10-Q 1 0001.txt FORM 10-Q FORM 10-Q SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 -------------------- [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarterly Period Ended September 30, 2000 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 94-2838567 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 209 Redwood Shores Parkway Redwood City, California 94065 (Address of principal executive offices) (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 ------- ------- Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Outstanding at Class of Common Stock November 6, 2000 --------------------- ----------------- $0.01 par value per share 132,200,897 ELECTRONIC ARTS INC. AND SUBSIDIARIES INDEX Part I - Financial Information Page ------------------------------ Item 1. Consolidated Financial Statements Consolidated Balance Sheets at September 30, 2000 and March 31, 2000 3 Consolidated Statements of Operations for the Three Months Ended September 30, 2000 and 1999 and the Six Months Ended September 30, 2000 and 1999 4 Consolidated Statements of Cash Flows for the Six Months Ended September 30, 2000 and 1999 5 Notes to Consolidated Financial Statements 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 20 Item 3. Quantitative and Qualitative Disclosures About Market Risk 46 Part II - Other Information --------------------------- Item 1. Legal Proceedings 48 Item 4. Submission of Matters to a Vote of Security Holders 48 Item 6. Exhibits and Reports on Form 8-K 48 Signatures 49 ---------- 2 PART I - FINANCIAL INFORMATION Item 1. Consolidated Financial Statements ELECTRONIC ARTS INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Dollars in thousands) (unaudited)
September 30, March 31, 2000 2000 ----------- ----------- ASSETS Current assets: Cash, cash equivalents and short-term investments $ 253,817 $ 339,804 Marketable securities 17,148 236 Receivables, less allowances of $56,094 and $65,067, respectively 148,096 234,087 Inventories, net 19,285 22,986 Deferred income taxes 27,058 26,963 Other current assets 116,700 81,247 ----------- ----------- Total current assets 582,104 705,323 Property and equipment, net 335,962 285,466 Long-term investments 8,400 8,400 Investments in affiliates 18,975 22,601 Goodwill and other intangibles, net 108,586 117,236 Other assets 61,073 53,286 ----------- ----------- $ 1,115,100 $1,192,312 =========== ========== LIABILITIES, MINORITY INTEREST AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 74,689 $ 97,703 Accrued and other liabilities 142,219 167,599 ----------- ----------- Total current liabilities 216,908 265,302 Minority interest in consolidated joint venture 4,194 3,617 Stockholders' equity: Preferred stock, $0.01 par value. Authorized 10,000,000 shares -- -- Common Stock Class A common stock, $0.01 par value. Authorized 400,000,000 shares; issued and outstanding 131,969,802 and 128,869,088 shares, respectively 1,320 1,288 Class B common stock, $0.01 par value. Authorized 100,000,000 shares; issued and outstanding 6,250,000 and 6,000,000, respectively 63 60 Paid-in capital 459,437 412,038 Retained earnings 435,188 516,368 Accumulated other comprehensive loss (2,010) (6,361) ----------- ----------- Total stockholders' equity 893,998 923,393 ----------- ----------- $ 1,115,100 $1,192,312 =========== ========== See accompanying notes to consolidated financial statements.
3 ELECTRONIC ARTS INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share data) (unaudited)
Three Months Ended Six Months Ended September 30, September 30, 2000 1999 2000 1999 --------- --------- --------- --------- Net revenues $ 219,900 $ 338,887 $ 374,699 $ 525,007 Cost of goods sold 118,775 177,147 196,682 263,398 --------- --------- --------- --------- Gross profit 101,125 161,740 178,017 261,609 --------- --------- --------- --------- Operating expenses: Marketing and sales 38,263 46,100 73,456 79,947 General and administrative 26,292 22,301 48,501 40,009 Research and development 92,008 67,026 171,221 113,601 Amortization of intangibles 4,716 2,616 9,370 5,204 --------- --------- --------- --------- Total operating expenses 161,279 138,043 302,548 238,761 --------- --------- --------- --------- Operating income (loss) (60,154) 23,697 (124,531) 22,848 Interest and other income, net 4,102 3,133 7,938 7,271 --------- --------- --------- --------- Income (loss) before provision for (benefit from) income taxes and minority interest (56,052) 26,830 (116,593) 30,119 Provision for (benefit from) income taxes (17,376) 8,586 (36,144) 9,638 --------- --------- --------- --------- Income (loss) before minority interest (38,676) 18,244 (80,449) 20,481 Minority interest in consolidated joint venture (233) (112) (731) (23) --------- --------- --------- --------- Net income (loss) $ (38,909) $ 18,132 $ (81,180) $ 20,458 ========= ========= ========= ========= Net income per share: Basic N/A $ 0.15 N/A $ 0.17 Diluted N/A $ 0.14 N/A $ 0.16 Number of shares used in computation: Basic N/A 124,834 N/A 123,886 Diluted N/A 131,215 N/A 129,819 Class A common stock: Net loss: Basic $ (34,860) N/A $ (73,474) N/A Diluted $ (38,909) N/A $ (81,180) N/A --------- --------- Net loss per share: Basic $ (0.27) N/A $ (0.57) N/A Diluted $ (0.30) N/A $ (0.62) N/A Number of shares used in computation: Basic 130,691 N/A 129,966 N/A Diluted 131,343 N/A 130,618 N/A Class B common stock: Net loss, net of retained interest in EA.com $ (4,049) N/A $ (7,706) N/A --------- --------- Net loss per share: Basic $ (0.67) N/A $ (1.28) N/A Diluted $ (0.67) N/A $ (1.28) N/A Number of shares used in computation: Basic 6,000 N/A 6,000 N/A Diluted 6,000 N/A 6,000 N/A See accompanying notes to consolidated financial statements.
4 ELECTRONIC ARTS INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands) (unaudited)
Six Months Ended September 30, 2000 1999 --------- --------- Operating activities: Net income (loss) $ (81,180) $ 20,458 Adjustments to reconcile net income (loss) to net cash used in operating activities: Minority interest in consolidated joint venture 731 23 Equity in net (income) loss of affiliates 197 (336) Gain on sale of affiliate -- (842) Depreciation and amortization 31,583 20,655 Loss on sale of fixed assets 420 198 Gain on sale of marketable securities -- (1,286) Provision for doubtful accounts 3,014 2,140 Tax benefit from exercise of stock options -- 9,889 Change in assets and liabilities: Receivables 82,977 (118,421) Inventories 3,701 (1,502) Other assets (36,332) (52,434) Accounts payable (23,014) 31,977 Accrued liabilities (26,047) (4,563) Deferred income taxes 996 94 --------- --------- Net cash used in operating activities (42,954) (93,950) --------- --------- Investing activities: Proceeds from sale of property and equipment 3,958 55 Proceeds from sales of marketable securities, net -- 1,489 Purchase of marketable securities, net (2,465) -- Proceeds from sale of affiliate -- 8,842 Capital expenditures (86,861) (47,338) Investment in affiliates, net 722 (2,949) Change in short-term investments, net 19,632 (19,420) Acquisition of subsidiaries, net of cash acquired -- (582) --------- --------- Net cash used in investing activities (65,014) (59,903) --------- --------- Financing activities: Proceeds from sales of shares through employee stock plans and other plans 47,434 42,987 --------- --------- Net cash provided by financing activities 47,434 42,987 --------- --------- Translation adjustment (5,897) 3,918 --------- --------- Decrease in cash and cash equivalents (66,431) (106,948) Beginning cash and cash equivalents 246,265 242,208 --------- --------- Ending cash and cash equivalents 179,834 135,260 Short-term investments 73,983 89,084 --------- --------- Ending cash, cash equivalents and short-term investments $ 253,817 $ 224,344 ========= =========
5 ELECTRONIC ARTS INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (continued) (Dollars in thousands) (unaudited) Six Months Ended September 30, 2000 1999 ------- ------- Supplemental cash flow information: Cash paid during the year for income taxes $ 7,992 $ 4,944 ======= ======= Non-cash investing activities: Change in unrealized appreciation of investments and marketable securities $ 9,670 $ (29) ======= ======= See accompanying notes to consolidated financial statements. 6 ELECTRONIC ARTS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. Basis of Presentation 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 period. The results of operations for the current interim period are not necessarily indicative of results to be expected for the current year or any other period. Certain amounts have been reclassified to conform to the fiscal 2001 presentation. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in Electronic Arts Inc. (the "Company") Annual Report on Form 10-K for the fiscal year ended March 31, 2000 as filed with the Securities and Exchange Commission ("Commission") on June 29, 2000. Note 2. Fiscal Year The Company's fiscal year is reported on a 52/53-week period that ends on the Saturday nearest to March 31 in each year. The results of operations for fiscal 2001 will contain 53 weeks. Accordingly, the results of operations for the first half of fiscal 2001 and the first half of fiscal 2000 contain 27 weeks and 26 weeks, respectively. The results of operations for the fiscal quarter ended June 30, 2000 and the fiscal quarter ended June 30, 1999 contain 14 weeks and 13 weeks, respectively. Since the results of an additional week are not material, and for clarity of presentation, all fiscal periods are treated as ending on a calendar month. Note 3. Approval of the Tracking Stock Proposal On March 22, 2000, the shareholders of Electronic Arts voted on and approved a proposal (the "Tracking Stock Proposal") to authorize the issuance of a new series of common stock to be designated as Class B common stock ("Tracking Stock"), intended to reflect the performance of Electronic Arts' online and e-Commerce division ("EA.com"). As a result of the approval of the Tracking Stock Proposal, Electronic Arts' existing common stock has been re-classified as Class A common stock ("Class A Stock") and that stock will reflect the performance of Electronic Arts' other businesses ("EA Core"). Note 4. Stock Split On August 14, 2000, the Company's Board of Directors authorized a two-for-one stock split of its Class A common stock which was distributed on September 8, 2000 in the form of a stock dividend for shareholders of record at the close of business on August 25, 2000. All authorized and outstanding share and per share amounts of Class A common stock in the accompanying consolidated financial statements for all periods have been restated to reflect the stock split. 7 ELECTRONIC ARTS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Note 5. Prepaid Royalties Prepaid royalties consist primarily of prepayments for manufacturing royalties, original equipment manufacturer (OEM) fees and license fees paid to celebrities and professional sports organizations for use of their trade name. Also included in prepaid royalties are prepayments made to independent software developers under development arrangements that have alternative future uses. Prepaid royalties are expensed at the contractual royalty rate as cost of goods sold based on actual net product sales. Management evaluates the future realization of prepaid royalties quarterly and charges to income any amounts that management deems unlikely to be realized through product sales. Royalty advances are classified as current and non-current assets based upon estimated net product sales for the following year. The current portion of prepaid royalties, included in other current assets, was $70,366,000 and $54,970,000 at September 30, 2000 and March 31, 2000, respectively. The long-term portion of prepaid royalties, included in other assets, was $15,735,000 and $11,373,000 at September 30, 2000 and March 31, 2000, respectively. Note 6. Inventories Inventories are stated at the lower of cost or market. Inventories at September 30, 2000 and March 31, 2000 consisted of (in thousands): ------------------------------------------------------------------------------- September 30, 2000 March 31, 2000 ------------------------------------------------------------------------------- Raw materials and work in process $3,918 $ 920 Finished goods 15,367 22,066 ------------------------------------------------------------------------------- $19,285 $22,986 =============================================================================== Note 7. Accrued and Other Liabilities Accrued liabilities at September 30, 2000 and March 31, 2000 consisted of (in thousands): ------------------------------------------------------------------------------- September 30, 2000 March 31, 2000 ------------------------------------------------------------------------------- Accrued compensation and benefits $51,441 $59,580 Accrued expenses 39,433 37,840 Accrued royalties 25,518 36,566 Deferred revenue 17,501 1,847 Warranty reserve 7,461 8,886 Deferred income taxes 865 198 Accrued income taxes - 22,682 ------------------------------------------------------------------------------- $142,219 $167,599 =============================================================================== 8 ELECTRONIC ARTS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Note 8. Segment Information In 1999, the Company adopted SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information", which supersedes SFAS No. 14, "Financial Reporting for Segments of a Business Enterprise". SFAS No. 131 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 the operating segments within the Company for making operational decisions and assessments of financial performance. The Company's chief operating decision maker is considered to be the Company's Chief Executive Officer ("CEO"). The CEO reviews financial information presented on a consolidated basis accompanied by disaggregated information about revenues by geographic region and by product lines for purposes of making operating decisions and assessing financial performance. As a result of the approval of the Tracking Stock proposal to authorize issuance of a new series of common stock designated as Class B common stock, intended to reflect the performance of EA.com, management considers EA.com to be a separate reportable segment. Accordingly, prior period information has been restated to disclose separate segments. The Company operates in two principal business segments globally: o Electronic Arts core ("EA Core") business segment: creation, marketing and distribution of entertainment software. o EA.com business segment: creation, marketing and distribution of entertainment software which can be played or sold online and ongoing management of subscriptions of online games. Please see the discussion regarding segment reporting in the MD&A. 9 ELECTRONIC ARTS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Information about Electronic Arts business segments is presented below for the three and six months ended September 30, 2000 and 1999 (in thousands): ---------------------------------------------------------------------------------------------------------------------------------
