UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-K

 

 

Commission File No. 0-17948

 

ELECTRONIC ARTS INC.

(Exact name of registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code:

(650) 628-1500

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:

None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes þ     No o

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer þ     Accelerated filer o     Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

The aggregate market value of the registrant’s common stock, $0.01 par value, held by non-affiliates of the registrant as of September 29, 2006, the last business day of the second fiscal quarter, was $17,149,452,000.

 

As of May 24, 2007 there were 311,473,084 shares of the registrant’s common stock, $0.01 par value, outstanding.

 

Documents Incorporated by Reference

 

Portions of the registrant’s definitive proxy statement for its 2007 Annual Meeting of Stockholders are incorporated by reference into Part III hereof.

 

ELECTRONIC ARTS INC.
2007 FORM 10-K ANNUAL REPORT

Table of Contents

 

 

This Report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All statements, other than statements of historical fact, including statements regarding industry prospects and future results of operations or financial position, made in this Report are forward looking. We use words such as “anticipate”, “believe”, “expect”, “intend”, “estimate” (and the negative of any of these terms), “future” and similar expressions to help identify forward-looking statements. These forward-looking statements are subject to business and economic risk and reflect management’s current expectations, and involve subjects that are inherently uncertain and difficult to predict. Our actual results could differ materially. We will not necessarily update information if any forward-looking statement later turns out to be inaccurate. Risks and uncertainties that may affect our future results include, but are not limited to, those discussed under the heading “Risk Factors”, beginning on page 13.

 

Overview

 

Electronic Arts develops, markets, publishes and distributes interactive software games and content that are playable by consumers on the following devices:

 

 

We also sell advertising in many of our games and on our websites.

 

We refer to consoles, PCs, mobile platforms and online collectively as “platforms”. In fiscal 2007, we developed or published products for 13 different platforms. Since our inception, we have published games for over 50 different platforms. This platform diversification continues to be a cornerstone of our product strategy.

 

The interactive software games that we develop and publish are broken down into two major categories: (1) games developed by our EA Studios, and (2) games that we co-publish with, or distribute on behalf of, another company through our EA Partners group. Our EA Studios games are either developed internally at our development and production studios located in the United States, Canada, England, Sweden, Germany, Singapore, China, Romania and India, or by third parties whom we engage to develop games on our behalf at their own development and production studios. We market, publish and distribute games in over 30 countries throughout the world.

 

We market the products produced by our studios under the EA^tm, EA SPORTS^tm, EA SPORTS BIG^tm, and POGO^tm brands.

 

We were initially incorporated in California in 1982. In September 1991, we reincorporated under the laws of Delaware. Our principal executive offices are located at 209 Redwood Shores Parkway, Redwood City, California 94065 and our telephone number is (650) 628-1500.

 

Development of Our Games

 

The console, handheld, PC and online games we publish are developed primarily by our EA Studios, while the games we offer for cellular handsets are developed primarily by third parties. In addition, through our EA Partners group, we team with other game development companies to assist them with the development of games on our behalf. For the fiscal years ended March 31, 2007, 2006 and 2005, research and development expenses were $1,041 million, $758 million and $633 million, respectively.

 

EA Studios

 

We develop packaged goods games internally at our development and production studios located in the United States, Canada, England, Sweden, Germany, Singapore and China. We invest in the creation of software tools to more efficiently develop games for multiple platforms. We also make investments in facilities and equipment that allow us to create and edit video and audio recordings that are used in our games. Employees whom we call “executive producers” are responsible for overseeing the development of one or more products or “franchises” (a series of sequeled or related products). We also engage third parties to develop games on our behalf at their own development and production studios.

 

Following our acquisition of JAMDAT Mobile Inc. in February 2006, we merged our existing cellular handset software game development and publishing business into JAMDAT’s to establish our EA Mobile business. We engage third parties to develop games for cellular handsets on our behalf at their own development and production studios and, to a lesser extent, we develop cellular handset games internally at our development and production studios located in the United States, Canada, England, Romania and India.

 

We develop online games and content internally at our development and production studios located in the United States, Canada and Singapore. In fiscal 2007, we acquired Mythic Entertainment, Inc., a developer and publisher of massively multiplayer online role-playing games. We also engage third parties to develop online games on our behalf at their own development and production studios.

 

In fiscal 2007, we generated approximately 65 percent of our net revenue from games developed by our EA Studios that were initially released during the year, as compared to approximately 73 percent in fiscal 2006. Excluding titles developed for cellular handsets, during fiscal 2007 we released 32 EA Studio titles compared to 31 EA Studio titles in fiscal 2006. In fiscal 2007, we released over 190,000 stock keeping units, or SKUs (a version of a title designed for play on a particular platform), for cellular handsets.

