10-Q 1 f02072e10vq.htm FORM 10-Q e10vq
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended September 30, 2004

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. 0-17948

ELECTRONIC ARTS INC.

(Exact name of registrant as specified in its charter)
     
Delaware
(State or other jurisdiction of
incorporation or organization)
  94-2838567
(I.R.S. Employer
Identification No.)
     
209 Redwood Shores Parkway
Redwood City, California

(Address of principal executive offices)
   
94065
(Zip Code)

(650) 628-1500
(Registrant’s 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 x NO o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES x NO o

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

                 
            Outstanding as of
    Par Value
  November 1, 2004
Common Stock
  $ 0.01     305,332,110

 


ELECTRONIC ARTS INC.
FORM 10-Q
FOR THE PERIOD ENDED SEPTEMBER 30, 2004

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 EXHIBIT 3.01
 EXHIBIT 15.1
 EXHIBIT 31.1
 EXHIBIT 31.2
 EXHIBIT 32.1
 EXHIBIT 32.2

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PART I – FINANCIAL INFORMATION

Item 1. Unaudited Condensed Consolidated Financial Statements

ELECTRONIC ARTS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS

                 
(unaudited)   September 30,     March 31,  
(In thousands, except share data)   2004     2004 (a)  
   

ASSETS

               

Current assets:

               
Cash and cash equivalents
  $ 1,386,026     $ 2,149,885  
Short-term investments
    1,103,633       264,461  
Marketable equity securities
    259       1,225  
Receivables, net of allowances of $122,577 and $154,682, respectively
    379,389       211,916  
Inventories
    79,272       55,143  
Deferred income taxes
    80,804       84,312  
Other current assets
    140,883       161,867  
 
 
 
Total current assets
    3,170,266       2,928,809  

Property and equipment, net

    297,485       298,073  
Investments in affiliates
    15,341       14,332  
Goodwill
    92,648       91,977  
Other intangibles, net
    17,215       18,468  
Long-term deferred income taxes
    43,639       40,755  
Other assets
    66,061       71,612  
 
 
 
TOTAL ASSETS
  $ 3,702,655     $ 3,464,026  
 
 
 

LIABILITIES AND STOCKHOLDERS’ EQUITY

               

Current liabilities:

               
Accounts payable
  $ 172,017     $ 114,087  
Accrued and other liabilities
    587,275       630,138  
 
 
 
Total current liabilities
    759,292       744,225  

Other liabilities

    36,615       41,443  
 
 
 
TOTAL LIABILITIES
    795,907       785,668  

Commitments and contingencies

           

Stockholders’ equity:

               
Preferred stock, $0.01 par value. 10,000,000 shares authorized
           
Common stock, $0.01 par value. 1,000,000,000 shares authorized; 305,099,241 and 301,332,458 shares issued and outstanding, respectively
    3,051       3,013  
Class B common stock, $0.01 par value. No shares authorized; 0 and 200,130 shares issued and outstanding, respectively
          2  
Paid-in capital
    1,264,563       1,153,680  
Retained earnings
    1,622,662       1,501,184  
Accumulated other comprehensive income
    16,472       20,479  
 
 
 
Total stockholders’ equity
    2,906,748       2,678,358  
 
 
 
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
  $ 3,702,655     $ 3,464,026  
 
 
 

See accompanying Notes to Condensed Consolidated Financial Statements.


(a)   Derived from audited financial statements.

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ELECTRONIC ARTS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

                                 
    Three Months Ended   Six Months Ended
(unaudited)   September 30,
  September 30,
(In thousands, except per share data)
 
  2004


2003

  2004


2003

Net revenue

  $ 715,728     $ 530,005     $ 1,147,369     $ 883,386  
Cost of goods sold
    283,911       213,762       460,666       363,725  
 
 
 
 
 

Gross profit

    431,817       316,243       686,703       519,661  

Operating expenses:

                               
Marketing and sales
    107,518       64,041       170,738       123,125  
General and administrative
    42,043       36,032       77,097       66,792  
Research and development
    156,839       113,493       287,481       204,615  
Amortization of intangibles
    623       810       1,245       1,490  
Restructuring charges
                388        
 
 
 
 
 

Total operating expenses

    307,023       214,376       536,949       396,022  
 
 
 
 
 

Operating income

    124,794       101,867       149,754       123,639  
Interest and other income, net
    12,183       9,130       21,342       13,979  
 
 
 
 
 

Income before provision for income taxes

    136,977       110,997       171,096       137,618  
Provision for income taxes
    39,724       34,409       49,618       42,662  
 
 
 
 
 

Net income

  $ 97,253     $ 76,588     $ 121,478     $ 94,956  
 
 
 
 
 
Net earnings per share:
                               
Common stock
                               
Net earnings per share:
                               
Basic
  $ 0.32     $ 0.26     $ 0.40     $ 0.32  
Diluted
  $ 0.31     $ 0.25     $ 0.38     $ 0.31  
Number of shares used in computation:
                               
Basic
    304,076       294,836       303,127       292,263  
Diluted
    316,049       307,779       315,778       304,013  

See accompanying Notes to Condensed Consolidated Financial Statements.

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ELECTRONIC ARTS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

                 
    Six Months Ended
(unaudited)   September 30,
(In thousands)
 
  2004

2003

OPERATING ACTIVITIES

               
Net income
  $ 121,478     $ 94,956  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation and amortization
    33,167       30,847  
Equity in net income of investment in affiliates
    (587 )     (113 )
Other-than-temporary impairment of investments in affiliates
          589  
Loss (gain) on sale of property, equipment and marketable equity securities
    (3,893 )     45  
Stock-based compensation
    273       429  
Tax benefit from exercise of stock options
    25,138       40,169  
Change in assets and liabilities:
               
Receivables, net
    (168,217 )     (133,034 )
Inventories
    (24,097 )     (406 )
Other assets
    26,590       19,063  
Accounts payable
    57,885       25,309  
Accrued and other liabilities
    (44,598 )     (49,607 )
 
 
 

Net cash provided by operating activities

    23,139       28,247  
 
 
 

INVESTING ACTIVITIES

               
Capital expenditures
    (45,339 )     (28,690 )
Proceeds from sale of property and equipment
    15,537       88  
Proceeds from sale of marketable equity securities
    3,115        
Purchase of investment in affiliate
    (250 )      
Proceeds from sale of investment in affiliate
          8,467  
Purchase of short-term investments
    (1,658,105 )     (1,270,579 )
Proceeds from maturities and sales of short-term investments
    812,521       547,792  
Purchase of minority interest
          (2,513 )
Acquisition of subsidiary, net of cash acquired
    (12 )      
 
 
 

Net cash used in investing activities

    (872,533 )     (745,435 )
 
 
 

FINANCING ACTIVITIES

               
Proceeds from sales of common stock through employee stock plans and other plans
    85,508       139,875  
Repurchase of Class B common stock
          (225 )
Repayment of Class B notes receivable
          128  
Dividend to joint venture
          (2,587 )
 
 
 

Net cash provided by financing activities

    85,508       137,191  
 
 
 

Effect of foreign exchange on cash and cash equivalents

    27       6,127  
 
 
 
Decrease in cash and cash equivalents
    (763,859 )     (573,870 )
Beginning cash and cash equivalents
    2,149,885       949,995  
 
 
 
Ending cash and cash equivalents
    1,386,026       376,125  
Short-term investments
    1,103,633       1,358,049  
 
 
 

Ending cash, cash equivalents and short-term investments

  $ 2,489,659     $ 1,734,174  
 
 
 

Supplemental cash flow information:

               
Cash paid during the period for income taxes
  $ 43,276     $ 4,567  
 
 
 

Non-cash investing activities:

               
Change in unrealized appreciation (loss) on investments
  $ (6,794 )   $ (2,186 )
 
 
 

See accompanying Notes to Condensed Consolidated Financial Statements.

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ELECTRONIC ARTS INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

(1) DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION

Electronic Arts develops, markets, publishes and distributes interactive software games that are playable by consumers on home videogame machines (such as the Sony PlayStation®2, Microsoft Xbox® and Nintendo GameCubeTM consoles), personal computers (PC), hand-held game machines (such as the Game Boy® Advance) and online, over the Internet and other proprietary online networks. Many of our games are based on content that we license from others (e.g., Madden NFL Football, Harry Potter and FIFA Soccer), and many of our games are based on intellectual property that is wholly-owned by us (e.g., The SimsTM and Medal of HonorTM). Our goal is to develop titles which appeal to the mass market and as a result, we develop, market, publish and distribute our games in over 100 countries, often translating and localizing them for sale in non-English-speaking countries. Our goal is 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 are our annual iterations of our sports-based franchises (e.g., NCAA Football and FIFA Soccer), titles based on long-lived movie properties (e.g., James BondTM) and wholly-owned properties that can be successfully sequeled (e.g., SimCityTM).

The Condensed Consolidated Financial Statements are unaudited and reflect all adjustments (consisting only of normal recurring accruals) that, in the opinion of management, are necessary for a fair presentation of the results for the interim periods presented. 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.

Certain prior year amounts have been reclassified to conform to the fiscal 2005 presentation.

At our Annual Meeting of Stockholders, held on July 29, 2004, our stockholders elected to amend and restate our Certificate of Incorporation to consolidate our Class A and Class B common stock into a single class of common stock by reclassifying each outstanding share of Class A common stock as one share of common stock and converting each outstanding share of Class B common stock into 0.001 share of common stock. Our stockholders also elected to further amend and restate our Certificate of Incorporation to increase the authorized common stock from 500 million total shares of Class A and Class B common stock combined to 1 billion shares of the newly consolidated single class of common stock. These amendments were effective on August 2, 2004. Prior year Class A common stock has been reclassified to reflect these amendments.

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, 2004 as filed with the Securities and Exchange Commission on June 4, 2004.

(2) FISCAL YEAR AND FISCAL QUARTER

Our fiscal year is reported on a 52/53-week period that ends on the final Saturday of March in each year. The results of operations for fiscal 2005 and 2004 contain 52 weeks. The results of operations for the fiscal quarters ended September 30, 2004 and September 30, 2003 each contain 13 weeks ending on September 25, 2004 and September 27, 2003, respectively. For simplicity of presentation, all fiscal periods are reported as ending on a calendar month end. On October 28, 2004, our Board of Directors approved a change in our fiscal year, such that beginning in fiscal 2006, we will end our fiscal year on the Saturday nearest March 31. This will result in fiscal 2006 being reported as a 53 week year with the first quarter containing 14 weeks instead of 13 weeks.

(3) EMPLOYEE STOCK-BASED COMPENSATION

We account for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees”. We have adopted the disclosure-only provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation”, as amended.

Had compensation cost for our stock-based compensation plans been measured based on the estimated fair value at the grant dates in accordance with the provisions of SFAS No. 123, we estimate that our reported net income and net earnings per share would have been the pro forma amounts indicated below. The fair value of each option grant is estimated on the date of grant

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using the Black-Scholes option-pricing model. The following weighted-average assumptions were used for grants made during the three and six months ended September 30, 2004 and 2003 under the stock plans:

                                 
    Three Months Ended   Six Months Ended
    September 30,
  September 30,
    2004

2003
  2004

2003
Risk-free interest rate
    3.0%       2.2%       3.0%       2.1%  
Expected volatility
    37.5%       54.4%       38.4%       54.9%  
Expected life (in years)
    2.96       3.08       3.04       3.03  
Assumed dividends
  None     None     None     None  

Our calculations are based on a multiple option valuation approach and forfeitures are recognized when they occur.

                                 
    Three Months Ended   Six Months Ended
    September 30,
  September 30,
(In thousands, except per share data)
 
  2004

2003
  2004

2003

Net income – as reported

  $ 97,253     $ 76,588     $ 121,478     $ 94,956  
Deduct: Total stock-based employee compensation expense determined under fair-value-based method for all awards, net of related tax effects
    (22,935 )     (23,750 )     (42,579 )     (43,923 )
Add: Stock-based employee compensation expense included in reported net income, net of related tax effects
    25       25       50       74  
 
 
 
 
 

Net income – pro forma

  $ 74,343     $ 52,863     $ 78,949     $ 51,107  
 
 
 
 
 

Net earnings per share:

                               
As reported – basic
  $ 0.32     $ 0.26     $ 0.40     $ 0.32  
Pro forma – basic
  $ 0.24     $ 0.18     $ 0.26     $ 0.17  
As reported – diluted
  $ 0.31     $ 0.25     $ 0.38     $ 0.31  
Pro forma – diluted
  $ 0.24     $ 0.17     $ 0.25     $ 0.17  

At our Annual Meeting of Stockholders, held on July 29, 2004, our stockholders approved an amendment to our 2000 Equity Incentive Plan (the “Equity Plan”) to (a) increase by 11 million the number of shares of common stock reserved for issuance under the Equity Plan, (b) provide for the issuance of awards of restricted stock units, (c) limit the total number of shares underlying awards of restricted stock and restricted stock units to 3 million, (d) provide that the exercise price of nonqualified stock options may not be less than 100% of the fair market value of a share of common stock, (e) reduce the size of initial and annual option grants to Directors under the Equity Plan, and (f) authorize the Compensation Committee to determine the vesting provisions of options granted to Directors under the Equity Plan. Our stockholders also approved an amendment to the 2000 Employee Stock Purchase Plan (the “ESPP”) to increase by 1.5 million the number of shares of common stock reserved for issuance under the ESPP.

In March 2004, the Financial Accounting Standards Board (“FASB”) issued an exposure draft on the Proposed SFAS, “Share-Based Payment — an amendment of FASB Statements No. 123 and 95”. The proposed statement addresses the accounting for share-based payment transactions with employees and other third parties. The proposed standard would eliminate the ability to account for share-based compensation transactions using APB No. 25, and generally would require that such transactions be accounted for using a fair-value-based method. If the final standard is approved as currently drafted in the exposure draft, it would have a material impact on the amount of earnings we report beginning in the second quarter of fiscal 2006. We have not yet determined the impact that the proposed statement will have on our business.

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(4) GOODWILL AND OTHER INTANGIBLE ASSETS, NET

Goodwill information is as follows (in thousands):

                                 
                    Effects of    
    As of           Foreign   As of
    March 31,   Goodwill   Currency   September 30,
    2004   Acquired   Translation   2004
   
Goodwill
  $ 91,977     $ 12     $ 659     $ 92,648  
   

Finite-lived intangibles consist of the following (in thousands):

                                         
    As of September 30, 2004
    Gross                           Other
    Carrying   Accumulated                   Intangibles,
    Amount   Amortization   Impairment   Other   Net
   
Developed/Core Technology
  $ 28,263     $ (18,886 )   $ (9,377 )   $     $  
Tradename
    35,169       (16,739 )     (1,211 )     (7 )     17,212  
Subscribers and Other Intangibles
    8,694       (6,302 )     (1,776 )     (613 )     3  
   
Total
  $ 72,126     $ (41,927 )   $ (12,364 )   $ (620 )   $ 17,215  
   
                                         
    As of March 31, 2004
    Gross                           Other
    Carrying   Accumulated                   Intangibles,
    Amount   Amortization   Impairment   Other   Net
   
Developed/Core Technology
  $ 28,263     $ (18,886 )   $ (9,377 )   $     $  
Tradename
    35,169       (15,494 )     (1,211 )           18,464  
Subscribers and Other Intangibles
    8,694       (6,302 )     (1,776 )     (612 )     4  
   
Total
  $ 72,126     $ (40,682 )   $ (12,364 )   $ (612 )   $ 18,468  
   

Amortization of intangibles for the three and six months ended September 30, 2004 was $0.6 million and $1.2 million, respectively. Amortization of intangibles for the three and six months ended September 30, 2003 was $0.8 million and $1.5 million, respectively. Finite-lived 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 twelve years. As of September 30, 2004 and March 31, 2004, the weighted-average remaining useful life for finite-lived intangible assets was approximately 7.0 years and 7.5 years, respectively.

