet Classification | ||||||||||||||
Assets |
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Money market funds |
$ | 398 | $ | 398 | $ | | $ | | Cash equivalents | |||||||||
Available-for-sale securities: |
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Corporate bonds |
151 | | 151 | | Short-term investments | |||||||||||||
Marketable equity securities |
143 | 143 | | | Marketable equity securities | |||||||||||||
U.S. Treasury securities |
138 | 138 | | | Short-term investments and cash equivalents | |||||||||||||
U.S. agency securities |
125 | | 125 | | Short-term investments and cash equivalents | |||||||||||||
Commercial paper |
18 | | 18 | | Short-term investments and cash equivalents | |||||||||||||
Deferred compensation plan assets (a) |
11 | 11 | | | Other assets | |||||||||||||
Foreign currency derivatives |
3 | | 3 | | Other current assets | |||||||||||||
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Total assets at fair value |
$ | 987 | $ | 690 | $ | 297 | $ | | ||||||||||
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Liabilities |
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Contingent consideration (b) |
$ | 159 | $ | | $ | | $ | 159 | Accrued and other current liabilities and other liabilities | |||||||||
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Total liabilities at fair value |
$ | 159 | $ | | $ | | $ | 159 | ||||||||||
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Fair Value Measurements Using Significant Unobservable Inputs (Level 3) |
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Contingent Consideration |
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Balance as of March 31, 2011 |
$ | 51 | ||||||||||||||||
Additions |
100 | |||||||||||||||||
Change in fair value (c) |
8 | |||||||||||||||||
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Balance as of December 31, 2011 |
$ | 159 | ||||||||||||||||
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As of March 31, 2011 |
(Level 1) | (Level 2) | (Level 3) | Balance Sheet Classification | ||||||||||||||
Assets |
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Money market funds |
$ | 774 | $ | 774 | $ | | $ | | Cash equivalents | |||||||||
Available-for-sale securities: |
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Corporate bonds |
253 | | 253 | | Short-term investments | |||||||||||||
Marketable equity securities |
161 | 161 | | | Marketable equity securities | |||||||||||||
U.S. Treasury securities |
129 | 129 | | | Short-term investments and cash equivalents | |||||||||||||
U.S. agency securities |
102 | | 102 | | Short-term investments | |||||||||||||
Commercial paper |
31 | | 31 | | Short-term investments and cash equivalents | |||||||||||||
Deferred compensation plan assets (a) |
12 | 12 | | | Other assets | |||||||||||||
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Total assets at fair value |
$ | 1,462 | $ | 1,076 | $ | 386 | $ | | ||||||||||
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Liabilities |
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Contingent consideration (b) |
$ | 51 | $ | | $ | | $ | 51 | Accrued and other current liabilities and other liabilities | |||||||||
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Total liabilities at fair value |
$ | 51 | $ | | $ | | $ | 51 | ||||||||||
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Fair Value Measurements Using Significant Unobservable Inputs (Level 3) |
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Contingent Consideration |
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Balance as of March 31, 2010 |
$ | 65 | ||||||||||||||||
Additions |
3 | |||||||||||||||||
Change in fair value (c) |
(17 | ) | ||||||||||||||||
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Balance as of March 31, 2011 |
$ | 51 | ||||||||||||||||
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(a) | The deferred compensation plan assets consist of various mutual funds. |
(b) | The contingent consideration as of December 31, 2011 represents the estimated fair value of the additional variable cash consideration payable primarily in connection with our acquisitions of PopCap Games, Inc. (PopCap), Playfish Limited (Playfish), KlickNation Corporation (KlickNation), and Chillingo Limited (Chillingo) that is contingent upon the |
9
achievement of certain performance milestones. The contingent consideration as of March 31, 2011 represents the estimated fair value of the additional variable cash consideration payable primarily in connection with our acquisitions of Playfish and Chillingo that is contingent upon the achievement of certain performance milestones. We estimated the fair value using expected future cash flows over the period in which the obligations are expected to be settled, and applied a discount rate that appropriately captures a market participants view of the risk associated with the obligations. In connection with the acquisition of PopCap during the second quarter of fiscal year 2012, we recognized an additional $95 million of contingent consideration. See Note 6 for additional information related to the PopCap contingent consideration and final allocation of purchase price. |
(c) | The change in fair value is reported as acquisition-related contingent consideration in our Condensed Consolidated Statements of Operations. |
Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis
There were no material impairment charges for assets and liabilities measured at fair value on a nonrecurring basis in periods subsequent to initial recognition during the three and nine months ended December 31, 2011 and 2010.
(4) FINANCIAL INSTRUMENTS
Cash and Cash Equivalents
As of December 31, 2011 and March 31, 2011, our cash and cash equivalents were $1,242 million and $1,579 million, respectively. Cash equivalents were valued at their carrying amounts as they approximate fair value due to the short maturities of these financial instruments.
Short-Term Investments
Short-term investments consisted of the following as of December 31, 2011 and March 31, 2011 (in millions):
As of December 31, 2011 | As of March 31, 2011 | |||||||||||||||||||||||||||||||
Cost
or Amortized Cost |
Gross Unrealized | Fair Value |
Cost
or Amortized Cost |
Gross Unrealized | Fair Value |
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Gains | Losses | Gains | Losses | |||||||||||||||||||||||||||||
Corporate bonds |
$ | 150 | $ | 1 | $ | | $ | 151 | $ | 252 | $ | 1 | $ | | $ | 253 | ||||||||||||||||
U.S. Treasury securities |
123 | | | 123 | 124 | | | 124 | ||||||||||||||||||||||||
U.S. agency securities |
120 | | | 120 | 102 | | | 102 | ||||||||||||||||||||||||
Commercial paper |
12 | | | 12 | 18 | | | 18 | ||||||||||||||||||||||||
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Short-term investments |
$ | 405 | $ | 1 | $ | | $ | 406 | $ | 496 | $ | 1 | $ | | $ | 497 | ||||||||||||||||
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We evaluate our investments for impairment quarterly. Factors considered in the review of investments with an unrealized loss include the credit quality of the issuer, the duration that the fair value has been less than the adjusted cost basis, severity of the impairment, reason for the decline in value and potential recovery period, the financial condition and near-term prospects of the investees, our intent to sell the investments, any contractual terms impacting the prepayment or settlement process, as well as if we would be required to sell an investment due to liquidity or contractual reasons before its anticipated recovery. Based on our review, we did not consider these investments to be other-than-temporarily impaired as of December 31, 2011 and March 31, 2011.
10
The following table summarizes the amortized cost and fair value of our short-term investments, classified by stated maturity as of December 31, 2011 and March 31, 2011 (in millions):
As of December 31, 2011 |
As of March 31, 2011 |
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Amortized Cost |
Fair Value |
Amortized Cost |
Fair Value |
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Short-term investments |
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Due in 1 year or less |
$ | 187 | $ | 187 | $ | 214 | $ | 214 | ||||||||
Due in 1-2 years |
118 | 118 | 156 | 157 | ||||||||||||
Due in 2-3 years |
100 | 101 | 126 | 126 | ||||||||||||
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Short-term investments |
$ | 405 | $ | 406 | $ | 496 | $ | 497 | ||||||||
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Marketable Equity Securities
Our investments in marketable equity securities consist of investments in common stock of publicly-traded companies and are accounted for as available-for-sale securities and are recorded at fair value. Unrealized gains and losses are recorded as a component of accumulated other comprehensive income in stockholders equity, net of tax, until either the security is sold or we determine that the decline in the fair value of a security to a level below its adjusted cost basis is other-than-temporary. We evaluate these investments for impairment quarterly. If we conclude that an investment is other-than-temporarily impaired, we will recognize an impairment charge at that time in our Condensed Consolidated Statements of Operations.
Marketable equity securities consisted of the following as of December 31, 2011 and March 31, 2011 (in millions):
Adjusted Cost |
Gross Unrealized Gains |
Gross Unrealized Losses |
Fair Value |
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As of December 31, 2011 |
$ | 32 | $ | 111 | $ | | $ | 143 | ||||||||
As of March 31, 2011 |
$ | 32 | $ | 129 | $ | | $ | 161 |
We did not recognize any impairment charges during the three and nine months ended December 31, 2011 on our marketable equity securities. We did not recognize impairment charges during the three months ended December 31, 2010 on our marketable equity securities. During the nine months ended December 31, 2010, we recognized impairment charges of $2 million on our investment in The9. Due to various factors, including but not limited to, the extent and duration during which the market price of this security had been below its adjusted cost and our intent to hold this security, we concluded the decline in value was other-than-temporary. The impairment charge for the nine months ended December 31, 2010 is included in gain on strategic investments, net in our Condensed Consolidated Statement of Operations.
We did not sell any of our marketable securities during the three and nine months ended December 31, 2011 and the three months ended December 31, 2010. During the nine months ended December 31, 2010, we received proceeds of $121 million from the sale of our investment in Ubisoft and realized gains of $28 million, net of costs to sell. During the nine months ended December 31, 2010, we sold the remaining portions of our investment in The9 and received proceeds of $11 million and realized losses of $3 million. The realized gains and losses for the nine months ended December 31, 2010 are included in gain on strategic investments, net in our Condensed Consolidated Statement of Operations.
0.75% Convertible Senior Notes Due 2016
The following table summarizes the carrying value and fair value of our 0.75% Convertible Senior Notes due 2016 (in millions):
As of December 31, 2011 | ||||||||
Carrying Value |
Fair Value |
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0.75% Convertible Senior Notes due 2016 |
$ | 534 | $ | 615 |
The carrying value of the 0.75% Convertible Senior Notes due 2016 excludes the fair value of the equity conversion feature, which was classified as equity upon issuance, while the fair value is based on quoted market prices for the 0.75% Convertible Senior Notes due 2016, which includes the equity conversion feature. See Note 12 for additional information related to our 0.75% Convertible Senior Notes due 2016.
11
(5) DERIVATIVE FINANCIAL INSTRUMENTS
The assets or liabilities associated with our derivative instruments and hedging activities are recorded at fair value in other current assets or accrued and other current liabilities, respectively, on our Condensed Consolidated Balance Sheets. As discussed below, the accounting for gains and losses resulting from changes in fair value depends on the use of the derivative instrument and whether it is designated and qualifies for hedge accounting.
We transact business in various foreign currencies and have significant international sales and expenses denominated in foreign currencies, subjecting us to foreign currency risk. We purchase foreign currency option contracts, generally with maturities of 15 months or less, to reduce the volatility of cash flows primarily related to forecasted revenue and expenses denominated in certain foreign currencies. In addition, we utilize foreign currency forward contracts to mitigate foreign exchange rate risk associated with foreign-currency-denominated monetary assets and liabilities, primarily intercompany receivables and payables. The foreign currency forward contracts generally have a contractual term of approximately three months or less and are transacted near month-end. At each quarter-end, the fair value of the foreign currency forward contracts generally is not significant. We do not use foreign currency option or foreign currency forward contracts for speculative or trading purposes.
Cash Flow Hedging Activities
Our foreign currency option contracts are designated and qualify as cash flow hedges. The effectiveness of the cash flow hedge contracts, including time value, is assessed monthly using regression analysis, as well as other timing and probability criteria. To qualify for hedge accounting treatment, all hedging relationships are formally documented at the inception of the hedges and must be highly effective in offsetting changes to future cash flows on hedged transactions. The effective portion of gains or losses resulting from changes in the fair value of these hedges is initially reported, net of tax, as a component of accumulated other comprehensive income in stockholders equity. The gross amount of the effective portion of gains or losses resulting from changes in the fair value of these hedges is subsequently reclassified into net revenue or research and development expenses, as appropriate, in the period when the forecasted transaction is recognized in our Condensed Consolidated Statements of Operations. In the event that the gains or losses in accumulated other comprehensive income are deemed to be ineffective, the ineffective portion of gains or losses resulting from changes in fair value, if any, is reclassified to interest and other income (expense), net, in our Condensed Consolidated Statements of Operations. In the event that the underlying forecasted transactions do not occur, or it becomes remote that they will occur, within the defined hedge period, the gains or losses on the related cash flow hedges are reclassified from accumulated other comprehensive income to interest and other income (expense), net, in our Condensed Consolidated Statements of Operations. During the reporting periods, all forecasted transactions occurred, and therefore, there were no such gains or losses reclassified into interest and other income (expense), net. As of December 31, 2011, we had foreign currency option contracts to purchase approximately $90 million in foreign currency and to sell approximately $46 million of foreign currency. All of the foreign currency option contracts outstanding as of December 31, 2011 will mature in the next 12 months. As of March 31, 2011, we had foreign currency option contracts to purchase approximately $40 million in foreign currency and to sell approximately $10 million of foreign currency. As of December 31, 2011 and March 31, 2011, the fair value of these outstanding foreign currency option contracts was immaterial and is included in other current assets.
The effect of the gains and losses from our foreign currency option contracts in our Condensed Consolidated Statements of Operations for the three and nine months ended December 31, 2011 and 2010 was immaterial, and is included in interest and other income (expense), net.
Balance Sheet Hedging Activities
Our foreign currency forward contracts are not designated as hedging instruments, and are accounted for as derivatives whereby the fair value of the contracts is reported as other current assets or accrued and other current liabilities on our Condensed Consolidated Balance Sheets, and gains and losses resulting from changes in the fair value are reported in interest and other income (expense), net, in our Condensed Consolidated Statements of Operations. The gains and losses on these foreign currency forward contracts generally offset the gains and losses in the underlying foreign-currency-denominated monetary assets and liabilities, which are also reported in interest and other income (expense), net, in our Condensed Consolidated Statements of Operations. As of December 31, 2011, we had foreign currency forward contracts to purchase and sell approximately $662 million in foreign currencies. Of this amount, $623 million represented contracts to sell foreign currencies in exchange for U.S. dollars, $30 million to purchase foreign currency in exchange for U.S. dollars, and $9 million to sell foreign currency in exchange for British pounds sterling. As of March 31, 2011, we had foreign currency forward contracts to purchase and sell approximately $187 million in foreign currencies. Of this amount, $140 million represented contracts to sell foreign currencies in exchange for U.S. dollars, $31 million to purchase foreign currency in exchange for U.S. dollars, and $16 million to sell foreign currency in exchange for British pounds sterling. As of December 31, 2011 and March 31, 2011, the fair value of our foreign currency forward contracts was immaterial and is included in accrued and other liabilities.
12
The effect of foreign currency forward contracts in our Condensed Consolidated Statements of Operations for the three and nine months ended December 31, 2011 and 2010, was as follows (in millions):
Gain Recognized in Income on Derivative | ||||||||||||||||||
Location of Gain |
Three Months Ended December 31, |
Nine Months Ended December 31, |
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2011 | 2010 | 2011 | 2010 | |||||||||||||||
Foreign currency forward contracts not designated as hedging instruments |
Interest and other income (expense), net |
$ | 19 | $ | 12 | $ | 33 | $ | 7 |
(6) BUSINESS COMBINATIONS
PopCap Games Inc. Acquisition
In August 2011, we acquired all of the outstanding shares of PopCap for an aggregate purchase price of approximately (1) $645 million in cash and (2) $87 million in privately-placed shares of our common stock to the founders and chief executive officer of PopCap. In addition, we agreed to grant over a four year period to PopCaps employees up to $50 million in long-term equity retention arrangements in the form of restricted stock unit awards and options to acquire our common stock. These awards and options will be accounted for as stock-based compensation in accordance with ASC 718, Compensation Stock Compensation. PopCap is a leading developer of games for mobile phones, tablets, PCs, and social network sites. This acquisition strengthens our participation in casual gaming and contributes to the growth of our digital product offerings. The following table summarizes the acquisition date fair value of the consideration transferred which consisted of the following (in millions):
Cash |
$ | 645 | ||||
Equity |
87 | |||||
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Total purchase price |
$ | 732 | ||||
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The equity included in the consideration above consisted of privately-placed shares of our common stock, whose fair value was determined based on the quoted market price of our common stock on the date of acquisition.
In addition, we may be required to pay additional variable cash consideration that is contingent upon the achievement of certain performance milestones through December 31, 2013 and is limited to a maximum of $550 million based on achievement of certain non-GAAP earnings targets before interest and tax. The estimated fair value of the contingent consideration arrangement at the acquisition date was $95 million. We estimated the fair value of the contingent consideration using probability assessments of expected future cash flows over the period in which the obligation is expected to be settled, and applied a discount rate that appropriately captures a market participants view of the risk associated with the obligation.
The final allocation of the purchase price was based on valuations of certain assets and liabilities and was completed during the third quarter of fiscal year 2012. The following table summarizes the fair values of assets acquired and liabilities assumed at the date of acquisition (in millions):
Current assets |
$ | 62 | ||||
Property and equipment, net |
6 | |||||
Goodwill |
563 | |||||
Finite-lived intangible assets |
302 | |||||
Contingent consideration |
(95 | ) | ||||
Deferred income taxes, net |
(51 | ) | ||||
Other liabilities |
(55 | ) | ||||
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Total purchase price |
$ | 732 | ||||
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13
All of the goodwill was assigned to our EA Brands Segment. None of the goodwill recognized upon acquisition is deductible for tax purposes. See Note 7 for additional information related to the changes in the carrying amount of goodwill and Note 17 for segment information.
Finite-lived intangible assets acquired in this transaction are being amortized on a straight-line basis over their estimated lives ranging from three to nine years. The intangible assets as of the date of the acquisition include:
Gross Carrying Amount (in millions) |
Weighted-Average Useful Life (in years) | |||||
Developed and core technology |
$ | 245 | 6 | |||
Trade names and trademarks |
40 | 9 | ||||
In-process research and development |
15 | 5 | ||||
Other intangibles |
2 | 4 | ||||
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Total finite-lived intangibles |
$ | 302 | 6 | |||
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In connection with our acquisition of PopCap, we acquired in-process research and development assets valued at approximately $15 million in relation to game software that had not reached technical feasibility as of the date of acquisition. The fair value of PopCaps products under development was determined using the income approach, which discounts expected future cash flows from the acquired in-process technology to present value. The discount rates used in the present value calculations were derived from an average weighted average cost of capital of 13 percent. Should the in-process software not be successfully completed, completed at a higher cost, or the development efforts go beyond the timeframe estimated by management, we may not receive the full benefits anticipated from the acquisition. Benefits from the development efforts are expected to begin to be received in the fourth quarter of fiscal year 2012 and the development efforts are expected to be completed in fiscal year 2013.
There were six in-process research and development projects acquired as of the acquisition date each with $4 million or less of assigned fair value and $15 million of aggregate fair value. Additionally each project had less than $2 million of estimated costs to complete and $5 million aggregate cost to complete. As of the acquisition date, the weighted-average estimated percentage completion of all six projects combined was 36 percent.
The results of operations of PopCap and the estimated fair market values of the assets acquired and liabilities assumed have been included in our Condensed Consolidated Financial Statements since the date of acquisition. Pro forma results of operations have not been presented because the effect of the acquisition was not material to our Condensed Consolidated Statements of Operations.
KlickNation and Other Fiscal 2012 Acquisitions
In November 2011, we acquired KlickNation, a developer of social role-playing games. During the nine months ended December 31, 2011, we completed three other acquisitions. These business combinations were completed for total cash consideration of approximately $55 million. These acquisitions were not material to our Consolidated Balance Sheets and Statements of Operations. The results of operations and the estimated fair value of the acquired assets and assumed liabilities have been included in our Consolidated Financial Statements since the date of the acquisitions. See Note 7 for information regarding goodwill and acquisition-related intangible assets. Pro forma results of operations have not been presented because the effect of the acquisitions was not material to our Condensed Consolidated Statements of Operations.
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(7) GOODWILL AND ACQUISITION-RELATED INTANGIBLES, NET
The changes in the carrying amount of goodwill are as follows (in millions):
EA Brands Segment | ||||
As of March 31, 2011 |
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Goodwill |
$ | 1,478 | ||
Accumulated impairment |
(368 | ) | ||
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Total |
1,110 | |||
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Goodwill acquired |
610 | |||
Effects of foreign currency translation |
(4 | ) | ||
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As of December 31, 2011 |
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Goodwill |
2,084 | |||
Accumulated impairment |
(368 | ) | ||
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Total |
$ | 1,716 | ||
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Acquisition-related intangibles consisted of the following (in millions):
As of December 31, 2011 | As of March 31, 2011 | |||||||||||||||||||||||
Gross Carrying Amount |
Accumulated Amortization |
Acquisition- Related Intangibles, Net |
Gross Carrying Amount |
Accumulated Amortization |
Acquisition- Related Intangibles, Net |
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Developed and core technology |
$ | 518 | $ | (212 | ) | $ | 306 | $ | 259 | $ | (180 | ) | $ | 79 | ||||||||||
Trade names and trademarks |
131 | (81 | ) | 50 | 90 | (70 | ) | 20 | ||||||||||||||||
Carrier contracts and related |
85 | (66 | ) | 19 | 85 | (62 | ) | 23 | ||||||||||||||||
Registered user base and other intangibles |
91 | (79 | ) | 12 | 86 | (64 | ) | 22 | ||||||||||||||||
In-process research and development |
15 | | 15 | | | | ||||||||||||||||||
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Total |
$ | 840 | $ | (438 | ) | $ | 402 | $ | 520 | $ | (376 | ) | $ | 144 | ||||||||||
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Amortization of intangibles for the three and nine months ended December 31, 2011 was $25 million (of which $14 million was recognized in cost of goods sold) and $62 million (of which $25 million was recognized in cost of goods sold), respectively. Amortization of intangibles for the three and nine months ended December 31, 2010 was $17 million (of which $3 million was recognized in cost of goods sold) and $53 million (of which $9 million was recognized in cost of goods sold), respectively. Acquisition-related intangible assets are amortized using the straight-line method over the lesser of their estimated useful lives or the agreement terms, typically from two to fourteen years. As of December 31, 2011 and March 31, 2011, the weighted-average remaining useful life for acquisition-related intangible assets was approximately 5.7 years and 5.1 years, respectively.
As of December 31, 2011, future amortization of acquisition-related intangibles that will be recorded in cost of goods sold and operating expenses is estimated as follows (in millions):
Fiscal Year Ending March 31, |
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2012 (remaining three months) |
$ | 21 | ||
2013 |
84 | |||
2014 |
70 | |||
2015 |
63 | |||
2016 |
52 | |||
Thereafter |
112 | |||
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Total |
$ | 402 | ||
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15
(8) RESTRUCTURING AND OTHER CHARGES
Restructuring and other restructuring plan-related information as of December 31, 2011 was as follows (in millions):
Fiscal
2011 Restructuring |
Fiscal
2010 Restructuring |
Fiscal
2009 Restructuring |
Fiscal
2008 Reorganization |
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Workforce | Other | Workforce | Facilities- related |
Other | Facilities- related |
Facilities- related |
Total | |||||||||||||||||||||||||
Balances as of March 31, 2010 |
$ | | $ | | $ | 8 | $ | 11 | $ | 7 | $ | 3 | $ | | $ | 29 | ||||||||||||||||
Charges to operations |
13 | 135 | | | 13 | | | 161 | ||||||||||||||||||||||||
Charges settled in cash |
(8 | ) | (32 | ) | (8 | ) | (6 | ) | (15 | ) | (1 | ) | | (70 | ) | |||||||||||||||||
Charges settled in non-cash |
(2 | ) | (2 | ) | | 1 | | | | (3 | ) | |||||||||||||||||||||
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Balances as of March 31, 2011 |
3 | 101 | | 6 | 5 | 2 | | 117 | ||||||||||||||||||||||||
Charges to operations |
(1 | ) | 19 | | (3 | ) | 12 | | (10 | ) | 17 | |||||||||||||||||||||
Charges settled in cash |
(2 | ) | (40 | ) | | (2 | ) | (14 | ) | | 10 | (48 | ) | |||||||||||||||||||
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Balances as of December 31, 2011 |
$ | | $ | 80 | $ | | $ | 1 | $ | 3 | $ | 2 | $ | | $ | 86 | ||||||||||||||||
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Fiscal 2011 Restructuring
In fiscal year 2011, we announced a plan focused on the restructuring of certain licensing and developer agreements in an effort to improve the long-term profitability of our packaged goods business. Under this plan, we amended certain licensing and developer agreements. To a much lesser extent, as part of this restructuring we had workforce reductions and facilities closures through March 31, 2011. Substantially all of these exit activities were completed by March 31, 2011.