 

Co-publishing, Distribution and Third Party Development

 

Through our EA Partners group, we team with other game development companies to assist with the development of their own interactive software games, which we then publish, market and distribute. We refer to these types of arrangements as “co-publishing”. For example, in fiscal 2007, we signed a co-publishing agreement with NAMCO BANDAI Games America for Hellgate: London^tm, which is being developed by Flagship Studios.

 

We also distribute interactive software games that are developed and published by other companies. An example of one of our recent distribution products is Half-Life^® 2: Episode One, which was developed and published by Valve and distributed worldwide by us.

 

We also engage third parties to develop games on our behalf.

 

Publishing Our Games — Marketing, Market Segments and Distribution

 

We market our products under four major brand names:

 

 

In addition, our EA Partners group operates under a variety of deal types and structures with the intent of making available our publishing marketing and distribution services to game developers who may not have the scale of our resources.

 

In fiscal 2007, we had two titles, Need for Speed Carbon and Madden NFL 07, published on 10 different platforms, each of which represented approximately 11 percent of our total net revenue. In fiscal 2006, we had one title, Need for Speed Most Wanted, published on eight different platforms, which represented approximately 10 percent of our total net revenue. In fiscal 2005, we had one title, Need for Speed Underground 2, published on five different platforms, which represented approximately 11 percent of our total net revenue.

 

Packaged Goods

 

The console, PC and handheld games that we publish are made available to consumers as packaged goods (usually Blu-ray Disc, CD, DVD, cartridge or Universal Media Disc format) that are typically sold in retail stores and through online stores (including our own online store). In North America and Europe, our largest markets, we sell these packaged goods products primarily to retailers, including mass market retailers (such as Wal-Mart), electronics specialty stores (such as Best Buy) or game software specialty stores (such as GameStop). Many of our PC products can also be purchased over the Internet through digital download.

 

We generated approximately 95 percent of our North American packaged goods net revenue from direct sales to retailers, with the remaining net revenue being generated through a limited number of specialized and regional distributors and rack jobbers in markets where we believe direct sales would not be economical. Outside of North America, we derive packaged goods revenue primarily from direct sales to retailers. In a few of our smaller markets, we sell our packaged goods products through distributors with whom we have written agreements or informal arrangements, depending on the business customs of the territories. We also distribute products of other companies through our rack jobbing business in Switzerland. We had direct sales to Wal-Mart Stores, Inc. which represented approximately 13 percent of total net revenue in both fiscal 2007 and 2006, and approximately 14 percent of total net revenue in fiscal 2005. We also had direct sales to GameStop Corp. which represented approximately 12 percent of total net revenue in fiscal 2007.

 

Video Games — Consoles, Handhelds and PCs.  Historically, there have been multiple video game consoles and handheld game players available to consumers, and there has been vigorous competition among manufacturers. While Sony’s PlayStation^® and PlayStation 2 consoles have significantly outsold their competitors in the past, the PLAYSTATION 3 faces very strong competition from new platforms such as Microsoft’s Xbox 360 and the Nintendo Wii. The PC also continues to be a strong interactive game platform. Similarly, while Nintendo’s Game Boy^® Advance and Nintendo DS are current and historic leaders in the handheld game player market, Sony’s PlayStation Portable is also a competitor in this segment.

 

Video game consoles have historically had a life cycle of four to six years, which causes the video game software market to be cyclical as well. With the release of Microsoft’s Xbox 360 in 2005 and the releases of Sony’s PLAYSTATION 3 and Nintendo’s Wii in 2006, our industry is at the beginning of a new cycle. As such, in fiscal 2008, we expect to release fewer titles for the PlayStation 2 than in fiscal 2007, a very small number of titles for the Xbox, and no titles for the Nintendo GameCube^tm. The following table details select information on some of the console platforms for which we have published titles:

 

The following table details select information on some of the handheld video game players for which we have published titles:

 

 

In fiscal 2007, we published 26 EA titles for the PC.

 

Cellular Handsets

 

Through EA Mobile, we are a leading global publisher of interactive entertainment software playable on cellular handsets, including games, ring tones, images and other content. Our customers typically purchase and download our games through a wireless carrier’s branded e-commerce service accessed directly from their cellular handsets. These wireless carrier services include, among others, Verizon Wireless’ Get It Now, Sprint PCS Vision, Cingular MEdia and Vodafone live!. Our customers are charged either a one-time or a monthly subscription fee on their cellular service invoice for the game. The wireless carriers generally retain a percentage of the fee and pay the remainder to us. The wireless distribution of our games eliminates traditional publishing complexities, including physical production, packaging, shipping, inventory management and return processing. Our customers may also purchase and download games directly from our website.