Three Months Ended September 30, 2000 EA Core Adjustments and (excl. EA.com) EA.com Eliminations Electronic Arts --------------------------------------------------------------------------------------------------------------------------------- Net revenues from unaffiliated customers $210,563 $ 9,337 $ - $ 219,900 Group sales 683 - (683)(a) - --------------------------------------------------------------------------------------------------------------------------------- Total net revenues 211,246 9,337 (683) 219,900 --------------------------------------------------------------------------------------------------------------------------------- Cost of goods sold from unaffiliated customers 116,085 2,690 - 118,775 Group cost of goods sold - 683 (683)(a) - --------------------------------------------------------------------------------------------------------------------------------- Total cost of goods sold 116,085 3,373 (683) 118,775 --------------------------------------------------------------------------------------------------------------------------------- Gross profit 95,161 5,964 - 101,125 Operating expenses: Marketing and sales 36,752 1,511 - 38,263 General and administrative 24,142 2,150 - 26,292 Research and development 64,195 16,887 10,926 (b) 92,008 Network development and support - 10,926 (10,926)(b) - Amortization of intangibles 3,221 1,495 - 4,716 --------------------------------------------------------------------------------------------------------------------------------- Total operating expenses 128,310 32,969 - 161,279 --------------------------------------------------------------------------------------------------------------------------------- Operating loss (33,149) (27,005) - (60,154) Interest and other income, net 4,090 12 - 4,102 --------------------------------------------------------------------------------------------------------------------------------- Loss before benefit from income taxes and minority interest (29,059) (26,993) - (56,052) Benefit from income taxes (17,376) - - (17,376) --------------------------------------------------------------------------------------------------------------------------------- Loss before minority interest (11,683) (26,993) - (38,676) Minority interest in consolidated joint venture (233) - - (233) --------------------------------------------------------------------------------------------------------------------------------- Net loss before retained interest in EA.com $(11,916) $(26,993) $ - $(38,909) ================================================================================================================================= Interest income $ 4,082 $ 21 $ - $ 4,103 Depreciation and amortization 11,746 4,813 - 16,559 Identifiable assets 953,087 162,013 - 1,115,100 Capital expenditures 15,120 21,073 - 36,193
10 ELECTRONIC ARTS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) ---------------------------------------------------------------------------------------------------------------------------------
Three Months Ended September 30, 1999 EA Core Adjustments and (excl. EA.com) EA.com Eliminations Electronic Arts --------------------------------------------------------------------------------------------------------------------------------- Net revenues from unaffiliated customers $334,107 $4,780 $ - $ 338,887 Group sales 614 - (614) (a) - --------------------------------------------------------------------------------------------------------------------------------- Total net revenues 334,721 4,780 (614) 338,887 --------------------------------------------------------------------------------------------------------------------------------- Cost of goods sold from unaffiliated customers 175,716 1,431 - 177,147 Group cost of goods sold - 614 (614) (a) - --------------------------------------------------------------------------------------------------------------------------------- Total cost of goods sold 175,716 2,045 (614) 177,147 --------------------------------------------------------------------------------------------------------------------------------- Gross profit 159,005 2,735 - 161,740 Operating expenses: Marketing and sales 45,773 327 - 46,100 General and administrative 21,925 376 - 22,301 Research and development 56,537 6,899 3,590 (b) 67,026 Network development and support - 3,590 (3,590) (b) - Amortization of intangibles 2,587 29 - 2,616 --------------------------------------------------------------------------------------------------------------------------------- Total operating expenses 126,822 11,221 - 138,043 --------------------------------------------------------------------------------------------------------------------------------- Operating income (loss) 32,183 (8,486) - 23,697 Interest and other income, net 3,133 - - 3,133 --------------------------------------------------------------------------------------------------------------------------------- Income (loss) before provision for income taxes and minority interest 35,316 (8,486) - 26,830 Provision for income taxes 8,586 - - 8,586 --------------------------------------------------------------------------------------------------------------------------------- Income (loss) before minority interest 26,730 (8,486) - 18,244 Minority interest in consolidated joint venture (112) - - (112) --------------------------------------------------------------------------------------------------------------------------------- Net income (loss) $26,618 $(8,486) $ - $18,132 ================================================================================================================================= Interest income $ 3,650 $ - $ - $ 3,650 Depreciation and amortization 10,686 72 - 10,758 Identifiable assets 990,047 13,563 - 1,003,610 Capital expenditures 19,989 8,568 - 28,557
11 ELECTRONIC ARTS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) ---------------------------------------------------------------------------------------------------------------------------
Six Months Ended September 30, 2000 EA Core Adjustments and (excl. EA.com) EA.com Eliminations Electronic Arts --------------------------------------------------------------------------------------------------------------------------- Net revenues from unaffiliated customers $356,609 $ 18,090 $ - $ 374,699 Group sales 1,043 - (1,043) (a) - --------------------------------------------------------------------------------------------------------------------------- Total net revenues 357,652 18,090 (1,043) 374,699 --------------------------------------------------------------------------------------------------------------------------- Cost of goods sold from unaffiliated customers 192,584 4,098 - 196,682 Group cost of goods sold - 1,043 (1,043) (a) - --------------------------------------------------------------------------------------------------------------------------- Total cost of goods sold 192,584 5,141 (1,043) 196,682 --------------------------------------------------------------------------------------------------------------------------- Gross profit 165,068 12,949 - 178,017 Operating expenses: Marketing and sales 70,012 3,444 - 73,456 General and administrative 43,889 4,612 - 48,501 Research and development 117,854 34,168 19,199 (b) 171,221 Network development and support - 19,199 (19,199) (b) - Amortization of intangibles 6,461 2,909 - 9,370 --------------------------------------------------------------------------------------------------------------------------- Total operating expenses 238,216 64,332 - 302,548 --------------------------------------------------------------------------------------------------------------------------- Operating loss (73,148) (51,383) - (124,531) Interest and other income, net 7,931 7 - 7,938 --------------------------------------------------------------------------------------------------------------------------- Loss before benefit from income taxes and minority interest (65,217) ( 51,376) - (116,593) Benefit from income taxes (36,144) - - (36,144) --------------------------------------------------------------------------------------------------------------------------- Loss before minority interest (29,073) (51,376) - (80,449) Minority interest in consolidated joint venture (731) - - (731) --------------------------------------------------------------------------------------------------------------------------- Net loss before retained interest in EA.com $(29,804) $ (51,376) $ - $ (81,180) =========================================================================================================================== Interest income $ 8,399 $ 49 $ - $ 8,448 Depreciation and amortization 21,910 9,673 - 31,583 Capital expenditures 29,250 57,611 - 86,861
12 ELECTRONIC ARTS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) ---------------------------------------------------------------------------------------------------------------------------
Six Months Ended September 30, 1999 EA Core Adjustments and (excl. EA.com) EA.com Eliminations Electronic Arts --------------------------------------------------------------------------------------------------------------------------- Net revenues from unaffiliated customers $515,837 $ 9,170 $ - $ 525,007 Group sales 908 - (908) (a) - --------------------------------------------------------------------------------------------------------------------------- Total net revenues 516,745 9,170 (908) 525,007 --------------------------------------------------------------------------------------------------------------------------- Cost of goods sold from unaffiliated customers 260,962 2,436 - 263,398 Group cost of goods sold - 908 (908) (a) - --------------------------------------------------------------------------------------------------------------------------- Total cost of goods sold 260,962 3,344 (908) 263,398 --------------------------------------------------------------------------------------------------------------------------- Gross profit 255,783 5,826 - 261,609 Operating expenses: Marketing and sales 79,225 722 - 79,947 General and administrative 39,379 630 - 40,009 Research and development 96,759 10,637 6,205 (b) 113,601 Network development and support - 6,205 (6,205) (b) - Amortization of intangibles 5,175 29 - 5,204 --------------------------------------------------------------------------------------------------------------------------- Total operating expenses 220,538 18,223 - 238,761 --------------------------------------------------------------------------------------------------------------------------- Operating income (loss) 35,245 (12,397) - 22,848 Interest and other income, net 7,271 - - 7,271 --------------------------------------------------------------------------------------------------------------------------- Income (loss) before provision for income taxes and minority interest 42,516 (12,397) - 30,119 Provision for income taxes 9,638 - - 9,638 --------------------------------------------------------------------------------------------------------------------------- Income (loss) before minority interest 32,878 (12,397) - 20,481 Minority interest in consolidated joint venture (23) - - (23) --------------------------------------------------------------------------------------------------------------------------- Net income (loss) $ 32,855 $(12,397) $ - $ 20,458 =========================================================================================================================== Interest income $ 6,602 $ - $ - $ 6,602 Depreciation and amortization 20,494 161 - 20,655 Capital expenditures 38,413 8,925 - 47,338 (a) Represents elimination of intercompany sales of Electronic Arts packaged goods products to EA.com, and represents elimination of royalties paid to Electronic Arts by EA.com for intellectual property rights. (b) Represents reclassification of Network Development and Support to Research and Development.