As part of our fiscal 2011 restructuring plan, we amended certain license agreements to terminate certain rights we previously had to use the licensors intellectual property. However, under these agreements we continue to be obligated to pay the contractual minimum royalty-based commitments set forth in the original agreements. Accordingly, we recognized losses and impairments of $121 million representing (1) the net present value of the estimated payments related to terminating these rights and (2) writing down assets associated with these agreements to their approximate fair value. In addition, for one agreement, the actual amount of the loss is variable and subject to periodic adjustments as it is dependent upon the actual revenue we generate from the games. Because the loss for one agreement will be paid in installments through June 2016, our accrued loss was computed using the effective interest method. We currently estimate recognizing in future periods through June 2016, approximately $13 million for the accretion of interest expense related to this obligation. This interest expense will be included in restructuring and other charges in our Condensed Consolidated Statement of Operations.
In addition, for the development of certain games, we previously entered into publishing agreements with independent software developers. Under these agreements, we were obligated to pay the independent software developers a predetermined amount (a Minimum Guarantee) upon delivery of a completed product. The independent software developers were thinly capitalized and they financed the development of products through bank borrowings. During fiscal year 2011, in order to more directly influence the development, product quality and product completion, we amended these agreements whereby we agreed to advance a portion of the Minimum Guarantee prior to completion of the product which were used by the independent software developers to repay their bank loans. In addition, we are committed to advance the remaining portion of the Minimum Guarantee during the remaining development period. As a result, we assumed development risk of the products.
Because the independent software developers are thinly capitalized, our sole ability to recover the Minimum Guarantee is effectively through publishing the software product in development. We also have exclusive rights to exploit the software product once completed. Therefore, we concluded that the substance of the arrangement is the purchase of research and development that has no alternative future use and was expensed upon acquisition. Accordingly, we recognized a $31 million charge in our Condensed Consolidated Statement of Operations during the fiscal year ended March 31, 2011. In addition, we will recognize the remaining portion of the Minimum Guarantee to be advanced during the development period as research and development expenses as the services are incurred.
Since the inception of the fiscal 2011 restructuring plan through December 31, 2011, we have incurred charges of $166 million, consisting of (1) $123 million related to the amendment of certain licensing agreements and other intangible asset impairment costs, (2) $31 million related to the amendment of certain developer agreements, and (3) $12 million in employee-related expenses. The $80 million restructuring accrual as of December 31, 2011 related to the fiscal 2011 restructuring is expected to be settled by June 2016. During the remainder of fiscal year 2012, we anticipate incurring less than $2 million of restructuring charges related to the fiscal 2011 restructuring (primarily interest expense accretion).
16
Overall, including $166 million in charges incurred through December 31, 2011, we expect to incur total cash and non-cash charges between $180 million and $185 million by June 2016. These charges will consist primarily of (1) charges, including accretion of interest expense, related to the amendment of certain licensing and developer agreements and other intangible asset impairment costs (approximately $170 million) and (2) employee-related costs ($12 million).
Fiscal 2010 Restructuring
In fiscal year 2010, we announced a restructuring plan to narrow our product portfolio to provide greater focus on titles with higher margin opportunities. Under this plan, we reduced our workforce by approximately 1,100 employees and have (1) consolidated or closed various facilities, (2) eliminated certain titles, and (3) incurred IT and other costs to assist in reorganizing certain activities. The majority of these exit activities were completed by March 31, 2010.
Since the inception of the fiscal 2010 restructuring plan through December 31, 2011, we have incurred charges of $138 million, consisting of (1) $62 million in employee-related expenses, (2) $57 million related to intangible asset impairment costs, abandoned rights to intellectual property, and other costs to assist in the reorganization of our business support functions, and (3) $19 million related to the closure of certain of our facilities. We do not expect to incur any additional restructuring charges under this plan. The $4 million restructuring accrual as of December 31, 2011 related to the fiscal 2010 restructuring is expected to be settled by March 2012.
Fiscal 2009 Restructuring
In fiscal year 2009, we announced a cost reduction plan as a result of our performance combined with the economic environment. This plan included a narrowing of our product portfolio, a reduction in our worldwide workforce of approximately 11 percent, or 1,100 employees, the closure of 10 facilities, and reductions in other variable costs and capital expenditures.
Since the inception of the fiscal 2009 restructuring plan through March 31, 2011, we have incurred charges of $55 million, consisting of (1) $33 million in employee-related expenses, (2) $20 million related to the closure of certain of our facilities, and (3) $2 million related to asset impairments. We do not expect to incur any additional restructuring charges under this plan. The restructuring accrual of $2 million as of December 31, 2011 related to the fiscal 2009 restructuring is expected to be settled by September 2016.
Fiscal 2008 Reorganization
As part of our fiscal 2008 reorganization, in December 2007, we commenced marketing our facility in Chertsey, England for sale. In August 2011, we completed the sale of our facility in Chertsey, England for $26 million and recognized a gain of $10 million. The gain is included in restructuring and other charges on our Condensed Consolidated Statement of Operations.
(9) ROYALTIES AND LICENSES
Our royalty expenses consist of payments to (1) content licensors, (2) independent software developers, and (3) co-publishing and distribution affiliates. License royalties consist of payments made to celebrities, professional sports organizations, movie studios and other organizations for our use of their trademarks, copyrights, personal publicity rights, content and/or other intellectual property. Royalty payments to independent software developers are payments for the development of intellectual property related to our games. Co-publishing and distribution royalties are payments made to third parties for the delivery of products.
Royalty-based obligations with content licensors and distribution affiliates are either paid in advance and capitalized as prepaid royalties or are accrued as incurred and subsequently paid. These royalty-based obligations are generally expensed to cost of goods sold generally at the greater of the contractual rate for contracts with guaranteed minimums, or an effective royalty rate based on the total projected net revenue. Prepayments made to thinly capitalized independent software developers and co-publishing affiliates are generally made in connection with the development of a particular product, and therefore, we are generally subject to development risk prior to the release of the product. Accordingly, payments that are due prior to completion of a product are generally expensed to research and development over the development period as the services are incurred. Payments due after completion of the product (primarily royalty-based in nature) are generally expensed as cost of goods sold.
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Our contracts with some licensors include minimum guaranteed royalty payments, which are initially recorded as an asset and as a liability at the contractual amount when no performance remains with the licensor. When performance remains with the licensor, we record guarantee payments as an asset when actually paid and as a liability when incurred, rather than recording the asset and liability upon execution of the contract. Royalty liabilities are classified as current liabilities to the extent such royalty payments are contractually due within the next 12 months.
Each quarter, we also evaluate the expected future realization of our royalty-based assets, as well as any unrecognized minimum commitments not yet paid to determine amounts we deem unlikely to be realized through product sales. Any impairments or losses determined before the launch of a product are charged to research and development expense. Impairments or losses determined post-launch are charged to cost of goods sold. We evaluate long-lived royalty-based assets for impairment generally using undiscounted cash flows when impairment indicators exist. Unrecognized minimum royalty-based commitments are accounted for as executory contracts, and therefore, any losses on these commitments are recognized when the underlying intellectual property is abandoned (i.e., cease use) or the contractual rights to use the intellectual property are terminated. During the three months ended December 31, 2011, we did not recognize any losses or impairment charges on unrecognized minimum royalty-based commitments and royalties-based assets. During the nine months ended December 31, 2011, we recognized additional losses of $14 million representing an adjustment to our fiscal 2011 restructuring. During the three months ended December 31, 2010, in connection with our fiscal 2011 restructuring, we recognized losses of $75 million on our previously unrecognized minimum royalty-based commitments and impairment charges of $27 million on our royalty-based assets. During the nine months ended December 31, 2010, we recognized losses of $85 million, inclusive of $75 million related to our fiscal 2011 restructuring, on our previously unrecognized minimum royalty-based commitments and impairment charges of $27 million on our royalty-based assets related to our fiscal 2011 restructuring.
The current and long-term portions of prepaid royalties and minimum guaranteed royalty-related assets, included in other current assets and other assets, consisted of (in millions):
As of December 31, |
As of March 31, |
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2011 | 2011 | |||||||
Other current assets |
$ | 65 | $ | 89 | ||||
Other assets |
99 | 22 | ||||||
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Royalty-related assets |
$ | 164 | $ | 111 | ||||
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At any given time, depending on the timing of our payments to our co-publishing and/or distribution affiliates, content licensors, and/or independent software developers, we recognize unpaid royalty amounts owed to these parties as accrued liabilities. The current and long-term portions of accrued royalties, included in accrued and other current liabilities and other liabilities, consisted of (in millions):
As of December 31, 2011 |
As of March 31, 2011 |
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Accrued and other current liabilities |
$ | 163 | $ | 136 | ||||
Other liabilities |
60 | 61 | ||||||
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Royalty-related liabilities |
$ | 223 | $ | 197 | ||||
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As of December 31, 2011, $80 million of restructuring accruals related to the fiscal 2011 restructuring plan is included in royalty-related liabilities in the table above. See Note 8 for details of restructuring and other restructuring plan-related activities and Note 10 for the details of our accrued and other current liabilities.
In addition, as of December 31, 2011, we were committed to pay approximately $896 million to content licensors, independent software developers, and co-publishing and/or distribution affiliates, but performance remained with the counterparty (i.e., delivery of the product or content or other factors) and such commitments were therefore not recorded in our Condensed Consolidated Financial Statements.
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(10) BALANCE SHEET DETAILS
Inventories
Inventories as of December 31, 2011 and March 31, 2011 consisted of (in millions):
As of December 31, 2011 |
As of March 31, 2011 |
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Raw materials and work in process |
$ | 2 | $ | 8 | ||||
Finished goods |
67 | 69 | ||||||
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Inventories |
$ | 69 | $ | 77 | ||||
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Property and Equipment, Net
Property and equipment, net, as of December 31, 2011 and March 31, 2011 consisted of (in millions):
As
of December 31, 2011 |
As
of March 31, 2011 |
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Computer equipment and software |
$ | 553 | $ | 504 | ||||
Buildings |
333 | 355 | ||||||
Leasehold improvements |
113 | 105 | ||||||
Office equipment, furniture and fixtures |
69 | 67 | ||||||
Land |
63 | 66 | ||||||
Construction in progress |
35 | 20 | ||||||
Warehouse equipment and other |
10 | 10 | ||||||
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1,176 | 1,127 | |||||||
Less: accumulated depreciation |
(629 | ) | (614 | ) | ||||
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Property and equipment, net |
$ | 547 | $ | 513 | ||||
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Depreciation expense associated with property and equipment was $23 million and $74 million for the three and nine months ended December 31, 2011, respectively. Depreciation expense associated with property and equipment was $26 million and $79 million for the three and nine months ended December 31, 2010, respectively.
Acquisition-Related Restricted Cash Included in Other Current Assets
Included in other current assets on our Condensed Consolidated Balance Sheets as of December 31, 2011 and March 30, 2011 was $106 million and $100 million, respectively, of acquisition-related restricted cash. In connection with our acquisition of Playfish in fiscal year 2010, we deposited $100 million into an escrow account to pay the former shareholders of Playfish in the event certain performance milestones through December 31, 2011 are achieved. In connection with our acquisition of PopCap in August 2011, we acquired $6 million of additional restricted cash held in an escrow account in the event certain liabilities become due. As these deposits are restricted in nature, they are excluded from cash and cash equivalents. Through the three and nine months ended December 31, 2011, no distributions were made from the restricted cash amount. We expect to pay approximately $50 million in connection with the Playfish earn-out. We expect the remaining $50 million in restricted cash will be released and converted to available cash and cash equivalents in the fourth quarter of fiscal year 2012.
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Accrued and Other Current Liabilities
Accrued and other current liabilities as of December 31, 2011 and March 31, 2011 consisted of (in millions):
As of December 31, 2011 |
As of March 31, 2011 |
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Other accrued expenses |
$ | 417 | $ | 359 | ||||
Accrued compensation and benefits |
211 | 232 | ||||||
Accrued royalties |
143 | 96 | ||||||
Deferred net revenue (other) |
75 | 81 | ||||||
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Accrued and other current liabilities |
$ | 846 | $ | 768 | ||||
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Deferred net revenue (other) includes the deferral of subscription revenue, deferrals related to our Switzerland distribution business, advertising revenue, licensing arrangements, and other revenue for which revenue recognition criteria has not been met.
Deferred Net Revenue (Packaged Goods and Digital Content)
Deferred net revenue (packaged goods and digital content) was $1,439 million as of December 31, 2011 and $1,005 million as of March 31, 2011. Deferred net revenue (packaged goods and digital content) includes the unrecognized revenue from (1) bundled sales of certain online-enabled packaged goods and digital content for which either we do not have VSOE for the online service that we provide in connection with the sale of the software or we have an obligation to provide future incremental unspecified digital content, (2) certain packaged goods sales of massively-multiplayer online role-playing games, and (3) sales of certain incremental content associated with our core subscription services that can only be played online, which are types of micro-transactions. We recognize revenue from sales of online-enabled packaged goods and digital content for which (1) we do not have VSOE for the online service that we provided in connection with the sale and (2) we have an obligation to deliver incremental unspecified digital content in the future without an additional fee on a straight-line basis generally over an estimated six-month period beginning in the month after shipment. However, we expense the cost of goods sold related to these transactions during the period in which the product is delivered (rather than on a deferred basis).
(11) INCOME TAXES
We estimate our annual effective tax rate at the end of each quarterly period, and we record the tax effect of certain discrete items, which are unusual or occur infrequently, in the interim period in which they occur, including changes in judgment about deferred tax valuation allowances. In addition, jurisdictions with a projected loss for the year, jurisdictions with a year-to-date loss where no tax benefit can be recognized, and jurisdictions where we are unable to estimate an annual effective tax rate are excluded from the estimated annual effective tax rate. The impact of such an exclusion could result in a higher or lower effective tax rate during a particular quarter depending on the mix and timing of actual earnings versus annual projections.
We recognize deferred tax assets and liabilities for both the expected impact of differences between the financial statement amount and the tax basis of assets and liabilities and for the expected future tax benefit to be derived from tax losses and tax credit carry forwards. We record a valuation allowance against deferred tax assets when it is considered more likely than not that all or a portion of our deferred tax assets will not be realized. In making this determination, we are required to give significant weight to evidence that can be objectively verified. It is generally difficult to conclude that a valuation allowance is not needed when there is significant negative evidence, such as cumulative losses in recent years. Forecasts of future taxable income are considered to be less objective than past results, particularly in light of the economic environment. Therefore, cumulative losses weigh heavily in the overall assessment. Based on the assumptions and requirements noted above, we have recorded a valuation allowance against most of our U.S. deferred tax assets. In addition, we expect to provide a valuation allowance on future U.S. tax benefits until we can sustain a level of profitability or until other significant positive evidence arises that suggest that these benefits are more likely than not to be realized.
During the three and nine months ended December 31, 2011, we recorded approximately $3 million and $58 million, respectively, of additional net deferred tax liabilities related to the PopCap and KlickNation acquisitions. These additional deferred tax liabilities create a new source of taxable income, thereby requiring us to release a portion of our deferred tax asset valuation allowance with a related reduction in income tax expense for the three and nine months ended December 31, 2011 of approximately $3 million and $58 million, respectively.
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The provision for (benefit from) income taxes reported for the three and nine months ended December 31, 2011 is based on our projected annual effective tax rate for fiscal year 2012, and also includes certain discrete tax benefits recorded during the period. Our effective tax rates for the three and nine months ended December 31, 2011 were a tax expense of 6.2 percent and tax benefit of 5.5 percent, respectively, compared to a tax expense of 6.3 percent and a tax benefit of 0.2 percent for the same periods of fiscal 2011. The effective tax rate for the three and nine months ended December 31, 2011 differs from the statutory rate of 35.0 percent primarily due to the utilization of U.S. deferred tax assets which were subject to a valuation allowance, a reduction in the U.S. valuation allowance related to the PopCap and KlickNation acquisitions, and non-U.S. profits subject to a reduced or zero tax rate. The effective tax rate for the three and nine months ended December 31, 2011 differs from the same period in fiscal year 2011 primarily due to greater tax benefits recorded in fiscal year 2012 related to the reduction of the U.S. valuation allowance as a result of the PopCap and KlickNation acquisitions.
During the three and nine months ended December 31, 2011, we recorded a net increase of $5 million and $13 million, respectively in gross unrecognized tax benefits. The total gross unrecognized tax benefits as of December 31, 2011 is $286 million, of which approximately $43 million is offset by prior cash deposits to tax authorities for issues pending resolution. A portion of our unrecognized tax benefits will affect our effective tax rate if they are recognized upon favorable resolution of the uncertain tax positions. As of December 31, 2011, if recognized, approximately $144 million of the unrecognized tax benefits would affect our effective tax rate and approximately $130 million would result in adjustments to deferred tax assets with corresponding adjustments to the valuation allowance.
During the three months ended December 31, 2011, we recorded a net decrease in taxes of $2 million for accrued interest and penalties related to tax positions taken on our tax returns. As of December 31, 2011, the combined amount of accrued interest and penalties related to uncertain tax positions included in income tax obligations on our Condensed Consolidated Balance Sheet was approximately $22 million.
The IRS has completed its examination of our federal income tax returns through fiscal year 2005, and is currently examining our fiscal years 2006, 2007 and 2008 tax returns. We are also currently under income tax examination in Canada for fiscal years 2004 and 2005, and in France for fiscal years 2006 through 2008. We remain subject to income tax examination for several other jurisdictions including Canada for fiscal years after 2003, in France for fiscal years after 2008, in Germany for fiscal years after 2007, in the United Kingdom for fiscal years after 2009, and in Switzerland for fiscal years after 2007.
On January 18, 2011, we received a Corporation Notice of Reassessment (the Notice) from the Canada Revenue Agency (CRA) claiming that we owe additional taxes, plus interest and penalties, for the 2004 and 2005 tax years. The incremental tax liability asserted by the CRA is $44 million, excluding interest and penalties. The Notice primarily relates to transfer pricing in connection with the reimbursement of costs for services rendered to our U.S. parent company by one of our subsidiaries in Canada. We do not agree with the CRAs position and we have filed a Notice of Objection with the appeals department of the CRA. We do not believe the CRAs position has merit and accordingly, we have not adjusted our liability for uncertain tax positions as a result of the Notice. If, upon resolution, we are required to pay an amount in excess of our liability for uncertain tax positions for this matter, the incremental amounts due would result in additional charges to income tax expense. In determining such charges, we would consider the impact of any correlative relief we may obtain in the form of additional tax deductions in the U.S.
The timing of the resolution of income tax examinations is highly uncertain, and the amounts ultimately paid, if any, upon resolution of the issues raised by the taxing authorities may differ materially from the amounts accrued for each year. Although potential resolution of uncertain tax positions involve multiple tax periods and jurisdictions, it is reasonably possible that a reduction of up to $55 million of the reserves for unrecognized tax benefits may occur within the next 12 months, some of which, depending on the nature of the settlement or expiration of statutes of limitations, may affect our income tax provision (benefit) and therefore benefit the resulting effective tax rate. The actual amount could vary significantly depending on the ultimate timing and nature of any settlements.
(12) FINANCING ARRANGEMENT
0.75% Convertible Senior Notes Due 2016
In July 2011, we issued $632.5 million aggregate principal amount of 0.75% Convertible Senior Notes due 2016 (the Notes). The Notes are senior unsecured obligations which pay interest semiannually in arrears at a rate of 0.75 percent per annum on January 15 and July 15 of each year, beginning on January 15, 2012 and will mature on July 15, 2016, unless earlier purchased or converted in accordance with their terms prior to such date. The Notes are senior in right of payment to any unsecured indebtedness that is expressly subordinated in right of payment to the Notes.
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The Notes are convertible into cash and shares of our common stock based on an initial conversion value of 31.5075 shares of our common stock per $1,000 principal amount of Notes (equivalent to an initial conversion price of approximately $31.74 per share). Upon conversion of the Notes, holders will receive cash up to the principal amount of each Note, and any excess conversion value will be delivered in shares of our common stock. Prior to April 15, 2016, the Notes are convertible only if (1) the last reported sale price of the common stock for at least 20 trading days (whether or not consecutive) during the period of 30 consecutive trading days ending on the last trading day of the immediately preceding fiscal quarter is greater than or equal to 130 percent of the conversion price ($41.26 per share) on each applicable trading day; (2) during the five business day period after any ten consecutive trading day period in which the trading price per $1,000 principal amount of notes falls below 98 percent of the last reported sale price of our common stock multiplied by the conversion rate on each trading day; or (3) specified corporate transactions, including a change in control, occur. On or after April 15, 2016 a holder may convert any of its Notes at any time prior to the close of business on the second scheduled trading day immediately preceding the maturity date. The conversion rate is subject to customary anti-dilution adjustments (for example, certain dividend distributions or tender or exchange offer of our common stock), but will not be adjusted for any accrued and unpaid interest. The Notes are not redeemable prior to maturity except for specified corporate transactions and events of default, and no sinking fund is provided for the Notes. The Notes do not contain any financial covenants.
We separately account for the liability and equity components of the Notes. The carrying amount of the equity component representing the conversion option is equal to the fair value of the Convertible Note Hedge, as described below, which is a substantially identical instrument and was purchased on the same day as the Notes. The carrying amount of the liability component was determined by deducting the fair value of the equity component from the par value of the Notes as a whole, and represents the fair value of a similar liability that does not have an associated convertible feature. A liability of $525 million as of the date of issuance was recognized for the principal amount of the Notes representing the present value of the Notes cash flows using a discount rate of 4.54 percent. The excess of the principal amount of the liability component over its carrying amount is amortized to interest expense over the term of the Notes using the effective interest method. The equity component is not remeasured as long as it continues to meet the conditions for equity classification.
In accounting for $15 million of issuance costs related to the Notes issuance, we allocated $13 million to the liability component and $2 million to the equity component. Debt issuance costs attributable to the liability component are being amortized to expense over the term of the Notes, and issuance costs attributable to the equity component were netted with the equity component in additional paid-in capital.
The carrying values of the liability and equity components of the Notes are reflected in our Condensed Consolidated Balance Sheet as follows (in millions):
As
of December 31, 2011 |
||||
Principal amount of Notes |
$ | 633 | ||
Unamortized discount of the liability component |
(99 | ) | ||
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Net carrying amount of Notes |
$ | 534 | ||
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Equity component, net |
$ | 105 | ||
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Interest expense recognized related to the Notes are as follows (in millions):
Three Months Ended December 31, 2011 |
Nine Months Ended December 31, 2011 |
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Amortization of debt discount |
$ | 5 | $ | 9 | ||||
Amortization of debt issuance costs |
| 1 | ||||||
Coupon interest expense |
1 | 2 | ||||||
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Total interest expense related to Notes |
$ | 6 | $ | 12 | ||||
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As of December 31, 2011, the remaining life of the Notes is 4.5 years.