 

Many of our games are designed to take advantage of multimedia enhancements in the latest generation of cellular handsets, including high-resolution color displays, increased processing power, improved audio capabilities and increased memory capabilities. We publish games in multiple categories designed to appeal to a broad range of wireless subscribers. Our portfolio is primarily based on intellectual properties that we create and own, and well-established brands and content that we license from third parties.

 

Online

 

We publish four types of games that are played online by consumers — online casual games, massively multiplayer online games, mid-session games, and online-enabled packaged goods. We derive revenue from these games primarily through paid subscriptions, advertising and sales of digital content.

 

Online Casual Games.  We offer online casual games such as card games, puzzle games and word games on our website, pogo.com, and on certain online services provided by third parties. We had over 1.5 million paying Club Pogo subscribers as of March 31, 2007, up from 1.2 million paying subscribers as of March 31, 2006.

 

Massively Multiplayer Online Games.  Players experience online-only “massively multiplayer online games” (sometimes called “persistent state world games” or “MMOs”) as interactive virtual worlds where thousands of other players can interact with one another. After installing the software on their PCs, players are able to subscribe and interact with other players online. We currently offer three MMO games: Ultima Online^tm, Dark Age of Camelot^® and The Sims Online^tm, and we are in the process of developing Warhammer^® Online.

 

Mid-session games.  Players experience mid-session games as interactive virtual worlds where players form small groups and interact with one another. We currently offer one mid-session game, EA Sports^tm FIFA Online, but anticipate offering more in future years. Although we offer EA Sports FIFA Online for free, players may purchase additional in-game content from us through micro-transactions.

 

Online-Enabled Packaged Goods.  We include online functionality in certain of our PC, PLAYSTATION 3, PlayStation 2, Xbox 360, Xbox and PSP products, which enable consumers to participate in online communities and play against one another via the Internet.

 

Digital Content.  We offer full-game downloads and additional content (such as booster packs, expansion packs and smaller pieces of game content referred to as micro-transactions) for our PC and console-based games through our EA.com website and online interfaces within game consoles. In addition, our POGO games are offered through third-party websites.

 

Advertising.  We derive revenue from advertising in our games and on our websites.

 

Competition

 

We compete in the entertainment industry for the leisure time and discretionary spending of consumers with other forms of media, such as motion pictures, television, social networking and music. Our competitors vary in size and cost structure from very small companies with limited resources to very large, diversified corporations with greater financial and marketing resources than ours. For example, we compete with venture capital funded start-ups, traditional independent video game publishers, hardware and software manufacturers, casual entertainment websites, social networking websites, mobile games developers, foreign games developers and large media companies. We also compete with satellite radio, traditional radio and all other forms of entertainment.

 

Our business is characterized by the continuous introduction of innovative new titles and the development of new technologies. Competition is also based on product quality and features, timing of product releases, brand-name recognition, quality of in-game content, access to distribution channels, effectiveness of marketing and price.

 

In addition to competing for product sales, we face heavy competition from other software game companies and large media companies to obtain license agreements granting us the right to use intellectual property included in our products. Some of these content licenses are controlled by the diversified media companies, which, in some cases, have decided to publish their own games based on popular entertainment properties that they control, rather than licensing the content to a software game company such as us. See “Intellectual Property” below.

 

Sales of Packaged Goods

 

The market for our packaged goods products is also characterized by significant price competition and we regularly face pricing pressures from our competitors. These pressures have, from time to time, required us to reduce our prices on certain products. Our experience has been that software game prices tend to decline once a generation of consoles has been in the market for a significant period of time due to the increasing number of software titles competing for acceptance by consumers and the introduction of new consoles. As our industry has transitioned to a new generation of consoles over the past two years, we have experienced this kind of price erosion with respect to games for the prior generation of consoles (e.g., PlayStation 2, Xbox and Nintendo GameCube).

 

For sales of packaged goods, we compete directly with Sony, Microsoft and Nintendo, each of which develop and publish software for their respective console platforms. We also compete with numerous companies which, like us, develop and publish software games that operate on their consoles. These competitors include Activision, Atari, Capcom, Koei, Konami, LucasArts, Midway, Namco, Sega, Take-Two Interactive, THQ and Ubisoft, among others. As discussed above, diversified media companies such as Fox, Disney, Time Warner, Viacom and Vivendi are also expanding their software game publishing efforts.

 

Sales for Cellular Handsets

 

The wireless entertainment applications market segment, for which we develop and publish games, ring tones and wallpapers for cellular handsets, is highly competitive and characterized by frequent product introductions, evolving wireless platforms and new technologies. As demand for applications continues to increase, we expect new competitors to enter the market and existing competitors to allocate more resources to develop and market applications. As a result, we expect competition in the wireless entertainment market segment to intensify.