13 ELECTRONIC ARTS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Information about the Company's operations in North America and foreign areas for the three and six months ended September 30, 2000 and 1999 is presented below: -----------------------------------------------------------------------------------------------------------------------------------
(In thousands) Asia Pacific North (excluding America Europe Japan) Japan Eliminations Total ---------------------------------------------------------------------------------------- Three months ended September 30, 2000 ------------------------------------- Net revenues from unaffiliated customers $152,842 $49,949 $9,527 $7,582 $ - $ 219,900 Intercompany revenues 1,303 4,337 2,539 - (8,179) - ---------------------------------------------------------------------------------------- Total net revenues 154,145 54,286 12,066 7,582 (8,179) 219,900 ======================================================================================== Operating income (loss) (33,210) (28,343) 454 792 153 (60,154) Interest income 3,115 830 158 - - 4,103 Depreciation and amortization 13,190 3,021 235 113 - 16,559 Identifiable assets 772,853 301,059 21,664 19,524 - 1,115,100 Capital expenditures 31,642 4,056 295 200 - 36,193 Long-lived assets 309,392 156,326 3,950 4,182 - 473,850 Six months ended September 30, 2000 ----------------------------------- Net revenues from unaffiliated customers $224,598 $101,843 $21,639 $26,619 $ - $ 374,699 Intercompany revenues 5,279 8,818 6,557 - (20,654) - ---------------------------------------------------------------------------------------- Total net revenues 229,877 110,661 28,196 26,619 (20,654) 374,699 ======================================================================================== Operating income (loss) (79,710) (51,212) 1,871 3,389 1,131 (124,531) Interest income 6,249 1,936 263 - - 8,448 Depreciation and amortization 25,660 5,270 373 280 - 31,583 Capital expenditures 73,435 12,481 671 274 - 86,861 Three months ended September 30, 1999 ------------------------------------- Net revenues from unaffiliated customers $225,608 $89,993 $13,516 $9,770 $ - $ 338,887 Intercompany revenues 4,088 7,853 2,135 - (14,076) - ---------------------------------------------------------------------------------------- Total net revenues 229,696 97,846 15,651 9,770 (14,076) 338,887 ======================================================================================== Operating income 21,087 1,776 1,279 595 (1,040) 23,697 Interest income 3,420 182 48 - - 3,650 Depreciation and amortization 6,884 3,430 105 339 - 10,758 Identifiable assets 666,710 294,281 25,174 17,445 - 1,003,610 Capital expenditures 12,973 15,241 298 45 - 28,557 Long-lived assets 195,831 118,266 3,134 3,589 320,820 Six months ended September 30, 1999 ----------------------------------- Net revenues from unaffiliated customers $327,658 $156,794 $25,454 $15,101 $ - $ 525,007 Intercompany revenues 7,720 12,646 2,905 - (23,271) - ---------------------------------------------------------------------------------------- Total net revenues 335,378 169,440 28,359 15,101 (23,271) 525,007 ======================================================================================== Operating income (loss) 27,624 (6,135) 2,184 215 (1,040) 22,848 Interest income 5,983 529 90 - - 6,602 Depreciation and amortization 14,468 5,447 242 498 - 20,655 Capital expenditures 20,462 26,152 592 132 - 47,338
14 ELECTRONIC ARTS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Information about the Company's net revenues by product line for the three and six months ended September 30, 2000 and 1999 is presented below: -------------------------------------------------------------------------------- (In thousands) Three Months Ended Six Months Ended September 30, September 30, 2000 1999 2000 1999 ------------------------------------------------- PC $81,669 $101,787 $152,150 $165,383 PlayStation 65,157 111,437 94,658 180,688 Online Subscription 7,145 3,593 15,456 6,974 PlayStation 2 2,737 - 13,018 - N64 10,161 45,965 10,767 57,807 License, OEM and Other 6,435 3,426 9,735 8,044 Affiliated label 46,596 72,679 78,915 106,111 -------------------------------------------------------------------------------- $219,900 $338,887 $374,699 $525,007 ================================================================================ Note 9. Comprehensive Income (Loss) The components of comprehensive income, net of tax, for the three and six months ended September 30, 2000 and 1999 were as follows: -----------------------------------------------------------------------------------------------------------------
(In thousands) Three Months Ended Six Months Ended September 30, September 30, 2000 1999 2000 1999 ----------------------------------------------------------------------------------------------------------------- Net income (loss) $(38,909) $18,132 $(81,180) $20,458 ----------------------------------------------------------------------------------------------------------------- Other comprehensive income (loss): Change in unrealized appreciation of investments, net of a tax provision of $(78), $468, $(424) and $402 10,864 995 10,094 855 Reclassification adjustment for gains realized in net income for 1999, net of a tax benefit of $(24) and $(412) - (52) - (874) Foreign currency translation adjustments (2,173) 3,394 (5,743) 3,495 ----------------------------------------------------------------------------------------------------------------- Total other comprehensive income 8,691 4,337 4,351 3,476 ----------------------------------------------------------------------------------------------------------------- ----------------------------------------------------------------------------------------------------------------- Total comprehensive income (loss) $(30,218) $22,469 $(76,829) $23,934 =================================================================================================================
The currency translation adjustments are not adjusted for income taxes as they relate to indefinite investments in non-U.S. subsidiaries. Note 10. Earnings (Loss) 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. 15 ELECTRONIC ARTS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Net income (loss) per share was calculated on a consolidated basis until Class A common stock and Class B common stock were created as a result of the approval of the Tracking Stock Proposal, see Note 3. Subsequent to the approval of the Tracking Stock Proposal, net income (loss) per share is computed individually for Class A common stock and Class B common stock. (in thousands, except per share amounts): --------------------------------------------------------------------------------------------------------------------------
Three months ended September 30, 2000 2000 2000 1999 Class A common Class A common Class B Electronic stock-EA Core stock-EA Core common Arts common Basic Diluted stock-EA.com stock -------------------------------------------------------------------------------------------------------------------------- Net income (loss) $(34,860) $(38,909) $(4,049) $18,132 -------------------------------------------------------------------------------------------------------------------------- Shares used to compute net income (loss) per share: Weighted-average common shares 130,691 130,691 6,000 124,834 Dilutive stock equivalents - 652 - 6,381 -------------------------------------------------------------------------------------------------------------------------- Dilutive potential common shares 130,691 131,343 6,000 131,215 ========================================================================================================================== -------------------------------------------------------------------------------------------------------------------------- Net income (loss) per share: Basic $(0.27) N/A $(0.67) $0.15 Diluted N/A $(0.30) $(0.67) $0.14 -------------------------------------------------------------------------------------------------------------------------- -------------------------------------------------------------------------------------------------------------------------- Six months ended September 30, 2000 2000 2000 1999 Class A common Class A common Class B Electronic stock-EA Core stock-EA Core common Arts common Basic Diluted stock-EA.com stock -------------------------------------------------------------------------------------------------------------------------- Net income (loss) $(73,474) $(81,180) $(7,706) $20,458 -------------------------------------------------------------------------------------------------------------------------- Shares used to compute net income (loss) per share: Weighted-average common shares 129,966 129,966 6,000 123,886 Dilutive stock equivalents - 652 - 5,933 -------------------------------------------------------------------------------------------------------------------------- Dilutive potential common shares 129,966 130,618 6,000 129,819 ========================================================================================================================== -------------------------------------------------------------------------------------------------------------------------- Net income (loss) per share: Basic $(0.57) N/A $(1.28) $0.17 Diluted N/A $(0.62) $(1.28) $0.16 --------------------------------------------------------------------------------------------------------------------------
16 ELECTRONIC ARTS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Due to the net loss reported for the three and six months ended September 30, 2000, for the EA core segment, stock options have been excluded from the Diluted EPS calculation. Had net income been reported in these periods, dilutive potential common shares would have been 138,087,000 and 136,614,000 for Class A common stock for the three and six months ended September 30, 2000, respectively. Excluded from the above computation of weighted-average shares for diluted EPS were options to purchase 805,212 and 1,318,595 shares of common stock for the three and six months ended September 30, 2000, respectively, as the options' exercise price was greater than the average market price of the common shares. For the three and six months ended September 30, 2000, the weighted-average exercise price of the respective options was $48.60 and $44.99, respectively. Excluded from the above computation of weighted-average shares for diluted EPS were options to purchase 82,000, and 1,112,000 shares of common stock for the three and six months ended September 30, 1999, respectively, as the options' exercise price was greater than the average market price of the common shares. For the three and six months ended September 30, 1999, the weighted-average exercise price of the respective options was $33.44 and $29.83, respectively. Note 11. New Accounting Pronouncements In July 2000, the Emerging Issues Task Force reached a consensus on issue No. 00-15 ("EITF 00-15"), "Classification in the Statement of Cash Flows of the Income Tax Benefit Realized by a Company upon Employee Exercise of a Nonqualified Stock Option". The EITF concluded that income tax benefits realized upon an employee's exercise of a nonqualified stock option should be classified as an operating cash flow. Accordingly, the Company reclassified tax benefits resulting from the exercise of stock options on its Consolidated Statements of Cash Flows. In July 2000, the Emerging Issues Task Force issued No. 00-10 ("EITF 00-10"), "Accounting for Shipping and Handling Fees and Costs", and concluded that all amounts billed to a customer in a sale transaction related to shipping and handling, if any, represent revenue to the vendor and, therefore, should be classified as revenue. The adoption of EITF 00-10 did not have a significant impact on the results of operations, financial position or cash flows. In May 2000, the Emerging Issues Task Force issued No. 00-14 ("EITF 00-14"), "Accounting for Certain Sales Incentives". EITF 00-14 states that for a sales incentive that will not result in a loss on the sale of a product or service, a vendor should recognize the cost of the incentive at the latter of the date at which the related revenue is recorded or the date at which the incentive is offered. If the sales incentive will result in a loss on the sale of the product or service, the vendor should not recognize a liability for the sales incentive until the related revenue is recognized. Secondly, for certain sales incentives that entitle a customer to receive a reduction 17 ELECTRONIC ARTS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) in the price of a product or service in the form of a refund or rebate, the vendor should recognize a liability for those sales incentives based on an estimated amount of refunds or rebates that may be claimed by customers. The Task Force also concluded that the reduction in or refund of the selling price resulting from any cash sales incentive should be classified as a reduction in revenue and if the sales incentive offered is a free product or service delivered at the time of sale, the cost of the free product or service should be classified as an expense. The adoption of EITF 00-14 did not have a material impact on its results of operations, financial position or cash flows for the Company. In March 2000, the Financial Accounting Standards Board issued Interpretation No. 44 ("FIN 44"), "Accounting for Certain Transactions Involving Stock Compensation (an interpretation of APB Opinion No. 25)". FIN 44 clarifies the application of APB Opinion No. 25 for certain issues: (a) the definition of employee for purposes of applying Opinion 25, (b) the criteria for determining whether a plan qualifies as a noncompensatory plan, (c) the accounting consequence of various modifications to the terms of a previously fixed stock option or award, and (d) the accounting for an exchange of stock compensation awards in a business combination. Generally, FIN 44 is effective July 1, 2000. The adoption of FIN 44 did not have a material impact on the Company's consolidated financial position or results of operations. In March 2000, the Emerging Issues Task Force issued No. 00-03 ("EITF 00-03"), "Application of AICPA SOP 97-2, "Software Revenue Recognition," to Arrangements That Include the Right to Use Software Stored on Another Entity's Hardware", which discusses the effect on revenue recognition of a software vendor's obligation to host its software that previously was licensed to a customer. The EITF has reached the conclusion that, if the customer is unable to utilize the software on the customer's hardware or contract with another party unrelated to the vendor to host the software, then the arrangement with the customer is outside the scope of SOP 97-2 and should be treated as a service contract. The adoption of EITF 00-03 did not have a material impact on the Company's financial position and results of operations. In March 2000, the Emerging Issues Task Force issued No. 00-02 ("EITF 00-02"), "Accounting for Web Site Development Costs". EITF 00-02 states that all costs relating to software used to operate a web site and relating to development of initial graphics and web page design should be accounted for using Statement of Position ("SOP") 98-1. Under this SOP, costs incurred in the preliminary project stage should be expensed as incurred, as should most training and data conversion costs. External direct costs of materials and services and internal direct payroll-related costs should be capitalized once certain criteria are met. EITF 00-02 is effective for all fiscal quarters beginning after June 30, 2000. The Company's accounting policy for internal-use software, as required by SOP 98-1, incorporated the requirements of EITF 00-02. In December 1999, the Securities and Exchange Commission ("SEC") issued Staff Accounting Bulletin No. 101("SAB 101"), "Revenue Recognition," which