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Convertible Note Hedge and Warrants Issuance
In addition, in July 2011, we entered into privately negotiated convertible note hedge transactions (the Convertible Note Hedge) with certain counterparties to reduce the potential dilution with respect to our common stock upon conversion of the Notes. The Convertible Note Hedge, subject to customary anti-dilution adjustments, provide us with the option to acquire, on a net settlement basis, approximately 19.9 million shares of our common stock at a strike price of $31.74, which corresponds to the conversion price of the Notes and is equal to the number of shares of our common stock that notionally underlie the Notes. As of December 31, 2011, we have not purchased any shares under the Convertible Note Hedge. We paid $107 million for the Convertible Note Hedge, which was recorded as an equity transaction.
Separately, we have also entered into privately negotiated warrant transactions with the certain counterparties whereby we sold to independent third parties warrants (the Warrants) to acquire, subject to customary anti-dilution adjustments that are substantially the same as the anti-dilution provisions contained in the Notes, up to 19.9 million shares of our common stock (which is also equal to the number of shares of our common stock that notionally underlie the Notes), with a strike price of $41.14. The Warrants could have a dilutive effect with respect to our common stock to the extent that the market price per share of its common stock exceeds $41.14 on or prior to the expiration date of the Warrants. We received proceeds of $65 million from the sale of the Warrants.
(13) COMMITMENTS AND CONTINGENCIES
Lease Commitments
As of December 31, 2011, we leased certain current facilities, furniture and equipment under non-cancelable operating lease agreements. We were required to pay property taxes, insurance and normal maintenance costs for certain of these facilities and any increases over the base year of these expenses on the remainder of our facilities.
Development, Celebrity, League and Content Licenses: Payments and Commitments
The products we produce in our studios are designed and created by our employee designers, artists, software programmers and by non-employee software developers (independent artists or third-party developers). We typically advance development funds to the independent artists and third-party developers during development of our games, usually in installment payments made upon the completion of specified development milestones. Contractually, these payments are generally considered advances against subsequent royalties on the sales of the products. These terms are set forth in written agreements entered into with the independent artists and third-party developers.
In addition, we have certain celebrity, league and content license contracts that contain minimum guarantee payments and marketing commitments that may not be dependent on any deliverables. Celebrities and organizations with whom we have contracts include: FIFA, FIFPRO Foundation, FAPL (Football Association Premier League Limited), and DFL Deutsche Fußball Liga GmbH (German Soccer League) (professional soccer); National Basketball Association (professional basketball); PGA TOUR, Tiger Woods and Augusta National (professional golf); National Hockey League and NHL Players Association (professional hockey); National Football League Properties, PLAYERS Inc., and Red Bear Inc. (professional football); Collegiate Licensing Company (collegiate football); ESPN (content in EA SPORTS games); Hasbro, Inc. (most of Hasbros toy and game intellectual properties); and LucasArts and Lucas Licensing (Star Wars: The Old Republic). These developer and content license commitments represent the sum of (1) the cash payments due under non-royalty-bearing licenses and services agreements and (2) the minimum guaranteed payments and advances against royalties due under royalty-bearing licenses and services agreements, the majority of which are conditional upon performance by the counterparty. These minimum guarantee payments and any related marketing commitments are included in the table below.
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The following table summarizes our unrecognized minimum contractual obligations as of December 31, 2011 (in millions):
Contractual Obligations | ||||||||||||||||||||||||
Fiscal Year Ending March 31, |
Leases (a) | Developer/ Licensor Commitments |
Marketing | Convertible Notes Interest (b) |
Other Purchase Obligations |
Total | ||||||||||||||||||
2012 (remaining three months) |
$ | 13 | $ | 50 | $ | 18 | $ | 2 | $ | 5 | $ | 88 | ||||||||||||
2013 |
52 | 191 | 58 | 5 | 9 | 315 | ||||||||||||||||||
2014 |
48 | 121 | 51 | 5 | 7 | 232 | ||||||||||||||||||
2015 |
39 | 116 | 32 | 5 | | 192 | ||||||||||||||||||
2016 |
28 | 84 | 33 | 5 | | 150 | ||||||||||||||||||
Thereafter |
36 | 334 | 95 | 2 | | 467 | ||||||||||||||||||
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Total |
$ | 216 | $ | 896 | $ | 287 | $ | 24 | $ | 21 | $ | 1,444 | ||||||||||||
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(a) | Lease commitments have not been reduced by minimum sub-lease rentals for unutilized office space resulting from our reorganization activities of approximately $7 million due in the future under non-cancelable sub-leases. |
(b) | In addition to the interest payments reflected in the table above, we will be obligated to pay the $632.5 million principal amount of the 0.75% Convertible Senior Notes due 2016 and any excess conversion value in shares of our common stock upon redemption after the maturity of the Notes on July 15, 2016 or earlier. See Note 12 for additional information related to our 0.75% Convertible Senior Notes due 2016. |
The amounts represented in the table above reflect our unrecognized minimum cash obligations for the respective fiscal years, but do not necessarily represent the periods in which they will be recognized and expensed in our Condensed Consolidated Financial Statements. In addition, the amounts in the table above are presented based on the dates the amounts are contractually due; however, certain payment obligations may be accelerated depending on the performance of our operating results.
In addition to what is included in the table above, as of December 31, 2011, we had a liability for unrecognized tax benefits and an accrual for the payment of related interest totaling $236 million, for which we are unable to make a reasonably reliable estimate of when cash settlement with a taxing authority will occur.
In addition to what is included in the table above as of December 31, 2011, primarily in connection with our PopCap, Playfish, KlickNation, and Chillingo acquisitions, we may be required to pay an additional $672 million of cash consideration based upon the achievement of certain performance milestones through March 31, 2014. As of December 31, 2011, we have accrued $159 million of contingent consideration on our Condensed Consolidated Balance Sheet representing the estimated fair value of the contingent consideration, of which $50 million relates to performance milestones earned through December 31, 2011 in connection with the Playfish acquisition and for which we expect to settle in the fourth quarter of fiscal year 2012.
Legal Proceedings
In June 2008, Geoffrey Pecover filed an antitrust class action in the United States District Court for the Northern District of California, alleging that EA obtained an illegal monopoly in a discreet antitrust market that consists of league-branded football simulation video games by bidding for, and winning, exclusive licenses with the NFL, Collegiate Licensing Company and Arena Football League. In December 20, 2010, the district court granted the plaintiffs request to certify a class of plaintiffs consisting of all consumers who purchased EAs Madden NFL, NCAA Football or Arena Football videogames after 2005. The parties are in the midst of fact discovery. The court has set a trial date for October 2012. The complaint seeks unspecified compensatory damages. We have not accrued any loss related to this matter. We believe the claims asserted are without merit and intend to vigorously defend against them.
We are also subject to claims and litigation arising in the ordinary course of business. We do not believe that any liability from any reasonably foreseeable disposition of such claims and litigation, individually or in the aggregate, would have a material adverse effect on our Condensed Consolidated Financial Statements.
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(14) STOCK-BASED COMPENSATION
Valuation Assumptions
We are required to estimate the fair value of share-based payment awards on the date of grant. We recognize compensation costs for stock-based payment awards to employees based on the grant-date fair value using a straight-line approach over the service period for which such awards are expected to vest.
We determine the fair value of our share-based payment awards as follows:
| Restricted Stock Units, Restricted Stock, and Performance-Based Restricted Stock Units. The fair value of restricted stock units, restricted stock, and performance-based restricted stock units (other than market-based restricted stock units) is determined based on the quoted market price of our common stock on the date of grant. Performance-based restricted stock units include grants made (1) to certain members of executive management primarily granted in fiscal year 2008 and (2) in connection with certain acquisitions. |
| Market-Based Restricted Stock Units. Market-based restricted stock units consist of grants of performance-based restricted stock units to certain members of executive management (referred to herein as market-based restricted stock units). The fair value of our market-based restricted stock units is determined using a Monte-Carlo simulation model. Key assumptions for the Monte-Carlo simulation model are the risk-free interest rate, expected volatility, expected dividends and correlation coefficient. |
| Stock Options and Employee Stock Purchase Plan. The fair value of stock options and stock purchase rights granted pursuant to our equity incentive plans and our 2000 Employee Stock Purchase Plan (ESPP), respectively, is determined using the Black-Scholes valuation model based on the multiple-award valuation method. Key assumptions of the Black-Scholes valuation model are the risk-free interest rate, expected volatility, expected term and expected dividends. |
The determination of the fair value of market-based restricted stock units, stock options and ESPP is affected by assumptions regarding subjective and complex variables. Generally, our assumptions are based on historical information and judgment is required to determine if historical trends may be indicators of future outcomes.
The estimated assumptions used in the Black-Scholes valuation model to value our stock option grants and ESPP were as follows:
Stock Option Grants | ESPP | |||||||||||||||||||||||
Three Months Ended | Nine Months Ended | Nine Months Ended | ||||||||||||||||||||||
December 31, | December 31, | December 31, | ||||||||||||||||||||||
2011 | 2010 | 2011 | 2010 | 2011 | 2010 | |||||||||||||||||||
Risk-free interest rate |
0.4 - 1.2% | 1.2 - 2.6% | 0.4 - 1.8% | 0.8 - 2.6% | 0.1% | 0.2 - 0.3% | ||||||||||||||||||
Expected volatility |
42 - 46% | 41 - 43% | 40 - 46% | 41 - 45% | 39 - 40% | 38% | ||||||||||||||||||
Weighted-average volatility |
45% | 42% | 43% | 43% | 39% | 38% | ||||||||||||||||||
Expected term |
4.1 years | 4.2 years | 4.4 years | 4.4 years | 6 -12 months | 6 -12 months | ||||||||||||||||||
Expected dividends |
None | None | None | None | None | None |
There were no ESPP shares valued during the three months ended December 31, 2011 and 2010.
The estimated assumptions used in the Monte-Carlo simulation model to value our market-based restricted stock units were as follows:
Nine Months Ended December 31, 2011 |
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Risk-free interest rate |
0.2 - 0.6% | |||
Expected volatility |
14 - 83% | |||
Weighted-average volatility |
35% | |||
Expected dividends |
None |
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There were no market-based restricted stock units granted during the three months ended December 31, 2011 and the three and nine months ended December 30, 2010.
Stock-Based Compensation Expense
Employee stock-based compensation expense recognized during the three and nine months ended December 31, 2011 and 2010 was calculated based on awards ultimately expected to vest and has been reduced for estimated forfeitures. In subsequent periods, if actual forfeitures differ from those estimates, an adjustment to stock-based compensation expense will be recognized at that time.
The following table summarizes stock-based compensation expense resulting from stock options, restricted stock, restricted stock units and the ESPP included in our Condensed Consolidated Statements of Operations (in millions):
Three Months Ended December 31, |
Nine Months Ended December 31, |
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2011 | 2010 | 2011 | 2010 | |||||||||||||
Cost of goods sold |
$ | | $ | 1 | $ | 1 | $ | 2 | ||||||||
Marketing and sales |
7 | 6 | 18 | 16 | ||||||||||||
General and administrative |
11 | 9 | 29 | 32 | ||||||||||||
Research and development |
30 | 30 | 81 | 86 | ||||||||||||
Restructuring and other charges |
| 2 | | 2 | ||||||||||||
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Stock-based compensation expense |
$ | 48 | $ | 48 | $ | 129 | $ | 138 | ||||||||
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During the three and nine months ended December 31, 2011 and 2010, we did not recognize any provision for or benefit from income taxes related to our stock-based compensation expense.
As of December 31, 2011, our total unrecognized compensation cost related to stock options was $17 million and is expected to be recognized over a weighted-average service period of 1.7 years. As of December 31, 2011, our total unrecognized compensation cost related to restricted stock, restricted stock units and notes payable in shares of common stock (collectively referred to as restricted stock rights) was $310 million and is expected to be recognized over a weighted-average service period of 2.0 years. During the nine months ended December 31, 2011, we determined that the performance criteria for certain performance-based restricted stock units was improbable of achievement and accordingly reversed stock-based compensation expense of $7 million previously recognized within our Condensed Consolidated Statement of Operations. As the criteria for these certain performance-based restricted stock was improbable of achievement, the related unrecognized compensation cost is excluded from the total unrecognized compensation cost related to restricted stock rights as of December 31, 2011.
Stock Options
The following table summarizes our stock option activity for the nine months ended December 31, 2011:
Options (in thousands) |
Weighted- Average Exercise Price |
Weighted-Average Remaining Contractual Term (in years) |
Aggregate Intrinsic Value (in millions) |
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Outstanding as of March 31, 2011 |
12,899 | $ | 31.39 | |||||||||||||
Granted |
431 | 20.79 | ||||||||||||||
Exercised |
(1,145 | ) | 19.61 | |||||||||||||
Forfeited, cancelled or expired |
(2,151 | ) | 23.90 | |||||||||||||
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Outstanding as of December 31, 2011 |
10,034 | 33.90 | 5.15 | $ | 10 | |||||||||||
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Exercisable as of December 31, 2011 |
8,440 | 35.43 | 4.69 | $ | 9 | |||||||||||
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The aggregate intrinsic value represents the total pre-tax intrinsic value based on our closing stock price as of December 31, 2011, which would have been received by the option holders had all the option holders exercised their options as of that date. The weighted-average grant date fair values of stock options granted during the three and nine months ended December 31, 2011 were $7.85 and $7.35, respectively. The weighted-average grant date fair values of stock options granted during the three and nine months ended December 31, 2010 were $5.58 and $6.20, respectively. We issue new common stock from our authorized shares upon the exercise of stock options.
26
Restricted Stock Rights
The following table summarizes our restricted stock rights activity, excluding performance-based and market-based restricted stock unit activity discussed below, for the nine months ended December 31, 2011:
Restricted Stock Rights (in thousands) |
Weighted- Average Grant Date Fair Value |
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Balance as of March 31, 2011 |
13,971 | $ | 22.01 | |||||
Granted |
9,433 | 22.17 | ||||||
Vested |
(5,123 | ) | 20.33 | |||||
Forfeited or cancelled |
(1,564 | ) | 20.22 | |||||
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Balance as of December 31, 2011 |
16,717 | 22.78 | ||||||
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The weighted-average grant date fair values of restricted stock rights granted during the three and nine months ended December 31, 2011 were $22.10 and $22.17, respectively. The weighted-average grant date fair values of restricted stock rights granted during the three and nine months ended December 31, 2010 were $15.59 and $17.25, respectively.
Performance-Based Restricted Stock Units
The following table summarizes our performance-based restricted stock unit activity for the nine months ended December 31, 2011:
Performance- Based Restricted Stock Units (in thousands) |
Weighted- Average Grant Date Fair Value |
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Balance as of March 31, 2011 |
1,993 | $ | 47.00 | |||||
Forfeited or cancelled |
(423 | ) | 34.80 | |||||
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Balance as of December 31, 2011 |
1,570 | 50.29 | ||||||
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Market-Based Restricted Stock Units
Our market-based restricted stock units vest contingent upon the achievement of pre-determined market and service conditions. If these market conditions are not met but service conditions are met, the restricted stock units will not vest; however, any compensation expense we have recognized to date will not be reversed. During the three months ended June 30, 2011, 670,000 market-based restricted stock units, representing the target number, were granted. The number of shares of common stock to be received at vesting will range from zero percent to 200 percent of the target number of stock units based on our total stockholder return (TSR) relative to the performance of companies in the NASDAQ-100 Index for each measurement period over a three year period. The maximum number of common shares that could vest is 1,340,000 for market-based restricted stock units granted in fiscal year 2012. The following table summarizes our market-based restricted stock unit activity for the nine months ended December 31, 2011:
Market-Based Restricted Stock Units (in thousands) |
Weighted- Average Grant Date Fair Value |
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Balance as of March 31, 2011 |
| $ | | |||||
Granted |
670 | 34.77 | ||||||
Forfeited or cancelled |
(35 | ) | 34.77 | |||||
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Balance as of December 31, 2011 |
635 | 34.77 | ||||||
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Stock Repurchase Program
On February 1, 2011, our Board of Directors authorized a program to repurchase up to $600 million of our common stock over the next 18 months. The timing and actual amount of the stock repurchases will depend on several factors including price, capital availability, regulatory requirements, alternative investment opportunities and other market conditions. We are not obligated to repurchase any specific number of shares under the program and the repurchase program may be modified, suspended or discontinued at any time. During nine months ended December 31, 2011, we repurchased and retired approximately 11 million shares of our common stock for approximately $230 million, net of commissions.
Annual Meeting of Stockholders
At our Annual Meeting of Stockholders, held on July 28, 2011, our stockholders approved (1) an amendment to our 2000 Equity Incentive Plan (the Equity Plan) to increase the number of shares authorized for issuance under the Equity Plan by 10 million shares and (2) an amendment to the ESPP to increase the number of shares authorized under the ESPP by 3.5 million shares.
(15) COMPREHENSIVE LOSS
We classify items of other comprehensive income (loss) by their nature in a financial statement and display the accumulated other comprehensive income balance separately from accumulated deficit and paid-in capital in the equity section of our balance sheets. Accumulated other comprehensive income primarily includes foreign currency translation adjustments and the net of tax amounts for unrealized gains (losses) on available-for-sale securities and derivative instruments designated as cash flow hedges. Foreign currency translation adjustments are not adjusted for income taxes as they relate to indefinite investments in non-U.S. subsidiaries.
The change in the components of comprehensive loss, net of related immaterial taxes, for the three and nine months ended December 31, 2011 and 2010 is summarized as follows (in millions):
Three Months Ended December 31, |
Nine Months Ended December 31, |
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2011 | 2010 | 2011 | 2010 | |||||||||||||
Net loss |
$ | (205 | ) | $ | (322 | ) | $ | (324 | ) | $ | (427 | ) | ||||
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Other comprehensive income (loss): |
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Change in unrealized gains on available-for-sale securities |
(72 | ) | | (16 | ) | (49 | ) | |||||||||
Reclassification adjustment for realized gains on available-for-sale securities |
| | (1 | ) | (27 | ) | ||||||||||
Change in unrealized losses on derivative instruments |
(1 | ) | (1 | ) | (2 | ) | (7 | ) | ||||||||
Reclassification adjustment for realized losses on derivative instruments |
1 | 1 | 3 | 2 | ||||||||||||
Foreign currency translation adjustments |
4 | 11 | (13 | ) | 8 | |||||||||||
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Total other comprehensive income (loss) |
(68 | ) | 11 | (29 | ) | (73 | ) | |||||||||
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Total comprehensive loss |
$ | (273 | ) | $ | (311 | ) | $ | (353 | ) | $ | (500 | ) | ||||
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(16) NET LOSS PER SHARE
As a result of our net loss for the three and nine months ended December 31, 2011, we have excluded all share-based payment awards from the diluted loss per share calculation as their inclusion would have had an antidilutive effect. Had we reported net income for these periods, an additional 6 million shares and 7 million shares of common stock would have been included in the number of shares used to calculate diluted earnings per share, respectively. Additionally, had we reported net income, options to purchase, restricted stock units and restricted stock to be released in the amount of 7 and 9 million shares of common stock would have been excluded from the treasury stock method computation of diluted shares for the three and nine months ended December 31, 2011 as their inclusion would have had an antidilutive effect.
As a result of our net loss for the three and nine months ended December 31, 2010, we have excluded all share-based payment awards from the diluted loss per share calculation as their inclusion would have had an antidilutive effect. Had we reported net income for these periods, an additional 3 million shares of common stock in each period would have been included in the number of shares used to calculate diluted earnings per share. Additionally, had we reported net income, options to purchase, restricted stock units and restricted stock to be released in the amount of 18 million shares of common stock in each period would have been excluded from the treasury stock method computation of diluted shares, as their inclusion would have had an antidilutive effect.
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Potentially dilutive shares of common stock related to our 0.75% Convertible Senior Notes due 2016, which have a conversion price of $31.74 per share and the associated Warrants, which have a conversion price of $41.14 per share were excluded from the computation of diluted loss per share for the three and nine months ended December 31, 2011 as their inclusion would have had an antidilutive effect resulting from the conversion price and our net loss for both periods. The Convertible Note Hedge was excluded from the calculation of diluted shares as the impact is always considered antidilutive since the call option would be exercised by us when the exercise price is lower than the market price. See Note 12 for additional information related to our 0.75% Convertible Senior Notes due 2016 and related Convertible Note Hedge and Warrants.
(17) SEGMENT INFORMATION
Our reporting segments are based upon: our internal organizational structure; the manner in which our operations are managed; the criteria used by our Chief Executive Officer, our Chief Operating Decision Maker (CODM), to evaluate segment performance; the availability of separate financial information; and overall materiality considerations.
Prior to the second quarter of fiscal year 2012, our business was organized around three labels, EA Games, EA SPORTS and EA Play, as well as EA Interactive (EAI). Our CODM regularly received separate financial information for the distinct businesses within the EAI organization. Accordingly, our CODM reviewed the results of the three Labels, as well as the businesses in EAI, including EA Mobile, the combined results of Pogo and Playfish, and Hasbro, in assessing performance and allocating resources amongst these six organizations.
During the second quarter of fiscal year 2012, we announced a recommitment of our focus on building our intellectual properties and franchises into businesses connected to the consumer on a year-round basis, growing our digital business and releasing Origin, our online commerce and content delivery system. In connection with this and our acquisition of PopCap, we implemented a number of changes to our management reporting structure, including expanding our three labels to four, with BioWare now considered a label separate from the EA Games Label, and aggregating these four labels into an overall EA Label organization with a President of EA Labels reporting directly to our CODM. In addition, our EAI business reported directly to our CODM (previously our EAI business reported into our Chief Operating Officer). Through the third quarter of fiscal year 2012, the President of the EA Labels and the Executive Vice President of EAI are were responsible for allocating resources within their organizations. The CODM reviews the disaggregated and aggregated results of the EA Labels and EAI organizations to assess overall performance and allocate resources between these two organizations while to a lesser degree, our CODM also reviews results based on geographic revenue performance. Because the EA Labels and EAI operating segments have similar economic characteristics, products, and distribution methods, they have been aggregated together into the EA Brands reportable segment.
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The following table summarizes the financial performance of the EA Brands segment and a reconciliation of the EA Brands segments profit to our consolidated operating income for the three and nine months ended December 31, 2011 and 2010. Prior periods reported below have been restated to reflect our current EA Brands reporting segment structure (in millions):
Three Months Ended | Nine Months Ended | |||||||||||||||
December 31, | December 31, | |||||||||||||||
2011 | 2010 | 2011 | 2010 | |||||||||||||
EA Brands segment: |
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Net revenue before revenue deferral |
$ | 1,613 | $ | 1,358 | $ | 3,131 | $ | 2,746 | ||||||||
Depreciation and amortization |
(13 | ) | (14 | ) | (43 | ) | (42 | ) | ||||||||
Other expenses |
(957 | ) | (940 | ) | (2,291 | ) | (2,124 | ) | ||||||||
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EA Brands segment profit |
643 | 404 | 797 | 580 | ||||||||||||
Reconciliation to consolidated operating loss: |
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Other: |
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Revenue deferral |
(1,370 | ) | (995 | ) | (2,420 | ) | (2,003 | ) | ||||||||
Recognition of revenue deferral |
780 | 638 | 1,986 | 1,669 | ||||||||||||
Other net revenue |
38 | 52 | 78 | 87 | ||||||||||||
Depreciation and amortization |
(35 | ) | (29 | ) | (93 | ) | (90 | ) | ||||||||
Acquisition-related contingent consideration |
11 | (1 | ) | (8 | ) | 25 | ||||||||||
Restructuring and other charges |
| (154 | ) | (17 | ) | (162 | ) | |||||||||
Stock-based compensation |
(48 | ) | (46 | ) | (129 | ) | (136 | ) | ||||||||
Other expenses |
(202 | ) | (172 | ) | (524 | ) | (427 | ) | ||||||||
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Consolidated operating loss |
$ | (183 | ) | $ | (303 | ) | $ | (330 | ) | $ | (457 | ) | ||||
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EA Brands segment profit differs from consolidated operating loss primarily due to the exclusion of (1) certain corporate and other functional costs that are not allocated to EA Brands, (2) the deferral of certain net revenue related to online-enabled packaged goods and digital content (see Note 10 for additional information regarding deferred net revenue (packaged goods and digital content)), and (3) our Switzerland distribution revenue and expenses that is not allocated to EA Brands. Our CODM reviews assets on a consolidated basis and not on a segment basis.