 

The current and potential competition in the wireless entertainment applications market segment includes major media companies, traditional video game publishing companies, wireless carriers, wireless software providers and other companies that specialize in wireless entertainment applications. We also compete with wireless content aggregators, who pool applications from multiple developers (and sometimes publishers) and

offer them to carriers or through other sales channels. In addition, new and existing competitors are beginning to offer wireless entertainment applications on an ad-supported basis. Currently, we consider our primary competitors in the wireless entertainment applications market segment to be Disney, Fox Mobile Entertainment, Gameloft, Glu Mobile, Hands-On Mobile, Namco, Sony Pictures and THQ Wireless.

 

Online Sales

 

The online games market segment is also highly competitive and characterized by frequent product introductions, new business models and new platforms. As the proportion of households with a broadband connection increases, we expect new competitors to enter the market and existing competitors to allocate more resources toward developing online games. As a result, we expect competition in the online games market segment to intensify.

 

Our current and potential competitors in the online games market segment include major media companies, traditional video game publishing companies, and companies that specialize in online games. Our competitors in the casual games segment include MSN, Popcap, Real, AOL and Yahoo!. In the massively multiplayer online game segment our competitors include Atari, Midway, NC Soft, Sony and Vivendi Games. In the mid-session game segment our competitors include Nexon.

 

Intellectual Property

 

Like other entertainment companies, our business is significantly based on the creation, acquisition, exploitation and protection of intellectual property. Some of this intellectual property is in the form of software code, patented technology, and other technology and trade secrets that we use to develop our games and to make them run properly on the platforms. Other intellectual property is in the form of audio-visual elements that consumers can see, hear and interact with when they are playing our games — we call this form of intellectual property “content”.

 

Each of our products embodies a number of separate forms of intellectual property protection: the software and the content of our products are copyrighted; our products may use patented inventions or trade secrets; our product brands and names may be trademarks of ours or others; our products may contain voices and likenesses of actors, athletes and/or commentators (which may be protected by personal publicity rights) and often contain musical compositions and recordings that are also copyrighted. Our products also may contain content licensed from others, such as trademarks, fictional characters, storylines and software code.

 

We acquire the rights to include wholly-owned intellectual property in our products by creating the intellectual property within our EA Studios. We also acquire the rights to include proprietary intellectual property in our products through acquisitions. We also enter into content license agreements such as those with sports leagues and player associations, movie studios and performing talent, music labels, music publishers and musicians. These licenses are typically limited to use of the licensed rights in products for specific time periods. In addition, our products that play on game consoles, handhelds and cellular handsets include technology that is owned by the console manufacturer and licensed non-exclusively to us for use. While we may have renewal rights for some licenses, our business and the justification for the development of many of our products is dependent on our ability to continue to obtain the intellectual property rights from the owners of these rights at reasonable rates.

 

Our products are susceptible to unauthorized copying. We typically distribute our PC products using copy protection technology that we license from other companies. In addition, console manufacturers, such as Sony, typically incorporate security devices in their consoles in an effort to prevent the use of unlicensed products. Our primary protection against unauthorized use, duplication and distribution of our products is enforcement of our copyright and trademark interests. We typically own the copyright to the software code as well as the brand or title name trademark under which our products are marketed. We register our copyrights and trademarks in the United States and other countries.

 

Significant Relationships

 

Hardware Platform Companies

 

Sony.  Under the terms of agreements we have entered into with Sony Computer Entertainment Inc. and its affiliates, we are authorized to develop and distribute disk-based software products and online content compatible with the PlayStation 2, PLAYSTATION 3 and PSP. Pursuant to these agreements, we engage Sony to supply PlayStation 2, PLAYSTATION 3 and PSP disks for our products.

 

Microsoft.  Under the terms of agreements we have entered into with Microsoft Corporation and its affiliates, we are authorized to develop and distribute DVD-based software products and online content compatible with the Xbox and Xbox 360.

 

Nintendo.  Under the terms of agreements we have entered into with Nintendo Co., Ltd. and its affiliates, we are authorized to develop and distribute proprietary optical format disk products and cartridges compatible with the Nintendo GameCube, the Wii, the Nintendo DS and Game Boy Advance. Pursuant to these agreements, we engage Nintendo to supply Wii proprietary optical format disk products and Nintendo DS cartridges for our products.

 

Cellular Handsets

 

We have agreements to distribute our wireless applications through more than 110 carriers in over 40 countries. Our customers download our applications to their cellular handsets and their wireless carrier invoices them a one-time fee or monthly subscription fee. Our carrier distribution agreements establish the fees to be retained by the carrier for distributing our applications. These arrangements are typically terminable on short notice. The agreements generally do not obligate the carriers to market or distribute any of our applications.

 

Content Licensors

 

Many of our products are based on or incorporate content and trademarks owned by others. For example, our EA, EA SPORTS and EA SPORTS BIG products include rights licensed from third parties, including major studios, publishers, artists, authors, celebrities, athletes and the major sports leagues and players associations.