outlines the basic criteria that must be met to recognize revenue and provides guidance for presentation of revenue and for disclosure related to revenue recognition policies in financial statements filed with the SEC. SAB 101 is effective the fourth fiscal quarter of fiscal years beginning after December 15, 18 ELECTRONIC ARTS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 1999 as amended by SAB 101B. The Company believes the adoption of SAB 101 will not have a material impact on the Company's financial position and results of operations. In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 133 ("SFAS 133") "Accounting for Derivative Instruments and Hedging Activities", as amended by SFAS 137 "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133 - an Amendment of FASB Statement No. 133" and SFAS 138 "Accounting for Certain Derivative Instruments and Certain Hedging Activities - an Amendment of FASB Statement No. 133" which establish accounting and reporting standards for derivative instruments and hedging activities. The terms of SFAS 133 and SFAS 138 are effective as of the beginning of the first quarter of the fiscal year beginning after June 15, 2000. The Company is determining the effect of SFAS 133, 137 and 138 on its financial statements. In March 1998, the American Institute of Certified Public Accountants ("AICPA") issued SOP 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use". SOP 98-1 requires that consulting, hardware, software and direct payroll-related costs associated with the implementation of customized internal-use software be capitalized and amortized over the estimated useful life of the software. These costs relate to game site application and infrastructure design and development, as well as costs related to providing customer account management and building in e-Commerce functionality and interfaces. SOP 98-1 is effective for financial statements issued for fiscal years beginning after December 15, 1998. As of September 30, 2000, the Company has capitalized $43,342,000 of these costs associated with the effort to build the EA.com website and infrastructure. Note 12. Subsequent Events o EA.com Gamesite Launch: On October 4, 2000, EA.com launched its gamesite on the worldwide web and Games Channel on AOL, in accordance with its agreement with AOL. This site provides online games to subscribers of AOL's service and to visitors of the AOL and EA web properties. o PlayStation 2: On October 26, 2000, Sony released its new console platform, PlayStation 2, in North America. 19 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations This Quarterly Report on Form 10-Q and, in particular, the following "Management's Discussion and Analysis of Financial Condition and Results of Operations" contains forward-looking statements about circumstances that have not yet occurred. All statements, trend analysis and other information contained below relating to markets, our products and trends in revenue, as well as other statements including words such as "anticipate", "believe" or "expect" and statements in the future tense are forward-looking statements. These forward-looking statements are subject to business and economic risks and actual events or our actual future results could differ materially from those set forth in the forward-looking statements due to such risks and uncertainties. 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 and performance include, but are not limited to, those discussed under the heading "Risk Factors" below at pages 37 to 45, as well as in our Annual Report on Form 10-K for the fiscal year ended March 31, 2000 as filed with the Securities and Exchange Commission on June 29, 2000 and other documents filed with the Commission. We derive revenues primarily from shipments of entertainment software, which includes EA Studio products for dedicated entertainment systems (that we call video game systems or consoles such as PlayStation, PlayStation 2 and Nintendo 64), EA Studio personal computer products (or PC), Co- Publishing products that are co-published and distributed by us, and Affiliated Label (or AL) products that are published by third parties and distributed by us. We also derive revenues from licensing of EA Studio products and AL products through hardware companies (or OEM), online subscription and e-Commerce revenues. Information about our net revenues for North America and foreign areas for the three and six months ended September 30, 2000 and 1999 is summarized below (in thousands): ----------------------------------------------------------------------------------------------------------
September 30, September 30, 2000 1999 Decrease % change ------------------------------------------------------------------------------- Net Revenues for the Three Months Ended: North America $152,842 $225,608 $(72,766) (32.3)% ------------------------------------------------------------------------------- Europe 49,949 89,993 (40,044) (44.5)% Asia Pacific 9,527 13,516 (3,989) (29.5)% Japan 7,582 9,770 (2,188) (22.4)% ------------------------------------------------------------------------------- International 67,058 113,279 (46,221) (40.8)% ------------------------------------------------------------------------------- Consolidated Net Revenues $219,900 $338,887 $(118,987) (35.1)% ===============================================================================
20 ----------------------------------------------------------------------------------------------------------
September 30, September 30, Increase/ 2000 1999 (Decrease) % change ------------------------------------------------------------------------------- Net Revenues for the Six Months Ended: North America $224,598 $327,658 $(103,060) (31.5)% ------------------------------------------------------------------------------- Europe 101,843 156,794 (54,951) (35.0)% Asia Pacific 21,639 25,454 (3,815) (15.0)% Japan 26,619 15,101 11,518 76.3% ------------------------------------------------------------------------------- International 150,101 197,349 (47,248) (23.9)% ------------------------------------------------------------------------------- Consolidated Net Revenues $374,699 $525,007 $(150,308) (28.6)% ===================== ====================== ================ =================
North America Net Revenues The decrease in North America net revenues for the three months ended September 30, 2000, compared to the same period last year was primarily due to: o A 38% decrease in PlayStation revenues due to the console transition to PlayStation 2. We released five titles in the quarter compared to seven in the comparable prior year period. o A 78% decrease in Nintendo 64 (or N64) revenues also related to the console transition. We released one title in the quarter compared to four releases in the comparable prior year period. o These decreases were partially offset by an increase in PC revenues due to the strong sales of The Sims and The Sims Livin' Large. The decrease in North America net revenues for the six months ended September 30, 2000, compared to the same period last year was primarily due to: o A 54% decrease in PlayStation revenues due to the console transition to PlayStation 2. We released six titles in the six months ended September 30, 2000 compared to ten in the comparable prior year period. o An 80% decrease in N64 revenues also related to the console transition. We released one title in the six months ended September 30, 2000 compared to four releases in the comparable prior year period. o These decreases were partially offset by an increase in PC revenues due to the strong sales of The Sims and The Sims Livin' Large. International Net Revenues The decrease in international net revenues for the three months ended September 30, 2000, compared to the same period last year was primarily attributable to: o Europe's net revenues decreased 45% primarily due to market weakness, lower PC sales with fewer titles shipping in the quarter and the strong sales of Command & Conquer Tiberian Sun for the PC in the comparable prior year period as well as weakness in the Euro currency. In addition, PlayStation revenue decreased 50% due to fewer titles shipping during the console transition. 21 o European AL sales decreased due to a weaker market and fewer hit titles as compared to the prior year. o Asia Pacific's net revenues decreased 30%, mainly in PC revenues, due to the strong sales of Command & Conquer Tiberian Sun in the comparable prior year period. o Japan's net revenues decreased 22% due to a 94% decrease in PlayStation revenues attributable to significantly reduced PlayStation market, no new titles released in the current quarter as well as strong sales of FIFA 1999 in the comparable prior year period. This was offset by the revenue on two PlayStation 2 titles: FIFA Soccer World Championship and Xfire. The decrease in international net revenues for the six months ended September 30, 2000, compared to the same period last year was primarily attributable to: o Europe's net revenues decreased 35% primarily due to market weakness, lower AL sales due to fewer hit titles released in the current year, lower PC sales with fewer titles shipping in the quarter and the strong sales of Command & Conquer Tiberian Sun for the PC in the comparable prior year period as well as weakness in the Euro currency. In addition, PlayStation revenue decreased 24% due to fewer titles shipping during the console transition period. o Asia Pacific's net revenues decreased 15%, mainly due to the decrease in PlayStation revenues as there were no significant new titles released in the current year. Lower AL sales also contributed to the decrease as compared to the prior year. o Japan's net revenues increased 76% compared to the prior year primarily due to the shipment of two PlayStation 2 titles, FIFA Soccer World Championship and Xfire. Information about our net revenues by product line for the three and six months ended September 30, 2000 and 1999 is presented below (in thousands): -----------------------------------------------------------------------------------------------------------
September 30, September 30, Increase/ 2000 1999 (Decrease) % change ------------------------------------------------------------------------ Net Revenues for the Three Months Ended: EA Studio: ---------- PC $81,669 $101,787 $(20,118) (19.8)% PlayStation 65,157 111,437 (46,280) (41.5)% Online Subscriptions 7,145 3,593 3,552 98.9% PlayStation 2 2,737 - 2,737 N/A N64 10,161 45,965 (35,804) (77.9)% License, OEM and Other 6,435 3,426 3,009 87.8% ------------------------------------------------------------------------ 173,304 266,208 (92,904) (34.9)% Affiliated Label: 46,596 72,679 (26,083) (35.9)% ----------------- ------------------------------------------------------------------------ Consolidated Net Revenues $219,900 $338,887 $(118,987) (35.1)% ========================================================================
22 -----------------------------------------------------------------------------------------------------------
September 30, September 30, Increase/ 2000 1999 (Decrease) % change ------------------------------------------------------------------------ Net Revenues for the Six Months Ended: EA Studio: ---------- PC $152,150 $165,383 $ (13,233) (8.0)% PlayStation 94,658 180,688 (86,030) (47.6)% Online Subscriptions 15,456 6,974 8,482 121.6 % PlayStation 2 13,018 - 13,018 N/A N64 10,767 57,807 (47,040) (81.4)% License, OEM and Other 9,735 8,044 1,691 21.0 % ------------------------------------------------------------------------ 295,784 418,896 (123,112) (29.4)% Affiliated Label: 78,915 106,111 (27,196) (25.6)% ----------------- ------------------------------------------------------------------------ Consolidated Net Revenues $374,699 $525,007 $(150,308) (28.6)% ========================================================================
Personal Computer Product Net Revenues We released four PC titles in the second quarter of the current fiscal year compared to six for the same period last year. The decrease in sales of PC products for the three and six months ended September 30, 2000 was primarily attributable to fewer titles and the release of a major title, Command & Conquer Tiberian Sun, in the second quarter of the previous year. This decrease was offset by strong sales of The Sims and The Sims Livin' Large in the current year. PlayStation Product Net Revenues We released five PlayStation titles in the second quarter of the current fiscal year compared to seven for the same period last year, including Madden NFL. As expected, PlayStation sales decreased for the three months and six months ended September 30, 2000 compared to the prior year primarily attributable to the PlayStation 2 platform transition. Although our PlayStation products are playable on the PlayStation 2 console, we expect sales of current PlayStation products to continue to decline in fiscal 2001. Under the terms of a licensing agreement with Sony Computer Entertainment of America in July 1994 (the "Sony Agreement"), as amended, we are authorized to develop and distribute CD-based software products compatible with the PlayStation. Pursuant to the Sony Agreement, we engage Sony to supply PlayStation CDs for distribution by us. Accordingly, we have limited ability to control our supply of PlayStation CD products or the timing of their delivery. See Risk Factors - "Our platform licensors are our chief competitors and frequently control the manufacturing of our video game products", below. Online Net Revenues The increase in online revenues for the three and six months ended September 30, 2000 as compared to the three and six months ended September 30, 1999 was attributable to the following: o We generated over $1,400,000 in subscription revenues for Kesmai and Worldplay products in the current quarter and over $3,800,000 for the six months ended September 30, 2000. These products were part of the Kesmai acquisition which occurred in the fourth 23 quarter of fiscal 2000. It is anticipated that the subscription revenues associated with these services will be eliminated as these products will be shut-down or converted into ad revenue-based offerings in future quarters. o The average number of paying customers for Ultima Online increased to over 190,000 for the three months ended September 30, 2000 as compared to over 120,000 for the same period last year and was over 194,000 for the six months ended September 30, 2000 as compared to over 116,000 for the same period last year. This increase was due to continued strong sales of Ultima Online, the addition of new events and parties within the Ultima worlds and the release of Ultima Renaissance in April 2000. Ultima Renaissance added features including new houses and land mass. o We established servers for Ultima Online in Korea in September 1999, Taiwan in November 1999 and Australia in January 2000 which resulted in new customers for the three months and six months ended September 30, 2000, as compared to the same periods last year. PlayStation 2 Product Net Revenues We released our first two PlayStation 2 titles, FIFA Soccer World Championship and Xfire, in Japan during the first half of fiscal 2001. N64 Product Net Revenues We released one N64 title in the second quarter of fiscal 2001 compared to four titles during the same period last year. The expected decrease in N64 revenues for the three months and six months ended September 30, 2000, compared to the same period last year was primarily due to fewer releases. The decrease is also due to the weaker market for Nintendo 64 products in the current year. We expect revenues for N64 products to continue to decline significantly in fiscal 2001. Under the terms of the N64 Agreement, we engage Nintendo to manufacture our N64 cartridges for distribution by us. Accordingly, we have little ability to control our supply of N64 cartridges or the timing of their delivery. A shortage of microchips