As we continue to evolve our business and more of our products are delivered to consumers digitally via the Internet, management places a greater emphasis and focus on assessing its performance through a review of net revenue by revenue composition rather than net revenue by platform. Information about our total net revenue by revenue composition for the three and nine months ended December 31, 2011 and 2010 is presented below (in millions):
Three Months Ended | Nine Months Ended | |||||||||||||||
December 31, | December 31, | |||||||||||||||
2011 | 2010 | 2011 | 2010 | |||||||||||||
Publishing and other |
$ | 738 | $ | 767 | $ | 1,835 | $ | 1,794 | ||||||||
Wireless, Internet-derived, advertising (digital) |
274 | 195 | 740 | 532 | ||||||||||||
Distribution |
49 | 91 | 200 | 173 | ||||||||||||
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Net revenue |
$ | 1,061 | $ | 1,053 | $ | 2,775 | $ | 2,499 | ||||||||
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30
Information about our operations in North America, Europe and Asia as of and for the three and nine months ended December 31, 2011 and 2010 is presented below (in millions):
Three Months Ended | Nine Months Ended | |||||||||||||||
December 31, | December 31, | |||||||||||||||
2011 | 2010 | 2011 | 2010 | |||||||||||||
Net revenue from unaffiliated customers |
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North America |
$ | 500 | $ | 528 | $ | 1,338 | $ | 1,306 | ||||||||
Europe |
505 | 477 | 1,271 | 1,056 | ||||||||||||
Asia |
56 | 48 | 166 | 137 | ||||||||||||
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Net revenue |
$ | 1,061 | $ | 1,053 | $ | 2,775 | $ | 2,499 | ||||||||
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As of December 31, | ||||||||
2011 | 2010 | |||||||
Long-lived assets |
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North America |
$ | 2,179 | $ | 1,286 | ||||
Europe |
438 | 449 | ||||||
Asia |
48 | 34 | ||||||
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Total |
$ | 2,665 | $ | 1,769 | ||||
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Our direct sales to GameStop Corp. represented approximately 14 percent and 15 percent of total net revenue for the three and nine months ended December 31, 2011, respectively. Our direct sales to GameStop Corp. represented approximately 14 percent and 15 percent of total net revenue for the three and nine months ended December 31, 2010, respectively. Our direct sales to Wal-Mart Stores Inc. did not exceed 10 percent of total net revenue for the three and nine months ended December 31, 2011. Our direct sales to Wal-Mart Stores Inc. represented approximately 10 percent of total net revenue for the three and nine months ended December 31, 2010.
(18) IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS
In May 2011, the FASB issued ASU 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. The amendments in this ASU generally represent clarification of Topic 820, but also include instances where a particular principle or requirement for measuring fair value or disclosing information about fair value measurements has changed. This update results in common principles and requirements for measuring fair value and for disclosing information about fair value measurements in accordance with U.S. Generally Accepted Accounting Principles and International Financial Reporting Standards. The amendments are effective for interim and annual periods beginning after December 15, 2011 and are to be applied prospectively. We do not expect the adoption of ASU 2011-04 to have a material impact on our Condensed Consolidated Financial Statements.
In June 2011, the FASB issued ASU 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income. ASU 2011-05 requires one of two alternatives for presenting comprehensive income and eliminates the option to report other comprehensive income and its components as a part of the Consolidated Statements of Stockholders Equity. Additionally, ASU 2011-05 requires presentation on the face of the financial statements reclassification adjustments for items that are reclassified from other comprehensive income to net income in the statement(s) where the components of net income and the components of other comprehensive income are presented. The requirement related to the reclassification adjustments from other comprehensive income to net income was deferred in December 2011, as a result of the issuance of ASU 2011-12, Deferral of the Effective Date for Amendments to the Presentation of Reclassications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update 2011-05 (Topic 220). The amendments in ASU 2011-05, as amended by ASU 2011-12, do not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. ASU 2011-05, as amended by ASU 2011-12 is effective for fiscal years and interim periods within those years beginning after December 15, 2011 and is to be applied retrospectively. We do not expect the adoption of ASU 2011-05, as amended by ASU 2011-12, to have a material impact on our Condensed Consolidated Financial Statements.
In September 2011, the FASB issued ASU 2011-08, Intangibles Goodwill and Other (Topic 350): Testing Goodwill for Impairment. ASU 2011-08 allows an entity to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test. If an entity concludes it is more likely than not that the fair value of a reporting unit exceeds its carrying amount, it need not perform the two-step impairment test. The amendments are effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011, with early adoption permitted. We do not expect the adoption of ASU 2011-08 to have an impact on our Condensed Consolidated Financial Statements.
31
In December 2011, the FASB issued ASU 2011-11, Disclosures about Offsetting Assets and Liabilities, which creates new disclosure requirements about the nature of an entitys rights of offset and related arrangements associated with its financial instruments and derivative instruments. The disclosure requirements are effective for annual reporting periods beginning on or after January 1, 2013, and interim periods therein, with retrospective application required. The new disclosures are designed to make financial statements that are prepared under U.S. Generally Accepted Accounting Principles more comparable to those prepared under International Financial Reporting Standards. We are currently evaluating the impact of ASU 2011-11 on our Condensed Consolidated Financial Statements.
32
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders
Electronic Arts Inc.:
We have reviewed the condensed consolidated balance sheets of Electronic Arts Inc. and subsidiaries (the Company) as of December 31, 2011 and January 1, 2011, the related condensed consolidated statements of operations and cash flows for the three- and nine-month periods ended December 31, 2011 and January 1, 2011. These condensed consolidated financial statements are the responsibility of the Companys management.
We conducted our reviews in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our reviews, we are not aware of any material modifications that should be made to the condensed consolidated financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.
We have previously audited, in accordance with standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Electronic Arts Inc. and subsidiaries as of April 2, 2011, and the related consolidated statements of operations, stockholders equity and comprehensive loss, and cash flows for the year then ended (not presented herein); and in our report dated May 24, 2011, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of April 2, 2011 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.
/s/ KPMG LLP | ||
Santa Clara, California | ||
February 6, 2012 |
33
Item 2. | Managements Discussion and Analysis of Financial Condition and Results of Operations |
CAUTIONARY NOTE ABOUT FORWARD-LOOKING STATEMENTS
This Quarterly Report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All statements, other than statements of historical fact, made in this Quarterly Report are forward looking. Examples of forward-looking statements include statements related to industry prospects, our future economic performance including anticipated revenues and expenditures, results of operations or financial position, and other financial items, our business plans and objectives, including our intended product releases, and may include certain assumptions that underlie the forward-looking statements. We use words such as anticipate, believe, expect, intend, estimate (and the negative of any of these terms), future and similar expressions to help identify forward-looking statements. These forward-looking statements are subject to business and economic risk and reflect managements current expectations, and involve subjects that are inherently uncertain and difficult to predict. Our actual results could differ materially from those in the forward-looking statements. We will not necessarily update information if any forward-looking statement later turns out to be inaccurate. Risks and uncertainties that may affect our future results include, but are not limited to, those discussed in this report under the heading Risk Factors in Part II, Item 1A, as well as in our Annual Report on Form 10-K for the fiscal year ended March 31, 2011 as filed with the Securities and Exchange Commission (SEC) on May 24, 2011 and in other documents we have filed with the SEC.
OVERVIEW
The following overview is a high-level discussion of our operating results, as well as some of the trends and drivers that affect our business. Management believes that an understanding of these trends and drivers is important in order to understand our results for the three and nine months ended December 31, 2011, as well as our future prospects. This summary is not intended to be exhaustive, nor is it intended to be a substitute for the detailed discussion and analysis provided elsewhere in this Form 10-Q, including in the remainder of Managements Discussion and Analysis of Financial Condition and Results of Operations, Risk Factors, and the Condensed Consolidated Financial Statements and related Notes. Additional information can be found in the Business section of our Annual Report on Form 10-K for the fiscal year ended March 31, 2011 as filed with the SEC on May 24, 2011 and in other documents we have filed with the SEC.
About Electronic Arts
We develop, market, publish and distribute game software and content that can be played by consumers on a variety of platforms, including video game consoles (such as the Sony PLAYSTATION 3, Microsoft Xbox 360, and Nintendo Wii), personal computers, mobile phones (such as the Apple iPhone and Google Android compatible phones), tablets and electronic readers (such as the Apple iPad and Amazon Kindle), the Internet, and handheld game players (such as the Sony PlayStation Portable (PSP) and the Nintendo DS and 3DS). Some of our games are based on content that we license from others (e.g., FIFA, Madden NFL, STAR WARS, Harry Potter, and Hasbros toy and game intellectual properties), and some of our games are based on our own wholly-owned intellectual property (e.g., The Sims, Need for Speed, Battlefield, and Dead Space). Our goal is to publish titles with global mass-market appeal, which often means translating and localizing them for sale in non-English speaking countries. In addition, we also attempt to create software game franchises that allow us to publish new titles on a recurring basis that are based on the same property. Examples of this franchise approach are the annual iterations of our sports-based products (e.g., FIFA, Madden NFL, and NCAA Football), wholly-owned properties that can be successfully sequeled (e.g., The Sims, Need for Speed, Battlefield, Mass Effect, and Dead Space) and titles based on long-lived literary and/or movie properties (e.g., Harry Potter and STAR WARS).
Financial Results
Total net revenue for the three months ended December 31, 2011 was $1,061 million, up $8 million as compared to the three months ended December 31, 2010. This increase is due to increased revenue recognized from our wireless, Internet-derived, and advertising (digital) products, partially offset by decreased revenue recognized from our distribution products. From a title perspective, the increase was primarily driven by Battlefield 3, FIFA 12 and Madden 12. At December 31, 2011, deferred net revenue associated with sales of online-enabled package goods and digital content increased by $590 million as compared to September 30, 2011, directly decreasing the amount of reported net revenue during the three months ended December 31, 2011. At December 31, 2010, deferred revenue associated with sales of online-enabled package goods and digital content increased by $357 million as compared to September 30, 2010, directly decreasing the amount of reported net revenue during the three months ended December 31, 2010. Without these changes in deferred net revenue, reported net revenue would have increased by approximately $241 million during the three months ended December 31, 2011 as compared to the three months ended December 31, 2010.
34
Net loss for the three months ended December 31, 2011 was $205 million as compared to a net loss of $322 million for the three months ended December 31, 2010. Diluted loss per share for the three months ended December 31, 2011 was $0.62 as compared to a diluted loss per share of $0.97 for the three months ended December 31, 2010. Net loss decreased during the three months ended December 31, 2011 as compared to the three months ended December 31, 2010 primarily as a result of (1) a $154 million decrease in restructuring activity and (2) a $34 million decrease in cost of goods sold primarily due to a change in the mix of our revenue toward non-license based products which resulted in decreased royalty expenses, offset by a $76 million increase in operating expenses, excluding restructuring activity primarily due to an increase in personnel-related costs resulting from an increase in headcount in connection with recent acquisitions.
Cash provided by operating activities decreased $77 million during the nine months ended December 31, 2011 as compared to the nine months ended December 31, 2010 primarily due to the settlement of higher accounts payable balances in the beginning of fiscal year 2012 as compared to fiscal year 2011 in connection with increased title releases in the fourth quarter of fiscal year 2011 as compared to fiscal year 2010.
Trends in Our Business
Digital Content Distribution and Services. Consumers are spending an ever-increasing portion of their money and time on interactive entertainment that is accessible online, or through mobile digital devices such as smart phones, or through social networks such as Facebook. We offer a variety of online-delivered products and services. Many of our games that are available as packaged goods products are also available through direct online download through the Internet, including on our own commerce site, called Origin. We also offer online-delivered content and services that are add-ons or related to our packaged goods products such as additional game content or enhancements of multiplayer services. Further, we offer other games, content and services that are available only via electronic delivery, such as Internet-only games and game services including games on social networking sites such as Facebook, and games for mobile devices.
Advances in mobile technology have resulted in a variety of new and evolving devices that are being used to play games by an ever-broadening base of consumers. We have responded to these advances in technology and consumer acceptance of digital distribution by offering different sales models, such as subscription services, online downloads for a one-time fee, and advertising-supported free-to-play games and game sites. In addition, we offer our consumers the ability to play a game across platforms on multiple devices. We significantly increased the revenue that we derive from wireless, Internet-derived and advertising (digital) products and services from $195 million during the three months ended December 31, 2010 to $274 million during the three months ended December 31, 2011 and we expect this portion of our business to continue to grow in the current fiscal year and beyond.
Wireless and other Emerging Platforms. Advances in technology have resulted in a variety of platforms for interactive entertainment. Examples include wireless technologies, streaming gaming services, and Internet-connected televisions. Our efforts in wireless interactive entertainment are focused in two areas games for handheld game systems and downloadable games for mobile devices. These platforms grow the consumer base for our business while also providing competition to existing established video game platforms. We expect sales of games for wireless and other emerging platforms to continue to be an important part of our business.
Concentration of Sales Among the Most Popular Games. We see a larger portion of packaged goods games sales concentrated on the most popular titles, and that those titles are typically sequels of prior games. We have responded to this trend by significantly reducing the number of games that we produce from 54 primary titles in fiscal year 2010 to 36 primary titles in fiscal year 2011. In fiscal year 2012, we expect to release 22 primary titles, including our December 2011 launch of the massively multiplayer online role-playing game Star Wars: The Old Republic. In addition, we have decreased the number of third-party games that we distribute, which have lower margins.
Catalog Sales. The video game industry is experiencing a change in retail sales patterns, which is decreasing revenue from catalog sales (sales of games in the periods subsequent to the quarter in which the title was launched). Currently, many console games experience sales cycles that are shorter than in the past. To mitigate this trend, we offer our consumers a direct-to-consumer service (such as head-to-head play or other multiplayer options) and/or additional content available through online services to further enhance the gaming experience and extend the time that consumers play our games after their initial purchase. We anticipate that in some cases these additional online services will also generate revenue to mitigate the effect of reduced catalog sales.
Used Games. Some retailers sell used video games, which are generally priced lower than new video games and do not result in revenue to the publisher of the games from the sale. We have observed that the market for used video games has been growing. If retailers continue to increase their sales of used video games, it could negatively affect our sales of new video games and have an adverse impact on our operating results.
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Recent Developments
Acquisition of PopCap Games, Inc. In August 2011, we acquired all of the outstanding shares of PopCap Games Inc. (PopCap) for an aggregate purchase price of approximately (1) $645 million in cash and (2) $87 million in privately placed shares of our common stock to the founders and chief executive officer of PopCap. In addition, we agreed to grant over a four year period to PopCaps employees up to $50 million in long-term equity retention arrangements in the form of restricted stock unit awards and options to acquire our common stock. PopCap is a leading developer of casual games for mobile phones, tablets, PCs, and social network sites. This acquisition strengthens our participation in casual gaming and contributes to our digital business.
0.75% Convertible Senior Notes Due 2016. In July 2011, we issued $632.5 million aggregate principal amount of 0.75% Convertible Senior Notes due 2016 (the Notes). The Notes are senior unsecured obligations which pay interest semiannually in arrears at a rate of 0.75 percent per annum on January 15 and July 15 of each year, beginning on January 15, 2012 and will mature on July 15, 2016, unless earlier purchased or converted in accordance with their terms prior to such date. The Notes are convertible into cash and shares of our common stock based on an initial conversion value of 31.5075 shares of our common stock per $1,000 principal amount of Notes (equivalent to an initial conversion price of approximately $31.74 per share). Upon conversion of the Notes, holders will receive cash up to the principal amount of each Note, and any excess conversion value will be delivered in shares of our common stock.
In addition, in July 2011, we entered into privately negotiated convertible note hedge transactions (the Convertible Note Hedge) with certain counterparties to reduce the potential dilution with respect to our common stock upon conversion of the Notes. The Convertible Note Hedge, subject to customary anti-dilution adjustments, provide us with the option to acquire, on a net settlement basis, approximately 19.9 million shares of our common stock at a strike price of $31.74, which corresponds to the conversion price of the Notes and is equal to the number of shares of our common stock that notionally underlie the Notes. As of December 31, 2011, we have not purchased any shares under the Convertible Note Hedge. We paid $107 million for the Convertible Note Hedge.
Separately, we have also entered into privately negotiated warrant transactions with the certain counterparties whereby we sold to independent third parties warrants (the Warrants) to acquire, subject to customary anti-dilution adjustments that are substantially the same as the anti-dilution provisions contained in the Notes, up to 19.9 million shares of our common stock (which is also equal to the number of shares of our common stock that notionally underlie the Notes), with a strike price of $41.14. The Warrants could have a dilutive effect with respect to our common stock to the extent that the market price per share of its common stock exceeds $41.14 on or prior to the expiration date of the Warrants. We received proceeds of $65 million from the sale of the Warrants.
See Note 12 to the Condensed Consolidated Financial Statements for additional information related to our 0.75% Convertible Senior Notes due 2016.
Stock Repurchase Program. In February 2011, we announced that our Board of Directors authorized a program to repurchase up to $600 million of our common stock over the next 18 months. As of December 31, 2011, we had repurchased $288 million of our common stock, or approximately 14 million shares, in the open market since the commencement of the program, including pursuant to pre-arranged stock trading plans.
Under the program, we may purchase stock in the open market or through privately negotiated transactions in accordance with applicable securities laws, including pursuant to pre-arranged stock trading plans. The timing and actual amount of the stock repurchases will depend on several factors including price, capital availability, regulatory requirements, alternative investment opportunities, and other market conditions. We are not obligated to repurchase any specific number of shares under the program and the repurchase program may be modified, suspended or discontinued at any time.
International Operations and Foreign Currency Exchange Impact. International sales (revenue derived from countries other than Canada and the United States), are a fundamental part of our business. Net revenue from international sales accounted for approximately 52 percent of our total net revenue during the nine months ended December 31, 2011 and approximately 48 percent of our total net revenue during the nine months ended December 31, 2010. Our net revenue is impacted by foreign exchange rates during the reporting period associated with net revenue before revenue deferral, as well as the foreign exchange rates associated with the recognition of deferred net revenue of online-enabled packaged goods and digital content that were established at the time we recorded this deferred net revenue on our Condensed Consolidated Balance Sheets. The foreign
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exchange rates during the reporting period may not always move in the same direction as the foreign exchange rate impact associated with the recognition of deferred net revenue of online-enabled packaged goods and digital content. During the nine months ended December 31, 2011, foreign exchange rates had an overall favorable impact on our net revenue of approximately $123 million, or 5 percent. In addition, our international investments and our cash and cash equivalents denominated in foreign currencies are subject to fluctuations in foreign currency exchange rates. If the U.S. dollar strengthens against these currencies, then foreign exchange rates may have an unfavorable impact on our results of operations and our financial condition.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Our Condensed Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these Condensed Consolidated Financial Statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, contingent assets and liabilities, and revenue and expenses during the reporting periods. The policies discussed below are considered by management to be critical because they are not only important to the portrayal of our financial condition and results of operations, but also because application and interpretation of these policies requires both management judgment and estimates of matters that are inherently uncertain and unknown. As a result, actual results may differ materially from our estimates.
Revenue Recognition, Sales Returns, Allowances and Bad Debt Reserves
We derive revenue principally from sales of interactive software games (1) on video game consoles (such as the PLAYSTATION 3, Xbox 360 and Wii), PCs, and handheld game players (such as the PSP and Nintendo DS and 3DS), (2) on mobile devices (such as cellular and smart phones including the Apple iPhone), (3) on tablets such as the Apple iPad, and (4) from software products and content and online services associated with these products. We evaluate revenue recognition based on the criteria set forth in Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 985-605, Software: Revenue Recognition and Staff Accounting Bulletin (SAB) No. 101, Revenue Recognition in Financial Statements, as revised by SAB No. 104, Revenue Recognition. We evaluate and recognize revenue when all four of the following criteria are met:
| Evidence of an arrangement. Evidence of an agreement with the customer that reflects the terms and conditions to deliver products must be present. |
| Delivery. Delivery is considered to occur when a product is shipped and the risk of loss and rewards of ownership have been transferred to the customer. For online game services, delivery is considered to occur as the service is provided. For digital downloads that do not have an online service component, delivery is generally considered to occur when the download is made available. |
| Fixed or determinable fee. If a portion of the arrangement fee is not fixed or determinable, we recognize revenue as the amount becomes fixed or determinable. |
| Collection is deemed probable. We conduct a credit review of each customer involved in a significant transaction to determine the creditworthiness of the customer. Collection is deemed probable if we expect the customer to be able to pay amounts under the arrangement as those amounts become due. If we determine that collection is not probable, we recognize revenue when collection becomes probable (generally upon cash collection). |
Determining whether and when some of these criteria have been satisfied often involves assumptions and management judgments that can have a significant impact on the timing and amount of revenue we report in each period. For example, for our multiple element software arrangements, we must make assumptions and judgments in order to (1) determine whether and when each element has been delivered, (2) determine whether undelivered products or services are essential to the functionality of the delivered products and services, (3) determine whether vendor specific objective evidence of fair value (VSOE) exists for each undelivered element, and (4) allocate the total price among the various elements we must deliver. Changes to any of these assumptions or management judgments, or changes to the elements in a software arrangement, could cause a material increase or decrease in the amount of revenue that we report in a particular period.
Depending on the type of product, we may offer an online service that permits consumers to play against others via the Internet and/or receive additional updates or content from us. For those games that consumers can play via the Internet, we may provide a matchmaking service that permits consumers to connect with other consumers to play against each other online. In those situations where we do not require an additional fee for this online service, we account for the sale of the software product and the online service as a bundled sale, or multiple element arrangement, in which we sell both the software product and the online service for one combined price. We defer net revenue from sales of these games for which we do not have VSOE for the online service that we provided in connection with the sale, and recognize the revenue from these games over the estimated online service period, which is generally estimated to be six months beginning in the month after shipment.
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In addition, for some software products we also provide updates or additional content (digital content) to be delivered via the Internet that can be used with the original software product. In many cases we separately sell digital content for an additional fee; however, some purchased digital content can only be accessed via the Internet (i.e., the consumer never takes possession of the digital content). We account for online transactions in which the consumer does not take possession of the digital content as a service transaction, and accordingly, we recognize the associated revenue over the estimated service period. In other transactions, at the date we sell the software product we have an obligation to provide incremental unspecified digital content in the future without an additional fee. In these cases, we account for the sale of the software product as a multiple element arrangement and recognize the revenue on a straight-line basis over the estimated period of game play.
Determining whether a transaction constitutes an online service transaction or a digital content download of a product requires judgment and can be difficult. The accounting for these transactions is significantly different. Revenue from product downloads is generally recognized when the download is made available (assuming all other recognition criteria are met). Revenue from an online game service is recognized as the service is rendered. If the service period is not defined, we recognize the revenue over the estimated service period. Determining the estimated service period is inherently subjective and is subject to regular revision based on historical online usage. In addition, determining whether we have an implicit obligation to provide incremental unspecified future digital content without an additional fee can be difficult.