As of September 30, 2004, future amortization of finite-lived intangibles was estimated as follows (in thousands):

         
Fiscal Year Ended March 31,
       
2005 (remaining 6 months)
  $ 1,245  
2006
    2,489  
2007
    2,489  
2008
    2,489  
2009
    2,489  
Thereafter
    6,014  
 
 
Total
  $ 17,215  
 
 

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(5) RESTRUCTURING AND ASSET IMPAIRMENT CHARGES

The following table summarizes the activity in the accrued restructuring accounts for all restructuring plans (in thousands):

                                                 
    Accrual           Charges   Charges           Accrual
    Beginning   Charges to   Utilized   Utilized   Adjustments   Ending
    Balance

Operations

in Cash

Non-cash

to Operations

Balance
Six Months Ended September 30, 2004
                                               
Workforce
  $ 1,585     $     $ (1,582 )   $     $ 142     $ 145  
Facilities-related
    12,731             (3,479 )           246       9,498  
 
 










Total
  $ 14,316     $     $ (5,061 )   $     $ 388     $ 9,643  
 
 










Year Ended March 31, 2004
                                               
Workforce
  $ 1,692     $ 1,741     $ (1,778 )   $     $ (70 )   $ 1,585  
Facilities-related
    9,063       7,007       (3,903 )           564       12,731  
Non-current assets
          466             (466 )            
 
 










Total
  $ 10,755     $ 9,214     $ (5,681 )   $ (466 )   $ 494     $ 14,316  
 
 










Over the last three fiscal years, we have entered into various restructurings based on management decisions as discussed in more detail below. As of September 30, 2004, an aggregate of $21.3 million in cash had been paid out under the fiscal 2004, 2003 and 2002 restructuring plans. In addition, we have made subsequent net adjustments of approximately $0.4 million during fiscal 2005 relating to projected future cash outlays under the fiscal 2004 restructuring plan. Of the remaining projected cash outlay of $9.6 million, $1.9 million is expected to be utilized in the third and fourth quarters of fiscal 2005, while the remaining $7.7 million is expected to be utilized by January 30, 2009. The facilities-related commitments discussed above are shown net of $16.5 million of estimated future sub-lease income. The restructuring accrual is included in other accrued expenses presented in Note 7 of the Notes to Condensed Consolidated Financial Statements.

Fiscal 2004 Studio Restructuring
During fiscal 2004, we closed the majority of our leased studio facility in Walnut Creek, California and our wholly-owned studio facility in Austin, Texas. As a result, we recorded total pre-tax charges of $9.2 million, consisting of $7.0 million for consolidation of facilities, $1.7 million for workforce reductions and $0.5 million for the write-off of non-current assets, primarily leasehold improvements.

Fiscal 2003 Studio Restructuring
During fiscal 2003, we closed our office located in San Francisco, California, our studio located in Seattle, Washington and approved a plan to consolidate the Los Angeles and Irvine, California and Las Vegas, Nevada, studios into one major game studio in Los Angeles. We recorded total pre-tax charges of $14.5 million, consisting of $8.9 million for consolidation of facilities, $3.5 million for the write-off of non-current assets, primarily leasehold improvements and equipment, and $2.1 million for workforce reductions.

Fiscal 2003 Online Restructuring
In March 2003, we consolidated the operations of EA.com into our core business and eliminated separate reporting for our Class B common stock for all future reporting periods after fiscal 2003. As a result, we recorded restructuring charges, including asset impairment, of $67.0 million, consisting of $1.8 million for workforce reductions, $2.3 million for consolidation of facilities and other administrative charges and $62.9 million for the write-off of non-current assets.

Fiscal 2002 Online Restructuring
In October 2001, we announced restructuring initiatives involving EA.com and the closure of EA.com’s San Diego studio and consolidation of its San Francisco and Virginia facilities. As a result, we recorded restructuring charges of $20.3 million, consisting of $4.2 million for workforce reductions, $3.3 million for consolidation of facilities and other administrative charges and $12.8 million for the write-off of non-current assets and facilities.

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(6) ROYALTIES AND LICENSES

Our royalty expenses consist of payments to (1) content licensors, (2) independent software developers and (3) co-publishing and/or distribution affiliates. License royalties consist of payments made to celebrities, professional sports organizations, movie studios and other organizations for our use of their trademark, copyright, 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 delivery of product.

Royalty-based payments made to content licensors and distribution affiliates are generally capitalized as prepaid royalties and expensed to cost of goods sold at the greater of the contractual or effective royalty rate based on net product sales. With regard to payments made to independent software developers and co-publishing affiliates, these payments are generally in connection with the development of a particular product and, therefore, we are generally subject to development risk prior to the general release of the product. Accordingly, payments that are due prior to completion of a product are generally expensed as research and development 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 at the higher of the contractual or effective royalty rate based on net product sales.

Minimum guaranteed royalty obligations are initially recorded as an asset and as a liability at the contractual amount when no significant performance remains with the licensor. When significant performance remains with the licensor, we record royalty payments as an asset when actually paid rather than upon execution of the contract. Minimum royalty payment obligations are classified as current liabilities to the extent such royalty payments are contractually due within the next twelve months. As of September 30, 2004 and March 31, 2004, approximately $49.1 million and $63.4 million, respectively, of minimum guaranteed royalty obligations had been recognized and are included in the tables below.

Each quarter, we also evaluate the 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 determined before the launch of a product are charged to research and development expense. Impairments determined post-launch are charged to cost of goods sold. In either case, we rely on estimated revenue to evaluate the future realization of prepaid royalties. If actual sales or revised revenue estimates fall below the initial revenue estimates, then the actual charge taken may be greater in any given quarter than anticipated.

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 thousands):

                 
    As of     As of  
    September 30,   March 31,
    2004
  2004
Other current assets
  $ 28,274     $ 31,165  
Other assets
    46,640       54,921  
 
 
 
Royalty-related assets
  $ 74,914     $ 86,086  
 
 
 

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 have unpaid royalty amounts due to these parties that are recognized as either accounts payable or accrued liabilities. The current and long-term portions of accrued royalties, included in accrued and other liabilities as well as other liabilities, consisted of (in thousands):

                 
    As of     As of  
    September 30,   March 31,
    2004
  2004
Accrued liabilities
  $ 113,476     $ 104,603  
Other liabilities
    36,615       41,443  
 
 
 
Accrued royalties
  $ 150,091     $ 146,046  
 
 
 

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In addition, at September 30, 2004, we have approximately $69.1 million that we are obligated to pay co-publishing and/or distribution affiliates and content licensors but that are generally contingent upon performance by the counterparty (i.e., delivery of the product or content) and are therefore not recorded in our Condensed Consolidated Financial Statements. See Note 8 of the Notes to Condensed Consolidated Financial Statements.

(7) BALANCE SHEET DETAILS

Inventories
Inventories as of September 30, 2004 and March 31, 2004 consisted of (in thousands):

                 
    As of     As of  
    September 30,   March 31,
    2004
  2004
Raw materials and work in process
  $ 7,544     $ 2,263  
Finished goods
    71,728       52,880  
 
 
 
Inventories
  $ 79,272     $ 55,143  
 
 
 

Property and Equipment, Net
Property and equipment, net, as of September 30, 2004 and March 31, 2004 consisted of (in thousands):

                 
    As of     As of  
    September 30,   March 31,
    2004
  2004
Computer equipment and software
  $ 360,122     $ 355,626  
Buildings
    99,227       118,251  
Land
    57,492       60,209  
Leasehold improvements
    56,202       37,409  
Office equipment, furniture and fixtures
    46,845       45,964  
Warehouse equipment and other
    12,934       11,757  
 
 
 
 
    632,822       629,216  
Less: Accumulated depreciation and amortization
    (335,337 )     (331,143 )
 
 
 
Property and equipment, net
  $ 297,485     $ 298,073  
 
 
 

Depreciation and amortization expense associated with property and equipment amounted to $16.3 million and $31.9 million for the three and six months ended September 30, 2004, respectively. Depreciation and amortization expense associated with property and equipment amounted to $16.8 million and $29.4 million for the three and six months ended September 30, 2003, respectively.

Accrued and Other Liabilities
Accrued and other liabilities as of September 30, 2004 and March 31, 2004 consisted of (in thousands):

                 
    As of     As of  
    September 30,   March 31,
    2004
  2004
Accrued income taxes
  $ 213,027     $ 225,878  
Other accrued expenses
    142,572       134,000  
Accrued royalties
    113,476       104,603  
Accrued compensation and benefits
    88,982       142,756  
Deferred revenue
    29,218       22,901  
 
 
 
Accrued and other liabilities
  $ 587,275     $ 630,138  
 
 
 

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(8) COMMITMENTS AND CONTINGENCIES

Lease Commitments and Residual Value Guarantees
We lease certain of our current facilities and certain equipment under non-cancelable operating lease agreements. We are required to pay property taxes, insurance and normal maintenance costs for certain of our facilities and will be required to pay any increases over the base year of these expenses on the remainder of our facilities.

In February 1995, we entered into a build-to-suit lease with a third party for our headquarters facility in Redwood City, California, which was refinanced with Keybank National Association in July 2001 and expires in July 2006. We accounted for this arrangement as an operating lease in accordance with SFAS No. 13, “Accounting for Leases”, as amended. Existing campus facilities developed in phase one comprise a total of 350,000 square feet and provide space for sales, marketing, administration and research and development functions. We have an option to purchase the property (land and facilities) for a maximum of $145.0 million or, at the end of the lease, to arrange for (i) an extension of the lease or (ii) sale of the property to a third party while we retain an obligation to the owner for approximately 90 percent of the difference between the sale price and the guaranteed residual value of up to $128.9 million if the sales price is less than this amount, subject to certain provisions of the lease.

In December 2000, we entered into a second build-to-suit lease with Keybank National Association for a five-year term beginning December 2000 to expand our Redwood City, California headquarters facilities and develop adjacent property adding approximately 310,000 square feet to our campus. Construction was completed in June 2002. We accounted for this arrangement as an operating lease in accordance with SFAS No. 13, as amended. The facilities provide space for marketing, sales and research and development. We have an option to purchase the property for a maximum of $130.0 million or, at the end of the lease, to arrange for (i) an extension of the lease, or (ii) sale of the property to a third party while we retain an obligation to the owner for approximately 90 percent of the difference between the sale price and the guaranteed residual value of up to $118.8 million if the sales price is less than this amount, subject to certain provisions of the lease.

We believe the estimated fair values of both properties under these operating leases are in excess of their respective guaranteed residual values as of September 30, 2004.

For the two lease agreements with Keybank National Association, as described above, the lease rates are based upon the Commercial Paper Rate and require us to maintain certain financial covenants as shown below, all of which we were in compliance with as of September 30, 2004.

                 
            Actual as of  
Financial Covenants
  Requirement
    September 30, 2004
 

Consolidated Net Worth

  $1,775 million     $2,906 million  
Fixed Charge Coverage Ratio
    3.00       25.12  
Total Consolidated Debt to Capital
    60%       7.9%  
Quick Ratio – Q1 & Q2
    1.00       11.52  
Q3 & Q4
    1.75       N/A  

In July 2003, we entered into a lease agreement with an independent third party (the “Landlord”) for a studio facility in Los Angeles, California, which commenced in October 2003 and expires in September 2013 with two five-year options to extend the lease term. Additionally, we have options to purchase the property after five and ten years based on the fair market value of the property at the date of sale, a right of first offer to purchase the property upon terms offered by the Landlord, and a right to share in the profits from a sale of the property. We have accounted for this arrangement as an operating lease in accordance with SFAS No. 13, as amended. Existing campus facilities comprise a total of 243,000 square feet and provide space for research and development functions. Our rental obligation under this agreement is $50.2 million over the initial ten-year term of the lease. This commitment is offset by sublease income of $5.8 million for the sublet to an affiliate of the Landlord of 18,000 square feet of the Los Angeles facility, which commenced in October 2003 and expires in September 2013, with options of early termination by the affiliate after five years and by us after four and five years.

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In June 2004, we entered into a lease agreement with an independent third party for a studio facility in Orlando, Florida, which will commence in January 2005 and expire in June 2010, with one five-year option to extend the lease term. The campus facilities comprise a total of 117,000 square feet, which we intend to use for research and development functions. We have accounted for this arrangement as an operating lease in accordance with SFAS No. 13, as amended. Our rental obligation over the initial five-and-a-half year term of the lease is $13.2 million.

Letters of Credit
In July 2002, we provided an irrevocable standby letter of credit to Nintendo of Europe. The standby letter of credit guarantees performance of our obligations to pay Nintendo of Europe for trade payables of up to 8.0 million. The standby letter of credit expires in July 2005. As of September 30, 2004, we had 5.3 million payable to Nintendo of Europe covered by this standby letter of credit.

In August 2003, we provided an irrevocable standby letter of credit to 300 California Associates II, LLC as a replacement for our security deposit for office space. The standby letter of credit guarantees performance of our obligations to pay our lease commitment up to $1.1 million. The standby letter of credit expires in December 2006. As of September 30, 2004, we did not have a payable balance on this standby letter of credit.

Development, Celebrity, League and Content Licenses: Payments and Commitments
The products produced by 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 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 are not dependent on any deliverables. Celebrities and organizations with whom we have contracts include: FIFA and UEFA (professional soccer); NASCAR (stock car racing); John Madden (professional football); National Basketball Association (professional basketball); PGA TOUR (professional golf); Tiger Woods (professional golf); National Hockey League and NHLPA (professional hockey); Warner Bros. (Harry Potter, Catwoman and Superman); MGM/Danjaq (James Bond); New Line Productions (The Lord of the Rings); National Football League and Players Inc. (professional football); Collegiate Licensing Company (collegiate football and basketball); ISC (stock car racing); Major League Baseball Properties; MLB Players Association (professional baseball) and Island Def Jam (fighting). These developer and content license commitments represent the sum of (i) the cash payments due under non-royalty-bearing licenses and services agreements, and (ii) the minimum 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 marketing commitments are included in the table below.

The following table summarizes our minimum contractual obligations and commercial commitments as of September 30, 2004 and the effect we expect them to have on our liquidity and cash flow in future periods (in thousands):

                                                 
    Contractual Obligations
  Commercial Commitments
     
Fiscal Year           Developer/             Bank and   Letters      
Ended           Licensee             Other   of      
March 31,

Leases

Commitments(1)

Marketing
  Guarantees

Credit
  Total
2005 (remaining 6 months)
  $ 13,467     $ 31,302     $ 15,753     $ 1,973     $ 6,464     $ 68,959  
2006
    27,807       32,951       6,892       223             67,873  
2007
    22,524       15,470       3,586       223             41,803  
2008
    17,372       15,822       3,586       223             37,003  
2009
    13,217       10,755       3,586       222             27,780  
Thereafter
    40,875       11,899       3,587       222             56,583  
 
 




 


 
Total
  $ 135,262     $ 118,199     $ 36,990     $ 3,086     $ 6,464     $ 300,001  
 
 




 


 

(1) Developer/licensee commitments include $49.1 million of commitments to developers or licensers that have been included in our Condensed Consolidated Balance Sheet as of September 30, 2004 because the developer does not have any significant performance obligations to us. These commitments are included in both current and long-term assets and liabilities.

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The lease commitments disclosed above exclude commitments included in our restructuring activities for contractual rental commitments of $26.0 million under real estate leases for unutilized office space, offset by $16.5 million of estimated future sub-lease income. These amounts were expensed in the periods of the related restructuring and are included in our accrued and other liabilities reported on our Condensed Consolidated Balance Sheet as of September 30, 2004. Please see Note 5 in the Notes to Condensed Consolidated Financial Statements for additional information.