or other factors outside our control could impair our ability to obtain an adequate supply of cartridges. In connection with our purchases of N64 cartridges for distribution in North America, Nintendo requires us to provide irrevocable letters of credit prior to Nintendo's acceptance of purchase orders from us for purchases of these cartridges. For purchases of N64 cartridges for distribution in Japan and Europe, Nintendo requires us to make cash deposits. Furthermore, Nintendo maintains a policy of not accepting returns of N64 cartridges. Because of these and other factors, the carrying of an inventory of cartridges entails significant capital and risk. See Risk Factors - "Our platform licensors are our chief competitors and frequently control the manufacturing of our video game products", below. License, OEM and Other Revenues The increase in license, OEM and other revenues for the three and six months ended September 30, 2000 was primarily a result of higher licensing revenue in Europe due to revenue generated from an exclusive distribution agreement. Affiliated Label Product Net Revenues The decrease in Affiliated Label net revenues for the three and six months ended September 30, 2000 compared to the same periods last year was primarily due to the strong sales of Final 24 Fantasy VIII in the prior year, the acquisition of Accolade, formerly an AL, by a third party in the first quarter of the prior year, our acquisition of DreamWorks Interactive, formerly an AL, in the fourth quarter of the prior year and fewer hit AL product releases. Operations by Segment As a result of the approval of the Tracking Stock proposal (see Note 3) to authorize issuance of a new series of common stock designated as Class B common stock, intended to reflect the performance of EA.com, management considers EA.com to be a separate reportable segment. Accordingly, prior period information has been restated to disclose this separate segment. We operate in two principal business segments globally: o Electronic Arts core ("EA Core") business segment: creation, marketing and distribution of entertainment software. o EA.com business segment: creation, marketing and distribution of entertainment software which can be played or sold online and ongoing management of subscriptions of online games. EA.com, a division of Electronic Arts Inc., represents Electronic Arts' online and e-Commerce businesses. EA.com's business includes subscription revenues collected for Internet game play on our websites, sales of packaged goods for Internet-only based games and sales of Electronic Arts games sold through EA.com websites. The statement of operations includes all revenues and costs directly attributable to EA.com, including charges for shared facilities, functions and services used by EA.com and provided by Electronic Arts. Certain costs and expenses have been allocated based on management's estimates of the cost of services provided to EA.com by Electronic Arts. 25 Information about our operations by segment for fiscal 2001 and 2000 is presented below (in thousands): ---------------------------------------------------------------------------------------------------------------------------------
Three Months Ended September 30, 2000 EA Core Adjustments and (excl. EA.com) EA.com Eliminations Electronic Arts --------------------------------------------------------------------------------------------------------------------------------- Net revenues from unaffiliated customers $210,563 $ 9,337 $ - $219,900 Group sales 683 - (683) (a) - --------------------------------------------------------------------------------------------------------------------------------- Total net revenues 211,246 9,337 (683) 219,900 --------------------------------------------------------------------------------------------------------------------------------- Cost of goods sold from unaffiliated customers 116,085 2,690 - 118,775 Group cost of goods sold - 683 (683) (a) - --------------------------------------------------------------------------------------------------------------------------------- Total cost of goods sold 116,085 3,373 (683) 118,775 --------------------------------------------------------------------------------------------------------------------------------- Gross profit 95,161 5,964 - 101,125 Operating expenses: Marketing and sales 36,752 1,511 - 38,263 General and administrative 24,142 2,150 - 26,292 Research and development 64,195 16,887 10,926 (b) 92,008 Network development and support - 10,926 (10,926) (b) - Amortization of intangibles 3,221 1,495 - 4,716 --------------------------------------------------------------------------------------------------------------------------------- Total operating expenses 128,310 32,969 - 161,279 --------------------------------------------------------------------------------------------------------------------------------- Operating loss (33,149) (27,005) - (60,154) Interest and other income, net 4,090 12 - 4,102 --------------------------------------------------------------------------------------------------------------------------------- Loss before benefit from income taxes and minority interest (29,059) (26,993) - (56,052) Benefit from income taxes (17,376) - - (17,376) --------------------------------------------------------------------------------------------------------------------------------- Loss before minority interest (11,683) (26,993) - (38,676) Minority interest in consolidated joint venture (233) - - (233) --------------------------------------------------------------------------------------------------------------------------------- Net loss before retained interest in EA.com $(11,916) $(26,993) $ - $(38,909) =================================================================================================================================
Allocation of retained interest (in thousands): ---------------------------------------------------------------------------------------------------------------------------------
Three Months Ended September 30, 2000 EA Core Adjustments and (excl. EA.com) EA.com Eliminations Electronic Arts --------------------------------------------------------------------------------------------------------------------------------- Net loss before retained interest in EA.com $(11,916) $(26,993) $ - $(38,909) Net loss related to retained interest in EA.com (22,944) 22,944 - - --------------------------------------------------------------------------------------------------------------------------------- Net loss $(34,860) $ (4,049) $ - $(38,909) =================================================================================================================================
26 ---------------------------------------------------------------------------------------------------------------------------------
Three Months Ended September 30, 1999 EA Core Adjustments and (excl. EA.com) EA.com Eliminations Electronic Arts --------------------------------------------------------------------------------------------------------------------------------- Net revenues from unaffiliated customers $334,107 $4,780 $ - $338,887 Group sales 614 - (614) (a) - --------------------------------------------------------------------------------------------------------------------------------- Total net revenues 334,721 4,780 (614) 338,887 --------------------------------------------------------------------------------------------------------------------------------- Cost of goods sold from unaffiliated customers 175,716 1,431 - 177,147 Group cost of goods sold - 614 (614) (a) - --------------------------------------------------------------------------------------------------------------------------------- Total cost of goods sold 175,716 2,045 (614) 177,147 --------------------------------------------------------------------------------------------------------------------------------- Gross profit 159,005 2,735 - 161,740 Operating expenses: Marketing and sales 45,773 327 - 46,100 General and administrative 21,925 376 - 22,301 Research and development 56,537 6,899 3,590 (b) 67,026 Network development and support - 3,590 (3,590) (b) - Amortization of intangibles 2,587 29 - 2,616 --------------------------------------------------------------------------------------------------------------------------------- Total operating expenses 126,822 11,221 - 138,043 --------------------------------------------------------------------------------------------------------------------------------- Operating income (loss) 32,183 (8,486) - 23,697 Interest and other income, net 3,133 - - 3,133 --------------------------------------------------------------------------------------------------------------------------------- Income (loss) before provision for income taxes and minority interest 35,316 (8,486) - 26,830 Provision for income taxes 8,586 - - 8,586 --------------------------------------------------------------------------------------------------------------------------------- Income (loss) before minority interest 26,730 (8,486) - 18,244 Minority interest in consolidated joint venture (112) - - (112) --------------------------------------------------------------------------------------------------------------------------------- Net income (loss) $26,618 $(8,486) $ - $18,132 =================================================================================================================================
27 ---------------------------------------------------------------------------------------------------------------------------
Six Months Ended September 30, 2000 EA Core Adjustments and (excl. EA.com) EA.com Eliminations Electronic Arts --------------------------------------------------------------------------------------------------------------------------- Net revenues from unaffiliated customers $356,609 $18,090 $ - $374,699 Group sales 1,043 - (1,043) (a) - --------------------------------------------------------------------------------------------------------------------------- Total net revenues 357,652 18,090 (1,043) 374,699 --------------------------------------------------------------------------------------------------------------------------- Cost of goods sold from unaffiliated customers 192,584 4,098 - 196,682 Group cost of goods sold - 1,043 (1,043) (a) - --------------------------------------------------------------------------------------------------------------------------- Total cost of goods sold 192,584 5,141 (1,043) 196,682 --------------------------------------------------------------------------------------------------------------------------- Gross profit 165,068 12,949 - 178,017 Operating expenses: Marketing and sales 70,012 3,444 - 73,456 General and administrative 43,889 4,612 - 48,501 Research and development 117,854 34,168 19,199 (b) 171,221 Network development and support - 19,199 (19,199) (b) - Amortization of intangibles 6,461 2,909 - 9,370 --------------------------------------------------------------------------------------------------------------------------- Total operating expenses 238,216 64,332 - 302,548 --------------------------------------------------------------------------------------------------------------------------- Operating loss (73,148) (51,383) - (124,531) Interest and other income, net 7,931 7 - 7,938 --------------------------------------------------------------------------------------------------------------------------- Loss before benefit from income taxes and minority interest (65,217) (51,376) - (116,593) Benefit from income taxes (36,144) - - (36,144) --------------------------------------------------------------------------------------------------------------------------- Loss before minority interest (29,073) (51,376) - (80,449) Minority interest in consolidated joint venture (731) - - (731) --------------------------------------------------------------------------------------------------------------------------- Net loss before retained interest in EA.com $(29,804) $(51,376) $ - $(81,180) ===========================================================================================================================
Allocation of retained interest (in thousands): ---------------------------------------------------------------------------------------------------------------------------
Six Months Ended September 30, 2000 EA Core Adjustments and (excl. EA.com) EA.com Eliminations Electronic Arts --------------------------------------------------------------------------------------------------------------------------- Net loss before retained interest in EA.com $(29,804) $(51,376) $ - $(81,180) Net loss related to retained interest in EA.com (43,670) 43,670 - - --------------------------------------------------------------------------------------------------------------------------- Net loss $(73,474) $ (7,706) $ - $(81,180) ===========================================================================================================================
28 ---------------------------------------------------------------------------------------------------------------------------
Six Months Ended September 30, 1999 EA Core Adjustments and (excl. EA.com) EA.com Eliminations Electronic Arts --------------------------------------------------------------------------------------------------------------------------- Net revenues from unaffiliated customers $515,837 $9,170 $ - $525,007 Group sales 908 - (908) (a) - --------------------------------------------------------------------------------------------------------------------------- Total net revenues 516,745 9,170 (908) 525,007 --------------------------------------------------------------------------------------------------------------------------- Cost of goods sold from unaffiliated customers 260,962 2,436 - 263,398 Group cost of goods sold - 908 (908) (a) - --------------------------------------------------------------------------------------------------------------------------- Total cost of goods sold 260,962 3,344 (908) 263,398 --------------------------------------------------------------------------------------------------------------------------- Gross profit 255,783 5,826 - 261,609 Operating expenses: Marketing and sales 79,225 722 - 79,947 General and administrative 39,379 630 - 40,009 Research and development 96,759 10,637 6,205 (b) 113,601 Network development and support - 6,205 (6,205) (b) - Amortization of intangibles 5,175 29 - 5,204 --------------------------------------------------------------------------------------------------------------------------- Total operating expenses 220,538 18,223 - 238,761 --------------------------------------------------------------------------------------------------------------------------- Operating income (loss) 35,245 (12,397) - 22,848 Interest and other income, net 7,271 - - 7,271 --------------------------------------------------------------------------------------------------------------------------- Income (loss) before provision for income taxes and minority interest 42,516 (12,397) - 30,119 Provision for income taxes 9,638 - - 9,638 --------------------------------------------------------------------------------------------------------------------------- Income (loss) before minority interest 32,878 (12,397) - 20,481 Minority interest in consolidated joint venture (23) - - (23) --------------------------------------------------------------------------------------------------------------------------- Net income (loss) $32,855 $(12,397) $ - $20,458 =========================================================================================================================== (a) Represents elimination of intercompany sales of Electronic Arts packaged goods products to EA.com, and represents elimination of royalties paid to Electronic Arts by EA.com for intellectual property rights. (b) Represents reclassification of Network Development and Support to Research and Development.