On April 3, 2011, we adopted FASB Accounting Standards Update (ASU) 2009-13, Revenue Recognition (Topic 605): Multiple-Deliverable Revenue Arrangements and ASU 2009-14, Software (Topic 985): Certain Revenue Arrangements that Include Software Elements. The new accounting principles establish a selling price hierarchy for determining the selling price of a deliverable and require the application of the relative selling price method to allocate the arrangement consideration to each deliverable in a multiple element arrangement that includes tangible products. In some of our multiple element arrangements, we sell tangible products with software and/or online services. These tangible products are generally either peripherals or ancillary collectors items. Prior to April 3, 2011, because either the software or other elements sold with the tangible products were essential to the functionality of the tangible product and/or we did not have VSOE for the tangible product, we did not separately account for the tangible product.
For our multiple element arrangements that include tangible products entered into after April 2, 2011, revenue is allocated to each separate unit of accounting for each deliverable using the relative selling prices of each deliverable in the arrangement based on the selling price hierarchy as described below. If the arrangement contains more than one software deliverable, the arrangement consideration is allocated to the software deliverables as a group and then allocated to each software deliverable in accordance with ASC 985-605.
We determine the selling price for a tangible product deliverable based on the following selling price hierarchy: VSOE (i.e., the price we charge when the tangible product is sold separately) if available, third-party evidence (TPE) of fair value (i.e., the price charged by others for similar tangible products) if VSOE is not available, or our best estimate of selling price (BESP) if neither VSOE nor TPE is available. Determining the BESP is a subjective process that is based on multiple factors including, but not limited to, recent selling prices and related discounts, market conditions, customer classes, sales channels and other factors.
As the result of the adoption of these standards, for the three and nine months ended December 31, 2011, we recognized $15 million more revenue than would have been recognized under previous accounting standards.
Product revenue, including sales to resellers and distributors (channel partners), is recognized when the above criteria are met. We reduce product revenue for estimated future returns, price protection, and other offerings, which may occur with our customers and channel partners. Price protection represents the right to receive a credit allowance if we lower our wholesale price on a particular product. The amount of the price protection is generally the difference between the old price and the new price. In certain countries, we have stock-balancing (inventory) programs for our PC and video game system software products, which allow for the exchange of these software products by resellers under certain circumstances. It is our general practice to exchange software products or give credits rather than to give cash refunds.
In certain countries, from time to time, we decide to provide price protection for our software products. When evaluating the adequacy of sales returns and price protection allowances, we analyze historical returns, current sell-through of distributor and retailer inventory of our software products, current trends in retail and the video game industry, changes in customer demand and acceptance of our software products, and other related factors. In addition, we monitor the volume of sales to our channel partners and their inventories, as substantial overstocking in the distribution channel could result in high returns or higher price protection costs in subsequent periods.
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In the future, actual returns and price protections may materially exceed our estimates as unsold software products in the distribution channels are exposed to rapid changes in consumer preferences, market conditions or technological obsolescence due to new platforms, product updates or competing software products. While we believe we can make reliable estimates regarding these matters, these estimates are inherently subjective. Accordingly, if our estimates change, our returns and price protection reserves would change, which would impact the total net revenue we report. For example, if actual returns and/or price protection were significantly greater than the reserves we have established, our actual results would decrease our reported total net revenue. Conversely, if actual returns and/or price protection were significantly less than our reserves, this would increase our reported total net revenue. In addition, if our estimates of returns and price protection related to online-enabled packaged goods software products change, the amount of deferred net revenue we recognize in the future would change.
Significant management judgment is required to estimate our allowance for doubtful accounts in any accounting period. We determine our allowance for doubtful accounts by evaluating customer creditworthiness in the context of current economic trends and historical experience. Depending upon the overall economic climate and the financial condition of our customers, the amount and timing of our bad debt expense and cash collection could change significantly.
Fair Value Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States often requires us to determine the fair value of a particular item in order to fairly present our financial statements. Without an independent market or another representative transaction, determining the fair value of a particular item requires us to make several assumptions that are inherently difficult to predict and can have a material impact on the accounting.
There are various valuation techniques used to estimate fair value. These include (1) the market approach where market transactions for identical or comparable assets or liabilities are used to determine the fair value, (2) the income approach, which uses valuation techniques to convert future amounts (for example, future cash flows or future earnings) to a single present value amount, and (3) the cost approach, which is based on the amount that would be required to replace an asset. For many of our fair value estimates, including our estimates of the fair value of acquired intangible assets and acquired in-process technology, we use the income approach. Using the income approach requires the use of financial models, which require us to make various estimates including, but not limited to (1) the potential future cash flows for the asset or liability being measured, (2) the timing of receipt or payment of those future cash flows, (3) the time value of money associated with the expected receipt or payment of such cash flows, and (4) the inherent risk associated with the cash flows (risk premium). Making these cash flow estimates is inherently difficult and subjective, and if any of the estimates used to determine the fair value using the income approach turns out to be inaccurate, our financial results may be negatively impacted. Furthermore, relatively small changes in many of these estimates can have a significant impact to the estimated fair value resulting from the financial models or the related accounting conclusion reached. For example, a relatively small change in the estimated fair value of an asset may change a conclusion as to whether an asset is impaired.
While we are required to make certain fair value assessments associated with the accounting for several types of transactions, the following areas are the most sensitive to these assessments:
Business Combinations. We must estimate the fair value of assets acquired, liabilities and contingencies assumed, acquired in-process technology, and contingent consideration issued in a business combination. Our assessment of the estimated fair value of each of these can have a material effect on our reported results as intangible assets and acquired in-process technology are amortized over various estimated useful lives. Furthermore, a change in the estimated fair value of an asset or liability often has a direct impact on the amount we recognize as goodwill, an asset that is not amortized. Determining the fair value of assets acquired requires an assessment of the highest and best use or the expected price to sell the asset and the related expected future cash flows. Determining the fair value of acquired in-process technology also requires an assessment of our expectations related to the use of that asset. Determining the fair value of an assumed liability requires an assessment of the expected cost to transfer the liability. Determining the fair value of contingent consideration issued requires an assessment of the expected future cash flows over the period in which the obligation is expected to be settled, and applying a discount rate that appropriately captures a market participants view of the risk associated with the obligation. This fair value assessment is also required in periods subsequent to a business combination. Such estimates are inherently difficult and subjective and can have a material impact on our Condensed Consolidated Financial Statements.
Assessment of Impairment of Goodwill, Intangibles, and Other Long-Lived Assets. Current accounting standards require that we assess the recoverability of our finite lived acquisition-related intangible assets and other long-lived assets whenever events or changes in circumstances indicate the remaining value of the assets recorded on our Condensed Consolidated Balance Sheets is potentially impaired. In order to determine if a potential impairment has occurred, management must make various
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assumptions about the estimated fair value of the asset by evaluating future business prospects and estimated future cash flows. For some assets, our estimated fair value is dependent upon predicting which of our products will be successful. This success is dependent upon several factors, which are beyond our control, such as which platforms will be successful in the marketplace. Also, our revenue and earnings are dependent on our ability to meet our product release schedules.
We are required to perform a two-step approach to testing goodwill for impairment for each reporting unit annually, or whenever events or changes in circumstances indicate the fair value of a reporting unit is below its carrying amount. Our reporting units are determined by the components of our operating segments that constitute a business for which (1) discrete financial information is available and (2) segment management regularly reviews the operating results of that component. We are required to perform the impairment test at least annually by applying a fair value-based test. The first step measures for impairment by applying fair value-based tests at the reporting unit level. The second step (if necessary) measures the amount of impairment by applying fair value-based tests to the individual assets and liabilities within each reporting unit.
To determine the fair value of each reporting unit used in the first step, we use a combination of the market approach, which utilizes comparable companies data, and/or the income approach, which utilizes discounted cash flows. Determining whether an event or change in circumstances does or does not indicate that the fair value of a reporting unit is below its carrying amount is inherently subjective. Each step requires us to make judgments and involves the use of significant estimates and assumptions. These estimates and assumptions include long-term growth rates, tax rates, and operating margins used to calculate projected future cash flows, risk-adjusted discount rates based on our weighted average cost of capital, future economic and market conditions and determination of appropriate market comparables. These estimates and assumptions have to be made for each reporting unit evaluated for impairment. As of the last annual assessment of goodwill in the fourth quarter of fiscal year 2011, we concluded that the estimated fair values of each of our reporting units adequately exceeded their carrying amounts and we have not identified any indicators of impairment since. Our estimates for market growth, our market share and costs are based on historical data, various internal estimates and certain external sources, and are based on assumptions that are consistent with the plans and estimates we are using to manage the underlying business. Our business consists of developing, marketing and distributing video game software using both established and emerging intellectual properties and our forecasts for emerging intellectual properties are based upon internal estimates and external sources rather than historical information and have an inherently higher risk of inaccuracy. If future forecasts are revised, they may indicate or require future impairment charges. We base our fair value estimates on assumptions we believe to be reasonable, but that are unpredictable and inherently uncertain. Actual future results may differ from those estimates.
Assessment of Impairment of Short-Term Investments and Marketable Equity Securities. We periodically review our short-term investments and marketable equity securities for impairment. Our short-term investments consist of securities with remaining maturities greater than three months at the time of purchase and our marketable equity securities consist of investments in common stock of publicly traded companies, both are accounted for as available-for-sale securities. Unrealized gains and losses on our short-term investments and marketable equity securities are recorded as a component of accumulated other comprehensive income in stockholders equity, net of tax, until either (1) the security is sold, (2) the security has matured, or (3) we determine that the fair value of the security has declined below its adjusted cost basis and the decline is other-than-temporary. Realized gains and losses on our short-term investments and marketable equity securities are calculated based on the specific identification method and are reclassified from accumulated other comprehensive income to interest and other income, net, and loss on strategic investments, respectively. Determining whether the decline in fair value is other-than-temporary requires management judgment based on the specific facts and circumstances of each security. The ultimate value realized on these securities is subject to market price volatility until they are sold. We consider various factors in determining whether we should recognize an impairment charge, including the credit quality of the issuer, the duration that the fair value has been less than the adjusted cost basis, severity of the impairment, reason for the decline in value and potential recovery period, the financial condition and near-term prospects of the investees, and our intent to sell and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in market value, any contractual terms impacting the prepayment or settlement process, as well as, if we would be required to sell an investment due to liquidity or contractual reasons before its anticipated recovery. Our ongoing consideration of these factors could result in impairment charges in the future, which could have a material impact on our financial results.
Assessment of Inventory Obsolescence. We regularly review inventory quantities on-hand. We write down inventory based on excess or obsolete inventories determined primarily by future anticipated demand for our products. Inventory write-downs are measured as the difference between the cost of the inventory and market value, based upon assumptions about future demand that are inherently difficult to assess. At the point of a loss recognition, a new, lower cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis.
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Stock-Based Compensation
We are required to estimate the fair value of share-based payment awards on the date of grant. We recognize compensation costs for stock-based payment awards to employees based on the grant-date fair value using a straight-line approach over the service period for which such awards are expected to vest.
We determine the fair value of our share-based payment awards as follows:
| Restricted Stock Units, Restricted Stock, and Performance-Based Restricted Stock Units. The fair value of restricted stock units, restricted stock, and performance-based restricted stock units (other than market-based restricted stock units) is determined based on the quoted market price of our common stock on the date of grant. Performance-based restricted stock units include grants made (1) to certain members of executive management primarily granted in fiscal year 2008 and (2) in connection with certain acquisitions. |
| Market-Based Restricted Stock Units. Market-based restricted stock units consist of grants of performance-based restricted stock units granted to certain members of executive management (referred to herein as market-based restricted stock units). The fair value of our market-based restricted stock units is determined using a Monte-Carlo simulation model. Key assumptions for the Monte-Carlo simulation model are the risk-free interest rate, expected volatility, expected dividends and correlation coefficient. |
| Stock Options and Employee Stock Purchase Plan. The fair value of stock options and stock purchase rights granted pursuant to our equity incentive plans and our 2000 Employee Stock Purchase Plan (ESPP), respectively, is determined using the Black-Scholes valuation model based on the multiple-award valuation method. Key assumptions of the Black-Scholes valuation model are the risk-free interest rate, expected volatility, expected term and expected dividends. |
The determination of the fair value of market-based restricted stock units, stock options and ESPP is affected by assumptions regarding subjective and complex variables. Generally, our assumptions are based on historical information and judgment is required to determine if historical trends may be indicators of future outcomes.
Employee stock-based compensation expense is calculated based on awards ultimately expected to vest and is reduced for estimated forfeitures. Forfeitures are revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates and an adjustment to stock-based compensation expense will be recognized at that time.
Changes to our assumptions used in the Black-Scholes option valuation or the Monte-Carlo simulation model calculations and our forfeiture rate, as well as future equity granted or assumed through acquisitions could significantly impact the compensation expense we recognize.
Royalties and Licenses
Our royalty expenses consist of payments to (1) content licensors, (2) independent software developers, and (3) co-publishing and distribution affiliates. License royalties consist of payments made to celebrities, professional sports organizations, movie studios and other organizations for our use of their trademarks, copyrights, personal publicity rights, content and/or other intellectual property. Royalty payments to independent software developers are payments for the development of intellectual property related to our games. Co-publishing and distribution royalties are payments made to third parties for the delivery of products.
Royalty-based obligations with content licensors and distribution affiliates are either paid in advance and capitalized as prepaid royalties or are accrued as incurred and subsequently paid. These royalty-based obligations are generally expensed to cost of goods sold generally at the greater of the contractual rate for contracts with guaranteed minimums, or an effective royalty rate based on the total projected net revenue. Significant judgment is required to estimate the effective royalty rate for a particular contract. Because the computation of effective royalty rates requires us to project future revenue, it is inherently subjective as our future revenue projections must anticipate a number of factors, including (1) the total number of titles subject to the contract, (2) the timing of the release of these titles, (3) the number of software units we expect to sell, which can be impacted by a number of variables, including product quality, the timing of the titles release and competition, and (4) future pricing. Determining the effective royalty rate for our titles is particularly challenging due to the inherent difficulty in predicting the popularity of entertainment products. Accordingly, if our future revenue projections change, our effective royalty rates would change, which could impact the amount and timing of royalty expense we recognize.
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Prepayments made to thinly capitalized independent software developers and co-publishing affiliates are generally made in connection with the development of a particular product, and therefore, we are generally subject to development risk prior to the release of the product. Accordingly, payments that are due prior to completion of a product are generally expensed to research and development over the development period as the services are incurred. Payments due after completion of the product (primarily royalty-based in nature) are generally expensed as cost of goods sold.
Our contracts with some licensors include minimum guaranteed royalty payments, which are initially recorded as an asset and as a liability at the contractual amount when no performance remains with the licensor. When performance remains with the licensor, we record guarantee payments as an asset when actually paid and as a liability when incurred, rather than recording the asset and liability upon execution of the contract. Royalty liabilities are classified as current liabilities to the extent such royalty payments are contractually due within the next 12 months.
Each quarter, we also evaluate the expected future realization of our royalty-based assets, as well as any unrecognized minimum commitments not yet paid to determine amounts we deem unlikely to be realized through product sales. Any impairments or losses determined before the launch of a product are charged to research and development expense. Impairments or losses determined post-launch are charged to cost of goods sold. We evaluate long-lived royalty-based assets for impairment generally using undiscounted cash flows when impairment indicators exist. Unrecognized minimum royalty-based commitments are accounted for as executory contracts, and therefore, any losses on these commitments are recognized when the underlying intellectual property is abandoned (i.e., cease use) or the contractual rights to use the intellectual property are terminated.
Income Taxes
We recognize deferred tax assets and liabilities for both the expected impact of differences between the financial statement amount and the tax basis of assets and liabilities and for the expected future tax benefit to be derived from tax losses and tax credit carry forwards. We record a valuation allowance against deferred tax assets when it is considered more likely than not that all or a portion of our deferred tax assets will not be realized. In making this determination, we are required to give significant weight to evidence that can be objectively verified. It is generally difficult to conclude that a valuation allowance is not needed when there is significant negative evidence, such as cumulative losses in recent years. Forecasts of future taxable income are considered to be less objective than past results, particularly in light of the economic environment. Therefore, cumulative losses weigh heavily in the overall assessment.
In addition to considering forecasts of future taxable income, we are also required to evaluate and quantify other possible sources of taxable income in order to assess the realization of our deferred tax assets, namely the reversal of existing deferred tax liabilities, the carry back of losses and credits as allowed under current tax law, and the implementation of tax planning strategies. Evaluating and quantifying these amounts involves significant judgments. Each source of income must be evaluated based on all positive and negative evidence; this evaluation involves assumptions about future activity. Certain taxable temporary differences that are not expected to reverse during the carry forward periods permitted by tax law cannot be considered as a source of future taxable income that may be available to realize the benefit of deferred tax assets.
Based on the assumptions and requirements noted above, we have recorded a valuation allowance against most of our U.S. deferred tax assets. In addition, we expect to provide a valuation allowance on future U.S. tax benefits until we can sustain a level of profitability or until other significant positive evidence arises that suggest that these benefits are more likely than not to be realized.
In the ordinary course of our business, there are many transactions and calculations where the tax law and ultimate tax determination is uncertain. As part of the process of preparing our Condensed Consolidated Financial Statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate prior to the completion and filing of tax returns for such periods. This process requires estimating both our geographic mix of income and our uncertain tax positions in each jurisdiction where we operate. These estimates involve complex issues and require us to make judgments about the likely application of the tax law to our situation, as well as with respect to other matters, such as anticipating the positions that we will take on tax returns prior to our actually preparing the returns and the outcomes of disputes with tax authorities. The ultimate resolution of these issues may take extended periods of time due to examinations by tax authorities and statutes of limitations. In addition, changes in our business, including acquisitions, changes in our international corporate structure, changes in the geographic location of business functions or assets, changes in the geographic mix and amount of income, as well as changes in our agreements with tax authorities, valuation allowances, applicable accounting rules, applicable tax laws and regulations, rulings and interpretations thereof, developments in tax audit and other matters, and variations in the estimated and actual level of annual pre-tax income can affect the overall effective income tax rate.
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We historically have considered undistributed earnings of our foreign subsidiaries to be indefinitely reinvested outside of the United States, and accordingly, no U.S. taxes have been provided thereon. We currently intend to continue to indefinitely reinvest the undistributed earnings of our foreign subsidiaries outside of the United States.
RESULTS OF OPERATIONS
Our fiscal year is reported on a 52- or 53-week period that ends on the Saturday nearest March 31. Our results of operations for the fiscal years ending or ended, as the case may be, March 31, 2012 and 2011 contain 52 weeks each and ends or ended, as the case may be, on March 31, 2012 and April 2, 2011, respectively. Our results of operations for the three months ended December 31, 2011 and 2010 contained 13 weeks each, and ended on December 31, 2011 and January 1, 2011, respectively. Our results of operations for the nine months ended December 31, 2011 and 2010 contained 39 weeks each, and ended on December 31, 2011 and January 1, 2011, respectively. For simplicity of disclosure, all fiscal periods are referred to as ending on a calendar month end.
Net Revenue
Net revenue consists of sales generated from (1) video games sold as packaged goods and designed for play on hardware consoles (such as the Sony PLAYSTATION 3, Microsoft Xbox 360 and Nintendo Wii), PCs, and handheld game players (such as the Sony PSP, Nintendo DS and 3DS), (2) video games for mobile devices (such as cellular and smart phones including the Apple iPhone), (3) video games for tablets such as the Apple iPad, (4) software products and content and online services associated with these products, (5) programming third-party websites with our game content, (6) allowing other companies to manufacture and sell our products in conjunction with other products, and (7) advertisements on our online web pages and in our games.
Net Revenue before Revenue Deferral, a non-GAAP financial measure, is provided in this section of Managements Discussion and Analysis of Financial Condition and Results of Operations (MD&A). See Non-GAAP Financial Measures below for an explanation of our use of this non-GAAP measure. A reconciliation to the corresponding measure calculated in accordance with accounting principles generally accepted in the United States is provided in the discussion below.
Revenue Deferral in this Net Revenue section includes the unrecognized revenue from (1) bundled sales of certain online-enabled packaged goods and PC digital downloads for which either we do not have VSOE for the online service that we provide in connection with the sale of the software or we have an obligation to provide future incremental unspecified digital content, (2) certain packaged goods sales of massively-multiplayer online role-playing games, and (3) sales of certain incremental digital content associated with our games, which are types of micro-transactions. Fluctuations in the Revenue Deferral are largely dependent upon the amounts of products that we sell with the online features and services previously discussed, while the Recognition of Revenue Deferral for a period is also dependent upon (1) the period of time the online features and services are to be provided and (2) the timing of the sale. For example, most Revenue Deferrals incurred in the first half of a fiscal year are recognized within the same fiscal year; however, substantially all of the Revenue Deferrals incurred in the last month of a fiscal year will be recognized in the subsequent fiscal year.
From a geographical perspective, our total Net Revenue for the three months ended December 31, 2011 and 2010 was as follows (in millions):
Three Months Ended December 31, | ||||||||||||||||||||||||||||||||
2011 | 2010 | |||||||||||||||||||||||||||||||
North America |
Europe | Asia | Total | North America |
Europe | Asia | Total | |||||||||||||||||||||||||
Net revenue before revenue deferral |
$ | 810 | $ | 740 | $ | 101 | $ | 1,651 | $ | 697 | $ | 640 | $ | 73 | $ | 1,410 | ||||||||||||||||
Revenue deferral |
(671 | ) | (613 | ) | (86 | ) | (1,370 | ) | (490 | ) | (453 | ) | (52 | ) | (995 | ) | ||||||||||||||||
Recognition of revenue deferral |
361 | 378 | 41 | 780 | 321 | 290 | 27 | 638 | ||||||||||||||||||||||||
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Net revenue |
$ | 500 | $ | 505 | $ | 56 | $ | 1,061 | $ | 528 | $ | 477 | $ | 48 | $ | 1,053 | ||||||||||||||||
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Worldwide
For the three months ended December 31, 2011, Net Revenue before Revenue Deferral was $1,651 million, primarily driven by Battlefield 3, FIFA 12 and Star Wars: The Old Republic. Net Revenue before Revenue Deferral for the three months ended December 31, 2011 increased $241 million, or 17 percent, as compared to the three months ended December 31, 2010. This was driven by an $815 million increase primarily from the Battlefield and FIFA franchises, as well as Star Wars: The Old Republic. This increase was partially offset by a $574 million decrease primarily from the Medal of Honor, Need for Speed and
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EA Sports Active franchises. We estimate that foreign exchange rates increased reported Net Revenue before Revenue Deferral by approximately $6 million, or less than 1 percent, for the three months ended December 31, 2011 as compared to the three months ended December 31, 2010. Excluding the effect of foreign exchange rates from Net Revenue before Revenue Deferral, we estimate that Net Revenue before Revenue Deferral increased by approximately $235 million, or 17 percent, for the three months ended December 31, 2011 as compared to the three months ended December 31, 2010.
Revenue Deferral for the three months ended December 31, 2011 increased $375 million, or 38 percent, as compared to the three months ended December 31, 2010. This increase was primarily due to an increase in sales of online-enabled products with an obligation to provide future incremental unspecified digital content on a when-and-if-available basis during the three months ended December 31, 2011 as compared to the three months ended December 31, 2010. This increase was driven by a $753 million increase primarily from the Battlefield and FIFA franchises, as well as Star Wars: The Old Republic. This increase was partially offset by a $378 million decrease primarily from the Medal of Honor, Need for Speed and EA Sports Active franchises.