 

Inventory, Working Capital, Backlog, Manufacturing and Suppliers

 

We manage inventory by communicating with our customers prior to the release of our products, and then using our industry experience to forecast demand on a product-by-product and territory-by-territory basis. Historically, we have experienced high turnover of our products, and the lead times on re-orders of our products are generally short, approximately two to three weeks. Further, as discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, we have practices in place with our customers (such as stock balancing and price protection) that reduce product returns.

 

We typically ship orders immediately upon receipt. To the extent that any backlog may or may not exist at the end of a reporting period, it would be both coincidental and an unreliable indicator of future results of any period.

 

The suppliers we use to manufacture our games and related materials include independent third parties, Sony and Nintendo.

 

In many instances, we are able to acquire materials on a volume-discount basis. We have multiple potential sources of supply for most materials, except for the disk component of our PLAYSTATION 3, PlayStation 2, PSP and Wii and Nintendo DS cartridges.

 

Our online games and cellular handset applications are delivered digitally, and therefore, are not manufactured.

 

International Operations

 

We conduct business and have wholly-owned subsidiaries throughout the world, including offices in Europe, Australia, Asia and Latin America. International net revenue increased by 4 percent to $1.425 billion, or

46 percent of total net revenue in fiscal 2007, compared to $1.367 billion, or 46 percent of total net revenue in fiscal 2006.

 

The amounts of net revenue and long-lived assets attributable to each of our geographic regions for each of the last three fiscal years are set forth in Note 18 of the Notes to Consolidated Financial Statements, included in Item 8 of this report.

 

Seasonality

 

Our business is highly seasonal. We typically experience our highest sales volume in the holiday season quarter ending in December and a seasonal low in sales volume in the quarter ending in June. Starting in fiscal 2008, we expect to defer the recognition of a significant amount of net revenue related to our online-enabled packaged goods over an extended period of time (which we currently estimate to be six months). As a result, the quarter in which we generate the highest sales volume may be different than the quarter in which we recognize the highest net revenue. Our results can also vary based on a number of factors, including title release dates, consumer demand for our products, shipment schedules and our revenue recognition policies.

 

Employees

 

As of March 31, 2007, we employed approximately 7,900 people, of whom over 4,500 were outside the United States. We believe that our ability to attract and retain qualified employees is a critical factor in the successful development of our products and that our future success will depend, in large measure, on our ability to continue to attract and retain qualified employees. Less than 3 percent of our employees, all of whom work for our Swedish development subsidiary, are represented by a union, guild or other collective bargaining organization.

 

Executive Officers

 

The following table sets forth information regarding our executive officers, who are appointed by and serve at the discretion of the Board of Directors as of May 29, 2007:

 

 

Mr. Riccitiello has served as Chief Executive Officer and a Director of Electronic Arts since April 2007. Prior to re-joining Electronic Arts, he was a co-founder and Managing Partner at Elevation Partners, a private equity fund. From October 1997 to April 2004, he served as President and Chief Operating Officer of Electronic Arts. Prior to joining Electronic Arts, Mr. Riccitiello served as President and Chief Executive Officer of the

worldwide bakery division at Sara Lee Corporation. Before joining Sara Lee, he served as President and CEO of Wilson Sporting Goods Co. and has also held executive management positions at Haagen-Dazs, PepsiCo, Inc. and The Clorox Company. Mr. Riccitiello holds a B.S. degree from the University of California, Berkeley.

 

Mr. Lee was named President, Worldwide Studios, in September 2005. He served as Executive Vice President and Chief Operating Officer, Worldwide Studios from August 2002 to September 2005. From 1998 to August 2002, he was Senior Vice President and Chief Operating Officer, Worldwide Studios. Prior to this, he served as General Manager of EA Canada, Chief Operating Officer of EA Canada, Chief Financial Officer of EA Sports and Vice President, Finance and Administration of EA Canada. Mr. Lee was a principal of Distinctive Software Inc. until it was acquired by Electronic Arts in 1991. Mr. Lee holds a Bachelor of Commerce degree from the University of British Columbia and is a Chartered Financial Analyst.

 

Dr. Florin has served as Executive Vice President, General Manager, International Publishing since September 2005. Previously he was Senior Vice President and Managing Director, European Publishing since April 2003. Prior to this, he served as Vice President, Managing Director for European countries since 2001. From the time he joined Electronic Arts in 1996 to 2001, he was the Managing Director for German speaking countries. Prior to joining Electronic Arts, Dr. Florin held various positions at BMG, the global music division of Bertelsmann AG, and worked as a consultant with McKinsey. Dr. Florin holds Masters and Ph.D. degrees in Economics from the University of Augsburg, Germany.