29 The following table presents pro-forma results of operations allocating taxes between EA Core and EA.com. Consolidated taxes have been allocated to EA Core and EA.com on a pro rata basis based on the consolidated effective tax rates, thereby giving EA.com the tax benefit of its losses which is utilized by the consolidated group. Such tax benefit could not be recognized by EA.com on a stand-alone basis. The sum of tax expense and tax benefit for EA Core and EA.com is the same as consolidated tax expense and tax benefit. This presentation represents how management analyzes each segment of the business (in thousands): ---------------------------------------------------------------------------------------------------------------------------
Three Months Ended September 30, 2000 EA Core EA.com Adjustments and (excl. EA.com) Eliminations Electronic Arts --------------------------------------------------------------------------------------------------------------------------- Loss before benefit from income taxes and minority interest $(29,059) $(26,993) $- $(56,052) Benefit from income taxes (9,008) (8,368) - (17,376) --------------------------------------------------------------------------------------------------------------------------- Loss before minority interest (20,051) (18,625) - (38,676) Minority interest in consolidated joint venture (233) - - (233) --------------------------------------------------------------------------------------------------------------------------- Net loss $(20,284) $(18,625) $- $(38,909) =========================================================================================================================== --------------------------------------------------------------------------------------------------------------------------- Three Months Ended September 30, 1999 EA Core Adjustments and (excl. EA.com) EA.com Eliminations Electronic Arts --------------------------------------------------------------------------------------------------------------------------- Income (loss) before provision for (benefit from) income taxes and minority interest $35,316 $(8,486) $- $26,830 Provision for (benefit from) income taxes 11,302 (2,716) - 8,586 --------------------------------------------------------------------------------------------------------------------------- Income (loss) before minority interest 24,014 (5,770) - 18,244 Minority interest in consolidated joint venture (112) - - (112) --------------------------------------------------------------------------------------------------------------------------- Net income (loss) $23,902 $(5,770) $- $18,132 =========================================================================================================================== --------------------------------------------------------------------------------------------------------------------------- Six Months Ended September 30, 2000 EA Core Adjustments and (excl. EA.com) EA.com Eliminations Electronic Arts --------------------------------------------------------------------------------------------------------------------------- Loss before benefit from income taxes and minority interest $(65,217) $(51,376) $- $(116,593) Benefit from income taxes (20,217) (15,927) - (36,144) --------------------------------------------------------------------------------------------------------------------------- Loss before minority interest (45,000) (35,449) - (80,449) Minority interest in consolidated joint venture (731) - - (731) --------------------------------------------------------------------------------------------------------------------------- Net loss $(45,731) $(35,449) $- $(81,180) =========================================================================================================================== --------------------------------------------------------------------------------------------------------------------------- Six Months Ended September 30, 1999 EA Core Adjustments and (excl. EA.com) EA.com Eliminations Electronic Arts --------------------------------------------------------------------------------------------------------------------------- Income (loss) before provision for (benefit from) income taxes and minority interest $42,516 $(12,397) $- $30,119 Provision for (benefit from) income taxes 13,606 (3,968) - 9,638 --------------------------------------------------------------------------------------------------------------------------- Income (loss) before minority interest 28,910 (8,429) - 20,481 Minority interest in consolidated joint venture (23) - - (23) --------------------------------------------------------------------------------------------------------------------------- Net income (loss) $28,887 $ (8,429) $- $20,458 ===========================================================================================================================
30 Costs and Expenses, Interest and Other Income, Net, Income Taxes and Net Income (Loss) Information about our costs and expenses, interest and other income, net, income taxes and net income (loss) for the three and six months ended September 30, 2000 and 1999 is presented below:
Percent of Net Revenues Percent of Net Revenues -------------------------- ------------------------- Three Months Ended Six Months Ended Sept 30, Sept 30, -------------------------- -------------------------- 2000 1999 2000 1999 --------- ------------- ------------ ---------- Cost of goods sold 54.0 % 52.3 % 52.5 % 50.2 % Marketing and sales 17.4 13.6 19.6 15.2 General and administrative 12.0 6.6 12.9 7.6 Research and development (includes 41.8 19.8 45.7 21.6 Network development and support) Amortization of intangibles 2.1 0.8 2.5 1.0 Interest and other income, net 1.9 0.9 2.1 1.4 Income taxes - effective tax rate 31.0 32.0 31.0 32.0 Net income (loss) (17.7) % 5.4 % (21.7) % 3.9 %
Cost of Goods Sold. Cost of goods sold as a percentage of net revenues increased for the three months and six months ended September 30, 2000 compared to the same period last year primarily due to: o A decrease in the average margins on PlayStation products due to an increase, as a percent of revenue, in lower margin catalogue products as compared to the prior year. o A decrease in the average margins on PC products due to an increase, as a percent of revenue, in lower margin catalogue products as compared to the prior year. In addition, prior year included higher sales of higher margin internally developed titles such as Command & Conquer Tiberian Sun, Sim City 3000, and Dungeon Keeper 2. o Offset by a decrease in sales of lower margin N64 titles. Marketing and Sales. Marketing and sales expenses for the three months ended September 30, 2000 decreased in absolute dollars by 17% and decreased 8% for the six months ended September 30, 2000, primarily attributed to: o Lower television, print and Internet advertising due to fewer number of releases in the quarter compared to the same period last year. In addition, prior year reflects a large advertising effort to support the release of Command & Conquer Tiberian Sun. o Decrease in cooperative advertising associated with lower revenues in Europe and North America. o Offset by an increase in EA.com marketing and sales staff required to support the future launch of the game site. In future periods, EA.com intends to further increase marketing and advertising spending in order to promote the game site and the Games Channel on AOL. 31 General and Administrative. General and administrative expenses increased for the three months ended September 30, 2000 in absolute dollars by 18% and increased 21% for the six months ended September 30, 2000, primarily attributed to: o The expansion of the EA.com staff and additional administrative-related costs required to support the growth of the EA.com business. We anticipate a continued increase in the absolute dollars spent on general and administrative related expenses. o Increase in bad debt due to a write off of a receivable as a result of the default of payment from a customer in Europe. o Increase in depreciation expense for Europe due to the implementation of a new online transaction processing system. Research and Development (excluding Network Development and Support). Research and development expenses increased for the three months ended September 30, 2000 in absolute dollars by 28% and 42% for the six months ended September 30, 2000, primarily attributed to: o Increase in research and development expenses by EA.com (including expenses incurred by EA core on behalf of EA.com) due to an increase in the number of online projects in development and increased development staff. The type of games that will be in development will most likely increase in complexity and depth. To support this effort, EA.com may be required to increase its development and production expenses. o An increase in development spending for next generation console products including development for the PlayStation 2 console. o The increase is also due to research and development expenses related to the acquisition of DreamWorks Interactive, a software development company, in the fourth quarter of the prior fiscal year. Network Development and Support. The increase in network development and support expenses was primarily due to increased spending for the EA.com network infrastructure and the network support organization in preparation for the launch of the EA.com game site and the Games Channel on the AOL service. Certain costs associated with EA.com's infrastructure build have been capitalized in accordance with SOP 98-1. EA.com will begin amortizing these costs commencing with the October launch of these sites. In addition, resources previously associated with developing this infrastructure will be reallocated to maintaining these sites and building new enhancements for EA.com web properties. As such, the related costs for these resources will be either expensed or capitalized as required by this SOP. Amortization of Intangibles. The amortization of intangibles results primarily from the acquisitions of Westwood, Kesmai, ABC Software and other acquisitions. Amortization of intangibles was $3,221,000 for EA Core and $1,495,000 for EA.com for the three months ended September 30, 2000. Amortization of intangibles was $6,461,000 for EA Core and $2,909,000 for EA.com for the six months ended September 30, 2000. Amortization of intangibles was $2,616,000 for EA Core for the three months ended September 30, 1999 and $5,204,000 for EA Core for the six months ended September 30, 1999. There was no amortization of intangibles for EA.com in the same periods of the prior year. Interest and Other Income, Net. Interest and other income, net, increased in absolute dollars for the three months ended September 30, 2000 primarily due to higher interest income in the 32 current year attributable to investments in longer term securities, with maturities no greater than three years, resulting in higher interest rates. Interest and other income, net, increased for the six months ended September 30, 2000 due to higher interest income in the current year offset by a gain on sale of marketable securities and a sale of a minority interest in an affiliate in the same period last year. Income Taxes. Our effective tax rate was 31.0% for the three months and six months ended September 30, 2000 and 32% for the three months and six months ended September 30, 1999. The effective tax rate was lower than the comparable prior year period primarily as a result of a projected higher portion of international income for fiscal 2001 subject to a lower foreign tax rate as compared to the prior year. Net Income (Loss). In absolute dollars, reported net loss increased for the three and six months ended September 30, 2000 primarily related to lower revenues and gross profits as well as higher costs and expenses, as a percent of net revenues, compared to the same period last year. The increase was also due to an increase in the number of products in development and higher network development and support costs in preparation for new online products and our game site and the Games Channel on the AOL service. Excluding goodwill and non-cash compensation charges in the amount of $3,951,000, net of taxes, for the three months ended September 30, 2000, net loss would have been $34,958,000. Excluding goodwill and non-cash compensation charges in the amount of $2,007,000, net of taxes, for the three months ended September 30, 1999, net income would have been $20,139,000. Excluding goodwill and non-cash compensation charges in the amount of $7,549,000, net of taxes, for the six months ended September 30, 2000, net loss would have been $73,631,000. Excluding goodwill and non-cash compensation charges in the amount of $3,838,00, net of taxes for the six months ended September 30, 1999, net income would have been $24,296,000. 33 LIQUIDITY AND CAPITAL RESOURCES As of September 30, 2000, our working capital was $365,196,000 compared to $440,021,000 at March 31, 2000. Cash, cash equivalents and short-term investments decreased by approximately $85,987,000 during the six months ended September 30, 2000 as we used $42,954,000 of cash in operations and $86,861,000 in capital expenditures, offset by $47,434,000 provided through the sale of equity securities under our stock plans as well as proceeds from the sale of property and equipment. Reserves for bad debts and sales returns decreased from $65,067,000 at March 31, 2000 to $56,094,000 at September 30, 2000. Reserves have been charged for returns of product and price protection credits issued for products sold in prior periods. Management believes these reserves are adequate based on historical experience and its current estimate of potential returns and allowances. Our principal source of liquidity is $253,817,000 in cash, cash equivalents and short-term investments. Management believes the existing cash, cash equivalents, short-term investments, marketable securities and cash generated from operations will be sufficient to meet cash and investment requirements on both a short-term and long-term basis. Included in the amounts above is the following for the EA.com business: o To date, EA.com has been funded solely by Electronic Arts. No interest charge has been reflected in the accompanying consolidated financial statements. Excess cash generated from operations is transferred to Electronic Arts. We anticipate these funding procedures will continue in the near-term. Electronic Arts may, at its discretion, provide funds to EA.com under a debt arrangement, instead of treating such funding as a capital contribution. o During the six months ended September 30, 2000, EA.com used $53,417,000 of cash in operations, $57,611,000 in capital expenditures for computer equipment, network infrastructure and related software (including $28,281,000 of consulting, hardware, software and direct payroll and payroll-related costs associated with the implementation of customized internal-use software), offset by $111,066,000 provided through the capital contribution from Electronic Arts. Impact of Recently Issued Accounting Standards In July 2000, the Emerging Issues Task Force reached a consensus on issue No. 00-15 ("EITF 00-15"), "Classification in the Statement of Cash Flows of the Income Tax Benefit Realized by a Company upon Employee Exercise of a Nonqualified Stock Option". The EITF concluded that income tax benefits realized upon an employee's exercise of a nonqualified stock option should be classified as an operating cash flow. Accordingly, the Company reclassified tax benefits resulting from the exercise of stock options on its Consolidated Statements of Cash Flows. 34 In July 2000, the Emerging Issues Task Force issued No. 00-10 ("EITF 00-10"), "Accounting for Shipping and Handling Fees and Costs", and concluded that all amounts billed to a customer in a sale transaction related to shipping and handling, if any, represent revenue to the vendor and, therefore, should be classified as revenue. The adoption of EITF 00-10 did not have a significant impact on the results of operations, financial position or cash flows. In May 2000, the Emerging Issues Task Force issued No. 00-14 ("EITF 00-14"), "Accounting for Certain Sales Incentives". EITF 00-14 states that for a sales incentive that will not result in a loss on the sale of a product or service, a vendor should recognize the cost of the incentive at the latter of the date at which the related revenue is recorded or the date at which the incentive is offered. If the sales incentive will result in a loss on the sale of the product or service, the vendor should not recognize a liability for the sales incentive until the related revenue is recognized. Secondly, for certain sales incentives that entitle a customer to receive a reduction in the price of a product or service in the form of a refund or rebate, the vendor should recognize a liability for those sales incentives based on an estimated amount of refunds or rebates that may be claimed by customers. The Task Force also concluded that the reduction in or refund of the selling price resulting from any cash sales incentive should be classified as a reduction in revenue and if the sales incentive offered is a free product or service delivered at the time of sale, the cost of the free product or service should be classified as an expense. The adoption of EITF 00-14 did not have a material impact on its results of operations, financial position or cash flows for the Company. In March 2000, the Financial Accounting Standards Board issued Interpretation No. 44 ("FIN 44"), "Accounting for Certain Transactions Involving Stock Compensation (an interpretation of APB Opinion No. 25)". FIN 44 clarifies the application of APB Opinion No. 25 for certain issues: (a) the definition of employee for purposes of applying Opinion 25, (b) the criteria for determining whether a plan qualifies as a noncompensatory plan, (c) the accounting consequence of various modifications to the terms of a previously fixed stock option or award, and (d) the accounting for an exchange of stock compensation awards in a business combination. Generally, FIN 44 is effective July 1, 2000. The adoption of FIN 44 did not have a material impact on the Company's consolidated financial position or results of operations. In March 2000, the Emerging Issues Task Force issued No. 00-03 ("EITF 00-03"), "Application of AICPA SOP 97-2, "Software Revenue Recognition," to Arrangements That Include the Right to Use Software Stored on Another Entity's Hardware", which discusses the effect on revenue recognition of a software vendor's obligation to host its software that previously was licensed to a customer. The EITF has reached the conclusion that, if the customer is unable to utilize the software on the customer's