Litigation
On July 29, 2004, a class action lawsuit, Kirschenbaum v. Electronic Arts Inc., was filed against us in Superior Court in San Mateo, California. The complaint alleges that we improperly classified “Image Production Employees” in California as exempt employees and seeks injunctive relief, unspecified monetary damages, interest and attorneys’ fees. We have not yet answered the complaint.

In addition, we are subject to other claims and litigation arising in the ordinary course of business. Our management, after review and consultation with counsel, considers that any liability from any reasonably foreseeable disposition of such claims and litigation, individually or in the aggregate, would not have a material adverse effect on our consolidated financial position or results of operations.

Director Indemnity Agreements
We have entered into an indemnification agreement with the members of our Board of Directors to indemnify our Directors 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 as a result of their service as members of our Board of Directors.

(9) COMPREHENSIVE INCOME

SFAS No. 130, “Reporting Comprehensive Income”, requires classification of other comprehensive income in a financial statement and display of other comprehensive income separately from retained earnings and additional paid-in capital. Other comprehensive income includes primarily foreign currency translation adjustments and unrealized gains (losses) on investments.

The change in the components of accumulated other comprehensive income, net of tax, for the three and six months ended September 30, 2004 and 2003 are summarized as follows (in thousands):

                                 
    Three Months Ended   Six Months Ended
    September 30,
  September 30,
    2004

2003
  2004

2003

Net income

  $ 97,253     $ 76,588     $ 121,478     $ 94,956  
Other comprehensive income (loss):
                               
Change in unrealized gain (loss) on investments, net of tax expense (benefit) of $2,782, $(793) and $(1,985), $(675), respectively
    4,826       (1,811 )     (3,067 )     (1,504 )
Adjustment for gain realized in net income, net of tax expense of $597, $0 and $597, $3, respectively
    (974 )           (974 )     (7 )
Foreign currency translation adjustments
    5,408       1,174       34       12,875  
 
 
 
 
 
Total other comprehensive income (loss)
  $ 9,260     $ (637 )   $ (4,007 )   $ 11,364  
 
 
 
 
 
   
                               
Total comprehensive income
  $ 106,513     $ 75,951     $ 117,471     $ 106,320  
 
 
 
 
 

The foreign currency translation adjustments are not adjusted for income taxes as they relate to indefinite investments in non-U.S. subsidiaries.

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(10) NET INCOME PER SHARE

The following summarizes the computations of Basic Earnings Per Share (“EPS”) and Diluted EPS. Basic EPS is computed as net earnings divided by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur from common shares issuable through stock-based compensation plans including stock options, restricted stock awards, warrants and other convertible securities using the treasury stock method. Effective August 2, 2004, each outstanding share of Class A common stock was reclassified as one share of common stock and prior year Class A common stock has been reclassified to reflect these amendments. See Note 1 in the Notes to Condensed Consolidated Financial Statements for more details.

                                 
    Three Months Ended   Six Months Ended
    September 30,
  September 30,
(In thousands, except per share amounts):
 
  2004

2003
  2004

2003

Net income

  $ 97,253     $ 76,588     $ 121,478     $ 94,956  
 
 
 
 
 
Weighted-average common stock outstanding – basic
    304,076       294,836       303,127       292,263  
Dilutive stock equivalents
    11,973       12,943       12,651       11,750  
 
 
 
 
 
Weighted-average common stock outstanding – diluted
    316,049       307,779       315,778       304,013  
 
 
 
 
 

Net earnings per share:

                               
Basic
  $ 0.32     $ 0.26     $ 0.40     $ 0.32  
Diluted
  $ 0.31     $ 0.25     $ 0.38     $ 0.31  

Excluded from the above computation of weighted-average common shares for Diluted EPS for the three and six months ended September 30, 2004 were options to purchase 899,000 and 537,000 shares of common stock, respectively, as the options’ exercise price was greater than the average market price of the common shares. The weighted-average exercise price of these options was $51.77 and $52.17 per share, respectively.

Excluded from the above computation of weighted-average common shares for Diluted EPS for the three and six months ended September 30, 2003 were options to purchase 339,000 and 574,000 shares of common stock, respectively, as the options’ exercise price was greater than the average market price of the common shares. The weighted-average exercise price of these options was $44.49 and $40.78 per share, respectively.

(11) RELATED PARTY TRANSACTION

On June 24, 2002, we hired Warren Jenson and agreed to loan him $4,000,000, to be forgiven over four years based on his continuing employment. The loan does not bear interest. On June 24, 2004, pursuant to the terms of the loan agreement, we forgave two million dollars of the loan and provided Mr. Jenson approximately $1.6 million to offset the tax implications of the forgiveness. As of September 30, 2004, the remaining outstanding loan balance was $2,000,000, which will be forgiven on June 24, 2006, provided that Mr. Jenson has not voluntarily resigned his employment with us or been terminated for cause prior to that time. No additional funds will be provided to offset the tax implications of the forgiveness of the remaining two million dollars.

(12) SEGMENT INFORMATION

SFAS No. 131, “Disclosures About Segments of an Enterprise and Related Information”, establishes standards for the reporting by public business enterprises of information about product lines, geographic areas and major customers. The method for determining what information to report is based on the way that management organizes our operating segments for making operational decisions and assessments of financial performance.

Our chief operating decision maker is considered to be our Chief Executive Officer (“CEO”). The CEO reviews financial information presented on a consolidated basis accompanied by disaggregated information about revenue by geographic region and by product lines for purposes of making operating decisions and assessing financial performance. Our view and reporting of

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business segments may change due to changes in the underlying business facts and circumstances and the evolution of our reporting to our CEO.

Information about our total net revenue by product line for the three and six months ended September 30, 2004 and 2003 is presented below (in thousands):

                                 
    Three Months Ended   Six Months Ended
    September 30,
  September 30,
    2004
  2003
  2004
  2003

PlayStation 2

  $ 311,839     $ 221,180     $ 473,815     $ 339,549  
PC
    140,702       93,022       207,453       173,360  
Xbox
    141,936       68,691       199,146       100,212  
Nintendo GameCube
    38,181       24,553       64,605       45,707  
Game Boy Advance
    10,081       3,809       28,069       6,168  
Subscription Services
    12,554       11,124       24,994       24,755  
 
 
 
 
 
EA Studio Net Product Revenue
    655,293       422,379       998,082       689,751  
Co-publishing and Distribution
    48,913       92,512       116,105       164,059  
Advertising, Programming, Licensing and Other
    11,522       15,114       33,182       29,576  
 
 
 
 
 
Total Net Revenue
  $ 715,728     $ 530,005     $ 1,147,369     $ 883,386  
 
 
 
 
 

Information about our operations in North America and in international regions for the three and six months ended September 30, 2004 and 2003 is presented below (in thousands):

                                         
                    Asia        
                    Pacific        
    North           (excluding        
    America

Europe

Japan)

Japan

Total

Three months ended September 30, 2004

                                       
Net revenue from unaffiliated customers
  $ 472,838     $ 209,639     $ 21,352     $ 11,899     $ 715,728  
Interest income, net
    7,348       1,853       61             9,262  
Depreciation and amortization
    11,343       5,083       272       262       16,960  
Total assets
    2,764,922       866,886       41,727       29,120       3,702,655  
Capital expenditures
    13,466       4,996       549       219       19,230  
Long-lived assets
    263,197       137,950       2,748       3,453       407,348  

Three months ended September 30, 2003

                                       
Net revenue from unaffiliated customers
  $ 358,184     $ 145,002     $ 17,617     $ 9,202     $ 530,005  
Interest income, net
    5,949       689       27             6,665  
Depreciation and amortization
    11,138       6,087       241       158       17,624  
Total assets
    2,051,368       573,289       29,908       25,666       2,680,231  
Capital expenditures
    12,610       3,621       324       (52 )     16,503  
Long-lived assets
    240,050       137,157       2,244       2,288       381,739  

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                    Asia        
                    Pacific        
    North           (excluding            
    America

Europe

Japan)

Japan

Total

Six months ended September 30, 2004

                                       
Net revenue from unaffiliated customers
  $ 683,989     $ 399,643     $ 38,952     $ 24,785     $ 1,147,369  
Interest income, net
    14,247       2,889       116             17,252  
Depreciation and amortization
    20,580       11,545       533       509       33,167  
Capital expenditures
    34,893       9,255       931       260       45,339  

Six months ended September 30, 2003

                                       
Net revenue from unaffiliated customers
  $ 557,025     $ 272,928     $ 32,088     $ 21,345     $ 883,386  
Interest income, net
    12,137       1,660       64             13,861  
Depreciation and amortization
    20,226       9,831       477       313       30,847  
Capital expenditures
    22,268       5,804       607       11       28,690  

Our direct sales to Wal-Mart Stores, Inc. represented approximately 15 and 14 percent of total net revenue for the three and six months ended September 30, 2004, respectively, and approximately 15 and 14 percent of total net revenue for the three and six months ended September 30, 2003, respectively.

(13) IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS

In March 2004, the FASB ratified the measurement and recognition guidance and certain disclosure requirements for impaired securities as described in Emerging Issues Task Force (“EITF”) Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”. In September 2004, the FASB issued a proposed Staff Position (“FSP”) EITF Issue No. 03-1-a, “Implementation Guidance for the Application of Paragraph 16 of EITF 03-1”. The proposed FSP will provide measurement and recognition guidance with respect to debt securities that are impaired solely due to interest rates and/or sector spreads. The FSP has delayed the effective date until such time that they issue the final standard. Management has not determined what impact the adoption of the measurement and recognition guidance in EITF Issue No. 03-1 will have on our financial statements.

(14) SUBSEQUENT EVENTS

In October 2004, Congress enacted, and the President signed into law, the American Jobs Creation Act of 2004 which provides for a reduced rate of tax on certain repatriations of accumulated foreign earnings. While we currently intend to indefinitely reinvest our accumulated foreign earnings outside the U.S., management is studying the new law and has not determined what impact the repatriation of our accumulated foreign earnings would have on our effective income tax rate or our financial statements were we to change our intention.

On October 18, 2004, our Board of Directors authorized a program to repurchase up to an aggregate of $750.0 million of shares of our common stock. Pursuant to the authorization, we may repurchase shares of our common stock from time to time in the open market or through privately negotiated transactions over the course of a twelve-month period.

On October 19, 2004, we completed our acquisition of Criterion Software Group Ltd., an indirect wholly-owned subsidiary of Canon Inc., for an approximate purchase price of $57 million plus the assumption of outstanding stock options under certain stock option plans. Based in the United Kingdom, Criterion Software Group Ltd. is a developer of video games and a provider of middleware solutions for the game development and publishing industry. While we are in the process of allocating the purchase price to the various assets and liabilities we have acquired or assumed, we anticipate recognizing pre-tax acquisition-related charges of between $10 million and $15 million during the third quarter of fiscal 2005.

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Shareholders
Electronic Arts, Inc.:

We have reviewed the condensed consolidated balance sheet of Electronic Arts, Inc. and subsidiaries (the Company) as of September 30, 2004, the related condensed consolidated statements of operations for the three and six-month periods ended September 30, 2004 and 2003, and the related condensed consolidated statements of cash flows for the six-month periods ended September 30, 2004 and 2003. These condensed consolidated financial statements are the responsibility of the Company’s 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 March 31, 2004, and the related consolidated statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for the year then ended (not presented herein); and in our report dated April 28, 2004, 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 March 31, 2004, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

KPMG LLP

San Francisco, California
October 19, 2004

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All statements, other than statements of historical fact, including statements regarding industry prospects and future results of operations or financial position, made in this Quarterly Report on Form 10-Q are forward looking. We use words such as “anticipates”, “believes”, “expects”, “intends”, “future” and similar expressions to help identify forward-looking statements. These forward-looking statements are subject to business and economic risk and management’s expectations, and are inherently uncertain and difficult to predict. Our actual results could differ materially from management’s expectations due to such risks. 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 below under the heading “Risk Factors”, as well as in our Annual Report on Form 10-K for the fiscal year ended March 31, 2004 as filed with the Securities and Exchange Commission (“SEC”) on June 4, 2004 and in other documents we have filed with the SEC.

OVERVIEW

The following overview is a top-level discussion of our operating results and the primary 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 quarter ended September 30, 2004, 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 “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, “Risk Factors” or the condensed consolidated financial statements and related notes. Additional information can be found within the “Business” section of our Annual Report on Form 10-K for the fiscal year ended March 31, 2004 as filed with the SEC on June 4, 2004 and in other documents we have filed with the SEC.

About Electronic Arts

Electronic Arts develops, markets, publishes and distributes interactive software games that are playable by consumers on home videogame machines (such as the Sony PlayStation®2, Microsoft Xbox® and Nintendo GameCubeTM consoles), personal computers (PC), hand-held game machines (such as the Game Boy® Advance) and online, over the Internet and other proprietary online networks. Many of our games are based on content that we license from others (e.g., Madden NFL Football, Harry Potter and FIFA Soccer), and many of our games are based on intellectual property that is wholly-owned by us (e.g., The SimsTM and Medal of HonorTM). Our goal is to develop titles which appeal to the mass market and as a result, we develop, market, publish and distribute our games in over 100 countries, often translating and localizing them for sale in non-English-speaking countries. Our goal is 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 are our annual iterations of our sports-based franchises (e.g., NCAA Football and FIFA Soccer), titles based on long-lived movie properties (e.g., James BondTM) and wholly-owned properties that can be successfully sequeled (e.g., SimCityTM).

Overview of Financial Results

Total net revenue for the three months ended September 30, 2004 was $716 million, up 35 percent, as compared to the three months ended September 30, 2003. Sales were driven by Madden NFL 2005, The Sims™ 2, BurnoutTM 3: Takedown™ and NCAA® Football 2005 – each reaching platinum status (over one million copies sold) in the quarter.

Net income for the three months ended September 30, 2004 was $97 million, a 27 percent increase as compared to the three months ended September 30, 2003 and diluted earnings per share were $0.31 as compared with $0.25 for the prior year.

We generated $23 million of cash in operations during the six months ended September 30, 2004 as compared to $28 million in the six months ended September 30, 2003. The decrease in cash flow was primarily the result of tax payments made during the six months ended September 30, 2004, partially offset by an increase in net income during the same period.

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Management’s Overview of Historical and Prospective Business Trends

Sales of “Hit” Titles. During fiscal 2004, sales of a number of “hit” titles contributed to our revenue growth, several of which were top sellers across a number of international markets. Continuing this trend, our top-five-selling titles across all platforms worldwide during the three months ended September 30, 2004 were the franchise titles Madden NFL 2005, The Sims 2, NCAA Football 2005, Burnout 3:Takedown and Def Jam® Fight for NYTM . Hit titles are important to our financial performance because they benefit from overall economies of scale. We have developed, and it is our objective to continue to develop, many of our hit titles to become franchise titles that can be regularly iterated.

Increased Console Installed Base. As consumers purchase the current generation of consoles, either as a first-time buyer or by upgrading from a previous generation, this increases the console installed base. As the installed base for a particular console increases, we are generally able to increase our unit volume; however, these unit volumes often begin to decrease as consumers anticipate the next generation of consoles. In the U.S. and Europe, we believe the installed base for the current generation of consoles – the PlayStation 2, Xbox and Nintendo GameCube – increased significantly during the three and six months ended September 30, 2004 as compared to the three and six months ended September 30, 2003. In March 2004, Microsoft reduced the retail price of its Xbox console in the U.S. and in May 2004 Sony did the same with its PlayStation 2 console. In August 2004, both companies also reduced their console retail price in Europe. As price reductions drive sales of consoles and the related installed base of these current generation consoles increases during fiscal 2005, we expect unit sales of current generation titles to remain strong. Accordingly, we believe the significant increase in the installed base for these consoles was a contributing factor to our total net revenue growth during the three and six months ended September 30, 2004.