Recognition of Revenue Deferral for the three months ended December 31, 2011 increased $142 million, or 22 percent, as compared to the three months ended December 31, 2010. This increase was primarily due to the Recognition of Revenue Deferral during the three months ended December 31, 2011 associated with the sales of online-enabled products with an obligation to provide future incremental unspecified digital content on a when-and-if-available basis during the preceding six months, with less comparable recognition during the three months ended December 31, 2010. This increase was driven by a $308 million increase primarily from the Battlefield, FIFA, and The Sims franchises. This increase was partially offset by a $166 million decrease primarily from the Medal of Honor, FIFA World Cup and Tiger Woods PGA Tour franchises.
For the three months ended December 31, 2011, Net Revenue was $1,061 million, driven by FIFA 12, Battlefield 3 and Madden 12. Net Revenue for the three months ended December 31, 2011 increased $8 million, or 1 percent, as compared to the three months ended December 31, 2010. This increase was driven by a $354 million increase primarily from the Battlefield and FIFA franchises. This increase was partially offset by a $346 million decrease from certain franchises, including the Medal of Honor, Harry Potter and Rock Band franchises. We estimate that foreign exchange rates increased reported Net Revenue by approximately $37 million, or 4 percent, for the three months ended December 31, 2011 as compared to the three months ended December 31, 2010. Excluding the effect of foreign exchange rates from Net Revenue, we estimate that Net Revenue decreased by approximately $29 million, or 3 percent, for the three months ended December 31, 2011 as compared to the three months ended December 31, 2010.
North America
For the three months ended December 31, 2011, Net Revenue before Revenue Deferral in North America was $810 million, driven by Battlefield 3, Madden 12 and Star Wars: The Old Republic. Net Revenue before Revenue Deferral for the three months ended December 31, 2011 increased $113 million, or 16 percent, as compared to the three months ended December 31, 2010. This increase was driven by a $424 million increase primarily from the Battlefield and Madden franchises, as well as Star Wars: The Old Republic. This increase was partially offset by a $311 million decrease from certain franchises, including the Medal of Honor, EA Sports Active and Need for Speed franchises.
Revenue Deferral for the three months ended December 31, 2011 increased $181 million, or 37 percent, as compared to the three months ended December 31, 2010. This increase was driven by a $383 million increase primarily from the Battlefield franchise, as well as Star Wars: The Old Republic. This increase was partially offset by a $202 million decrease primarily from the Medal of Honor, EA Sports Active and Need for Speed franchises.
Recognition of Revenue Deferral for the three months ended December 31, 2011 increased $40 million, or 12 percent, as compared to the three months ended December 31, 2010. This increase was driven by a $130 million increase primarily from the Battlefield and FIFA franchises. This increase was offset by a $90 million decrease primarily from the Medal of Honor, FIFA World Cup and Tiger Woods PGA Tour franchises.
For the three months ended December 31, 2011, Net Revenue in North America was $500 million, driven by Madden 12, Battlefield 3 and NCAA Football 12. Net Revenue for the three months ended December 31, 2011 decreased $28 million, or 5 percent, compared to the three months ended December 31, 2010. This decrease was driven by a $200 million decrease certain franchises, including the Rock Band, Medal of Honor and Harry Potter franchises. This decrease was partially offset by a $172 million increase primarily from the Battlefield and FIFA franchises.
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Europe
For the three months ended December 31, 2011, Net Revenue before Revenue Deferral in Europe was $740 million, driven by Battlefield 3, FIFA 12 and Star Wars: The Old Republic. Net Revenue before Revenue Deferral for the three months ended December 31, 2011 increased $100 million, or 16 percent, as compared to the three months ended December 31, 2010. This increase was driven by a $339 million increase primarily from the Battlefield and FIFA franchises, as well as Star Wars: The Old Republic. This increase was partially offset by a $239 million decrease primarily from the Medal of Honor, Need for Speed and Harry Potter franchises. We estimate that foreign exchange rates (primarily the Swiss Franc and British Pound) increased reported Net Revenue before Revenue Deferral by approximately $3 million, or 1 percent, for the three months ended December 31, 2011 as compared to the three months ended December 31, 2010. Excluding the effect of foreign exchange rates from Net Revenue before Revenue Deferral, we estimate that Net Revenue before Revenue Deferral increased by approximately $97 million, or 15 percent, for the three months ended December 31, 2011 as compared to the three months ended December 31, 2010.
Revenue Deferral for three months ended December 31, 2011 increased by $160 million, or 35 percent, as compared to three months ended December 31, 2010. This increase was driven by a $321 million increase primarily from the Battlefield and FIFA franchise, as well as Star Wars: The Old Republic. This increase was partially offset by a $161 million decrease primarily from the Medal of Honor, Need for Speed and EA Sports Active franchises.
Recognition of Revenue Deferral for the three months ended December 31, 2011 increased $88 million, or 30 percent, as compared to the three months ended December 31, 2010. This increase was driven by a $161 million increase primarily from the Battlefield, FIFA and The Sims franchises. This increase was partially offset by a $73 million decrease primarily from the Medal of Honor, FIFA World Cup and Tiger Woods PGA Tour franchises.
For the three months ended December 31, 2011, Net Revenue in Europe was $505 million, driven by FIFA 12, Battlefield 3 and FIFA 11. Net Revenue for the three months ended December 31, 2011 increased $28 million, or 6 percent, as compared to the three months ended December 31, 2010. This increase was driven by a $169 million increase primarily from the Battlefield, FIFA and The Sims franchises. This increase was partially offset by a $141 million decrease from certain franchises, including the Medal of Honor, Harry Potter and FIFA World Cup franchises. We estimate that foreign exchange rates (primarily the Swiss Franc, British Pound, and Euro) increased reported Net Revenue by approximately $31 million, or 6 percent, for the three months ended December 31, 2011 as compared to the three months ended December 31, 2010. Excluding the effect of foreign exchange rates from Net Revenue, we estimate that Net Revenue decreased by approximately $3 million, or less than 1 percent, for the three months ended December 31, 2011 as compared to the three months ended December 31, 2010.
Asia
For the three months ended December 31, 2011, Net Revenue before Revenue Deferral in Asia was $101 million, driven by Battlefield 3, FIFA World Class Soccer and FIFA 12. Net Revenue before Revenue Deferral for the three months ended December 31, 2011 increased by $28 million, or 38 percent, as compared to the three months ended December 31, 2010. This increase was driven by a $62 million increase primarily from the Battlefield and FIFA franchises. This increase was partially offset by a $34 million decrease primarily from the Medal of Honor, Need for Speed and EA Sports Active franchises. We estimate that foreign exchange rates (primarily the Japanese Yen) increased reported Net Revenue before Revenue Deferral by approximately $3 million, or 4 percent, for the three months ended December 31, 2011 as compared to the three months ended December 31, 2010. Excluding the effect of foreign exchange rates from Net Revenue before Revenue Deferral, we estimate that Net Revenue before Revenue Deferral increased by approximately $25 million, or 34 percent, for the three months ended December 31, 2011 as compared to the three months ended December 31, 2010.
Revenue Deferral for the three months ended December 31, 2011 increased $34 million, or 65 percent, as compared to the three months ended December 31, 2010. This increase was driven by a $59 million increase primarily from the Battlefield and FIFA franchises. This increase was partially offset by a $25 million decrease primarily from the Medal of Honor, Need for Speed and EA Sports Active franchises.
Recognition of Revenue Deferral for the three months ended December 31, 2011 increased $14 million, or 52 percent, as compared to the three months ended December 31, 2010. This increase was driven by a $23 million increase primarily from the Battlefield, FIFA and Alice franchises. This increase was partially offset by a $9 million decrease primarily from the Medal of Honor and FIFA World Cup franchises.
For the three months ended December 31, 2011, Net Revenue in Asia was $56 million, driven by Battlefield 3, FIFA 12 and FIFA Online 2. Net Revenue for the three months ended December 31, 2011 increased by $8 million, or 17 percent, as
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compared to the three months ended December 31, 2010. This increase was driven by a $26 million increase primarily from the Battlefield, FIFA and Alice franchises. This increase was offset by an $18 million decrease primarily from the Medal of Honor, FIFA World Cup and Harry Potter franchises. We estimate that foreign exchange rates (primarily the Japanese Yen) increased reported Net Revenue by approximately $6 million, or 13 percent, for the three months ended December 31, 2011 as compared to the three months ended December 31, 2010. Excluding the effect of foreign exchange rates from Net Revenue, we estimate that Net Revenue increased by approximately $2 million, or 4 percent, for the three months ended December 31, 2011 as compared to the three months ended December 31, 2010.
From a geographical perspective, our total Net Revenue for the nine months ended December 31, 2011 and 2010 was as follows (in millions):
Nine Months Ended December 31, | ||||||||||||||||||||||||||||||||
2011 | 2010 | |||||||||||||||||||||||||||||||
North America |
Europe | Asia | Total | North America |
Europe | Asia | Total | |||||||||||||||||||||||||
Net revenue before revenue deferral |
$ | 1,552 | $ | 1,465 | $ | 192 | $ | 3,209 | $ | 1,433 | $ | 1,260 | $ | 140 | $ | 2,833 | ||||||||||||||||
Revenue deferral |
(1,161 | ) | (1,123 | ) | (136 | ) | (2,420 | ) | (995 | ) | (914 | ) | (94 | ) | (2,003 | ) | ||||||||||||||||
Recognition of revenue deferral |
947 | 929 | 110 | 1,986 | 868 | 710 | 91 | 1,669 | ||||||||||||||||||||||||
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Net revenue |
$ | 1,338 | $ | 1,271 | $ | 166 | $ | 2,775 | $ | 1,306 | $ | 1,056 | $ | 137 | $ | 2,499 | ||||||||||||||||
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Worldwide
For the nine months ended December 31, 2011, Net Revenue before Revenue Deferral was $3,209 million, primarily driven by Battlefield 3, FIFA 12 and Madden 12. Net Revenue before Revenue Deferral for the nine months ended December 31, 2011 increased $376 million, or 13 percent, as compared to the nine months ended December 31, 2010. This increase was driven by a $1,152 million increase primarily from the Battlefield and FIFA franchises, as well as Star Wars: The Old Republic. This increase was partially offset by a $776 million decrease from certain franchises, including the Medal of Honor, FIFA World Cup and Need for Speed franchises. We estimate that foreign exchange rates increased reported Net Revenue before Revenue Deferral by approximately $80 million, or 3 percent, for the nine months ended December 31, 2011 as compared to the nine months ended December 31, 2010. Excluding the effect of foreign exchange rates from Net Revenue before Revenue Deferral, we estimate that Net Revenue before Revenue Deferral increased by approximately $296 million, or 10 percent, for the nine months ended December 31, 2011 as compared to the nine months ended December 31, 2010.
Revenue Deferral for the nine months ended December 31, 2011 increased $417 million, or 21 percent, as compared to the nine months ended December 31, 2010. This increase was primarily due to an increase in sales of online-enabled products with an obligation to provide future incremental unspecified digital content on a when-and-if-available basis during the nine months ended December 31, 2011 as compared to the nine months ended December 31, 2010. This increase was driven by a $979 million increase primarily from the Battlefield and FIFA franchises, as well as Star Wars: The Old Republic. This increase was partially offset by a $562 million decrease primarily from the Medal of Honor, FIFA World Cup and Need for Speed franchises.
Recognition of Revenue Deferral for the nine months ended December 31, 2011 increased $317 million, or 19 percent, as compared to the nine months ended December 31, 2010. This increase was primarily due to the Recognition of Revenue Deferral during the nine months ended December 31, 2011 associated with the sales of online-enabled products with an obligation to provide future incremental unspecified digital content on a when-and-if-available basis during the preceding six months, with less comparable recognition during the nine months ended December 31, 2010. This increase was driven by a $725 million increase from certain franchises, including the Crysis, Need for Speed, and FIFA franchises. This increase was partially offset by a $408 million decrease primarily from the FIFA World Cup and Army of Two franchises, as well as Dantes Inferno.
For the nine months ended December 31, 2011, Net Revenue was $2,775 million, driven by FIFA 12, FIFA 11 and Battlefield 3. Net Revenue for the nine months ended December 31, 2011 increased $276 million, or 11 percent, as compared to the nine months ended December 31, 2010. This increase was driven by an $871 million increase from certain franchises, including the Crysis, FIFA and Need for Speed franchises. This increase was partially offset by a $595 million decrease from certain franchises, including the FIFA World Cup and Rock Band franchises, as well as Dantes Inferno. We estimate that foreign exchange rates increased reported Net Revenue by approximately $123 million, or 5 percent, for the nine months ended December 31, 2011 as compared to the nine months ended December 31, 2010. Excluding the effect of foreign exchange rates from Net Revenue, we estimate that Net Revenue increased by approximately $153 million, or 6 percent, for the nine months ended December 31, 2011 as compared to the nine months ended December 31, 2010.
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North America
For the nine months ended December 31, 2011, Net Revenue before Revenue Deferral in North America was $1,552 million, driven by Battlefield 3, Madden 12, and NCAA Football 12. Net Revenue before Revenue Deferral for the nine months ended December 31, 2011 increased $119 million, or 8 percent, as compared to the nine months ended December 31, 2010. This increase was driven by a $550 million increase primarily from the Battlefield and Portal franchises, as well as Star Wars: The Old Republic. This increase was partially offset by a $431 million decrease from certain franchises, including the Medal of Honor, Rock Band, and FIFA World Cup franchises.
Revenue Deferral for the nine months ended December 31, 2011 increased $166 million, or 17 percent, as compared to the nine months ended December 31, 2010. This increase was driven by a $457 million increase primarily from the Battlefield and Madden franchises, as well as Star Wars: The Old Republic. This increase was partially offset by a $291 million decrease from certain franchises, including the Medal of Honor, FIFA World Cup and Need for Speed franchises.
Recognition of Revenue Deferral for the nine months ended December 31, 2011 increased $79 million, or 9 percent, as compared to the nine months ended December 31, 2010. This increase was driven by a $314 million increase from certain franchises, including the Crysis, Need for Speed and Dead Space franchises. This increase was partially offset by a $235 million decrease from certain franchises, including the FIFA World Cup and Army of Two franchises, as well as Dantes Inferno.
For the nine months ended December 31, 2011, Net Revenue in North America was $1,338 million, driven by Madden 12, Battlefield 3, and Portal 2. Net Revenue for the nine months ended December 31, 2011 increased $32 million, or 2 percent, as compared to the nine months ended December 31, 2010. This increase was driven by a $398 million increase from certain franchises, including the Portal, Crysis and Need for Speed franchises. This increase was partially offset by a $366 million decrease from certain franchises, including the Rock Band and FIFA World Cup franchises, as well as Dantes Inferno.
Europe
For the nine months ended December 31, 2011, Net Revenue before Revenue Deferral in Europe was $1,465 million, driven by FIFA 12, Battlefield 3 and Need for Speed The Run. Net Revenue before Revenue Deferral for the nine months ended December 31, 2011 increased $205 million, or 16 percent, as compared to the nine months ended December 31, 2010. This increase was driven by a $525 million increase primarily from the Battlefield and FIFA franchises, as well as Star Wars: The Old Republic. This increase was partially offset by a $320 million decrease primarily from the Medal of Honor, FIFA World Cup and Need for Speed franchises. We estimate that foreign exchange rates (primarily Swiss Franc, British Pound, and Euro) increased reported Net Revenue before Revenue Deferral by approximately $66 million, or 5 percent, for the nine months ended December 31, 2011 as compared to the nine months ended December 31, 2010. Excluding the effect of foreign exchange rates from Net Revenue before Revenue Deferral, we estimate that Net Revenue before Revenue Deferral increased by approximately $139 million, or 11 percent, for the nine months ended December 31, 2011 as compared to the nine months ended December 31, 2010.
Revenue Deferral for the nine months ended December 31, 2011 increased by $209 million, or 23 percent, as compared to nine months ended December 31, 2010. This increase was driven by a $468 million increase primarily from the Battlefield and FIFA franchises, as well as Star Wars: The Old Republic. This increase was partially offset by a $259 million decrease primarily from the Medal of Honor, FIFA World Cup and Need for Speed franchises.
Recognition of Revenue Deferral for the nine months ended December 31, 2011 increased $219 million, or 31 percent, as compared to the nine months ended December 31, 2010. This increase was driven by a $374 million increase primarily from the FIFA, Crysis and Need for Speed franchises. This increase was partially offset by a $155 million decrease primarily from the FIFA World Cup and Army of Two franchises, as well as Dantes Inferno.
For the nine months ended December 31, 2011, Net Revenue in Europe was $1,271 million, driven by FIFA 12, FIFA 11 and Battlefield 3. Net Revenue for the nine months ended December 31, 2011 increased $215 million, or 20 percent, as compared to the nine months ended December 31, 2010. This increase was driven by a $419 million increase primarily from the FIFA, Crysis and Need for Speed franchises. This increase was partially offset by a $204 million decrease from certain franchises, including the FIFA World Cup and Harry Potter franchises, as well as Dantes Inferno. We estimate that foreign exchange rates (primarily the Swiss Franc, British Pound, and Euro) increased reported Net Revenue by approximately $101 million, or 10 percent, for the nine months ended December 31, 2011 as compared to the nine months ended December 31, 2010. Excluding the effect of foreign exchange rates from Net Revenue, we estimate that Net Revenue increased by approximately $114 million, or 10 percent, for the nine months ended December 31, 2011 as compared to the nine months ended December 31, 2010.
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Asia
For the nine months ended December 31, 2011, Net Revenue before Revenue Deferral in Asia was $192 million, driven by Battlefield 3, FIFA 12 and FIFA Online 2. Net Revenue before Revenue Deferral for the nine months ended December 31, 2011 increased by $52 million, or 37 percent, as compared to the nine months ended December 31, 2010. This increase was driven by a $98 million increase primarily from the Battlefield, FIFA and Portal franchises. This increase was partially offset by a $46 million decrease primarily from the Medal of Honor, FIFA World Cup and Need for Speed franchises. We estimate that foreign exchange rates (primarily the Australian Dollar and Japanese Yen) increased reported Net Revenue before Revenue Deferral by approximately $14 million, or 10 percent, for the nine months ended December 31, 2011 as compared to the nine months ended December 31, 2010. Excluding the effect of foreign exchange rates from Net Revenue before Revenue Deferral, we estimate that Net Revenue before Revenue Deferral increased by approximately $38 million, or 27 percent, for the nine months ended December 31, 2011 as compared to the nine months ended December 31, 2010.
Revenue Deferral for the nine months ended December 31, 2011 increased $42 million, or 45 percent, as compared to the nine months ended December 31, 2010. This increase was driven by a $78 million increase primarily from the Battlefield, FIFA and Alice franchises. This increase was partially offset by a $36 million decrease primarily from the Medal of Honor, FIFA World Cup and Need for Speed franchises.
Recognition of Revenue Deferral for the nine months ended December 31, 2011 increased $19 million, or 21 percent, as compared to the nine months ended December 31, 2010. This increase was driven by a $51 million increase primarily from the Crysis, Need for Speed, and FIFA franchises. This increase was partially offset by a $32 million decrease primarily from the FIFA World Cup and Battlefield franchises, as well as Dantes Inferno.
For the nine months ended December 31, 2011, Net Revenue in Asia was $166 million, driven by FIFA Online 2, FIFA 12 and Crysis 2. Net Revenue for the nine months ended December 31, 2011 increased by $29 million, or 21 percent, as compared to the nine months ended December 31, 2010. This increase was driven by a $69 million increase from certain franchises, including the FIFA, Crysis and Need for Speed franchises. This increase was partially offset by a $40 million decrease from certain franchises, including the FIFA World Cup and Battlefield franchises, as well as Dantes Inferno. We estimate that foreign exchange rates (primarily the Australian Dollar and Japanese Yen) increased reported Net Revenue by approximately $22 million, or 16 percent, for the nine months ended December 31, 2011 as compared to the nine months ended December 31, 2010. Excluding the effect of foreign exchange rates from Net Revenue, we estimate that Net Revenue increased by approximately $7 million, or 5 percent, for the nine months ended December 31, 2011 as compared to the nine months ended December 31, 2010.
Non-GAAP Financial Measures
Net Revenue before Revenue Deferral is a non-GAAP financial measure that excludes the impact of Revenue Deferral and the Recognition of Revenue Deferral on Net Revenue related to packaged goods games and digital content. We defer Net Revenue from sales of certain online-enabled packaged goods and digital content for which we are not able to objectively determine the fair value (as defined by accounting principles generally accepted in the United States for software sales) of the online service that we provide in connection with the sale. We recognize the revenue from these games over the estimated online service period. We also defer Net Revenue from sales of certain online-enabled packaged goods and digital content for which we had an obligation to deliver incremental unspecified digital content in the future without an additional fee. We recognize the revenue for these games on a straight-line basis over the estimated period of game play.
We believe that excluding the impact of Revenue Deferral and the Recognition of Revenue Deferral related to packaged goods games and digital content from our operating results is important to facilitate comparisons between periods in understanding our underlying sales performance for the period. We use this non-GAAP measure internally to evaluate our operating performance, when planning, forecasting and analyzing future periods, and when assessing the performance of our management team. While we believe that this non-GAAP financial measure is useful in evaluating our business, this information should be considered as supplemental in nature and is not meant to be considered in isolation from or as a substitute for the related financial information prepared in accordance with GAAP. In addition, this non-GAAP financial measure may not be the same as non-GAAP measures presented by other companies.
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Cost of Goods Sold
Cost of goods sold for our packaged-goods business consists of (1) product costs, (2) certain royalty expenses for celebrities, professional sports and other organizations and independent software developers, (3) manufacturing royalties, net of volume discounts and other vendor reimbursements, (4) expenses for defective products, (5) write-offs of post-launch prepaid royalty costs, (6) amortization of certain intangible assets, (7) personnel-related costs, and (8) warehousing and distribution costs. We generally recognize volume discounts when they are earned from the manufacturer (typically in connection with the achievement of unit-based milestones); whereas other vendor reimbursements are generally recognized as the related revenue is recognized. Cost of goods sold for our online products consists primarily of data center and bandwidth costs associated with hosting our websites, credit card fees and royalties for use of third-party properties. Cost of goods sold for our website advertising business primarily consists of server costs.
Cost of goods sold for the three and nine months ended December 31, 2011 and 2010 was as follows (in millions):
December 31, 2011 |
% of Net Revenue |
December 31, 2010 |
% of
Net Revenue |
% Change | Change as a % of Net Revenue |
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Three months ended |
$ | 552 | 52.0 | % | $ | 586 | 55.7 | % | (5.8 | %) | (3.7 | %) | ||||||||||||
Nine months ended |
$ | 1,224 | 44.1 | % | $ | 1,171 | 46.9 | % | 4.5 | % | (2.8 | %) |
During the three months ended December 31, 2011, cost of goods sold decreased by 3.7 percent as a percentage of total net revenue as compared to the three months ended December 31, 2010. This decrease was primarily due to improved gross margin on sales of EA studio products resulting from increased associated digital revenue, decrease in peripherals bundled with our games, and decreased associated royalties which positively impacted cost of goods sold as a percentage of total revenue by approximately 7.6 percent. This decrease was partially offset by a $233 million increase in the change in deferred net revenue related to certain online-enabled packaged goods and digital content for the three months ended December 31, 2011, as compared to the three months ended December 31, 2011, which negatively impacted cost of goods sold as a percentage of total net revenue by approximately 4.5 percent.