hardware or contract with another party unrelated to the vendor to host the software, then the arrangement with the customer is outside the scope of SOP 97-2 and should be treated as a service contract. The adoption of EITF 00-03 did not have a material impact on the Company's financial position and results of operations. In March 2000, the Emerging Issues Task Force issued No. 00-02 ("EITF 00-02"), "Accounting for Web Site Development Costs". EITF 00-02 states that all costs relating to software used to operate a web site and relating to development of initial graphics and web page design should be accounted for using Statement of Position ("SOP") 98-1. Under this SOP, costs incurred in the preliminary project stage should be expensed as incurred, as should most training and data conversion costs. External direct costs of materials and services and internal direct payroll- 35 related costs should be capitalized once certain criteria are met. EITF 00-02 is effective for all fiscal quarters beginning after June 30, 2000. The Company's accounting policy for internal-use software, as required by SOP 98-1, incorporated the requirements of EITF 00-02. In December 1999, the Securities and Exchange Commission ("SEC") issued Staff Accounting Bulletin No. 101("SAB 101"), "Revenue Recognition," which outlines the basic criteria that must be met to recognize revenue and provides guidance for presentation of revenue and for disclosure related to revenue recognition policies in financial statements filed with the SEC. SAB 101 is effective the fourth fiscal quarter of fiscal years beginning after December 15, 1999 as amended by SAB 101B. The Company believes the adoption of SAB 101 will not have a material impact on the Company's financial position and results of operations. In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 133 ("SFAS 133") "Accounting for Derivative Instruments and Hedging Activities", as amended by SFAS 137 "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133 - an Amendment of FASB Statement No. 133" and SFAS 138 "Accounting for Certain Derivative Instruments and Certain Hedging Activities - an Amendment of FASB Statement No. 133" which establishes accounting and reporting standards for derivative instruments and hedging activities. The terms of SFAS 133 and SFAS 138 are effective as of the beginning of the first quarter of the fiscal year beginning after June 15, 2000. The Company is determining the effect of SFAS 133, 137 and 138 on its financial statements. In March 1998, the American Institute of Certified Public Accountants ("AICPA") issued SOP 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use". SOP 98-1 requires that consulting, hardware, software and direct payroll-related costs associated with the implementation of customized internal-use software be capitalized and amortized over the estimated useful life of the software. These costs relate to game site application and infrastructure design and development, as well as costs related to providing customer account management and building in e-Commerce functionality and interfaces. SOP 98-1 is effective for financial statements issued for fiscal years beginning after December 15, 1998. As of September 30, 2000, the Company has capitalized $43,342,000 of these costs associated with the effort to build the EA.com website and infrastructure. 36 RISK Factors Electronic Arts' business is subject to many risks and uncertainties which may affect our future financial performance. Some of those important risks and uncertainties which may cause our operating results to vary or which may materially and adversely affect our operating results are as follows: Risk Factors Relating to Our Core Business Platform Transitions Such as the One Now Occurring Typically Depress the Market for Video Game Software Until New Platforms Achieve a Wide Market Acceptance When new video game platforms are announced or introduced into the market, consumers typically reduce their purchases of video games for current platforms in anticipation of new platforms being available. During that period, sales of our video game products can be expected to slow or even decline until new platforms have achieved a wide market and consumer acceptance. We are currently in such a transition. Sony has shipped its PlayStation 2 product in Japan and North America and expects to ship the PlayStation 2 console in Europe in November 2000. For the December quarter and the current fiscal year, the manufacturing shortages announced by Sony of the PlayStation 2 units in North America and Europe pose serious uncertainty. In addition, Nintendo and Microsoft have announced that their new console systems will be released in calendar year 2001. Current sales of our products for the existing PlayStation and Nintendo 64 platforms have been adversely affected. We expect this trend to continue until one or more of these new consoles achieve a wide installed base of consumers. New Video Game Platforms Create Additional Technical and Business Model Uncertainties Large portions of our revenues are derived from the sale of products for play on proprietary video game platforms such as the Sony PlayStation. The success of our products is significantly affected by acceptance of the new video game hardware systems and the life span of older hardware platforms and our ability to accurately predict which platforms will be most successful. Sometimes we will spend development and marketing resources on products designed for new video game systems that have not yet achieved large installed bases or will continue product development for older hardware platforms that may have shorter life cycles than we expected. Conversely, if we do not develop for a platform that achieves significant market acceptance, or discontinue development for a platform that has a longer life cycle than expected, our revenue growth may be adversely affected. For example, the Sega Dreamcast console launched in Japan in early 1999 and in the United States in September of 1999. We have no products under development for this platform. Should this platform achieve wide market acceptance, our revenue growth may be adversely affected. Similarly, we released a variety of products for the new Sony platform, the PlayStation 2. Should that platform not achieve wide acceptance by consumers, we will have spent a disproportionate amount of our resources for this platform. Additionally, we have not negotiated publishing agreements with Sony, Sega or Nintendo for their next generation platforms, or with Microsoft for their new console system, and we do not know whether the terms of those agreements will be favorable. Product Development Schedules Are Frequently Unreliable and Make Predicting Quarterly Results Difficult Product development schedules, particularly for new hardware platforms and high-end multimedia personal computers, or PCs, are difficult to predict because they involve creative processes, use of new 37 development tools for new platforms and the learning process, research and experimentation associated with development for new technologies. For example, Tiberian Sun, which was expected to ship in fiscal 1999 at the time of our acquisition of Westwood Studios, was not released until the second quarter of fiscal 2000 due to development delays. Additionally, development risks for CD-ROM products can cause particular difficulties in predicting quarterly results because brief manufacturing lead times allow finalizing products and projected release dates late in a quarter. Our revenues and earnings are dependent on our ability to meet our product release schedules, and our failure to meet those schedules could result in revenues and earnings which fall short of analysts' expectations for any individual quarter and the fiscal year. Our Business Is Both Seasonal and Cyclical Our business is highly seasonal with a significant percentage of our revenues occurring in the December quarter. In our 2001 fiscal year, we expect these seasonal trends to be magnified by general industry factors, including the current platform transition and the concentration of our product releases in the second half of fiscal 2001. In addition, we are continuing to invest significantly in our online operation, EA.com. Our business is also cyclical; video game platforms have historically had a life cycle of four to six years, and decline as more advanced platforms are being introduced. As one group of platforms is reaching the end of its cycle and new platforms are emerging, buying patterns may change. Purchases of products for older platforms may slow at a faster rate than sales of new platforms. We are currently in such a platform transition. Sega introduced its latest platform in the United States in September 1999, and Sony has shipped its PlayStation 2 console in Japan and North America and expects to ship its PlayStation 2 product in Europe in November 2000. Nintendo and Microsoft have also announced that their new console systems will be released in calendar year 2001. Sales of our current products for the current Nintendo and Sony platforms have already been adversely affected, and we expect this trend to continue until one or more new platforms achieves a wide installed base of consumers. The Impact of e-Commerce and Online Games on Our Business Is Not Known While we do not currently derive significant revenues from online sales of our packaged products, we believe that such form of distribution will become a more significant factor in our business in the future. E-commerce is becoming an increasingly popular method for conducting business with consumers. How that form of distribution will affect the more traditional retail distribution, at which we have historically had success, and over what time period, is uncertain. In addition, we expect the number and popularity of online games to increase and become a significant factor in the interactive games business generally. We do not know how that increase generally, or the emerging business of EA.com specifically, will affect the sales of packaged goods. Our Business, Our Products, and Our Distribution Are Subject to Increasing Regulation in Key Territories Legislation is increasingly introduced which may affect the content of our products and their distribution. For example, privacy rules in the United States and Europe impose various restrictions on our web sites. Those rules vary by territory while of course the Internet recognizes no geographical boundaries. Other countries such as Germany have adopted laws regulating content transmitted over the Internet that are stricter than current United States laws. In the United States, in response to recent events, the federal and several state governments are considering content restrictions on products such as those made by us as well as restrictions on distribution of such products. Any one or more of these factors could harm our business. 38 Our Platform Licensors Are Our Chief Competitors and Frequently Control the Manufacturing of Our Video Game Products Our agreements with hardware licensors, which are also our chief competitors, typically give significant control to the licensor over the approval and manufacturing of our products. This fact could, in certain circumstances, leave us unable to get our products approved, manufactured and shipped to customers. 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. For example, in prior years, we experienced delays in obtaining approvals for and manufacturing of PlayStation products which caused delays in shipping those products. The potential for additional delay or refusal to approve or manufacture our products continues with our platform licensors. Such occurrences would harm our business and adversely affect our financial performance. Proliferation and Assertion of Patents Poses Serious Risks to our Business Many patents have been issued that may apply to widely used game technologies. Additionally, many recently issued patents are now being asserted against Internet implementations of existing games. Several such patents have been asserted against us. For example, we currently have a lawsuit pending regarding our publication of games that can be played both alone and with others over the Internet in which the patent holder has moved to enjoin the sale of EA personal computer products that can be played alone and over the Internet. Such claims can harm our business. We will 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. Risk Factors Relating to Our Online Business Because of EA.com's Limited Operating History, It Will Be Difficult To Evaluate its Business and Prospects EA.com's business is still in the developing stages, so evaluating its business and prospects will be more difficult than would be the case for a more mature business. We will continue to encounter the risks and difficulties faced in launching a new business, and we may not achieve our goals or may be compelled to change the manner in which we seek to develop the business. These uncertainties as to the future operations of EA.com will increase the difficulty we face in completing and pursuing the essential plans for the development of the business and will also make it more difficult for our stockholders and securities analysts to predict the operating results of this business. EA.com Has a History of Losses and Expects To Continue To Incur Losses and May Never Achieve Profitability EA.com has incurred substantial losses to date, including the current fiscal year. We expect EA.com to continue to incur losses as it develops its business. EA.com will be required to maintain the significant support, service and product enhancement demands of online users, and we cannot be certain that EA.com will produce sufficient revenues from its operations to support these costs. Even if profitability is achieved, EA.com may not be able to sustain it over a period of time. 39 Our Agreements with America Online May Not Prove Successful to the Development of EA.com's Business We have announced a series of agreements with America Online ("AOL") for the offering of our games through AOL for online play. These agreements require that we make substantial guaranteed payments to AOL and that we commit our resources to the pursuit of the online game opportunity. We cannot be assured that the substantial costs associated with the AOL agreements will be justified by the revenues generated from that relationship. In addition, restrictions included in the AOL agreements limiting other channels we may develop for offering online games may limit our ability to diversify our online distribution strategies. The success for us of the AOL agreements will also be a result of AOL's performance under the agreements, a factor over which we will have very little control. We Have Very Limited Experience with Online Games and May Not Be Able To Operate This Business Effectively Offering games solely for online play is a substantial departure from our traditional business of selling packaged software games. We anticipate employing various pricing models, including subscription fees, "pay to play fees" and advertising. We have very little experience with developing optimal pricing strategies for online games and no experience in "pay to play" pricing or in securing advertising revenue for online services. Similarly, we are inexperienced in predicting usage patterns for our games. Because of our inexperience in this area, we may not be effective in achieving success that may otherwise be attainable from offering our games online. Online Games Have Risks That Are Not Associated with Our Traditional Business Online games, particularly multiplayer games, pose risks to player enjoyment that do not generally apply to packaged game sales. Players frequently would not be acquainted with other players, which may adversely affect the playing experience. Social issues raised by a player's conduct may impact the experience for other players. We have not determined whether or how we might monitor or proctor player behavior to mitigate behavior that impairs the game experience. In addition, there are substantial technical challenges to be met both in the introduction of our games online and in maintaining an effective game playing environment over time. If these risks are not successfully controlled and technical challenges resolved, potential customers for our games may be unwilling to play in sufficient volume to allow us to attain or sustain profitability. We May Not Be Able To Obtain the Required Licenses To Offer Our Games Online If we are unable to reach terms with certain licensors for our games, we will not be able to offer certain of our games for online play. Many of Electronic Arts' most popular games feature characters, trademarks, people or concepts for which we have licenses from third parties. As an example, our EA SPORTS products typically contain content licensed from a sports and players' association. In certain instances, the terms of these licenses will not allow us to offer the games for online play without negotiating an additional license. We cannot be certain that the licensors will be amenable to a license for online games involving their content or, even if they are, that we will be able to reach terms with them for such use. We may be forced to agree to terms that ultimately materially impair the economic value to us of the online game market. Proliferation and Assertion of Patents Poses Serious Risks to the Business of EA.com Many patents have been issued that may apply to widely used Internet technologies. Additionally, many recently issued patents are now being asserted against Internet implementations of older technologies. Several such patents have been asserted against us. For example, we currently have a lawsuit pending regarding our publication of games that can be played both alone and with others over 40 the Internet in which the patent holder has moved to enjoin the sale of EA personal computer products that can be played alone and over the Internet. Such claims can harm our business. We will 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. Development of EA.com's Business Will Require Significant Capital, and We Cannot Be Assured That It Will Be Available EA.com will not be successful if it does not receive the very substantial financing that will be required to launch its business. Electronic Arts has agreed to provide a limited amount of funding to EA.com, but this financing alone will not be sufficient for the development of EA.com's business. Any additional funding that is obtained from EA may either be treated as a revolving credit advance or would increase EA's retained interest in EA.com and correspondingly decrease the interest of the holders of outstanding shares of