Software Prices. As current-generation console prices decrease, we expect more value-oriented consumers to become part of the interactive entertainment software market. We experienced this trend several years ago when prices were reduced on previous-generation consoles (e.g., Sony PlayStation and Nintendo 64). We believe that most hit titles will continue to be launched at premium price points and will maintain those premium price points longer than less popular games. However, as a result of a more value-oriented consumer base, and a greater number of software titles being published, we expect average software prices to gradually decline, which may have a negative impact on our gross margin.

International Sales Growth. During the first six months of fiscal 2005, net revenue from international sales accounted for approximately 40 percent of our total net revenue, up from 37 percent during the first six months of fiscal 2004. Our second quarter increase in international net revenue was primarily driven by increased sales in Europe, where UEFA Euro 2004 benefited from being released in conjunction with the UEFA Euro 2004 football (soccer) tournament. For the remainder of fiscal 2005, we anticipate that international net revenue will continue to increase – although not at the same rate as in fiscal 2004 – as we strengthen our presence in new territories (particularly in Asia) and as the console installed base expands outside of North America.

Foreign Exchange Impact. Given that a significant portion of our business is conducted internationally in foreign currency, fluctuations in currency prices can have a material impact on our results of operations. For example, the average exchange rate for the Euro, as compared to the U.S. dollar, increased from $1.13 per Euro during the three months ended September 30, 2003 to $1.22 per Euro during the three months ended September 30, 2004. As a result of the fluctuations in currency prices, we had a total foreign exchange benefit on total net revenue of approximately $23 million during the three months ended September 30, 2004. Although we intend to continue to utilize foreign exchange forward and option contracts to either mitigate or hedge against some foreign currency exposures, we cannot predict the effect foreign currency fluctuations will have on us in fiscal 2005.

Increasing Cost of Titles. Hit titles have become increasingly more expensive to produce and market as the platforms on which they are played continue to advance technologically and consumers demand continual improvements in the overall game play experience. We expect this trend to continue as (1) we require larger production teams to create our titles, (2) the technology needed to develop titles becomes more complex, (3) the number and nature of the platforms for which we develop titles increases and becomes more diverse, (4) the cost of licensing the third-party intellectual property we use in many of our titles potentially increases, (5) we continue to develop additional Internet capabilities included in our products, and (6) we develop new methods to distribute our content via the Internet.

Expansion of Studio Resources and Technology. During fiscal 2004, as part of our effort to more efficiently utilize our resources and technology, we expanded our studio facilities in Los Angeles and Vancouver, allowing us to consolidate several smaller studios and resources. In fiscal 2005, we expect to devote significant resources primarily to the expansion of our studios

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in North America and Europe. As we move through the life cycle of current generation consoles, we will devote increased resources to developing selected current generation titles and increase spending associated with tools and technologies for the next generation of platforms and technology. We also expect our studio expansions to enable us to support these investments and allow us to develop new titles. We expect these activities to increase our research and development expenses and decrease our third-party development costs, both as a percentage of total net revenue.

Increased Presence in China and Japan. We believe that in order to succeed in China and Japan, it is important to develop content locally for each market. As such, we expect to devote significant resources to hire local development talent and expand our infrastructure in each market, most notably, the expansion and creation of studio facilities in those countries. In addition, we anticipate establishing online game marketing, publishing and distribution functions in China. As part of this strategy, we may seek to partner with established local companies through acquisitions, joint ventures or other similar arrangements.

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 judgment and estimates of matters that are inherently uncertain and unknown. As a result, actual results may differ materially from our estimates.

Sales returns and allowances and bad debt reserves

We principally derive revenue from sales of packaged interactive software games designed for play on videogame platforms (such as the PlayStation 2, Xbox and Nintendo GameCube), PCs and hand-held game machines (such as the Nintendo Game Boy Advance). Product revenue is recognized net of sales allowances. We also have stock-balancing programs for our PC products, which allow for the exchange of PC products by resellers under certain circumstances. We may decide to provide price protection for both our personal computer and videogame system products. In making this determination, we evaluate inventory remaining in the channel, the rate of inventory sell-through in the channel, and our remaining inventory on hand. It is our general practice to exchange products or give credits, rather than give cash refunds.

We estimate potential future product returns, price protection and stock-balancing programs related to current-period product revenue. We analyze historical returns, current sell-through of distributor and retailer inventory of our products, current trends in the videogame market and the overall economy, changes in customer demand and acceptance of our products and other related factors when evaluating the adequacy of the sales returns and price protection allowances. In addition, management monitors the volume of our sales to retailers and distributors and their inventories, as substantial overstocking in the distribution channel can result in high returns or substantial price protection requirements in subsequent periods. In the past, actual returns and price protection have not generally exceeded our reserves. However, actual returns and price protections may materially exceed our estimates as unsold 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 products. For example, the risk of product returns and/or price protection for our products may increase as the PlayStation 2, Xbox and Nintendo GameCube consoles pass the midpoint of their lifecycle and an increasing number and aggregate amount of competitive products heighten pricing and competitive pressures. While management believes it can make reliable estimates regarding these matters, these estimates are inherently subjective. Accordingly, if our estimates changed, 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.

Similarly, significant 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. 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.

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Royalties & Licenses

Our royalty expenses consist of payments to (1) content licensors, (2) independent software developers and (3) co-publishing and/or distribution affiliates. License royalties consist of payments made to celebrities, professional sports organizations, movie studios and other organizations for our use of their trademark, copyright, 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 delivery of product.

Royalty-based payments made to content licensors and distribution affiliates are generally capitalized as prepaid royalties and expensed to cost of goods sold at the greater of the contractual or effective royalty rate based on net product sales. With regard to payments made to independent software developers and co-publishing affiliates, these payments are generally in connection with the development of a particular product and, therefore, we are generally subject to development risk prior to the general release of the product. Accordingly, payments that are due prior to completion of a product are generally expensed as research and development 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 at the higher of the contractual or effective royalty rate based on net product sales.

Minimum guaranteed royalty obligations are initially recorded as an asset and as a liability at the contractual amount when no significant performance remains with the licensor. When significant performance remains with the licensor, we record royalty payments as an asset when actually paid rather than upon execution of the contract. Minimum royalty payment obligations are classified as current liabilities to the extent such royalty payments are contractually due within the next twelve months. As of September 30, 2004 and March 31, 2004, approximately $49.1 million and $63.4 million, respectively, of minimum guaranteed royalty obligations had been recognized.

Each quarter, we also evaluate the 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 determined before the launch of a product are charged to research and development expense. Impairments determined post-launch are charged to cost of goods sold. In either case, we rely on estimated revenue to evaluate the future realization of prepaid royalties. If actual sales or revised revenue estimates fall below the initial revenue estimate, then the actual charge taken may be greater in any given quarter than anticipated. As of September 30, 2004, we had $74.9 million of royalty-based assets and $69.1 million of unrecognized minimum commitments not yet paid that could be impaired if our revenue estimates change.

Valuation of long-lived assets

We evaluate both purchased intangible assets and other long-lived assets in order to determine if events or changes in circumstances indicate a potential impairment in value exists. This evaluation requires us to estimate, among other things, the remaining useful lives of the assets and future cash flows of the business. These evaluations and estimates require the use of judgment. Our actual results could differ materially from our current estimates.

Under current accounting standards, we make judgments about the remaining useful lives of purchased intangible assets and other long-lived assets whenever events or changes in circumstances indicate a potential impairment in the remaining value of the assets recorded on our consolidated balance sheet. In order to determine if a potential impairment has occurred, management makes various assumptions about the future value of the asset by evaluating future business prospects and estimated cash flows. Our future net cash flows are primarily dependent on the sale of products for play on proprietary videogame consoles, hand-held game machines and PCs (“platforms”). The success of our products is affected by our ability to accurately predict which platforms and which products we develop will be successful. Also, our revenue and earnings are dependent on our ability to meet our product release schedules. Due to product sales shortfalls, we may not realize the future net cash flows necessary to recover our long-lived assets, which may result in an impairment charge being recorded in the future. There were no impairment charges recorded in the three and six months ended September 30, 2004 or September 30, 2003.

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Income taxes

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 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 current tax exposures in each jurisdiction where we operate. These estimates involve complex issues, require extended periods of time to resolve, and require us to make judgments, 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. We are also required to make the determinations of the need to record deferred tax liabilities and the recoverability of deferred tax assets. A valuation allowance is established to the extent recovery of deferred tax assets is not likely based on our estimation of future taxable income in each jurisdiction.

In addition, changes in our business, including acquisitions, changes in the geographic location of business functions, changes in the geographic mix of income, as well as changes in valuation allowances, the applicable accounting rules, the 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 and result in a variance between the projected effective tax rate for any quarters and final effective tax rate for the fiscal year. For example, in the fourth quarter of fiscal 2004, we resolved certain tax-related matters with the Internal Revenue Service, which lowered our income tax expense by $19.7 million and resulted in a 2.5 percent rate reduction during the fourth quarter of fiscal 2004. By contrast, an adverse development in an audit, applicable law, or a new election that we may make under the U.S. income tax rules regarding the allocation between U.S. and foreign jurisdictions tax deductions attributable to employee stock option compensation, could, for example, result in an increase in our tax expense.

To determine our projected effective income tax rate each quarter prior to the end of a fiscal year, we are required to make a projection of several items, including our projected mix of full-year income in each jurisdiction in which we operate and the related income tax expense in each jurisdiction. The estimated effective income tax rate is also adjusted for taxes related to significant unusual items. The actual results could vary from those projected, and as such, the overall effective income tax rate for a fiscal year could be different from that previously projected for the full year.

RESULTS OF OPERATIONS

Our fiscal year is reported on a 52/53-week period that ends on the final Saturday of March in each year. The results of operations for fiscal 2005 and 2004 contain 52 weeks. The results of operations for the fiscal quarters ended September 30, 2004 and September 30, 2003 each contain 13 weeks ending on September 25, 2004 and September 27, 2003, respectively. For simplicity of presentation, all fiscal periods are reported as ending on a calendar month end. On October 28, 2004, our Board of Directors approved a change in our fiscal year, such that beginning in fiscal 2006, we will end our fiscal year on the Saturday nearest March 31. This will result in fiscal 2006 being reported as a 53 week year with the first quarter containing 14 weeks instead of 13 weeks.

Net Revenue

We principally derive net revenue from sales of packaged interactive software games designed for play on videogame consoles (such as the PlayStation 2, Xbox and Nintendo GameCube), PCs and hand-held game machines (such as the Nintendo Game Boy Advance). Additionally, in Europe and Asia we generate a significant portion of net revenue by marketing and selling third-party interactive software games through our established distribution network. We also derive net revenue from selling subscriptions to some of our online games, programming third-party web sites with our game content, allowing other companies to manufacture and sell our products in conjunction with other products, and selling advertisements on our online web pages.

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From a geographical perspective, our total net revenue for the three and six months ended September 30, 2004 and 2003 were as follows (in thousands):

                                                 
    Three Months Ended September 30,
          %
    2004
  2003
  Increase
  Change

North America

  $ 472,838       66.1 %   $ 358,184       67.6 %   $ 114,654       32.0 %
 
 


 


 
 
Europe
    209,639       29.3 %     145,002       27.4 %     64,637       44.6 %
Asia Pacific
    21,352       3.0 %     17,617       3.3 %     3,735       21.2 %
Japan
    11,899       1.6 %     9,202       1.7 %     2,697       29.3 %
 
 


 


 
 
International
    242,890       33.9 %     171,821       32.4 %     71,069       41.4 %
 
 


 


 
 
Total Net Revenue
  $ 715,728       100.0 %   $ 530,005       100.0 %   $ 185,723       35.0 %
 
 


 


 
 
                                                 
    Six Months Ended September 30,
          %
    2004
  2003
  Increase
  Change

North America

  $ 683,989       59.6 %   $ 557,025       63.1 %   $ 126,964       22.8 %
 
 


 


 
 
Europe
    399,643       34.8 %     272,928       30.9 %     126,715       46.4 %
Asia Pacific
    38,952       3.4 %     32,088       3.6 %     6,864       21.4 %
Japan
    24,785       2.2 %     21,345       2.4 %     3,440       16.1 %
 
 


 


 
 
International
    463,380       40.4 %     326,361       36.9 %     137,019       42.0 %
 
 


 


 
 
Total Net Revenue
  $ 1,147,369       100.0 %   $ 883,386       100.0 %   $ 263,983       29.9 %
 
 


 


 
 

North America

For the three months ended September 30, 2004, net revenue in North America increased by 32.0 percent as compared to the three months ended September 30, 2003. From a franchise perspective, the net revenue increase was primarily driven by higher sales of products in the following franchises: Def Jam, Madden, The Sims, Burnout and NCAA Football. Increased sales in these franchises resulted in increased net revenue of $119.8 million for the three months ended September 30, 2004 as compared to the three months ended September 30, 2003. This increase was offset by an $11.7 million decrease in our SimCity and Battlefield franchises during the three months ended September 30, 2004 as compared to the three months ended September 30, 2003.

For the six months ended September 30, 2004, net revenue in North America increased by 22.8 percent as compared to the six months ended September 30, 2003. From a franchise perspective, the net revenue increase was primarily driven by higher sales of products in the following franchises: Fight Night, Harry Potter, Madden, Burnout, Need for Speed, The Sims and MVP Baseball. Increased sales in these franchises resulted in increased net revenue of $174.0 million for the six months ended September 30, 2004 as compared to the six months ended September 30, 2003. This increase was offset by a $47.6 million decrease in our NBA STREET franchise during the six months ended September 30, 2004 as compared to the six months ended September 30, 2003.

Europe

For the three months ended September 30, 2004, net revenue in Europe increased by 44.6 percent as compared to the three months ended September 30, 2003. We estimate foreign exchange rates (primarily the Euro and the British pound sterling) strengthened reported European net revenue by approximately $21 million, or 14 percent, for the three months ended September 30, 2004 as compared to the three months ended September 30, 2003. From a franchise perspective, the net revenue increase was primarily due to (1) higher sales of The Sims franchise, (2) sales from our Burnout franchise and (3) sales of Catwoman, which was released in conjunction with the movie of the same title during the three months ended September 30, 2004. Titles from these franchises were released in the three months ended September 30, 2004 with no corresponding release in fiscal 2004. Together, the three items noted above increased net revenue by $93.3 million during the three months ended September 30, 2004 as compared to the three months ended September 30, 2003. This increase was partially offset by lower sales of Soul Calibur II and Freedom Fighters, which reduced net revenue by $27.4 million in the three months ended September 30, 2004 as compared to the three months ended September 30, 2003.

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For the six months ended September 30, 2004, net revenue in Europe increased by 46.4 percent as compared to the six months ended September 30, 2003. We estimate foreign exchange rates (primarily the Euro and the British pound sterling) strengthened reported European net revenue by approximately $32 million, or 12 percent, for the six months ended September 30, 2004 as compared to the six months ended September 30, 2003. From a franchise perspective, the net revenue increase was primarily due to (1) higher sales of the Harry Potter franchise as Harry Potter and the Prisoner of Azkaban was released in conjunction with the blockbuster movie of the same title during the six months ended September 30, 2004, (2) sales of the Burnout franchise, (3) sales of the UEFA Euro franchise as UEFA Euro 2004 was released during the six months ended September 30, 2004 in conjunction with the UEFA Euro 2004 football tournament held in Europe, and (4) higher sales of The Sims franchise. Titles from these franchises were released in the six months ended September 30, 2004 with no corresponding release in fiscal 2004. Together, the four items noted above increased net revenue by $145.5 million during the six months ended September 30, 2004 as compared to the six months ended September 30, 2003. This increase was partially offset by lower sales of Soul Calibur II and Freedom Fighters, which reduced net revenue by $25.1 million in the six months ended September 30, 2004 as compared to the six months ended September 30, 2003.