 

Mr. Gibeau has served as Executive Vice President, General Manager, North America Publishing since September 2005. Previously he was Senior Vice President of North American Marketing, a position he held since 2002. Mr. Gibeau has held various publishing positions since joining the company in 1991. Mr. Gibeau holds a B.S. degree from the University of Southern California and an M.B.A. from Santa Clara University.

 

Mr. Jenson joined Electronic Arts in June 2002 as Executive Vice President, Chief Financial and Administrative Officer. Before joining Electronic Arts, he was the Senior Vice President and Chief Financial Officer for Amazon.com from 1999 to 2002. From 1998 to 1999, he was the Chief Financial Officer and Executive Vice President for Delta Air Lines. Prior to that, he worked in several positions as part of the General Electric Company. Most notably, he served as Chief Financial Officer and Senior Vice President for the National Broadcasting Company, a subsidiary of General Electric. Mr. Jenson earned his Masters of Accountancy-Business Taxation, and B.S. in Accounting from Brigham Young University.

 

Mr. Linzner has served as Executive Vice President, Business and Legal Affairs since March 2005. From April 2004 to March 2005, he served as Senior Vice President, Business and Legal Affairs. From October 2002 to April 2004, Mr. Linzner held the position of Senior Vice President of Worldwide Business Affairs and from July 1999 to October 2002, he held the position of Vice President of Worldwide Business Affairs. Prior to joining Electronic Arts in July 1999, Mr. Linzner served as outside litigation counsel to Electronic Arts and several other companies in the video game industry. Mr. Linzner earned his J.D. from Boalt Hall at the University of California, Berkeley, after graduating from Brandeis University. He is a member of the Bar of the State of California and is admitted to practice in the United States Supreme Court, the Ninth Circuit Court of Appeals and several United States District Courts.

 

Ms. Smith was named Executive Vice President, General Manager, The Sims Franchise in September 2005. Prior to this position, she served as Executive Vice President and General Manager, North American Publishing since March 1998. From October 1996 to March 1998, Ms. Smith served as Executive Vice President, North American Sales. She previously held the position of Senior Vice President of North American Sales and Distribution from July 1993 to October 1996 and as Vice President of Sales from 1988 to 1993. Ms. Smith has also served as Western Regional Sales Manager and National Sales Manager since she joined Electronic Arts in 1984. Ms. Smith holds a B.S. degree in management and organizational behavior from the University of San Francisco.

 

Ms. Toledano has served as Executive Vice President, Human Resources since April 2007. From February 2006 to April 2007, Ms. Toledano held the position of Senior Vice President, Human Resources. Prior to joining Electronic Arts, Ms. Toledano worked at Siebel Systems, Inc. from July 2002 to February 2006 where she held a number of positions, including Senior Vice President of Human Resources. From September 2000

to June 2002, she served as Senior Director of Human Resources for Microsoft Corporation, and from September 1998 until September 2000, she served as Director of Human Resources and Recruiting for Microsoft. Ms. Toledano earned both her undergraduate degree in Humanities and her graduate degree in Education from Stanford University.

 

Mr. Barker has served as Senior Vice President, Chief Accounting Officer since April 2006. From June 2003 to April 2006, Mr. Barker held the position of Vice President, Chief Accounting Officer. Prior to joining Electronic Arts, Mr. Barker was employed at Sun Microsystems, Inc., as Vice President and Corporate Controller from October 2002 to June 2003 and Assistant Corporate Controller from April 2000 to September 2002. Prior to that, he was an audit partner at Deloitte. Mr. Barker graduated from the University of Notre Dame with a B.A. degree in Accounting.

 

Mr. Bené has served as Senior Vice President, General Counsel and Corporate Secretary since October 2004. From April 2004 to October 2004, Mr. Bené held the position of Vice President, Acting General Counsel and Corporate Secretary, and from June 2003 to April 2004, he held the position of Vice President and Associate General Counsel. Prior to June 2003, Mr. Bené had served as internal legal counsel since joining the Company in March 1995. Mr. Bené earned his J.D. from Stanford Law School, and received his B.S. in Mechanical Engineering from Rice University. Mr. Bené is a member of the Bar of the State of California.

 

Mr. Marchetti was named Senior Vice President and General Manager of EA Mobile in April 2007. He joined Electronic Arts in February 2006 as Vice President and Chief Operating Officer of EA Mobile. From December 2000 to February 2006, he served as Chief Financial Officer of JAMDAT Mobile Inc. Prior to this, Mr. Marchetti served as Vice President Finance for eCompanies LLC from April 2000 to December 2000. Mr. Marchetti served as a Vice President in the Emerging Telecommunications and the Global Leveraged Finance groups of Merrill Lynch, where he worked from July 1996 to April 2000. Prior to Merrill Lynch, Mr. Marchetti practiced law at Cahill Gordon & Reindel from 1994 to 1996. Mr. Marchetti earned a J.D. from Brooklyn Law School, cum laude, and received his B.A. degree from Brooklyn College City University, magna cum laude.