During the nine months ended December 31, 2011, cost of goods sold decreased by 2.8 percent as a percentage of total net revenue as compared to the nine months ended December 31, 2010. This decrease was primarily due to (1) improved gross margin on sales of EA studio products resulting from increased associated digital revenue, decrease in peripherals bundled with our games, and decreased associated royalties, which positively impacted cost of goods sold as a percentage of total net revenue by approximately 3.8 percent, and (2) improved gross margin resulting from a decreased level of price protection reserves on sales of our products, which positively impacted cost of goods sold as a percentage of total net revenue by approximately 1.3 percent. This decrease was partially offset by an increased proportion of our total net revenue coming from our co-publishing and distribution products, which have a lower margin than our EA studio products, which negatively impacted cost of goods sold as a percentage of total net revenue by approximately 2.3 percent.
Marketing and Sales
Marketing and sales expenses consist of personnel-related costs, related overhead costs, advertising, marketing and promotional expenses, net of qualified advertising cost reimbursements from third parties.
Marketing and sales expenses for the three and nine months ended December 31, 2011 and 2010 were as follows (in millions):
December 31, 2011 |
% of Net Revenue |
December 31, 2010 |
% of Net Revenue |
$ Change | % Change | |||||||||||||||||||
Three months ended |
$ | 269 | 25 | % | $ | 253 | 24 | % | $ | 16 | 6 | % | ||||||||||||
Nine months ended |
$ | 631 | 23 | % | $ | 553 | 22 | % | $ | 78 | 14 | % |
Marketing and sales expenses increased by $16 million, or 6 percent, during the three months ended December 31, 2011, as compared to the three months ended December 31, 2010 primarily due to (1) a $16 million increase in personnel-related costs resulting from an increase in headcount in connection with recent acquisitions and (2) a $6 million increase in contracted service costs related to online initiatives. This was offset by a $9 million decrease in marketing, advertising and promotional spending on our franchises.
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Marketing and sales expenses increased by $78 million, or 14 percent, during the nine months ended December 31, 2011, as compared to the nine months ended December 31, 2010 primarily due to (1) a $39 million increase in personnel-related costs resulting from an increase in headcount in connection with recent acquisitions, (2) a $19 million increase in marketing, advertising and promotional spending on our franchises, and (3) a $14 million increase in contracted service costs related to online initiatives.
General and Administrative
General and administrative expenses consist of personnel and related expenses of executive and administrative staff, related overhead costs, fees for professional services such as legal and accounting, and allowances for doubtful accounts.
General and administrative expenses for the three and nine months ended December 31, 2011 and 2010 were as follows (in millions):
December 31, 2011 |
% of Net Revenue |
December 31, 2010 |
% of Net Revenue |
$ Change | % Change | |||||||||||||||||||
Three months ended |
$ | 98 | 9 | % | $ | 75 | 7 | % | $ | 23 | 31 | % | ||||||||||||
Nine months ended |
$ | 260 | 9 | % | $ | 226 | 9 | % | $ | 34 | 15 | % |
General and administrative expenses increased $23 million, or 31 percent, during the three months ended December 31, 2011, as compared to the three months ended December 31, 2010 primarily due to (1) a $10 million increase in contracted service costs related to online initiatives and litigation and (2) a $9 million increase in personnel-related costs resulting from an increase in headcount in connection with recent acquisitions and increased incentive-based compensation expense.
General and administrative expenses increased $34 million, or 15 percent, during the nine months ended December 31, 2011, as compared to the nine months ended December 31, 2010 primarily due to (1) a $21 million increase in contracted service costs related to online initiatives, litigation, and recent acquisitions and (2) a $10 million increase in bad debt expense.
Research and Development
Research and development expenses consist of expenses incurred by our production studios for personnel-related costs, related overhead costs, contracted services, depreciation and any impairment of prepaid royalties for pre-launch products. Research and development expenses for our online products include expenses incurred by our studios consisting of direct development and related overhead costs in connection with the development and production of our online games. Research and development expenses also include expenses associated with the development of website content, software licenses and maintenance, network infrastructure and management overhead.
Research and development expenses for the three and nine months ended December 31, 2011 and 2010 were as follows (in millions):
December 31, 2011 |
% of Net Revenue |
December 31, 2010 |
% of Net Revenue |
$ Change | % Change | |||||||||||||||||||
Three months ended |
$ | 325 | 31 | % | $ | 273 | 26 | % | $ | 52 | 19 | % | ||||||||||||
Nine months ended |
$ | 928 | 33 | % | $ | 825 | 33 | % | $ | 103 | 12 | % |
Research and development expenses increased by $52 million, or 19 percent, during the three months ended December 31, 2011, as compared to the three months ended December 31, 2010 due to (1) a $47 million increase in personnel-related costs and (2) a $6 million increase in facilities related expenses both primarily resulting from an increase in headcount in connection with recent acquisitions.
Research and development expenses increased by $103 million, or 12 percent, during the nine months ended December 31, 2011, as compared to the nine months ended December 31, 2010 due to (1) a $87 million increase in personnel-related costs and (2) an $14 million increase in facilities related expenses both primarily resulting from an increase in headcount in connection with recent acquisitions.
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Amortization of Intangibles
Amortization of intangibles for the three and nine months ended December 31, 2011 and 2010 were as follows (in millions):
December 31, 2011 |
% of Net Revenue |
December 31, 2010 |
% of Net Revenue |
$ Change | % Change | |||||||||||||||||||
Three months ended |
$ | 11 | 1 | % | $ | 14 | 1 | % | $ | (3 | ) | (21 | %) | |||||||||||
Nine months ended |
$ | 37 | 1 | % | $ | 44 | 2 | % | $ | (7 | ) | (16 | %) |
During the three and nine months ended December 31, 2011, amortization of intangibles decreased by $3 million, or 21 percent, and $7 million, or 16 percent, respectively, as compared to the three and nine months ended December 31, 2010, primarily due to the completion of amortization related to certain of our prior acquisitions.
Acquisition-Related Contingent Consideration
Acquisition-related contingent consideration for the three and nine months ended December 31, 2011 and 2010 were as follows (in millions):
December 31, 2011 |
% of Net Revenue |
December 31, 2010 |
% of Net Revenue |
$ Change | % Change | |||||||||||||||||||
Three months ended |
$ | (11 | ) | (1 | %) | $ | 1 | | $ | (12 | ) | (1200 | %) | |||||||||||
Nine months ended |
$ | 8 | | $ | (25 | ) | (1 | %) | $ | 33 | 132 | % |
During the three months ended December 31, 2011, acquisition-related contingent consideration decreased by $12 million as compared to the three months ended December 31, 2010, primarily resulting from revisions in our estimate of the expected future cash flows over the period in which the obligation is expected to be settled.
During the nine months ended December 31, 2011, acquisition-related contingent consideration increased by $33 million, or 132 percent, as compared to the nine months ended December 31, 2010, primarily related to a $25 million decrease of our accrual in connection with our Playfish acquisition resulting from revisions in the prior year in our estimate of the expected future cash flows over the period in which the obligation is expected to be settled.
Restructuring and Other Charges
Restructuring and other charges for the three and nine months ended December 31, 2011 and 2010 were as follows (in millions):
December 31, 2011 |
% of Net Revenue |
December 31, 2010 |
% of Net Revenue |
$ Change | % Change | |||||||||||||||||||
Three months ended |
$ | | | $ | 154 | 15 | % | $ | (154 | ) | (100 | %) | ||||||||||||
Nine months ended |
$ | 17 | 1 | % | $ | 162 | 6 | % | $ | (145 | ) | (90 | %) |
During the three months ended December 31, 2011, restructuring and other charges decreased by $154 million, or 100 percent, as compared to the three months ended December 31, 2010, due to no new restructuring initiatives in fiscal year 2012.
During the nine months ended December 31, 2011, restructuring and other charges decreased by $145 million, or 90 percent, as compared to the nine months ended December 31, 2010, due to (1) no new restructuring initiatives in fiscal year 2012 and (2) a gain of $10 million recognized during the second quarter of fiscal year 2012 on the sale of our facility in Chertsey, England related to our fiscal year 2008 reorganization, offset by adjustments to the estimated loss for the amendment of certain licensing agreements related to our fiscal 2011 restructuring.
Gain on Strategic Investments, Net
We did not recognize any impairment charges or losses during the three and nine months ended December 31, 2011 on our marketable equity securities. During the nine months ended December 31, 2010, we realized a gain of $28 million, net of costs to sell, from the sale of our investment in Ubisoft, offset by realized losses of $3 million, from the sale of our investment in The9.
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Interest and Other Income (Expense), Net
Interest and other income (expense), net, for the three and nine months ended December 31, 2011 and 2010 were as follows (in millions):
December 31, 2011 |
% of Net Revenue |
December 31, 2010 |
% of Net Revenue |
$ Change | % Change | |||||||||||||||||||
Three months ended |
$ | (10 | ) | (1 | %) | $ | | | $ | (10 | ) | | ||||||||||||
Nine months ended |
$ | (13 | ) | | $ | 6 | | $ | (19 | ) | (317 | %) |
Interest and other income (expense), net decreased by $10 million during the three months ended December 31, 2011 as compared to the three months ended December 31, 2010, primarily due to (1) a $10 million increase in foreign currency transaction losses as compared to the same period in the prior year and (2) a $6 million increase in interest expense, including amortization of debt discount, recognized in connection to our 0.75% Convertible Senior Notes due 2016. This was partially offset by an increase of $7 million from gains on derivatives which hedge the effects of our foreign currency transactions.
Interest and other income (expense), net decreased by $19 million, or 317 percent, during the nine months ended December 31, 2011 as compared to the nine months ended December 31, 2010, primarily due to (1) a $34 million increase in foreign currency transaction losses as compared to the same period in the prior year and (2) a $11 million increase in interest expense, including amortization of debt discount, recognized in connection to our 0.75% Convertible Senior Notes due 2016. This was partially offset by an increase of $26 million from gains on derivatives which hedge the effects of our foreign currency transactions.
Income Taxes
Provisions for (benefit from) income taxes for the three and nine months ended December 31, 2011 and 2010 were as follows (in millions):
December 31, 2011 |
Effective Tax Rate |
December 31, 2010 |
Effective Tax Rate |
% Change | ||||||||||||||||
Three months ended |
$ | 12 | 6.2 | % | $ | 19 | 6.3 | % | (37 | %) | ||||||||||
Nine months ended |
$ | (19 | ) | (5.5 | %) | $ | (1 | ) | (0.2 | %) | 1800 | % |
During the three and nine months ended December 31, 2011, we recorded approximately $3 million and $58 million, respectively, of additional net deferred tax liabilities related to the PopCap and KlickNation acquisitions. These additional deferred tax liabilities create a new source of taxable income, thereby requiring us to release a portion of our deferred tax asset valuation allowance with a related reduction in income tax expense for the three and nine months ended December 31, 2011 of approximately $3 million and $58 million, respectively.
The tax provision reported for the three months ended December 31, 2011 and the tax benefit reported for the nine months ended December 31, 2011 are based on our projected annual effective tax rate for fiscal year 2012, and also include certain discrete tax charges and benefits recorded during the period. Our effective tax rates for the three and nine months ended December 31, were a tax expense of 6.2 percent and tax benefit of 5.5 percent, respectively. The effective tax rate for the three and nine months ended December 31, 2011 differs from the statutory rate of 35.0 percent primarily due to the utilization of U.S. deferred tax assets which were subject to a valuation allowance, a reduction in the U.S. valuation allowance related to the PopCap and KlickNation acquisitions, and non-U.S. profits subject to a reduced or zero tax rate. The effective tax rate for the three and nine months ended December 31, 2011 differs from the same period in fiscal year 2011 primarily due to greater tax benefits recorded in fiscal year 2012 related to the reduction of the U.S. valuation allowance as a result of the PopCap and KlickNation acquisitions.
Our effective income tax rates for fiscal year 2012 and future periods will depend on a variety of factors, including changes in the deferred tax valuation allowance, as well as changes in our business such as acquisitions and intercompany transactions, changes in our international structure, changes in the geographic location of business functions or assets, changes in the geographic mix of income, changes in or termination of our agreements with tax authorities, applicable accounting rules, applicable tax laws and regulations, rulings and interpretations thereof, developments in tax audit and other matters, and
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variations in our annual pre-tax income or loss. We incur certain tax expenses that do not decline proportionately with declines in our pre-tax consolidated income or loss. As a result, in absolute dollar terms, our tax expense will have a greater influence on our effective tax rate at lower levels of pre-tax income or loss than at higher levels. In addition, at lower levels of pre-tax income or loss, our effective tax rate will be more volatile.
Certain taxable temporary differences that are not expected to reverse during the carry forward periods permitted by tax law cannot be considered as a source of future taxable income that may be available to realize the benefit of deferred tax assets.
We historically have considered undistributed earnings of our foreign subsidiaries to be indefinitely reinvested outside of the United States, and accordingly, no U.S. taxes have been provided thereon. We currently intend to continue to indefinitely reinvest the undistributed earnings of our foreign subsidiaries outside of the United States.
Impact of Recently Issued Accounting Standards
In May 2011, the FASB issued ASU 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. The amendments in this ASU generally represent clarification of Topic 820, but also include instances where a particular principle or requirement for measuring fair value or disclosing information about fair value measurements has changed. This update results in common principles and requirements for measuring fair value and for disclosing information about fair value measurements in accordance with U.S. Generally Accepted Accounting Principles and International Financial Reporting Standards. The amendments are effective for interim and annual periods beginning after December 15, 2011 and are to be applied prospectively. We do not expect the adoption of ASU 2011-04 to have a material impact on our Condensed Consolidated Financial Statements.
In June 2011, the FASB issued ASU 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income. ASU 2011-05 requires one of two alternatives for presenting comprehensive income and eliminates the option to report other comprehensive income and its components as a part of the Consolidated Statements of Stockholders Equity. Additionally, ASU 2011-05 requires presentation on the face of the financial statements reclassification adjustments for items that are reclassified from other comprehensive income to net income in the statement(s) where the components of net income and the components of other comprehensive income are presented. The requirement related to the reclassification adjustments from other comprehensive income to net income was deferred in December 2011, as a result of the issuance of ASU 2011-12, Deferral of the Effective Date for Amendments to the Presentation of Reclassications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update 2011-05 (Topic 220). The amendments in ASU 2011-05, as amended by ASU 2011-12, do not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. ASU 2011-05, as amended by ASU 2011-12 is effective for fiscal years and interim periods within those years beginning after December 15, 2011 and is to be applied retrospectively. We do not expect the adoption of ASU 2011-05, as amended by ASU 2011-12 to have a material impact on our Condensed Consolidated Financial Statements.
In September 2011, the FASB issued ASU 2011-08, IntangiblesGoodwill and Other (Topic 350): Testing Goodwill for Impairment. ASU 2011-08 allows an entity to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test. If an entity concludes it is more likely than not that the fair value of a reporting unit exceeds its carrying amount, it need not perform the two-step impairment test. The amendments are effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011, with early adoption permitted. We do not expect the adoption of ASU 2011-08 to have an impact on our Condensed Consolidated Financial Statements.
In December 2011, the FASB issued ASU 2011-11, Disclosures about Offsetting Assets and Liabilities, which creates new disclosure requirements about the nature of an entitys rights of offset and related arrangements associated with its financial instruments and derivative instruments. The disclosure requirements are effective for annual reporting periods beginning on or after January 1, 2013, and interim periods therein, with retrospective application required. The new disclosures are designed to make financial statements that are prepared under U.S. Generally Accepted Accounting Principles more comparable to those prepared under International Financial Reporting Standards. We are currently evaluating the impact of ASU 2011-11 on our Condensed Consolidated Financial Statements.
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LIQUIDITY AND CAPITAL RESOURCES
(In millions) | As of December 31, 2011 |
As
of March 31, 2011 |
Increase / (Decrease) |
|||||||||
Cash and cash equivalents |
$ | 1,242 | $ | 1,579 | $ | (337 | ) | |||||
Short-term investments |
406 | 497 | (91 | ) | ||||||||
Marketable equity securities |
143 | 161 | (18 | ) | ||||||||
|
|
|
|
|
|
|||||||
Total |
$ | 1,791 | $ | 2,237 | $ | (446 | ) | |||||
|
|
|
|
|
|
|||||||
Percentage of total assets |
31 | % | 45 | % | ||||||||
Nine months Ended December 31, | ||||||||||||
(In millions) | 2011 | 2010 | Change | |||||||||
Cash provided by (used in) operating activities |
$ | (10 | ) | $ | 67 | $ | (77 | ) | ||||
Cash used in investing activities |
(689 | ) | (7 | ) | (682 | ) | ||||||
Cash provided by financing activities |
388 | 17 | 371 | |||||||||
Effect of foreign exchange on cash and cash equivalents |
(26 | ) | 3 | (29 | ) | |||||||
|
|
|
|
|
|
|||||||
Net increase (decrease) in cash and cash equivalents |
$ | (337 | ) | $ | 80 | $ | (417 | ) | ||||
|
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|
|
|
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Changes in Cash Flow
Operating Activities. Cash provided by operating activities decreased $77 million during the nine months ended December 31, 2011 as compared to nine months ended December 31, 2010 primarily due to the settlement of higher accounts payable balances in the beginning of fiscal year 2012 as compared to fiscal year 2011 in connection with increased title releases in the fourth quarter of fiscal year 2011 as compared to fiscal year 2010.
Investing Activities. Cash used in investing activities increased $682 million during the nine months ended December 31, 2011 as compared to the nine months ended December 31, 2010 primarily due to (1) $660 million increase in cash used for acquisitions, the majority of which was used to fund our acquisition of PopCap, (2) $132 million in proceeds received from the sale of our Ubisoft and The9 investments in the nine months ended December 31, 2010, and (3) a $90 million increase in capital expenditures. These items were partially offset by a $181 million increase in proceeds received from the maturities and sales of short-term investments.
Financing Activities. Cash provided by financing activities increased $371 million during the nine months ended December 31, 2011 as compared to the nine months ended December 31, 2010 primarily due to (1) $617 million in proceeds received from the sale of 0.75% Convertible Senior Notes due 2016, net of issuance costs and (2) $65 million proceeds received from the issuance of Warrants in connection with the Notes. These items were partially offset by (1) $230 million, net of commissions, paid for the repurchase and retirement of our common stock pursuant to our Stock Repurchase Program and (2) $107 million paid for the purchase of the Convertible Note Hedge.
Short-term Investments and Marketable Equity Securities
Due to our mix of fixed and variable rate securities, our short-term investment portfolio is susceptible to changes in short-term interest rates. As of December 31, 2011, our short-term investments had gross unrealized gains of $1 million, or less than 1 percent of the total in short-term investments, and gross unrealized losses of less than $1 million, or less than 1 percent of the total in short-term investments. From time to time, we may liquidate some or all of our short-term investments to fund operational needs or other activities, such as capital expenditures, business acquisitions or stock repurchase programs. Depending on which short-term investments we liquidate to fund these activities, we could recognize a portion, or all, of the gross unrealized gains or losses.
The fair value of our marketable equity securities decreased to $143 million as of December 31, 2011 from $161 million as of March 31, 2011 primarily due to a decrease in the value of our investment in Neowiz.
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Restricted Cash and Contingent Consideration
Primarily in connection with our acquisitions of PopCap, Playfish, KlickNation, and Chillingo, we may be required to pay an additional $672 million of cash consideration based upon the achievement of certain performance milestones through March 31, 2014. In connection with our Playfish acquisition, we deposited $100 million into an escrow account related to the contingent consideration. In addition, in connection with our PopCap acquisition, we acquired an additional $6 million of restricted cash which is held in an escrow account in the event that certain liabilities become due. As these deposits are restricted in nature, they are excluded from cash and cash equivalents. As of December 31, 2011, the restricted cash of $106 million is included in other current assets in our Condensed Consolidated Balance Sheets. Through the three and nine months ended December 31, 2011, no distributions were made from the restricted cash amount. As of December 31, 2011, we have accrued $159 million of contingent consideration on our Condensed Consolidated Balance Sheet, of which $50 million relates to performance milestones earned through December 31, 2011 in connection with the Playfish acquisition. We expect the remaining $50 million in restricted cash will be released and converted to available cash and cash equivalents in the fourth quarter of fiscal year 2012.
Fiscal 2011 Restructuring
In connection with our fiscal 2011 restructuring plan, we expect to incur cash expenditures through June 2016 of approximately (1) $8 million during the remainder of fiscal year 2012, (2) $25 million in fiscal year 2013, (3) $25 million in fiscal year 2014, (4) $17 million in fiscal year 2015, and (5) $15 million thereafter. The actual cash expenditures are variable as they will be dependent upon the actual revenue we generate from certain games.
Financing Arrangement
In July 2011, we issued $632.5 million aggregate principal amount of 0.75% Convertible Senior Notes due 2016 (the Notes). The Notes are senior unsecured obligations which pay interest semiannually in arrears at a rate of 0.75 percent per annum on January 15 and July 15 of each year, beginning on January 15, 2012 and will mature on July 15, 2016, unless earlier purchased or converted in accordance with their terms prior to such date. The Notes are convertible into cash and shares of our common stock based on an initial conversion value of 31.5075 shares of our common stock per $1,000 principal amount of Notes (equivalent to an initial conversion price of approximately $31.74 per share). Upon conversion of the Notes, holders will receive cash up to the principal amount of each Note, and any excess conversion value will be delivered in shares of our common stock.
Prior to April 15, 2016, the Notes will be convertible only upon the occurrence of certain events and during certain periods, and thereafter, at any time until the close of business on the second scheduled trading day immediately preceding the maturity date of the Notes. The Notes do not contain any financial covenants.
The conversion rate is subject to customary anti-dilution adjustments, but will not be adjusted for any accrued and unpaid interest. Following certain corporate events described in the indenture governing the notes (the Indenture) that occur prior to the maturity date, the conversion rate will be increased for a holder who elects to convert its Notes in connection with such corporate event in certain circumstances. The Notes are not redeemable prior to maturity, and no sinking fund is provided for the Notes.
If we undergo a fundamental change, as defined in the Indenture, subject to certain conditions, holders may require us to purchase for cash all or any portion of their Notes. The fundamental change purchase price will be 100 percent of the principal amount of the Notes to be purchased plus any accrued and unpaid interest up to but excluding the fundamental change purchase date.
The Indenture contains customary terms and covenants, including that upon certain events of default occurring and continuing, either the trustee or the holders of at least 25 percent in principal amount of the outstanding Notes may declare 100 percent of the principal and accrued and unpaid interest on all the Notes to be due and payable.
In addition, in July 2011, we entered into privately negotiated convertible note hedge transactions (the Convertible Note Hedge) with certain counterparties to reduce the potential dilution with respect to our common stock upon conversion of the Notes. The Convertible Note Hedge, subject to customary anti-dilution adjustments, provide us with the option to acquire, on a net settlement basis, approximately 19.9 million shares of our common stock at a strike price of $31.74, which corresponds to the conversion price of the Notes and is equal to the number of shares of our common stock that notionally underlie the Notes.
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As of December 31, 2011, we have not purchased any shares under the Convertible Note Hedge. We paid $107 million for the Convertible Note Hedge.
Separately, we have also entered into privately negotiated warrant transactions with the certain counterparties whereby we sold to independent third parties warrants (the Warrants) to acquire, subject to customary anti-dilution adjustments that are substantially the same as the anti-dilution provisions contained in the Notes, up to 19.9 million shares of our common stock (which is also equal to the number of shares of our common stock that notionally underlie the Notes), with a strike price of $41.14. The Warrants could have a dilutive effect with respect to our common stock to the extent that the market price per share of its common stock exceeds $41.14 on or prior to the expiration date of the Warrants. We received proceeds of $65 million from the sale of the Warrants.