Asia Pacific

For the three months ended September 30, 2004, net revenue from sales in the Asia Pacific region, excluding Japan, increased by 21.2 percent as compared to the three months ended September 30, 2003. The growth in net revenue was primarily due to higher sales of The Sims and Burnout franchises, as discussed above, partially offset by lower sales in our Rugby franchise. We estimate foreign exchange rates strengthened reported Asia Pacific net revenue by approximately $1 million, or 8 percent, for the three months ended September 30, 2004.

For the six months ended September 30, 2004, net revenue from sales in the Asia Pacific region, excluding Japan, increased by 21.4 percent as compared to the six months ended September 30, 2003. The growth in net revenue was primarily due to higher sales in the Need for Speed, Harry Potter and The Sims franchises, partially offset by lower sales in our Rugby and Command and Conquer franchises. We estimate foreign exchange rates strengthened reported Asia Pacific net revenue by approximately $3 million, or 9 percent, for the six months ended September 30, 2004.

Japan

For the three months ended September 30, 2004, net revenue from sales in Japan increased by 29.3 percent as compared to the three months ended September 30, 2003 primarily due to sales of Gundam GNO 2, Monocrome (Limited), the Need for Speed franchise and Blood Rayne, partially offset by lower sales of the F1 franchise. In addition, we estimate foreign exchange rates strengthened reported Japan net revenue by approximately $1 million, or 9 percent, for the three months ended September 30, 2004.

For the six months ended September 30, 2004, net revenue from sales in Japan increased by 16.1 percent as compared to the six months ended September 30, 2003 primarily due to higher sales of the Harry Potter franchise, Memories Off – Soreka and Gundam GNO 2, partially offset by lower sales of MAX Payne and the MVP Baseball franchise. In addition, we estimate foreign exchange rates strengthened reported Japan net revenue by approximately $2 million, or 8 percent, for the six months ended September 30, 2004.

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Our total net revenue by product line for the three and six months ended September 30, 2004 and 2003 were as follows (in thousands):

                                                 
    Three Months Ended September 30,
  Increase/   %
    2004
  2003
  (Decrease)
  Change

PlayStation 2

  $ 311,839       43.6 %   $ 221,180       41.7 %   $ 90,659       41.0 %
PC
    140,702       19.7 %     93,022       17.6 %     47,680       51.3 %
Xbox
    141,936       19.8 %     68,691       13.0 %     73,245       106.6 %
Nintendo GameCube
    38,181       5.3 %     24,553       4.6 %     13,628       55.5 %
Game Boy Advance
    10,081       1.4 %     3,809       0.7 %     6,272       164.7 %
Subscription Services
    12,554       1.8 %     11,124       2.1 %     1,430       12.9 %
 
 


 


 
 
EA Studio Net Product Revenue
    655,293       91.6 %     422,379       79.7 %     232,914       55.1 %
Co-publishing and Distribution
    48,913       6.8 %     92,512       17.5 %     (43,599 )     (47.1 %)
Advertising, Programming, Licensing, and Other
    11,522       1.6 %     15,114       2.8 %     (3,592 )     (23.8 %)
 
 


 


 
 
Total Net Revenue
  $ 715,728       100.0 %   $ 530,005       100.0 %   $ 185,723       35.0 %
 
 


 


 
 
                                                 
    Six Months Ended September 30,
  Increase/   %
    2004
  2003
  (Decrease)
  Change

PlayStation 2

  $ 473,815       41.3 %   $ 339,549       38.4 %   $ 134,266       39.5 %
PC
    207,453       18.1 %     173,360       19.6 %     34,093       19.7 %
Xbox
    199,146       17.4 %     100,212       11.4 %     98,934       98.7 %
Nintendo GameCube
    64,605       5.6 %     45,707       5.2 %     18,898       41.3 %
Game Boy Advance
    28,069       2.4 %     6,168       0.7 %     21,901       355.1 %
Subscription Services
    24,994       2.2 %     24,755       2.8 %     239       1.0 %
 
 


 


 
 
EA Studio Net Product Revenue
    998,082       87.0 %     689,751       78.1 %     308,331       44.7 %
Co-publishing and Distribution
    116,105       10.1 %     164,059       18.6 %     (47,954 )     (29.2 %)
Advertising, Programming, Licensing, and Other
    33,182       2.9 %     29,576       3.3 %     3,606       12.2 %
 
 


 


 
 
Total Net Revenue
  $ 1,147,369       100.0 %   $ 883,386       100.0 %   $ 263,983       29.9 %
 
 


 


 
 

PlayStation 2

In the three and six months ended September 30, 2004, net revenue from PlayStation 2 products increased $90.7 million and $134.3 million, respectively, as compared to the corresponding periods in the prior year. As a percentage of total net revenue, sales of PlayStation 2 products increased by 1.9 percentage points and 2.9 percentage points in the three and six months ended September 30, 2004, respectively. The increase in net revenue was primarily due to growth in the installed base driven by Sony’s price reductions in the U.S. in May 2004 and in Europe in August 2004, and overall greater demand for our products. We released nine and twelve titles, respectively, on the PlayStation 2 platform during the three and six months ended September 30, 2004, as compared to six and nine titles, respectively, being released in the three and six months ended September 30, 2003.

PC

In the three and six months ended September 30, 2004, net revenue from PC-based products increased $47.7 million and $34.1 million, respectively, as compared to the corresponding periods in the prior year. As a percentage of total net revenue, sales of PC products increased by 2.1 percentage points and decreased by 1.5 percentage points, respectively, during the three and six months ended September 30, 2004. PC net revenue increased primarily due to higher sales in The Sims and Harry Potter franchises as discussed above, which were partially offset by lower sales in the Medal of Honor and Command and Conquer franchises. We released six and nine titles, respectively, for the PC during the three and six months ended September 30, 2004, as compared to ten and twelve titles, respectively, being released in the three and six months ended September 30, 2003.

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Xbox

In the three and six months ended September 30, 2004, net revenue from Xbox products increased $73.2 million and $98.9 million, respectively, as compared to the corresponding periods in the prior year. As a percentage of total net revenue, sales of Xbox products increased by 6.8 percentage points and 6.0 percentage points, respectively, in the three and six months ended September 30, 2004. The increase in net revenue was primarily due to growth in the installed base driven by Microsoft’s price reductions in the U.S. in March 2004 and in Europe in August 2004, and overall greater demand for our products. We released eight and eleven titles, respectively, on the Xbox platform during the three and six months ended September 30, 2004, as compared to five and seven titles, respectively, being released in the three and six months ended September 30, 2003.

Nintendo GameCube

In the three and six months ended September 30, 2004, net revenue from Nintendo GameCube products increased $13.6 million and $18.9 million, respectively, as compared to the corresponding periods in the prior year. As a percentage of total net revenue, sales of Nintendo GameCube products increased by 0.7 percentage points and 0.4 percentage points, respectively, in the three and six months ended September 30, 2004. The increase in net revenue was primarily due to growth in the installed base of the Nintendo GameCube driven by Nintendo’s price reduction in the U.S. in September 2003. We released seven and eight titles, respectively, on the Nintendo GameCube platform during the three and six months ended September 30, 2004, as compared to four and seven titles, respectively, being released in the three and six months ended September 30, 2003.

Game Boy Advance

In the three and six months ended September 30, 2004, net revenue from Game Boy Advance products increased $6.3 million and $21.9 million, respectively, as compared to the corresponding periods in the prior year, primarily due to sales in the Harry Potter franchise.

Co-Publishing and Distribution

In the three and six months ended September 30, 2004, net revenue from co-publishing and distribution products decreased $43.6 million and $48.0 million, respectively, as compared to the corresponding periods in the prior year. The decrease was primarily due to no co-publishing and distribution titles being released during the three months ended September 30, 2004 and two co-publishing and distribution titles being released during the six months ended September 30, 2004 as compared to six co-publishing and distribution titles being released during the three and six months ended September 30, 2003.

Advertising, Programming, Licensing and Other

In the three months ended September 30, 2004, net revenue from advertising, programming, licensing and other products decreased from $15.1 million to $11.5 million as compared to the three months ended September 30, 2003. The decrease was primarily due to lower net revenue from the Sony PlayStation platform, partially offset by an increase in advertising net revenue.

In the six months ended September 30, 2004, net revenue from advertising, programming, licensing and other products increased from $29.6 million to $33.2 million as compared to the six months ended September 30, 2003. The increase was primarily due to license revenue related to the Nokia N-Gage in the six months ended September 30, 2004, partially offset by a decrease in net revenue from the Sony PlayStation platform.

Cost of Goods Sold

Cost of goods sold for our disk-based and cartridge-based products 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, (4) expenses for defective products, (5) write-off of post-launch prepaid royalty costs, and (6) operations expenses. Cost of goods sold for our online product subscription business 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 ad serving costs.

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Costs of goods sold for the three and six months ended September 30, 2004 and 2003 were as follows (in thousands):

                                         
    September 30,     % of Net     September 30,     % of Net        
    2004     Revenue     2003     Revenue     % Change  

 
Three months ended
  $ 283,911       39.7%     $ 213,762       40.3%       32.8%  

 
Six months ended
  $ 460,666       40.1%     $ 363,725       41.2%       26.7%  

 

In the three months ended September 30, 2004, cost of goods sold as a percentage of total net revenue decreased by 0.6 percentage points to 39.7 percent from 40.3 percent for the three months ended September 30, 2003. This was primarily due to a 2.7 percent decrease in royalty costs offset by increases in inventory-related costs, online and warranty costs, all as a percentage of total net revenue. We also experienced a higher average selling price driven by the release of The Sims 2 on the PC platform.

The 2.7 percent decrease in royalty costs was primarily the result of:

    Lower co-publishing and distribution royalties as a percentage of total net revenue due to the lower mix of co-publishing and distribution net revenue during the three months ended September 30, 2004 as compared to the three months ended September 30, 2003. We estimate that lower co-publishing and distribution royalties as a percentage of total net revenue increased gross margin by 3.9 percentage points.
    Partially offset by higher third-party development royalties as a percentage of total net revenue primarily due to development royalties incurred from sales of Burnout 3: Takedown with no comparable title in the three months ended September 30, 2003. We estimate that higher development royalties as a percentage of total net revenue decreased gross margin by 1.3 percentage points.

The decrease in cost of goods sold was partially offset by the following:

    A 1.2 percent increase in inventory-related costs, which was partially the result of higher inventory management costs associated with the recall of the PlayStation 2 Tiger Woods PGA Tour 2005 game in Europe.
    A 0.9 percent increase in warranty costs and online costs, which was primarily the result of an increase in warranty usage and higher online costs.

In the six months ended September 30, 2004, cost of goods sold as a percentage of total net revenue decreased by 1.1 percentage points to 40.1 percent from 41.2 percent for the six months ended September 30, 2003. This decrease was primarily due to a 3.5 percent decrease in royalty costs offset by increases in inventory-related costs, online and warranty costs, all as a percentage of total net revenue.

The 3.5 percent decrease in royalty costs was primarily the result of:

    Lower co-publishing and distribution royalties as a percentage of total net revenue due to the lower mix of co-publishing and distribution net revenue during the six months ended September 30, 2004 as compared to the six months ended September 30, 2003. We estimate that lower co-publishing and distribution royalties as a percentage of total net revenue increased gross margin by 3.2 percentage points.
    Lower third-party development royalties as a percentage of total net revenue primarily due to a higher mix of titles internally developed in the six months ended September 30, 2004 offset by higher license royalty rates as a percentage of total net revenue. We estimate that the lower development royalties offset by the higher license royalties as a percentage of total net revenue increased gross margin by 0.3 percentage points.

The decrease in cost of goods sold was partially offset by:

    A 1.8 percent increase in inventory-related costs, which was partially the result of higher inventory management costs associated with the recall of the PlayStation 2 Tiger Woods PGA Tour 2005 in Europe.
    A 0.6 percent increase in warranty and online costs, due to increased warranty usage and higher online costs.

Cost of goods sold as a percentage of total net revenue may increase in fiscal 2005 as compared to fiscal 2004 as a result of (1) a gradual decrease in average selling prices as current-generation platforms mature and our industry transitions to next-generation

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technology, (2) overall product mix, and (3) higher inventory-related costs offset by lower co-publishing and distribution royalties, both as a percentage of total net revenue.

Marketing and Sales

Marketing and sales expenses consist of personnel-related costs and advertising, marketing and promotional expenses, net of advertising expense reimbursements from third parties.

Marketing and sales expenses for the three and six months ended September 30, 2004 and 2003 were as follows (in thousands):

                                                 
    September 30,     % of Net     September 30,     % of Net              
    2004     Revenue     2003     Revenue     $ Change     % Change  

 
Three months ended
  $ 107,518       15.0%     $ 64,041       12.1%     $ 43,477       67.9%  

 
Six months ended
  $ 170,738       14.9%     $ 123,125       13.9%     $ 47,613       38.7%  

 

Marketing and sales expenses increased by 67.9 percent and 38.7 percent, for the three and six months ended September 30, 2004, respectively, as compared to the three and six months ended September 30, 2003, primarily due to:

    An increase in our marketing, advertising, contract services and promotional expenses as we incrementally increased our advertising campaigns in Europe, and to a lesser extent in North America, to support the release of our new titles during the quarter, which included Sims 2, Burnout 3: Takedown, Catwoman and Def Jam Fight For NY and increased pre-launch spending to support Madden NFL 2005 and NCAA Football 2005, on multiple platforms – $37.5 million in the three months ended September 30, 2004; $37.6 million in the six months ended September 30, 2004.
    An increase in personnel-related costs due to an increase in headcount – $4.4 million in the three months ended September 30, 2004; $7.0 million in the six months ended September 30, 2004 and an increase in facilities-related expenses – $1.6 million in the three months ended September 30, 2004; $3.0 million in the six months ended September 30, 2004, both to help support the growth of our marketing and sales functions worldwide.

As a percentage of total net revenue, marketing and sales expenses increased for both the three and six months ended September 30, 2004 as compared to the three and six months ended September 30, 2003.

General and Administrative

General and administrative expenses consist of personnel and related expenses of executive and administrative staff, fees for professional services such as legal and accounting, and allowances for bad debts.

General and administrative expenses for the three and six months ended September 30, 2004 and 2003 were as follows (in thousands):

                                                 
    September 30,     % of Net     September 30,     % of Net              
    2004     Revenue     2003     Revenue     $ Change     % Change  

 
Three months ended
  $ 42,043       5.9%     $ 36,032       6.8%     $ 6,011       16.7%  

 
Six months ended
  $ 77,097       6.7%     $ 66,792       7.6%     $ 10,305       15.4%  

 

For the three and six months ended September 30, 2004, general and administrative expenses increased by 16.7 percent and 15.4 percent, respectively, as compared to the three and six months ended September 30, 2003 primarily due to:

    An increase in professional and contracted services to support various corporate initiatives – $6.0 million in the three months ended September 30, 2004; $9.9 million in the six months ended September 30, 2004.

The increases discussed above were partially offset in the six months ended September 30, 2004 by a gain of $2.4 million on the sale of our property in Austin, Texas.

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As a percentage of total net revenue, general and administrative expenses declined for both the three and six months ended September 30, 2004 as compared to the three and six months ended September 30, 2003.

Research and Development

Research and development expenses consist of expenses incurred by our production studios for personnel-related costs, consulting, equipment depreciation and any impairment of prepaid royalties for pre-launch products. Research and development expenses for our online business include expenses incurred by our studios consisting of direct development costs and related overhead costs in connection with the development and production of our online games. Research and development expenses also include expenses associated with development of website content, network infrastructure direct expenses, software licenses and maintenance, and network and management overhead.