Class B common stock. The attraction of additional equity or debt financing for EA.com from third parties may not be possible or may only be possible on terms that result in significant dilution to Class A and Class B common stockholders or interest or other costs and debt-related restrictions on the operation of the business. If Use of the Internet Does Not Continue To Develop and Reliably Support the Demands Placed on It by Electronic Commerce, EA.com's Business Will Be Harmed EA.com's success depends upon growth in the use of the Internet as a medium for playing games. Although the Internet is experiencing rapid growth in the number of users, this growth is a recent phenomenon and may not continue. Furthermore, despite this growth in usage, the use of the Internet for sophisticated games like ours is relatively new. Our business would be seriously harmed if: o use of the Internet does not continue to increase or increases more slowly than expected, o the infrastructure for the Internet does not effectively support online game play, o concerns over the secure transmission of confidential information over public networks inhibit the growth of the Internet as a means of conducting commercial transactions, or o government regulations regarding Internet content, privacy or other conditions impede the effectiveness of the Internet to users. Capacity Restraints May Restrict the Use of the Internet as a Forum for Game Play, Resulting in Decreased Demand for Our Products The Internet infrastructure may not be able to support the demands placed on it by increased usage or the limited capacity of networks to transmit large amounts of data. Other risks associated with commercial use of the Internet could slow its growth, including: o outages and other delays resulting from the inadequate reliability of the network infrastructure, o slow development of enabling technologies and complementary products, and o limited availability of cost-effective, high speed access. Delays in the development or adoption of new equipment standards or protocols required to handle increased levels of Internet activity, or increased governmental regulation, would cause the 41 Internet to fail to gain, or lose, viability as a means of game playing. If these or any other factors cause use of the Internet for commerce to slow or decline, the Internet may not prove viable as a commercial marketplace. This, in turn, would result in decreased demand for EA.com's products and services. To Become and Remain Competitive, EA.com Must Continually Develop and Expand New Content. This Is Inherently Risky and Expensive. EA.com's success depends on our ability to develop products and services for the initial launch of the EA.com site and our ability to continually expand the content on that site. Our agreement with AOL requires us to develop new games under our relationship with AOL. We cannot assure you that products will be developed on time, in a cost effective manner, or that they will be successful. We May Not Be Able To Respond to Rapid Technological Change The market for Internet products and services is characterized by rapid technological change and evolving industry standards. Both in completing the design and implementation of our network infrastructure and thereafter, we will be required to continually improve performance, features, reliability and capacity of our network infrastructure. We cannot assure you that we will be successful in responding rapidly or in a cost effective manner to such developments. Increasing Governmental Regulation of the Internet Could Limit the Market for Our Products As Internet commerce continues to evolve, we expect that federal, state and foreign governments will adopt laws and regulations covering issues such as user privacy, taxation of goods and services provided over the Internet, pricing, content and quality of products and services. It is possible that legislation could expose companies involved in electronic commerce to liability, taxation or other increased costs, any of which could limit the growth of electronic commerce generally. Legislation could dampen the growth in Internet usage and decrease its acceptance as a communications and commercial medium. If enacted, these laws and regulations could limit the market for EA.com's products. If We Do Not Maintain Our Relationship with Outside Consultants Such as Andersen Consulting, Our Ability To Develop Our Online Business Will Be Impaired Because approximately 20% of the staff creating, designing, and developing the infrastructure for EA.com's website and network interface is being provided by outside consultants such as Andersen Consulting, losing the business relationship with such consultants would cause EA.com to lose an important component of its website implementation team. Given the intense competition for qualified technical consultants, EA.com may not be able to retain these consultants or, if necessary, replace them. If it cannot do so, its ability to develop its business will be impaired. Our Revenues Have Been Heavily Dependent on a Single Product and Would Be Adversely Affected if That Product's Popularity Were To Decline In the near term, EA.com's revenues to date have consisted primarily of revenues from sales of our online product Ultima Online, and we would be adversely affected if revenues from that product were to decline for any reason and not be replaced. We expect the online game market to become increasingly competitive, and it is possible that other producer's current or future games could cause our revenue from Ultima Online to decline. In addition, popularity of Ultima Online could decline over time simply because of consumer preference for new game experiences. 42 We Invest Very Heavily in Research and Development and Network Development and Support for EA.com, and We Cannot Be Assured That We Will Achieve Revenues That Validate This Level of Spending We have invested, and expect to continue to invest, very heavily in research and development and network development and support for our website and online games. We will need to expand EA.com's revenues substantially for it to achieve profitability with these levels of expenditure being required, and we may not be able to do so. If we cannot increase revenues to profitable levels, the value of EA.com will be impaired. In order to develop the broad games offerings that we envision for our online operations it will be necessary to engage in significant developmental efforts both to adapt existing EA games to the online format and to create new online games. Our agreements with AOL require us to maintain a substantial commitment to online game development and we cannot be assured that we will realize acceptable returns from this investment. Online Product Development Schedules Are Unreliable and Make Predicting Quarterly Results Difficult Online product development schedules, particularly for Internet based games are difficult to predict because they involve creative processes, use of new development tools, Internet latency issues, a learning process to better understand Internet based game mechanics, and research and experimentation associated with development for new online technologies. Additionally, development risks for Internet based products can cause particular difficulties in predicting quarterly results because of the challenges associated with game testing, live Beta testing, integration into network servers and integration on to the Games web site and may impact the release ("go live") dates of products during a particular quarter. Our revenues and operating costs are dependent on our ability to meet our product "go live" schedules, and our failure to meet those schedules could result in revenues falling short of analysts' expectations, with no corresponding decrease in expenses, resulting in increased operating losses for EA.com. General Risk Factors We Face Intense Competition for Talent from Highly Valued Internet Companies Competition for employees in the interactive software business continues to be intense. Recently, the most intense competition for recruiting and retaining key employees is from Internet companies. The large equity positions frequently offered to key executives and creative talent in such companies and the actual or perceived opportunity for rapid stock price appreciation of these companies make their compensation packages attractive to those who are already working in more mature companies. This situation creates difficulty for us to compete for the attraction and retention of executive and key creative talent. Because of the Intense Competition for Qualified Technical, Creative, Marketing and Other Personnel, We May Not Be Able To Attract and Retain the Personnel Necessary for our Businesses The market for technical, creative, marketing and other personnel essential to the development of online businesses and management of our online and core businesses is extremely competitive, and we may not be able to attract and retain the employees we need. In addition, the rising cost of real estate in the San Francisco Bay area - the location of our headquarters and largest studio, has increased dramatically, and has made recruiting from other areas and relocating employees to our headquarters more difficult. If we cannot successfully recruit and retain the employees we need, our ability to develop and manage our businesses will be impaired. 43 Foreign Sales and Currency Fluctuations For both the six months ended September 30, 2000 and the fiscal year ended March 31, 2000 international net revenues comprised 40% of total consolidated net revenues. We expect foreign sales to continue to account for a significant and growing portion of our revenues. Such sales are subject to unexpected regulatory requirements, tariffs and other barriers. Additionally, foreign sales are primarily made in local currencies which may fluctuate. While we hedge against foreign currency fluctuations, we cannot control translation issues such as that currently present with the Euro. For example, our European revenues in the six months ended September 30, 2000 were adversely impacted by a devaluation of the Euro as compared to the prior year. If the current trend continues, the devaluation will have a continued adverse effect for the year on our sales and net income. Any of these factors may significantly harm our business. Increased Difficulties in Forecasting Results During platform transition periods, where the success of our products is significantly impacted by the changing market for our products, forecasting our revenues and earnings is more difficult than in more stable or rising product markets. The demand for our products may decline during a transition faster than we anticipate, negatively impacting both revenues and earnings. Sony announced that it has shipped only half of the number of PlayStation 2 units to retail in North America at launch than it had originally planned, and that it expects to ship significantly fewer units than planned at launch in November in Europe as well. Shortages were announced as being caused by shortages of components for manufacturing. Depending on the number and the timing of units actually available for the December 2000 holidays and the quarter ended March 31, 2001, these shortages will adversely impact our sales of PlayStation 2 products in the same periods. We cannot predict the impact of recent actions and comments by the SEC and FASB Recent actions and comments from the SEC have focused on the integrity of financial reporting. In addition, the FASB and other regulatory accounting agencies have recently introduced several new or proposed accounting standards, some of which represent a significant change from current industry practices. For example, In December 1999, the SEC issued Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements." SAB 101 provides guidance on the recognition, presentation, and disclosure of revenue in financial statements of all public registrants. In response to numerous requests for interpretive guidance of SAB 101, the effective date of the standard has been delayed twice. SAB 101 became effective during the first quarter of fiscal 2001. SAB 101 did not have a material effect on the underlying strength or weakness of our consolidated business operations as measured by the dollar value of our product shipments and cash flows. Fluctuations in Stock Price Due to analysts' expectations of continued growth and other factors, any shortfall in earnings could have an immediate and significant adverse effect on the trading price of our common stock in any given period. 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 over a short period of time. These fluctuations may be due to factors specific to us, to changes in analysts' earnings estimates, or to factors affecting the computer, software, Internet, entertainment, media or electronics businesses or the securities markets in general. 44 For example, during fiscal year ended March 31, 2000, the price per share of our common stock ranged from $22.82 to $60.47 and $26.59 to $54.47 during the six months ended September 30, 2000. Because of these and other factors affecting our operating results and financial condition, past financial performance should not be considered a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods. 45 Item 3: Quantitative and Qualitative Disclosures About Market Risk Market Risk ----------- We are exposed to various market risks, including the 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 contracts used to 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 contracts to hedge foreign currency exposures of underlying assets and liabilities, primarily certain intercompany receivables that are denominated in foreign currencies thereby limiting our risk. Gains and losses on foreign exchange contracts are reflected in the income statement. At September 30, 2000, we had foreign exchange contracts, all with maturities of less than six months to purchase and sell approximately $206,572,000 in foreign currencies, primarily British Pounds, European Currency Units ("Euro"), Canadian Dollars, Japanese Yen and other currencies. Fair value represents the difference in value of the contracts at the spot rate and the forward rate. The counter parties to these contracts are substantial and creditworthy multinational commercial banks. The risks of counter party 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 hedging activities will adequately protect us against the risks associated with foreign currency fluctuations. The table below provides information about our foreign currency forward exchange contracts at September 30, 2000. The information is provided in U.S. dollar equivalents and presents the notional amount (forward amount), the weighted average contractual foreign currency exchange rates and fair value. -------------------------------------------------------------------------------------------------------------------
Weighted- Average Contract Amount Contract Rate Fair Value ------------------------------------------------------------------------------------------------------------------- (in thousands) (in thousands) Foreign currency to be sold under contract: British Pound $136,081 1.4743 $(95) Euro 29,019 0.9068 750 Japanese Yen 13,984 102.9800 667 Canadian Dollar 7,447 1.4772 129 South African Rand 4,309 7.1936 25 Brazilian Real 910 1.8670 (11) Korean Won 894 1119.0000 (3) Norway Krone 773 9.0493 2 Denmark Krone 595 8.4000 3 Sweden Krone 314 9.5536 3 ------------------------------------------------------------------------------------------------------------------- Total $194,326 $1,470 ------------------------------------------------------------------------------------------------------------------- 46 ------------------------------------------------------------------------------------------------------------------- Foreign currency to be purchased under contract: British Pound $12,246 1.4754 $ 102 ------------------------------------------------------------------------------------------------------------------- Total $12,246 $ 102 ------------------------------------------------------------------------------------------------------------------- ------------------------------------------------------------------------------------------------------------------- Grand Total $206,572 $1,572 -------------------------------------------------------------------------------------------------------------------
While the contract amounts provide one measurement of the volume of these transactions, they do not represent the amount of our exposure to credit risk. The amounts (arising from the possible inabilities of counterparties to meet the terms of their contracts) are generally limited to the amounts, if any, by which the counterparties' obligations exceed our obligations as these contracts can be settled on a net basis at our option. We control credit risk through credit approvals, limits and monitoring procedures. 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. We also manage our interest rate risk by maintaining sufficient cash and cash equivalent balances such that we are typically able to hold our investments to maturity. At September 30, 2000, our cash equivalents, short-term and long-term investments included debt securities of $178,077,000. 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 at September 30, 2000: ---------------------------------------------------------------------- Average Interest Rate Cost Fair Value ---------------------------------------------------------------------- (Dollars in thousands) Cash equivalents Fixed rate 0.00% $ - $ - Variable rate 5.86% $95,694 $95,694 Short-term investments Fixed rate 4.05% $64,198 $63,983 Variable rate 6.63% $10,000 $10,000 Long-term investments Fixed rate 0.00% $ - $ - Variable rate 6.35% $8,400 $8,328 ---------------------------------------------------------------------- Maturity dates for short-term investments range from 6 months to 3 years. 47 PART II - OTHER INFORMATION Item 1. Legal Proceedings The Company is subject to pending claims. Management, after review and consultation with counsel, considers that any liability from the disposition of such lawsuits in the aggregate would not have a material adverse effect upon the consolidated financial position or results of operations of the Company. Item 4. Submission of Matters to a Vote of Security Holders None Item 6. Exhibits and Reports on Form 8-K (a) Exhibits: None (b) Reports on Form 8-K: None 48 SIGNATURES 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/E. STANTON MCKEE ---------------------------------- DATED: E. STANTON MCKEE November 14, 2000 Executive Vice President and Chief Financial and Administrative Officer 49