 

Mr. Schappert was named Senior Vice President, Chief Operating Officer, Worldwide Studios in November 2006. Prior to being named to this position, from January 2003 to October 2006, Mr. Schappert served as Senior Vice President, Group General Manager, Worldwide Studios. Mr. Schappert served as Vice President, General Manager of EA Canada from July 2002 to January 2003, and Vice President, General Manager of EA Tiburon from April 1998 to July 2002. Mr. Schappert founded Tiburon Entertainment in 1994, which was acquired by Electronic Arts in 1998.

 

Investor Information

 

We file various reports with, or furnish them to, the Securities and Exchange Commission (the “SEC”), including our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to such reports. These reports are available free of charge on the Investor Relations section of our website, http://investor.ea.com, as soon as reasonably practicable after we electronically file the reports with, or furnish them to, the SEC.

 

The charters of our Audit, Compensation, and Nominating and Governance committees of our Board of Directors, as well as our Global Code of Conduct (which includes code of ethics provisions applicable to our directors, principal executive officer, principal financial officer, principal accounting officer, and other senior financial officers), are available in the Investor Relations section of our website at http://investor.ea.com. We will post amendments to our Global Code of Conduct in the Investor Relations section of our website. Copies of our charters and Global Code of Conduct are available without charge by contacting our Investor Relations department at (650) 628-1500.

 

Stockholders of record may hold their shares of our common stock in book-entry form. This eliminates costs related to safekeeping or replacing paper stock certificates. In addition, stockholders of record may request electronic movement of book-entry shares between their account with our stock transfer agent and their broker.

Stock certificates may be converted to book-entry shares at any time. Questions regarding this service may be directed to our stock transfer agent, Wells Fargo Bank, N.A., at 1-800-468-9716.

 

Our business is subject to many risks and uncertainties, which may affect our future financial performance. If any of the events or circumstances described below occurs, our business and financial performance could be harmed, our actual results could differ materially from our expectations and the market value of our stock could decline. The risks and uncertainties discussed below are not the only ones we face. There may be additional risks and uncertainties not currently known to us or that we currently do not believe are material that may harm our business and financial performance.

 

Our business is highly dependent on the success and availability of video game hardware systems manufactured by third parties, as well as our ability to develop commercially successful products for these systems.

 

We derive most of our revenue from the sale of products for play on video game hardware systems (which we also refer to as “platforms”) manufactured by third parties, such as Sony’s PlayStation 2 and PLAYSTATION 3, Microsoft’s Xbox 360 and Nintendo’s Wii. The success of our business is driven in large part by the commercial success and adequate supply of these video game hardware systems, our ability to accurately predict which systems will be successful in the marketplace, and our ability to develop commercially successful products for these systems. We must make product development decisions and commit significant resources well in advance of anticipated product ship dates. A platform for which we are developing products may not succeed or may have a shorter life cycle than anticipated. If consumer demand for the systems for which we are developing products are lower than our expectations, our revenue will suffer, we may be unable to fully recover the investments we have made in developing our products, and our financial performance will be harmed. Alternatively, a system for which we have not devoted significant resources could be more successful than we had initially anticipated, causing us to miss out on meaningful revenue opportunities.

 

Our industry is cyclical and is beginning its next cycle. During the transition, consumers may be slower to adopt new video game systems than we anticipate, and our operating results may suffer and become more difficult to predict.

 

Video game hardware systems have historically had a life cycle of four to six years, which causes the video game software market to be cyclical as well. Microsoft launched the Xbox 360 in November 2005, while Sony and Nintendo launched the PLAYSTATION 3 and the Wii, respectively, in November 2006. We have continued to develop and market new titles for prior-generation video game systems such as the PlayStation 2 while also making significant investments in products for the new systems. As the prior-generation systems reach the end of their life cycle and the installed base of the new systems continues to grow, our sales of video games for prior-generation systems will continue to decline as (1) we produce fewer titles for prior-generation systems, (2) consumers replace their prior-generation systems with the new systems, and/or (3) consumers defer game software purchases until they are able to purchase a new video game hardware system. This decline in prior-generation product sales may be greater than we anticipate, and sales of products for the new platforms may be lower than we anticipate. Moreover, we expect development costs for the new video game systems to be greater on a per-title basis than development costs for prior-generation video game systems. As a result of these factors, during the next several quarters, we expect our operating results to be more volatile and difficult to predict, which could cause our stock price to fluctuate significantly.