Research and development expenses for the three and six months ended September 30, 2004 and 2003 were as follows (in thousands):

                                                 
    September 30,     % of Net     September 30,     % of Net              
    2004     Revenue     2003     Revenue     $ Change     % Change  

 
Three months ended
  $ 156,839       21.9%     $ 113,493       21.4%     $ 43,346       38.2%  

 
Six months ended
  $ 287,481       25.1%     $ 204,615       23.2%     $ 82,866       40.5%  

 

For the three and six months ended September 30, 2004, research and development expenses increased by 38.2 percent and 40.5 percent, respectively, as compared to the three and six months ended September 30, 2003 primarily due to:

    An increase in personnel-related costs due to an increase in employee headcount in our North American studios – $29.6 million in the three months ended September 30, 2004; $51.2 million in the six months ended September 30, 2004.
    An overall increase in external development expenses primarily related to the development of new products with our co-publishing partners – $8.6 million in the three months ended September 30, 2004; $22.9 million in the six months ended September 30, 2004.
    An increase in facilities-related expenses to support our studio expansions in North America and Japan – $5.2 million in the three months ended September 30, 2004; $7.9 million in the six months ended September 30, 2004.

As a percentage of total net revenue, research and development expenses increased during the three and six months ended September 30, 2004 as compared to the three and six months ended September 30, 2003, as we continued to support the global growth of our research and development capabilities. We expect increased research and development spending to continue in fiscal 2005 as we continue to invest in next-generation tools and technologies, products for new platforms, and, to a lesser extent, as we increase spending on titles for the PC and current-generation console products.

Interest and Other Income, Net

Interest and other income, net, for the three and six months ended September 30, 2004 and 2003 were as follows (in thousands):

                                                 
    September 30,     % of Net     September 30,     % of Net              
    2004     Revenue     2003     Revenue     $ Change     % Change  

 
Three months ended
  $ 12,183       1.7%     $ 9,130       1.7%   $ 3,053       33.4%  

 
Six months ended
  $ 21,342       1.9%     $ 13,979       1.6%     $ 7,363       52.7%  

 

Interest and other income, net, during the three and six months ended September 30, 2004 increased from the three and six months ended September 30, 2003 primarily due to:

    An increase of $4.8 million due to a gain of $4.2 million on investments in the three and six months ended September 30, 2004 compared to a loss of $0.6 million in the three and six months ended September 30, 2003.

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    An increase in interest income as a result of higher average cash, cash equivalents and short-term investments balances in the current year – $2.9 million in the three months ended September 30, 2004; $3.7 million in the six months ended September 30, 2004.

The increases discussed above were partially offset by increases in the net losses from our foreign currency activities – $4.7 million in the three months ended September 30, 2004; $2.1 million in the six months ended September 30, 2004.

Income Taxes

Income taxes for the three and six months ended September 30, 2004 and 2003 were as follows (in thousands):

                                         
    September 30,     Effective     September 30,     Effective        
    2004     Tax Rate     2003     Tax Rate     % Change  

 
Three months ended
  $ 39,724       29.0%     $ 34,409       31.0%       15.4%  

 
Six months ended
  $ 49,618       29.0%     $ 42,662       31.0%       16.3%  

 

Our effective income tax rate reflects tax benefits derived from significant operations outside the U.S., which are generally taxed at rates lower than the U.S. statutory rate of 35 percent. Our effective income tax rate was 29 percent for the three and six months ended September 30, 2004 and 31 percent for the three and six months ended September 30, 2003. Our reduced effective income tax rate in the three and six months ended September 30, 2004 primarily reflects the projected geographic mix of taxable income subject to lower tax rates for fiscal 2005.

We intend to indefinitely reinvest our international earnings outside the U.S. and, accordingly, have not provided U.S. taxes that would be incurred if such earnings were repatriated back to the U.S.

We are currently projecting an effective income tax rate of approximately 29 percent for fiscal 2005; however, our actual effective income tax rates for fiscal 2005 and future periods can differ from this projected effective income tax rates due to a variety of factors.

Impact of Recently Issued Accounting Standards

In March 2004, the Financial Accounting Standards Board (“FASB”) issued an exposure draft on the Proposed Statement of Financial Accounting Standards, “Share-Based Payment – an amendment of FASB Statements No. 123 and 95”. The proposed statement addresses the accounting for share-based payment transactions with employees and other third-parties. The proposed standard would eliminate the ability to account for share-based compensation transactions using Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees”, and generally would require that such transactions be accounted for using a fair-value-based method. If the final standard is approved as currently drafted in the exposure draft, it would have a material impact on the amount of earnings we report beginning in the second quarter of fiscal 2006. We have not yet determined the impact that the proposed statement will have on our business.

In March 2004, the FASB ratified the measurement and recognition guidance and certain disclosure requirements for impaired securities as described in Emerging Issues Task Force (“EITF”) Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”. In September 2004, the FASB issued a proposed Staff Position (“FSP”) EITF Issue No. 03-1-a, “Implementation Guidance for the Application of Paragraph 16 of EITF 03-1”. The proposed FSP will provide measurement and recognition guidance with respect to debt securities that are impaired solely due to interest rates and/or sector spreads. The FSP has delayed the effective date until such time that they issue the final standard. Management has not determined what impact the adoption of the measurement and recognition guidance in EITF Issue No. 03-1 will have on our financial statements.

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LIQUIDITY AND CAPITAL RESOURCES

                         
    As of September 30,
     
                    Increase/  
(In millions)   2004     2003     (Decrease)  
   
 
 
 

Cash, cash equivalents and short-term investments

  $ 2,490     $ 1,734     $ 756  
Marketable equity securities
          1       (1 )
   
 
 
 
 
  $ 2,490     $ 1,735     $ 755  
   
 
 
 

Percentage of total assets

    67.2%       64.7%          
                         
    Six Months Ended
     
    September 30,     September 30,        
(In millions)   2004     2003     Decrease  
   
 
 
 

Cash provided by operating activities

  $ 23     $ 28     $ (5 )
Cash used in investing activities
    (873 )     (745 )     (128 )
Cash provided by financing activities
    86       137       (51 )
Effect of foreign exchange on cash and cash equivalents
          6       (6 )
   
 
 
 
Net decrease in cash and cash equivalents
  $ (764 )   $ (574 )   $ (190 )
   
 
 
 

Changes in Cash Flow
During the six months ended September 30, 2004, we generated $23.1 million of cash in operating activities as compared to $28.2 million for the six months ended September 30, 2003. The decrease in cash flow was primarily the result of tax payments made during the six months ended September 30, 2004, partially offset by an increase in net income during the same period. We expect to make payments of approximately $57 million related to our acquisition of Criterion Software Group Ltd. (an investing activity) during the third quarter of fiscal 2005; however, we expect to generate significant operating cash flow during the remainder of fiscal 2005. For the six months ended September 30, 2004, our primary use of cash in non-operating activities consisted of net purchases of $845.6 million in short-term investments and $45.3 million in capital expenditures, primarily related to the expansions of our Los Angeles and Vancouver studios as well as upgrades to our worldwide ERP systems. These non-operating expenditures were partially offset by $85.5 million in proceeds from the sale of our common stock through stock plans and $15.5 million in proceeds from the sale of property during the six months ended September 30, 2004. We anticipate making continued capital investments in our Vancouver studio during the remainder of fiscal 2005.

Receivables, net
Our gross accounts receivable balances were $502.0 million and $366.6 million as of September 30, 2004 and March 31, 2004, respectively. The increase in our accounts receivable balance was expected, due to our seasonal product release schedule. We typically experience our highest sales levels during our third quarter ending December 31st, as a result of holiday season sales and, accordingly, we expect our accounts receivable balance to increase during our third quarter. Reserves for sales returns, pricing allowances and doubtful accounts decreased from $154.7 million as of March 31, 2004 to $122.6 million as of September 30, 2004. Our reserves remained relatively constant as a percentage of trailing nine month total net revenue as of September 30, 2004. We believe these reserves are adequate based on historical experience and our current estimate of potential returns, price protection and allowances.

Inventories
Inventories increased to $79.3 million as of September 30, 2004 from $55.1 million as of March 31, 2004 primarily due to the seasonality of our business as we build inventory levels to support holiday season sales in the third quarter. No single title represented more than $6.0 million of inventory as of September 30, 2004.

Other current assets
Other current assets decreased to $140.9 million as of September 30, 2004 from $161.9 million as of March 31, 2004 primarily due to the receipt of other non-trade receivables.

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Accounts payable
Accounts payable increased to $172.0 million as of September 30, 2004 from $114.1 million as of March 31, 2004 primarily due to the higher cost of goods sold volume and the increased marketing and advertising spending we experienced in the second quarter of fiscal 2005 as compared to the fourth quarter of fiscal 2004.

Accrued and other liabilities
Our accrued and other liabilities decreased to $587.3 million as of September 30, 2004 from $630.1 million as of March 31, 2004, primarily as a result of the payment of our fiscal 2004 bonus accrual. We anticipate that our accrued and other liabilities balance will increase during our third quarter as we typically experience higher balances to support our operations during the holiday season.

Financial Condition
We believe the existing cash, cash equivalents, short-term investments, marketable equity securities and cash generated from operations will be sufficient to meet our operating requirements for at least the next twelve months, including working capital requirements, capital expenditures, our share repurchase program, and potential future acquisitions or strategic investments. We may choose at any time to raise additional capital to strengthen our financial position, facilitate expansion, pursue strategic investments or to take advantage of business opportunities as they arise. There can be no guarantee 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.

A portion of our cash is generated from operations domiciled in foreign tax jurisdictions (approximately $505.5 million as of September 30, 2004) that is designated as indefinitely reinvested in the respective tax jurisdiction. While we have no plans to repatriate these funds to the United States in the short-term, if we were required to do so to fund our operations in the United States, we would accrue and pay additional taxes in connection with their repatriation.

On October 18, 2004, our Board of Directors authorized a program to repurchase up to an aggregate of $750 million of shares of our common stock. Pursuant to the authorization, we may repurchase shares of our common stock from time to time in the open market or through privately negotiated transactions over the course of a twelve-month period.

On January 8, 2004, we filed an amended registration statement on Form S-3 with the SEC. This registration statement, including the base prospectus contained therein, became effective on January 15, 2004 and uses a “shelf” registration process. This shelf registration statement allows us, at any time, to offer any combination of securities described in the prospectus in one or more offerings up to a total amount of $2.0 billion. Unless otherwise specified in a prospectus supplement accompanying the base prospectus, we will 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 (1) customer demand and acceptance of our titles on new platforms and new versions of our titles on existing platforms, (2) our ability to collect our accounts receivable as they become due, (3) successfully achieving our product release schedules and attaining our forecasted sales objectives, (4) the impact of competition, (5) domestic and international economic conditions, (6) seasonality in operating results, (7) risks of product returns and the other risks described in the “Risk Factors” section below.

Contractual Obligations and Commercial Commitments

Letters of Credit
In July 2002, we provided an irrevocable standby letter of credit to Nintendo of Europe. The standby letter of credit guarantees performance of our obligations to pay Nintendo of Europe for trade payables of up to 8.0 million. The standby letter of credit expires in July 2005. As of September 30, 2004, we had 5.3 million payable to Nintendo of Europe covered by this standby letter of credit.

In August 2003, we provided an irrevocable standby letter of credit to 300 California Associates II, LLC as a replacement for our security deposit for office space. The standby letter of credit guarantees performance of our obligations to pay our lease commitment up to $1.1 million. The standby letter of credit expires in December 2006. As of September 30, 2004, we did not have a payable balance on this standby letter of credit.

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Development, Celebrity, League and Content Licenses: Payments and Commitments
The products produced by 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 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 are not dependent on any deliverables. Celebrities and organizations with whom we have contracts include: FIFA and UEFA (professional soccer); NASCAR (stock car racing); John Madden (professional football); National Basketball Association (professional basketball); PGA TOUR (professional golf); Tiger Woods (professional golf); National Hockey League and NHLPA (professional hockey); Warner Bros. (Harry Potter, Catwoman and Superman); MGM/Danjaq (James Bond); New Line Productions (The Lord of the Rings); National Football League and Players Inc. (professional football); Collegiate Licensing Company (collegiate football and basketball); ISC (stock car racing); Major League Baseball Properties; MLB Players Association (professional baseball) and Island Def Jam (fighting). These developer and content license commitments represent the sum of (i) the cash payments due under non-royalty-bearing licenses and services agreements, and (ii) the minimum 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 marketing commitments are included in the table below.

The following table summarizes our minimum contractual obligations and commercial commitments as of September 30, 2004, and the effect we expect them to have on our liquidity and cash flow in future periods (in thousands):

                                                 
    Contractual Obligations
  Commercial Commitments
     
Fiscal Year           Developer/             Bank and     Letters          
Ended           Licensee             Other     of        
March 31,   Leases (1)     Commitments (2)     Marketing     Guarantees     Credit     Total  

 
 
 
 
 
2005 (remaining six months)
  $ 13,467     $ 31,302     $ 15,753     $ 1,973     $ 6,464     $ 68,959  
2006
    27,807       32,951       6,892       223             67,873  
2007
    22,524       15,470       3,586       223             41,803  
2008
    17,372       15,822       3,586       223             37,003  
2009
    13,217       10,755       3,586       222             27,780  
Thereafter
    40,875       11,899       3,587       222             56,583  
   
 
 
 
 
 

Total

  $ 135,262     $ 118,199     $ 36,990     $ 3,086     $ 6,464     $ 300,001  
   
 
 
 
 
 

(1) See discussion on operating leases in the “Off-Balance Sheet Commitments” section below and Note 8 in the Notes to Condensed Consolidated Financial Statements, included in Item 1 hereof, for additional information.

(2) Developer/licensee commitments include $49.1 million of commitments to developers or licensers that have been included in our Condensed Consolidated Balance Sheet as of September 30, 2004 because the developer does not have any significant performance obligations to us. These commitments are included in both current and long-term assets and liabilities.

The lease commitments disclosed above exclude commitments included in our restructuring activities for contractual rental commitments of $26.0 million under real estate leases for unutilized office space, offset by $16.5 million of estimated future sub-lease income. These amounts were expensed in the periods of the related restructuring and are included in our accrued and other liabilities reported on our Condensed Consolidated Balance Sheet as of September 30, 2004. Please see Note 5 in the Notes to Condensed Consolidated Financial Statements, included in Item 1 hereof, for additional information.

Litigation
On July 29, 2004, a class action lawsuit, Kirschenbaum v. Electronic Arts Inc., was filed against us in Superior Court in San Mateo, California. The complaint alleges that we improperly classified “Image Production Employees” in California as exempt employees and seeks injunctive relief, unspecified monetary damages, interest and attorneys’ fees. We have not yet answered the complaint.

In addition, we are subject to other claims and litigation arising in the ordinary course of business. Our management, after review and consultation with counsel, considers that any liability from any reasonably foreseeable disposition of such claims and

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litigation, individually or in the aggregate, would not have a material adverse effect on our consolidated financial position or results of operations.

Director Indemnity Agreements
We have entered into an indemnification agreement with the members of our Board of Directors to indemnify our Directors 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 as a result of their service as members of our Board of Directors.

Transactions with Related Parties

On June 24, 2002, we hired Warren Jenson and agreed to loan him $4,000,000, to be forgiven over four years based on his continuing employment. The loan does not bear interest. On June 24, 2004, pursuant to the terms of the loan agreement, we forgave two million dollars of the loan and provided Mr. Jenson approximately $1.6 million to offset the tax implications of the forgiveness. As of September 30, 2004, the remaining outstanding loan balance was $2,000,000, which will be forgiven on June 24, 2006, provided that Mr. Jenson has not voluntarily resigned his employment with us or been terminated for cause prior to that time. No additional funds will be provided to offset the tax implications of the forgiveness of the remaining two million dollars.

OFF-BALANCE SHEET COMMITMENTS

Lease Commitments
We lease certain of our current facilities and certain equipment under non-cancelable operating lease agreements. We are required to pay property taxes, insurance and normal maintenance costs for certain of our facilities and will be required to pay any increases over the base year of these expenses on the remainder of our facilities.