See Note 12 to the Condensed Consolidated Financial Statements for additional information related to our 0.75% Convertible Senior Notes due 2016.
Financial Condition
We believe that cash, cash equivalents, short-term investments, marketable equity securities, cash generated from operations and available financing facilities will be sufficient to meet our operating requirements for at least the next 12 months, including working capital requirements, capital expenditures, and potentially, future acquisitions, stock repurchases, or strategic investments. We may choose at any time to raise additional capital to strengthen our financial position, facilitate expansion, repurchase our stock, pursue strategic acquisitions and investments, and/or to take advantage of business opportunities as they arise. There can be no assurance, however, that such additional capital will be available to us on favorable terms, if at all, or that it will not result in substantial dilution to our existing stockholders.
As of December 31, 2011, approximately $908 million of our cash, cash equivalents, and short-term investments and $68 million of our marketable equity securities were domiciled in foreign tax jurisdictions. While we have no plans to repatriate these funds to the United States in the short term, if we choose to do so, we would be required to accrue and pay additional taxes on any portion of the repatriation where no United States income tax had been previously provided.
In February 2011, our Board of Directors authorized a program to repurchase up to $600 million of our common stock over the next 18 months. The timing and actual amount of the stock repurchases will depend on several factors including price, capital availability, regulatory requirements, alternative investment opportunities and other market conditions. We are not obligated to repurchase any specific number of shares under the program and the repurchase program may be modified, suspended or discontinued at any time.
We have a shelf registration statement on Form S-3 on file with the SEC. This shelf registration statement, which includes a base prospectus, allows us at any time to offer any combination of securities described in the prospectus in one or more offerings. Unless otherwise specified in a prospectus supplement accompanying the base prospectus, we would use the net proceeds from the sale of any securities offered pursuant to the shelf registration statement for general corporate purposes, including for working capital, financing capital expenditures, research and development, marketing and distribution efforts, and if opportunities arise, for acquisitions or strategic alliances. Pending such uses, we may invest the net proceeds in interest-bearing securities. In addition, we may conduct concurrent or other financings at any time.
Our ability to maintain sufficient liquidity could be affected by various risks and uncertainties including, but not limited to, those related to customer demand and acceptance of our products, our ability to collect our accounts receivable as they become due, successfully achieving our product release schedules and attaining our forecasted sales objectives, the impact of acquisitions and other strategic transactions in which we may engage, the impact of competition, economic conditions in the United States and abroad, the seasonal and cyclical nature of our business and operating results, risks of product returns and the other risks described in the Risk Factors section, included in Part II, Item 1A of this report.
Contractual Obligations and Commercial Commitments
Development, Celebrity, League and Content Licenses: Payments and Commitments
The products we produce in our studios are designed and created by our employee designers, artists, software programmers and by non-employee software developers (independent artists or third-party developers). We typically advance development funds to the independent artists and third-party developers during development of our games, usually in installment payments made upon the completion of specified development milestones. Contractually, these payments are generally considered advances against subsequent royalties on the sales of the products. These terms are set forth in written agreements entered into with the independent artists and third-party developers.
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In addition, we have certain celebrity, league and content license contracts that contain minimum guarantee payments and marketing commitments that may not be dependent on any deliverables. Celebrities and organizations with whom we have contracts include: FIFA, FIFPRO Foundation, FAPL (Football Association Premier League Limited), and DFL Deutsche Fußball Liga GmbH (German Soccer League) (professional soccer); National Basketball Association (professional basketball); PGA TOUR, Tiger Woods and Augusta National (professional golf); National Hockey League and NHL Players Association (professional hockey); National Football League Properties, PLAYERS Inc., and Red Bear Inc. (professional football); Collegiate Licensing Company (collegiate football); ESPN (content in EA SPORTS games); Hasbro, Inc. (most of Hasbros toy and game intellectual properties); and LucasArts and Lucas Licensing (Star Wars: The Old Republic). These developer and content license commitments represent the sum of (1) the cash payments due under non-royalty-bearing licenses and services agreements and (2) the minimum guaranteed payments and advances against royalties due under royalty-bearing licenses and services agreements, the majority of which are conditional upon performance by the counterparty. These minimum guarantee payments and any related marketing commitments are included in the table below.
The following table summarizes our unrecognized minimum contractual obligations as of December 31, 2011, and the effect we expect them to have on our liquidity and cash flow in future periods (in millions):
Contractual Obligations | ||||||||||||||||||||||||
Fiscal Year Ending March 31, |
Leases (a) | Developer/ Licensor Commitments |
Marketing | Convertible Notes Interest (b) |
Other Purchase Obligations |
Total | ||||||||||||||||||
2012 (remaining three months) |
$ | 13 | $ | 50 | $ | 18 | $ | 2 | $ | 5 | $ | 88 | ||||||||||||
2013 |
52 | 191 | 58 | 5 | 9 | 315 | ||||||||||||||||||
2014 |
48 | 121 | 51 | 5 | 7 | 232 | ||||||||||||||||||
2015 |
39 | 116 | 32 | 5 | | 192 | ||||||||||||||||||
2016 |
28 | 84 | 33 | 5 | | 150 | ||||||||||||||||||
Thereafter |
36 | 334 | 95 | 2 | | 467 | ||||||||||||||||||
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|
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Total |
$ | 216 | $ | 896 | $ | 287 | $ | 24 | $ | 21 | $ | 1,444 | ||||||||||||
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(a) | See discussion on operating leases in the Off-Balance Sheet Commitments section below for additional information. Lease commitments have not been reduced by minimum sub-lease rentals for unutilized office space resulting from our reorganization activities of approximately $7 million due in the future under non-cancelable sub-leases. |
(b) | In addition to the interest payments reflected in the table above, we will be obligated to pay the $632.5 million principal amount of the 0.75% Convertible Senior Notes due 2016 and any excess conversion value in shares of our common stock upon redemption after the maturity of the Notes on July 15, 2016 or earlier. See Note 12 to the Condensed Consolidated Financial Statements for additional information related to our 0.75% Convertible Senior Notes due 2016. |
The amounts represented in the table above reflect our unrecognized minimum cash obligations for the respective fiscal years, but do not necessarily represent the periods in which they will be recognized and expensed in our Condensed Consolidated Financial Statements. In addition, the amounts in the table above are presented based on the dates the amounts are contractually due; however, certain payment obligations may be accelerated depending on the performance of our operating results.
In addition to what is included in the table above, as of December 31, 2011, we had a liability for unrecognized tax benefits and an accrual for the payment of related interest totaling $236 million, for which we are unable to make a reasonably reliable estimate of when cash settlement with a taxing authority will occur.
In addition to what is included in the table above as of December 31, 2011, primarily in connection with our PopCap, Playfish KlickNation, and Chillingo acquisitions, we may be required to pay an additional $672 million of cash consideration based upon the achievement of certain performance milestones through March 31, 2014. As of December 31, 2011, we have accrued $159 million of contingent consideration on our Condensed Consolidated Balance Sheet, of which $50 million relates to performance milestones earned through December 31, 2011 in connection with the Playfish acquisition and for which we expect to settle in the fourth quarter of fiscal year 2012.
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OFF-BALANCE SHEET COMMITMENTS
Lease Commitments
As of December 31, 2011, we leased certain of our current facilities, furniture and equipment under non-cancelable operating lease agreements. We were required to pay property taxes, insurance and normal maintenance costs for certain of these facilities and any increases over the base year of these expenses on the remainder of our facilities.
Director Indemnity Agreements
We entered into indemnification agreements with each of the members of our Board of Directors at the time they joined the Board to indemnify them to the extent permitted by law against any and all liabilities, costs, expenses, amounts paid in settlement and damages incurred by the directors as a result of any lawsuit, or any judicial, administrative or investigative proceeding in which the directors are sued or charged as a result of their service as members of our Board of Directors.
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Item 3. | Quantitative and Qualitative Disclosures About Market Risk |
MARKET RISK
We are exposed to various market risks, including changes in foreign currency exchange rates, interest rates and market prices, which have experienced significant volatility in light of the global economic downturn. Market risk is the potential loss arising from changes in market rates and market prices. We employ established policies and practices to manage these risks. Foreign currency option and forward contracts are used to hedge anticipated exposures or mitigate some existing exposures subject to foreign exchange risk as discussed below. While we do not hedge our short-term investment portfolio, we protect our short-term investment portfolio against different market risks, including interest rate risk as discussed below. Our cash and cash equivalents portfolio consists of highly liquid investments with insignificant interest rate risk and original or remaining maturities of three months or less at the time of purchase. We also do not currently hedge our market price risk relating to our marketable equity securities and we do not enter into derivatives or other financial instruments for trading or speculative purposes.
Foreign Currency Exchange Rate Risk
Cash Flow Hedging Activities. From time to time, we hedge a portion of our foreign currency risk related to forecasted foreign-currency-denominated sales and expense transactions by purchasing foreign currency option contracts that generally have maturities of 15 months or less. These transactions are designated and qualify as cash flow hedges. The derivative assets associated with our hedging activities are recorded at fair value in other current assets on our Condensed Consolidated Balance Sheets. The effective portion of gains or losses resulting from changes in the fair value of these hedges is initially reported, net of tax, as a component of accumulated other comprehensive income in stockholders equity. The gross amount of the effective portion of gains or losses resulting from changes in the fair value of these hedges is subsequently reclassified into net revenue or research and development expenses, as appropriate, in the period when the forecasted transaction is recognized in our Condensed Consolidated Statements of Operations. In the event that the gains or losses in accumulated other comprehensive income are deemed to be ineffective, the ineffective portion of gains or losses resulting from changes in fair value, if any, is reclassified to interest and other income (expense), net, in our Condensed Consolidated Statements of Operations. In the event that the underlying forecasted transactions do not occur, or it becomes remote that they will occur, within the defined hedge period, the gains or losses on the related cash flow hedges are reclassified from accumulated other comprehensive income to interest and other income (expense), net, in our Condensed Consolidated Statements of Operations. During the reporting periods, all forecasted transactions occurred, and therefore, there were no such gains or losses reclassified into interest and other income (expense), net. Our hedging programs are designed to reduce, but do not entirely eliminate, the impact of currency exchange rate movements in net revenue and research and development expenses. As of December 31, 2011, we had foreign currency option contracts to purchase approximately $90 million in foreign currency and to sell approximately $46 million of foreign currency. All of the foreign currency option contracts outstanding as of December 31, 2011 will mature in the next 12 months. As of March 31, 2011, we had foreign currency option contracts to purchase approximately $40 million in foreign currency and to sell approximately $10 million of foreign currency. As of December 31, 2011 and March 31, 2011, the fair value of these outstanding foreign currency option contracts was immaterial and is included in other current assets.
Balance Sheet Hedging Activities. We use foreign currency forward contracts to mitigate foreign currency risk associated with foreign-currency-denominated monetary assets and liabilities, primarily intercompany receivables and payables. The foreign currency forward contracts generally have a contractual term of three months or less and are transacted near month-end. Our foreign currency forward contracts are not designated as hedging instruments, and are accounted for as derivatives whereby the fair value of the contracts is reported as other current assets or accrued and other current liabilities on our Condensed Consolidated Balance Sheets, and gains and losses resulting from changes in the fair value are reported in interest and other income (expense), net, in our Condensed Consolidated Statements of Operations. The gains and losses on these foreign currency forward contracts generally offset the gains and losses on the underlying foreign-currency-denominated monetary assets and liabilities, which are also reported in interest and other income (expense), net, in our Condensed Consolidated Statements of Operations. In certain cases, the amount of such gains and losses will significantly differ from the amount of gains and losses recognized on the underlying foreign-currency-denominated monetary asset or liability, in which case our results will be impacted. As of December 31, 2011, we had foreign currency forward contracts to purchase and sell approximately $662 million in foreign currencies. Of this amount, $623 million represented contracts to sell foreign currencies in exchange for U.S. dollars, $30 million to purchase foreign currency in exchange for U.S. dollars, and $9 million to sell foreign currency in exchange for British pounds sterling. As of March 31, 2011, we had foreign currency forward contracts to purchase and sell approximately $187 million in foreign currencies. Of this amount, $140 million represented contracts to sell foreign currencies in exchange for U.S. dollars, $31 million to purchase foreign currency in exchange for U.S. dollars, and $16 million to sell foreign currency in exchange for British pounds sterling. As of December 31, 2011 and March 31, 2011, the fair value of our foreign currency forward contracts was immaterial and is included in accrued and other liabilities.
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We believe the counterparties to these foreign currency forward and option contracts are creditworthy multinational commercial banks. While we believe the risk of counterparty nonperformance is not material, the disruption in the global financial markets has impacted some of the financial institutions with which we do business. Further, the continued sovereign debt crisis in Europe could lead to increased counterparty risk with respect to financial institutions and other business partners, who are particularly vulnerable to the instability in certain European markets. A sustained decline in the financial stability of financial institutions as a result of the disruption in the financial markets could affect our ability to secure credit-worthy counterparties for our foreign currency hedging programs.
Notwithstanding our efforts to mitigate some foreign currency exchange rate risks, there can be no assurance that our hedging activities will adequately protect us against the risks associated with foreign currency fluctuations. As of December 31, 2011, a hypothetical adverse foreign currency exchange rate movement of 10 percent or 15 percent would have resulted in potential declines in the fair value of the premiums on our foreign currency option contracts used in cash flow hedging of $2 million in each scenario. As of December 31, 2011, a hypothetical adverse foreign currency exchange rate movement of 10 percent or 15 percent would have resulted in potential losses on our foreign currency forward contracts used in balance sheet hedging of $69 million and $103 million, respectively. This sensitivity analysis assumes a parallel adverse shift of all foreign currency exchange rates against the U.S. dollar; however, all foreign currency exchange rates do not always move in such manner and actual results may differ materially.
Interest Rate Risk
Our exposure to market risk for changes in interest rates relates primarily to our short-term investment portfolio. We manage our interest rate risk by maintaining an investment portfolio generally consisting of debt instruments of high credit quality and relatively short maturities. However, because short-term investments mature relatively quickly and are required to be reinvested at the then-current market rates, interest income on a portfolio consisting of short-term investments is more subject to market fluctuations than a portfolio of longer term investments. Additionally, the contractual terms of the investments do not permit the issuer to call, prepay or otherwise settle the investments at prices less than the stated par value. Our investments are held for purposes other than trading. Also, we do not use derivative financial instruments in our short-term investment portfolio.
As of December 31, 2011 and March 31, 2011, our short-term investments were classified as available-for-sale securities, and consequently, were recorded at fair value with unrealized gains or losses resulting from changes in fair value reported as a separate component of accumulated other comprehensive income, net of tax, in stockholders equity. Our portfolio of short-term investments consisted of the following investment categories, summarized by fair value as of December 31, 2011 and March 31, 2011 (in millions):
As of December 31, 2011 |
As of March 31, 2011 |
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Corporate bonds |
$ | 151 | $ | 253 | ||||
U.S. Treasury securities |
123 | 124 | ||||||
U.S. agency securities |
120 | 102 | ||||||
Commercial paper |
12 | 18 | ||||||
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Total short-term investments |
$ | 406 | $ | 497 | ||||
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Notwithstanding our efforts to manage interest rate risks, there can be no assurance that we will be adequately protected against risks associated with interest rate fluctuations. At any time, a sharp change in interest rates could have a significant impact on the fair value of our investment portfolio. The following table presents the hypothetical changes in the fair value of our short-term investment portfolio as of December 31, 2011, arising from potential changes in interest rates. The modeling technique estimates the change in fair value from immediate hypothetical parallel shifts in the yield curve of plus or minus 50 basis points (BPS), 100 BPS, and 150 BPS.
(In millions) | Valuation of Securities Given an Interest Rate Decrease of X Basis Points |
Fair Value as of December 31, 2011 |
Valuation of Securities Given an Interest Rate Increase of X Basis Points |
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(150 BPS) | (100 BPS) | (50 BPS) | 50 BPS | 100 BPS | 150 BPS | |||||||||||||||||||||||
Corporate bonds |
$ | 154 | $ | 153 | $ | 152 | $ | 151 | $ | 150 | $ | 149 | $ | 148 | ||||||||||||||
U.S. Treasury securities |
125 | 124 | 123 | 123 | 121 | 121 | 120 | |||||||||||||||||||||
U.S. agency securities |
123 | 122 | 121 | 120 | 120 | 119 | 118 | |||||||||||||||||||||
Commercial paper |
12 | 12 | 12 | 12 | 12 | 12 | 12 | |||||||||||||||||||||
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Total short-term investments |
$ | 414 | $ | 411 | $ | 408 | $ | 406 | $ | 403 | $ | 401 | $ | 398 | ||||||||||||||
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Market Price Risk
The fair value of our marketable equity securities in publicly traded companies is subject to market price volatility and foreign currency risk for investments denominated in foreign currencies. As of December 31, 2011 and March 31, 2011, our marketable equity securities were classified as available-for-sale securities, and consequently, were recorded on our Condensed Consolidated Balance Sheets at fair value with unrealized gains or losses resulting from changes in fair value reported as a separate component of accumulated other comprehensive income, net of tax, in stockholders equity. The fair value of our marketable equity securities as of December 31, 2011 and March 31, 2011 was $143 million and $161 million, respectively.
Our marketable equity securities have been, and may continue to be, adversely impacted by volatility in the public stock markets. At any time, a sharp change in market prices in our investments in marketable equity securities could have a significant impact on the fair value of our investments. The following table presents hypothetical changes in the fair value of our marketable equity securities as of December 31, 2011, arising from changes in market prices of plus or minus 25 percent, 50 percent, and 75 percent.
(In millions) | Valuation of Securities Given an X Percentage Decrease in Each Stocks Market Price |
Fair Value as of December 31, 2011 |
Valuation of Securities Given an X Percentage Increase in Each Stocks Market Price |
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(75%) | (50%) | (25%) | 25% | 50% | 75% | |||||||||||||||||||||||
Marketable equity securities |
$ | 36 | $ | 72 | $ | 107 | $ | 143 | $ | 179 | $ | 215 | $ | 250 |
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Item 4. | Controls and Procedures |
Definition and limitations of disclosure controls
Our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the Exchange Act)) are controls and other procedures that are designed to ensure that information required to be disclosed in our reports filed under the Exchange Act, such as this report, is recorded, processed, summarized and reported within the time periods specified in the SECs rules and forms. Disclosure controls and procedures are also designed to ensure that such information is accumulated and communicated to our management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Our management evaluates these controls and procedures on an ongoing basis.
There are inherent limitations to the effectiveness of any system of disclosure controls and procedures. These limitations include the possibility of human error, the circumvention or overriding of the controls and procedures and reasonable resource constraints. In addition, because we have designed our system of controls based on certain assumptions, which we believe are reasonable, about the likelihood of future events, our system of controls may not achieve its desired purpose under all possible future conditions. Accordingly, our disclosure controls and procedures provide reasonable assurance, but not absolute assurance, of achieving their objectives.
Evaluation of disclosure controls and procedures
Our Chief Executive Officer and our Chief Financial Officer, after evaluating the effectiveness of our disclosure controls and procedures, believe that as of the end of the period covered by this report, our disclosure controls and procedures were effective in providing the requisite reasonable assurance that material information required to be disclosed in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SECs rules and forms, and is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding the required disclosure.
Changes in internal control over financial reporting
There has been no change in our internal control over financial reporting identified in connection with our evaluation that occurred during the three months ended December 31, 2011 that has materially affected or is reasonably likely to materially affect our internal control over financial reporting.
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Item 1. | Legal Proceedings |
In June 2008, Geoffrey Pecover filed an antitrust class action in the United States District Court for the Northern District of California, alleging that EA obtained an illegal monopoly in a discreet antitrust market that consists of league-branded football simulation video games by bidding for, and winning, exclusive licenses with the NFL, Collegiate Licensing Company and Arena Football League. In December 20, 2010, the district court granted the plaintiffs request to certify a class of plaintiffs consisting of all consumers who purchased EAs Madden NFL, NCAA Football or Arena Football videogames after 2005. The parties are in the midst of fact discovery. The court has set a trial date for October 2012. The complaint seeks unspecified compensatory damages. We have not accrued any loss related to this matter. We believe the claims asserted are without merit and intend to vigorously defend against them.
We are also subject to claims and litigation arising in the ordinary course of business. We do not believe that any liability from any reasonably foreseeable disposition of such claims and litigation, individually or in the aggregate, would have a material adverse effect on our Condensed Consolidated Financial Statements.
Item 1A. | Risk Factors |
Our business is subject to many risks and uncertainties, which may affect our future financial performance. If any of the events or circumstances described below occurs, our business and financial performance could be harmed, our actual results could differ materially from our expectations and the market value of our stock could decline. The risks and uncertainties discussed below are not the only ones we face. There may be additional risks and uncertainties not currently known to us or that we currently do not believe are material that may harm our business and financial performance.
Our business is intensely competitive and hit driven. If we do not deliver hit products and services, or if consumers prefer our competitors products or services over our own, our operating results could suffer.
Competition in our industry is intense and we expect new competitors to continue to emerge throughout the world. Our competitors range from large established companies to emerging start-ups. In our industry, though many new products and services are regularly introduced, only a relatively small number of hit titles accounts for a significant portion of total revenue for the industry. We have significantly reduced the number of games that we develop, publish and distribute: in fiscal year 2010, we published 54 primary titles, and in fiscal year 2011, we published 36. In fiscal year 2012, we expect to release 22 primary titles, including our December 2011 launch of the massively multiplayer online role-playing game Star Wars: The Old Republic. Publishing fewer titles means that we concentrate more of our development spending on each title, and driving hit titles often requires large marketing budgets and media spend. The underperformance of a title may have a large adverse impact on our financial results. Also, hit products or services offered by our competitors may take a larger share of consumer spending than we anticipate, which could cause revenue generated from our products and services to fall below expectations.
In addition, both the online and mobile games marketplaces are characterized by frequent product introductions, relatively low barriers to entry, and new and evolving business methods, technologies and platforms for development. We expect competition in these markets to intensify. It is also possible that consumer adoption of these new platforms for games and other technological advances in online or mobile game offerings could negatively impact our sales of console, handheld and traditional PC products before we have sufficiently developed profitable businesses in these markets. If our competitors develop and market more successful products or services, offer competitive products or services at lower price points or based on payment models perceived as offering a better value proposition (such as free-to-play or subscription-based models), or if we do not continue to develop consistently high-quality and well-received products and services, our revenue, margins, and profitability will decline.
Our operating results will be adversely affected if we do not consistently meet our product development schedules or if key events or sports seasons that we tie our product release schedules to are delayed or cancelled.
Our business is highly seasonal, with the highest levels of consumer demand and a significant percentage of our sales occurring in the December quarter. If we miss these key selling periods for any reason, including product delays, product cancellations, or delayed introduction of a new platform for which we have developed products, our sales will suffer disproportionately. Our ability to meet product development schedules is affected by a number of factors, including the creative processes involved, the coordination of large and sometimes geographically dispersed development teams required by the increasing complexity of our products and the platforms for which they are developed, and the need to fine-tune our products prior to their release. We have experienced development delays for our products in the past, which caused us to push back or cancel release dates. We also
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seek to release certain products in conjunction with specific events, such as the beginning of a sports season or major sporting event, or the release of a related movie. If a key event or sports season to which our product release schedule is tied were to be delayed or cancelled, our sales would also suffer disproportionately