In February 1995, we entered into a build-to-suit lease with a third party for our headquarters facility in Redwood City, California, which was refinanced with Keybank National Association in July 2001 and expires in July 2006. We accounted for this arrangement as an operating lease in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 13, “Accounting for Leases”, as amended. Existing campus facilities developed in phase one comprise a total of 350,000 square feet and provide space for sales, marketing, administration and research and development functions. We have an option to purchase the property (land and facilities) for a maximum of $145.0 million or, at the end of the lease, to arrange for (i) an extension of the lease or (ii) sale of the property to a third party while we retain an obligation to the owner for approximately 90 percent of the difference between the sale price and the guaranteed residual value of up to $128.9 million if the sales price is less than this amount, subject to certain provisions of the lease.

In December 2000, we entered into a second build-to-suit lease with Keybank National Association for a five-year term beginning December 2000 to expand our Redwood City, California headquarters facilities and develop adjacent property adding approximately 310,000 square feet to our campus. Construction was completed in June 2002. We accounted for this arrangement as an operating lease in accordance with SFAS No. 13, as amended. The facilities provide space for marketing, sales and research and development. We have an option to purchase the property for a maximum of $130.0 million or, at the end of the lease, to arrange for (i) an extension of the lease, or (ii) sale of the property to a third party while we retain an obligation to the owner for approximately 90 percent of the difference between the sale price and the guaranteed residual value of up to $118.8 million if the sales price is less than this amount, subject to certain provisions of the lease.

We believe the estimated fair values of both properties under these operating leases are in excess of their respective guaranteed residual values as of September 30, 2004.

For the two lease agreements with Keybank National Association, as described above, the lease rates are based upon the Commercial Paper Rate and require us to maintain certain financial covenants as shown below, all of which we were in compliance with as of September 30, 2004.

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            Actual as of
            September 30,
Financial Covenants
  Requirement
  2004

Consolidated Net Worth

  $1,775 million   $2,906 million
Fixed Charge Coverage Ratio    3.00    25.12
Total Consolidated Debt to Capital    60%    7.9%
Quick Ratio -
  Q1 & Q2    1.00    11.52
 
  Q3 & Q4    1.75    N/A

In July 2003, we entered into a lease agreement with an independent third party (the “Landlord”) for a studio facility in Los Angeles, California, which commenced in October 2003 and expires in September 2013 with two five-year options to extend the lease term. Additionally, we have options to purchase the property after five and ten years based on the fair market value of the property at the date of sale, a right of first offer to purchase the property upon terms offered by the Landlord, and a right to share in the profits from a sale of the property. We have accounted for this arrangement as an operating lease in accordance with SFAS No. 13, as amended. Existing campus facilities comprise a total of 243,000 square feet and provide space for research and development functions. Our rental obligation under this agreement is $50.2 million over the initial ten-year term of the lease. This commitment is offset by sublease income of $5.8 million for the sublet to an affiliate of the Landlord of 18,000 square feet of the Los Angeles facility, which commenced in October 2003 and expires in September 2013, with options of early termination by the affiliate after five years and by us after four and five years.

In June 2004, we entered into a lease agreement with an independent third party for a studio facility in Orlando, Florida, which will commence in January 2005 and expire in June 2010, with one five-year option to extend the lease term. The campus facilities comprise a total of 117,000 square feet, which we intend to use for research and development functions. We have accounted for this arrangement as an operating lease in accordance with SFAS No. 13, as amended. Our rental obligation over the initial five-and-a-half year term of the lease is $13.2 million.

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RISK FACTORS

Our business is subject to many risks and uncertainties, which may affect our future financial performance. 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. 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 securities could decline.

Our industry is cyclical and if we experience a decline in sales as consumers anticipate next generation products, our operating results will suffer.

Our industry is cyclical. Videogame platforms have historically had a life cycle of four to six years. Over the course of the next few years, we expect Sony, Microsoft and Nintendo to introduce new videogame platforms into the market. As one group of platforms is reaching the end of its cycle and new platforms are emerging, sales of videogames for such consoles generally decline. For example, consumers often defer game software purchases until the new platforms are available. This decline may not be offset by increased sales of products for the new platform. For example, following the launch of Sony’s PlayStation 2 platform, we experienced a significant decline in revenue from sales of products for Sony’s older PlayStation game console, which was not immediately offset by revenue generated from sales of products for the PlayStation 2 platform. If we experience a similar trend as the next generation of products is introduced into the market, our operating results will suffer and our financial position will be harmed.

Our business is highly dependent on the success and timely release of new videogame platforms, as well as our ability to develop commercially successful products for these platforms.

We derive most of our revenue from the sale of products for play on videogame platforms manufactured by third parties, such as Sony’s PlayStation 2. The success of our products is driven in large part by the timely release and success of new videogame hardware systems, our ability to accurately predict which platforms will be most successful in the marketplace, and our ability to develop commercially successful products for these platforms. We must make product development decisions and commit significant resources well in advance of the anticipated introduction of a new platform. A new platform for which we are developing products may be delayed, may not succeed or may have a shorter life cycle than anticipated. If the platforms for which we are developing products are not released when anticipated or do not attain wide market acceptance, our revenue growth will suffer, we may be unable to fully recover the resources we have committed, and our financial performance will be harmed.

Our platform licensors set the royalty rates and other fees that we must pay to publish games for their platforms, and therefore have significant influence on our costs. If one or more of the platform licensors adopt a different fee structure for future game consoles or we are unable to obtain such licenses, our profitability will be materially impacted.

In the next few years, we expect our platform licensors to introduce new game machines into the market. For example, Sony has indicated that it plans to release a next-generation successor to the PlayStation 2 as soon as late 2005 or early 2006. In order to publish products for a new game machine, we must take a license from the platform licensor which gives the platform licensor the opportunity to set the fee structure that we must pay in order to publish games for that platform. Similarly, the platform licensors have retained the flexibility to change their fee structures for online gameplay and features for their consoles. The control that platform licensors have over the fee structures for their future platforms and online access makes it difficult for us to predict our costs and profitability in the medium to long term. It is also possible that platform licensors will not renew our licenses. Because publishing products for videogame consoles is the largest portion of our business, any increase in fee structures or failure to secure a license relationship would have a significant negative impact on our business model and profitability.

If we do not consistently meet our product development schedules, our operating results will be adversely affected.

Our business is highly seasonal, with the highest levels of consumer demand, and a significant percentage of our revenue, occurring in the December quarter. In addition, we seek to release many of our products in conjunction with specific events, such as the release of a related movie or the beginning of a sports season or major sporting event. If we miss these key selling periods, due to product delays 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

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the increasing complexity of our products, and the need to refine and tune our products prior to their release. We have in the past experienced development delays for several of our products. Failure to meet anticipated production or “go live” schedules may cause a shortfall in our revenue and profitability and cause our operating results to be materially different from expectations.

Our business is intensely competitive and increasingly “hit” driven. If we do not continue to deliver “hit” products or if consumers prefer our competitors’ products over our own, our operating results could suffer.

Competition in our industry is intense, new products are regularly introduced, and a relatively small number of “hit” titles accounts for a significant portion of total sales. If our competitors develop more successful products, offer competitive products at lower price points, or if we do not continue to develop consistently high-quality and well-received products, our revenue, margins, and profitability will decline.

If we are unable to maintain or acquire licenses to intellectual property, we will publish fewer hit titles and our revenue, profitability and cash flows will decline. Competition for these licenses may make them more expensive, and increase our costs.

Many of our products are based on or incorporate intellectual property owned by others. For example, our EA SPORTSTM products include rights licensed from the major sports leagues and players associations. Similarly, many of our hit EA GAMESTM franchises, such as Bond, Harry Potter and Lord of the Rings, are based on key film and literary licenses. Competition for these licenses is intense. If we are unable to maintain these licenses and obtain additional licenses with significant commercial value, our revenues and profitability will decline significantly. Competition for these licenses may also drive up the advances, guarantees and royalties that we must pay to the licensor, which could significantly increase our costs.

If patent claims continue to be asserted against us, we may be unable to sustain our current business models or profits.

Many patents have been issued that may apply to widely used game technologies. Additionally, infringement claims under many recently issued patents are now being asserted against Internet implementations of existing games. Several such claims have been asserted against us. Such claims can harm our business. We incur substantial expenses in evaluating and defending against such claims, regardless of the merits of the claims. In the event that there is a determination that we have infringed a third-party patent, we could incur significant monetary liability and be prevented from using the rights in the future.

Other intellectual property claims may increase our product costs or require us to cease selling affected products.

Many of our products include extremely realistic graphical images, and we expect that as technology continues to advance, images will become even more realistic. Some of the images and other content are based on real-world examples that may inadvertently infringe upon the intellectual property rights of others. Although we believe that we make reasonable efforts to ensure that our products do not violate the intellectual property rights of others, it is possible that third parties still may claim infringement. From time to time, we receive communications from third parties regarding such claims. Existing or future infringement claims against us, whether valid or not, may be time consuming and expensive to defend. Such claims or litigations could require us to stop selling the affected products, redesign those products to avoid infringement, or obtain a license, all of which would be costly and harm our business.

From time to time we may become involved in other litigation which could adversely affect us.

We are currently, and from time to time in the future may become, subject to other claims and litigation, which could be expensive, lengthy, and disruptive to normal business operations. For further information regarding certain claims and litigation in which we are involved, see “Part II – Item 1. Legal Proceedings” below. The outcome of any claims or litigation may be difficult to predict and could have a material adverse effect on our business, operating results, or financial condition.

Our business, our products and our distribution are subject to increasing regulation in key territories of content, consumer privacy and online delivery. If we do not successfully respond to these regulations, our business may suffer.

Legislation is continually being introduced that may affect both the content of our products and their distribution. For example, privacy laws in the United States and Europe impose various restrictions on our web sites. Those rules vary by territory although the Internet recognizes no geographical boundaries. Other countries, such as Germany, have adopted laws regulating content both in packaged goods and those transmitted over the Internet that are stricter than current United States laws. In the United

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States, the federal and several state governments are considering content restrictions on products such as ours, as well as restrictions on distribution of such products. Any one or more of these factors could harm our business by limiting the products we are able to offer to our customers and by requiring additional differentiation between products for different territories to address varying regulations. This additional product differentiation would be costly.

Technology changes rapidly in our business, and if we fail to anticipate new technologies, the quality, timeliness and competitiveness of our products will suffer.

Rapid technology changes in our industry require us to anticipate, sometimes years in advance, which technologies our products must take advantage of in order to make them competitive in the market at the time they are released. Therefore, we usually start our product development with a range of technical development goals that we hope to be able to achieve. We may not be able to achieve these goals, or our competition may be able to achieve them more quickly than we can. In either case, our products may be technologically inferior to competitive products, or less appealing to consumers, or both. If we cannot achieve our technology goals within the original development schedule of our products, then we may delay products until these technology goals can be achieved, which may delay or reduce revenue and increase our development expenses. Alternatively, we may increase the resources employed in research and development in an attempt to accelerate our development of new technologies, either to preserve our product launch schedule or to keep up with our competition, which would increase our development expenses.

If we do not continue to attract and retain key personnel, we will be unable to effectively conduct our business.

The market for technical, creative, marketing and other personnel essential to the development and marketing of our products and management of our businesses is extremely competitive. Our leading position within the interactive entertainment industry makes us a prime target for recruiting of executives and key creative talent. If we cannot successfully recruit and retain the employees we need, or replace key employees following their departure, our ability to develop and manage our businesses will be impaired.

Our platform licensors are our chief competitors and frequently control the manufacturing of and/or access to our videogame products. If they do not approve our products, we will be unable to ship to our customers.

Our agreements with hardware licensors (such as Sony for the PlayStation 2, Microsoft for the Xbox and Nintendo for the Nintendo GameCube) typically give significant control to the licensor over the approval and manufacturing of our products, which could, in certain circumstances, leave us unable to get our products approved, manufactured and shipped to customers. These hardware licensors are also our chief competitors. In most events, control of the approval and manufacturing process by the platform licensors increases both our manufacturing lead times and costs as compared to those we can achieve independently. While we believe that our relationships with our hardware licensors are currently good, the potential for these licensors to delay or refuse to approve or manufacture our products exists. Such occurrences would harm our business and our financial performance.

We compete directly with Microsoft and Sony for sales of products with online capabilities. We also require compatibility code and the consent of each in order to include online capabilities in our products for their respective platforms. As online capabilities for videogame platforms become more significant, Microsoft and Sony could restrict our ability to provide online capabilities for our console platform products. If Microsoft or Sony refused to approve our products with online capabilities or significantly impacted the financial terms on which these services are offered to our customers, our business could be harmed.

Our international net revenue is subject to currency fluctuations.

For the six months ended September 30, 2004, international net revenue comprised 40 percent of our total net revenue. For the fiscal year ended March 31, 2004, international net revenue comprised 45 percent of total net revenue. We expect foreign sales to continue to account for a significant portion of our total net revenue. Such sales are subject to unexpected regulatory requirements, tariffs and other barriers. Additionally, foreign sales are primarily made in local currencies, which may fluctuate against the dollar. While we utilize foreign exchange forward contracts to mitigate foreign currency risk associated with foreign currency denominated assets and liabilities (primarily certain intercompany receivables and payables) and from time to time, foreign currency option contracts to hedge foreign currency forecasted transactions (primarily related to revenue generated by our operational subsidiaries), our results of operations and financial condition may, nonetheless, be adversely affected by foreign currency fluctuations.

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Changes in our tax rates or exposure to additional tax liabilities could adversely affect our operating results and financial condition.

We are subject to income taxes in the United States and in various foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes and, in the ordinary course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. We are also required to estimate what our taxes will be in the future. Although we believe our tax estimates are reasonable, they are not binding on tax authorities. Our effective tax rate could be adversely affected by changes in our business, including the mix of earnings in countries with differing statutory tax rates, changes in the elections we make, changes in applicable tax laws as well as other factors. Further, our tax determinations are regularly subject to audit by tax authorities and developments in those audits could adversely affect our income tax provision. Should our ultimate tax liability exceed our estimates, our income tax provision and net income could be materially affected.

We are also required to pay taxes other than income taxes, such as payroll, sales, use, value-added, net worth, property and goods and services taxes, in both the United States and various foreign jurisdictions. We are regularly under examination by tax authorities with respect to these non-income taxes. There can be no assurance that the outcomes from these examinations, changes in our business or changes in applicable tax rules will not have an adverse effect on our operating results and financial condition.

Changes in our worldwide operating structure could have adverse tax consequences.

We are in the process of examining our worldwide operating structure in light of changing tax laws, our current and anticipated business operations, and the pending expiration of an offshore advanced pricing agreement with a foreign tax authority in December 2005 under which our current business operates. In addition, while our current intention is to invest indefinitely our undistributed foreign earnings offshore, we are studying certain provisions of the American Jobs Creation Act of 2004 which provide for a reduced rate of tax on certain repatriations of accumulated foreign earnings. Although we have not yet determined the impact on our effective income tax rate, any significant changes to our operating structure, the failure to reach agreements with tax authorities in the future, or the repatriation of our offshore cash could adversely affect our effective income tax rates for fiscal 2005 and beyond.

Our reported financial results could be adversely affected by changes in financial accounting standards or by the application of existing or future accounting standards to our business as it evolves.

As a result of the enactment of the Sarbanes-Oxley Act and the review of accounting policies by the SEC and national and international accounting standards bodies, the frequency of accounting policy changes may accelerate. For example, the FASB has proposed changes to GAAP that would require us to adopt a different method of determining and accounting for the compensation expense of our employee stock options. This change, as well as other possible changes to accounting standards, could adversely affect our reported results of operations although not necessarily our cash flows. Further, accounting policies affecting software revenue recognition have been the subject of frequent interpretations, which could significantly affect the way we account for revenue related to our products. As we enhance, expand and diversify our business and product offerings, the application of existing or future financial accounting standards, particularly those relating to the way we account for revenue, could have a significant adverse effect on our reported results although not necessarily on our cash flows.

The majority of our sales are made to a relatively small number of key customers. If these customers reduce their purchases of our products or become unable to pay for them, our business could be harmed.

In the U.S., during the six months ended September 30, 2004, over 65 percent of our U.S. sales were made to six key customers. In Europe, our top ten customers accounted for over 35 percent of our sales in that territory in the six months ended September 30, 2004. Worldwide, we had direct sales to one customer, Wal-Mart Stores, Inc., which represented 14 percent of total net revenue during the six months ended September 30, 2004. Though our products are available to consumers through a variety of retailers, the concentration of our sales in one, or a few, large customers could lead to short-term disruption in our sales if one or more of these customers significantly reduced their purchases or ceased to carry our products, and could make us more vulnerable to collection risk if one or more of these large customers became unable to pay for our products. Additionally, our receivables from these large customers increase significantly in the December quarter as they stock up for the holiday selling season. Also, having such a large portion of our total net revenue concentrated in a few customers reduces our negotiating leverage with these customers.

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Acquisitions, investments and other strategic transactions could result in operating difficulties, dilution to our investors and other negative consequences.

We have evaluated, and expect to continue to evaluate, a wide array of potential strategic transactions, including (1) acquisitions of companies, businesses, intellectual properties, and other assets and (2) investments in new interactive entertainment businesses (for example, online and mobile games). Any of these strategic transactions could be material to our financial condition and results of operations. Although we regularly search for opportunities to engage in strategic transactions, we may not be successful in identifying suitable opportunities. We may not be able to consummate potential acquisitions or investments or an acquisition or investment may not enhance our business or may decrease rather than increase our earnings. In addition, the process of integrating an acquired company or business, or successfully exploiting acquired intellectual property or other assets, could divert a significant amount of our management’s time and focus and may create unforeseen operating difficulties and expenditures. Additional risks we face include:

    The need to implement or remediate controls, procedures and policies appropriate for a public company in an acquired company that, prior to the acquisition, lacked these controls, procedures and policies,
    Cultural challenges associated with integrating employees from an acquired company or business into our organization,
    Retaining employees from the businesses we acquire,
    The need to integrate an acquired company’s accounting, management information, human resource and other administrative systems to permit effective management, and
    To the extent that we engage in strategic transactions outside of the United States, we face additional risks, including risks related to integration of operations across different cultures and languages, currency risks and the particular economic, political and regulatory risks associated with specific countries.

Future acquisitions and investments could involve the issuance of our equity securities, potentially diluting our existing stockholders, the incurrence of debt, contingent liabilities or amortization expenses, or write-offs of goodwill, any of which could harm our financial condition. Our stockholders may not have the opportunity to review, vote on or evaluate future acquisitions or investments.

We have begun the implementation of a common set of financial information systems throughout our worldwide organization, which, if not completed in a successful and timely manner, could impede our ability to accurately process, prepare and analyze important financial data.

As part of our effort to improve efficiencies throughout our worldwide organization, we have begun the implementation of a common set of practices, processes and financial information systems. The successful conversion from our current financial information systems to new financial information systems entails a number of risks due to the complexity of the conversion and implementation process. Such risks include verifying the accuracy of the business data and information prior to conversion, the actual conversion of that data and information to the new systems and then using that business data and information in the new systems after the conversion. In addition, because the implementation is company-wide, there is a need for substantial and comprehensive company-wide employee training. While testing of these new systems and processes and training of employees are done in advance of implementation, there are inherent limitations in our ability to simulate a full-scale operating environment in advance of implementation. Finally, there can be no assurance that the conversion to, and the implementation of, the new financial information systems will not impede our ability to accurately and timely process, prepare and analyze the financial data we use in making operating decisions and which form the basis of the financial information we include in the periodic reports we file with the SEC.

Our products are subject to the threat of piracy by a variety of organizations and individuals. If we are not successful in combating and preventing piracy, our sales and profitability could be harmed significantly.

In many countries around the world, more pirated copies of our products are sold than legitimate copies. Though piracy has not had a material impact on our operating results to date, highly organized pirate operations have been expanding globally. In addition, the proliferation of technology designed to circumvent the protection measures we use in our products, the availability of broadband access to the Internet, the ability to download pirated copies of our games from various Internet sites, and the widespread proliferation of Internet cafes using pirated copies of our products, all have contributed to ongoing and expanding piracy. Though we take steps to make the unauthorized copying and distribution of our products more difficult, as do the manufacturers of consoles on which our games are played, neither our efforts nor those of the console manufacturers may be

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successful in controlling the piracy of our products. This could have a negative effect on our growth and profitability in the future.

Our stock price has been volatile and may continue to fluctuate significantly.

As a result of the factors discussed in this report and other factors that may arise in the future, the market price of our common stock historically has been, and we expect will continue to be, subject to significant fluctuations. These fluctuations may be due to factors specific to us, to changes in analysts’ earnings estimates, to factors affecting the computer, software, Internet, entertainment, media or electronics businesses, or to national and international economic conditions.

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 and interest rates. Market risk is the potential loss arising from changes in market rates and prices. Foreign exchange forward and option contracts used to either mitigate or hedge foreign currency exposures and short-term investments are subject to market risk. We do not consider our cash and cash equivalents to be subject to interest rate risk due to their short maturities. We do not enter into derivatives or other financial instruments for trading or speculative purposes.

Foreign Currency Exchange Rate Risk
We utilize foreign exchange forward contracts to mitigate foreign currency risk associated with foreign currency denominated assets and liabilities, primarily certain intercompany receivables and payables. Our foreign exchange forward contracts are accounted for as derivatives whereby the gains and losses on these contracts are reflected in the Condensed Consolidated Statements of Operations. Gains and losses on open contracts at the end of each accounting period resulting from changes in the forward rate are recognized in earnings and are designed to offset gains and losses on the underlying foreign-currency-denominated assets and liabilities. As of September 30, 2004, we had foreign exchange forward contracts, all with maturities of less than one month, to sell approximately $240.7 million in foreign currencies, consisting primarily of British Pounds, Euros and Japanese Yen. Of this amount, $230.1 million represents contracts to sell foreign currency in exchange for U.S. dollars and $10.6 million represents contracts to sell foreign currency in exchange for British Pounds.

From time to time, we hedge our foreign currency risk related to anticipated future sales transactions by purchasing option contracts that generally have maturities of 15 months or less. If qualified, these transactions are designated as cash flow hedges. For the three and six months ended September 30, 2004, we recognized a loss of $0.6 million and $1.2 million, respectively, in earnings associated with the time value of these option contracts.

The counterparties to these forward and options contracts are creditworthy multinational commercial and investment banks. The risks of counterparty nonperformance associated with these contracts are not considered to be material. Notwithstanding our efforts to manage foreign exchange risks, there can be no assurances that our mitigating or hedging activities will adequately protect us against the risks associated with foreign currency fluctuations.

The following table provides information about our foreign currency forward and option contracts as of September 30, 2004. The information is provided in U.S. dollar equivalents. The weighted average contract rate is stated in terms of how many U.S. dollars would be purchased by one unit of foreign currency. The forward contract rates approximate the foreign exchange rates as of September 30, 2004; therefore, the mark-to-market on the contracts is approximately zero. The fair value of our forward and option contracts are recorded in other current assets on our Condensed Consolidated Balance Sheets.

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            Weighted-  
    Notional     Average  
(In thousands, except contract rates)   Amount     Contract Rate  
   
 

Foreign currency to be sold under forward contracts:

               
British Pound
  $ 128,794       1.7888  
Euro
    72,238       1.2244  
Japanese Yen
    15,516       0.0090  
Swiss Franc
    4,757       0.7928  
Swedish Krona
    4,327       0.1352  
Danish Krone
    4,608       0.1646  
South African Rand
    4,472       0.0862  
Norwegian Krone
    3,217       0.1462  
Australian Dollar
    2,820       0.7050  
 
 
 
         
Total
  $ 240,749          
 
 
 
         

Foreign currency to be purchased under forward contracts:

               
British Pound
  $ 10,596       1.7888  
 
 
 
         

Option contracts purchased

               
Sell Euro / Buy U.S. Dollar
  $ 84,868       1.1316  
 
 
 
         

Interest Rate Risk
Our exposure to market rate risk for changes in interest rates relates primarily to our investment portfolio. We do not use derivative financial instruments in our investment portfolio. We manage our interest rate risk by maintaining an investment portfolio primarily consisting of debt instruments of high credit quality and relatively short average maturities. Though we maintain sufficient cash and cash equivalent balances such that we are typically able to hold our investments to maturity, currently, the majority of our investments are callable by the issuer.

As of September 30, 2004, our cash equivalents and short-term investments included $2.3 billion of debt securities, consisting primarily of U.S. agency bonds and money market funds. Notwithstanding our efforts to manage interest rate risks, there can be no assurances that we will be adequately protected against the risks associated with interest rate fluctuations.

The table below presents the amounts and related weighted-average interest rates of our investment portfolio as of September 30, 2004 (in thousands):

                         
    Weighted-              
    Average              
    Interest Rate     Cost     Fair Value  
   
 

Cash equivalents

                       
Variable rate
    1.36%       1,194,524       1,194,524  

Short-term investments

                       
Fixed rate
    1.99%       1,059,506       1,053,467  
Variable rate
    1.83%       50,000       50,229  
           
 
 
          $ 2,304,030     $ 2,298,220  
           
 

Maturity dates for short-term investments range from 4 months to 23 months, with call dates ranging from 1 month to 4 months.

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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 SEC’s 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 and Administrative 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 Chief Financial and Administrative 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 SEC’s rules and forms, and is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial and Administrative Officer, as appropriate to allow timely decisions regarding the required disclosure.

Changes in internal controls. During our last fiscal quarter, no changes occurred in our internal control over financial reporting that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. However, following the enactment of the Sarbanes-Oxley Act and related SEC regulations, we have enhanced our internal controls and disclosure systems through various measures including: detailing certain internal accounting policies; establishing a disclosure committee for the preparation of all periodic SEC reports; establishing an internal audit function; requiring certifications from various trial balance controllers and other financial personnel responsible for our financial statements; and automating certain manual-entry royalty accounting activities through the implementation of new software management systems.

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PART II – OTHER INFORMATION

Item 1.  Legal Proceedings

On July 29, 2004, a class action lawsuit, Kirschenbaum v. Electronic Arts Inc., was filed against us in Superior Court in San Mateo, California. The complaint alleges that we improperly classified “Image Production Employees” in California as exempt employees and seeks injunctive relief, unspecified monetary damages, interest and attorneys’ fees. We have not yet answered the complaint.

In addition, we are subject to other claims and litigation arising in the ordinary course of business. Our management, after review and consultation with counsel, considers that any liability from any reasonably foreseeable disposition of such claims and litigation, individually or in the aggregate, would not have a material adverse effect on our consolidated financial position or results of operations.

Item 4.  Submission of Matters to a Vote of Security Holders

At our Annual Meeting of Stockholders, held on July 29, 2004, our stockholders elected the following individuals to the Board of Directors for one-year terms:

                 
    For     Withheld  
   
 
M. Richard Asher
    262,668,767       8,447,837  
William J. Byron
    263,862,872       7,253,732  
Leonard S. Coleman
    260,652,635       10,463,969  
Gary M. Kusin
    265,881,344       5,235,260  
Gregory B. Maffei
    264,501,294       6,615,310  
Timothy Mott
    263,913,479       7,203,125  
Robert W. Pittman
    267,053,713       4,062,891  
Lawrence F. Probst III
    263,815,801       7,300,803  
Linda J. Srere
    267,119,824       3,996,780  

In addition, the following matters were voted on and approved by the stockholders:

To amend our 2000 Equity Incentive Plan to (a) increase by 11 million the number of shares of common stock reserved for issuance under the Plan, (b) provide for the issuance of awards of restricted stock units, (c) limit the total number of shares underlying awards of restricted stock and restricted stock units to 3 million, (d) provide that the exercise price of nonqualified stock options may not be less than 100% of the fair market value of a share of common stock, (e) reduce the size of initial and annual option grants to Directors under the Plan, and (f) authorize the Compensation Committee to determine the vesting provisions of options granted to Directors under the Plan.

                         
For   Against     Abstain     Broker Non-vote  

 
205,313,855
    43,426,675       1,887,173       20,488,901  

To amend the 2000 Employee Stock Purchase Plan to increase by 1,500,000 the number of shares of common stock reserved for issuance thereunder.

                         
For   Against     Abstain     Broker Non-vote  

 
241,362,977
    7,968,877       1,319,449       20,465,301  

To amend and restate our Certificate of Incorporation to consolidate our Class A and Class B common stock into a single class of common stock by reclassifying each outstanding share of Class A common stock as one share of common stock and converting each outstanding share of Class B common stock into 0.001 share of common stock.

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For   Against     Abstain     Broker Non-vote  

 
269,645,511
    167,780       1,303,313        

To further amend and restate our Certificate of Incorporation to increase the authorized common stock from 500 million total shares of Class A and Class B common stock to 1 billion shares of a single class of common stock.

                         
For   Against     Abstain     Broker Non-vote  

 
227,828,942
    42,006,711       1,280,951        

To ratify the appointment of KPMG LLP as our independent registered public accounting firm for fiscal 2005.

                         
For   Against     Abstain     Broker Non-vote  

 
265,228,938
    4,188,547       1,699,119        

Item 6.  Exhibits

The following exhibits (other than exhibits 32.1 and 32.2, which are furnished with this report) are filed as part of this report:

     
Exhibit    
Number   Title
 
   
3.01 
  Amended and Restated Certificate of Incorporation.
 
   
15.1 
  Awareness Letter of KPMG LLP, Independent Registered Public Accounting Firm.
 
   
31.1 
  Certification of Chairman and Chief Executive Officer pursuant to Rule 13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 
   
31.2
  Certification of Executive Vice President, Chief Financial and Administrative Officer pursuant to Rule 13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 
   
Additional exhibits furnished with this report:
 
   
32.1 
  Certification of Chairman and Chief Executive Officer pursuant to Rule 13a-14(b) of the Exchange Act and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
   
32.2 
  Certification of Executive Vice President, Chief Financial and Administrative Officer pursuant to Rule 13a-14(b) of the Exchange Act and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

     
  ELECTRONIC ARTS INC.
  (Registrant)
 
   
 
   
   /s/ Warren C. Jenson
 
DATED:
  WARREN C. JENSON
November 3, 2004
  Executive Vice President,
  Chief Financial and Administrative Officer

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ELECTRONIC ARTS INC.
FORM 10-Q
FOR THE PERIOD ENDED SEPTEMBER 30, 2004

EXHIBIT INDEX

     
EXHIBIT    
NUMBER   EXHIBIT TITLE
 
   
3.01
  Amended and Restated Certificate of Incorporation.
 
   
15.1
  Awareness Letter of KPMG LLP, Independent Registered Public
Accounting Firm.
 
   
31.1
  Certification of Chairman and Chief Executive Officer pursuant to
Rule 13a-14(a) of the Exchange Act, as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
 
   
31.2
  Certification of Executive Vice President, Chief Financial and
Administrative Officer pursuant to Rule 13a-14(a) of the
Exchange Act, as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
 
   
Additional exhibits furnished with this report:
 
   
32.1
  Certification of Chairman and Chief Executive Officer pursuant to
Rule 13a-14(b) of the Exchange Act and 18 U.S.C. Section 1350,
as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
   
32.2
  Certification of Executive Vice President, Chief Financial and
Administrative Officer pursuant to Rule 13a-14(b) of the
Exchange Act and 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.

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