 

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

 

Our business is highly seasonal, with the highest levels of consumer demand and a significant percentage of our sales occurring in the December quarter. In addition, we seek to release many of our products in conjunction with specific events, such as the release of a related movie or the beginning of a sports season or major sporting event. If we miss these key selling periods for any reason, including product delays or delayed introduction of a new platform for which we have developed products, our sales will suffer disproportionately.

Likewise, if a key event to which our product release schedule is tied were to be delayed or cancelled, our sales would also suffer disproportionately. Our ability to meet product development schedules is affected by a number of factors, including the creative processes involved, the coordination of large and sometimes geographically dispersed development teams required by the increasing complexity of our products and the platforms for which they are developed, and the need to fine-tune our products prior to their release. We have experienced development delays for our products in the past, which caused us to push back release dates. In the future, any failure to meet anticipated production or release schedules would likely result in a delay of revenue and/or possibly a significant shortfall in our revenue, harm our profitability, and cause our operating results to be materially different than anticipated.

 

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

 

Competition in our industry is intense and we expect new competitors to continue to emerge in the United States and abroad. While many new products and services are regularly introduced, only a relatively small number of “hit” titles accounts for a significant portion of total revenue in our industry. Hit products or services offered by our competitors may take a larger share of consumer spending than we anticipate, which could cause revenue generated from our products and services to fall below expectations. If our competitors develop more successful products or services, offer competitive products or services at lower price points or based on payment models perceived as offering a better value proposition (such as pay-for-play or subscription-based models), or if we do not continue to develop consistently high-quality and well-received products and services, our revenue, margins, and profitability will decline.

 

Technology changes rapidly in our business and if we fail to anticipate or successfully implement new technologies or the manner in which people play our games, the quality, timeliness and competitiveness of our products and services will suffer.

 

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

 

The video game hardware manufacturers set the royalty rates and other fees that we must pay to publish games for their platforms, and therefore have significant influence on our costs. If one or more of these manufacturers adopt a different fee structure for future game consoles, our profitability will be materially impacted.

 

In order to publish products for a video game system such as the Xbox 360, PLAYSTATION 3 or Wii, we must take a license from the manufacturer, which gives it the opportunity to set the fee structure that we must pay in order to publish games for that platform. Similarly, certain manufacturers have retained the flexibility to change their fee structures, or adopt different fee structures for online gameplay and other new features for their consoles. The control that hardware manufacturers have over the fee structures for their platforms and online access makes it difficult for us to predict our costs, profitability and impact on margins. Because publishing products for video game systems is the largest portion of our business, any increase in fee structures would significantly harm our ability to generate revenues and/or profits.

 

The video game hardware manufacturers are among our chief competitors and frequently control the manufacturing of and/or access to our video game products. If they do not approve our products, we will be unable to ship to our customers.

 

Our agreements with hardware licensors (such as Sony for the PLAYSTATION 3, Microsoft for the Xbox 360, and Nintendo for the Wii) typically give significant control to the licensor over the approval and manufacturing of our products, which could, in certain circumstances, leave us unable to get our products approved, manufactured and shipped to customers. These hardware licensors are also among our chief competitors. Generally, control of the approval and manufacturing process by the hardware licensors increases both our manufacturing lead times and costs as compared to those we can achieve independently. While we believe that our relationships with our hardware licensors are currently good, the potential for these licensors to delay or refuse to approve or manufacture our products exists. Such occurrences would harm our business and our financial performance.

 

We also require compatibility code and the consent of Microsoft, Sony and Nintendo in order to include online capabilities in our products for their respective platforms. As online capabilities for video game systems become more significant, Microsoft, Sony and Nintendo could restrict the manner in which we provide online capabilities for our products. If Microsoft, Sony or Nintendo refused to approve our products with online capabilities or significantly impacted the financial terms on which these services are offered to our customers, our business could be harmed.

 

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

 

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

 

Our business is subject to risks generally associated with the entertainment industry, any of which could significantly harm our operating results.

 

Our business is subject to risks that are generally associated with the entertainment industry, many of which are beyond our control. These risks could negatively impact our operating results and include: the popularity, price and timing of our games and the platforms on which they are played; economic conditions that adversely affect discretionary consumer spending; changes in consumer demographics; the availability and popularity of other forms of entertainment; and critical reviews and public tastes and preferences, which may change rapidly and cannot necessarily be predicted.

 

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

 

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

 

If patent claims continue to be asserted against us, we may be unable to sustain our current business models or profits, or we may be precluded from pursuing new business opportunities in the future.

 

Many patents have been issued that may apply to widely-used game technologies, or to potential new modes of delivering, playing or monetizing game software products. For example, infringement claims under many issued patents are now being asserted against interactive software or online game sites. Several such claims

have been asserted against us. We incur substantial expenses in evaluating and defending against such claims, regardless of the merits of the claims. In the event that there is a determination that we have infringed a third-party patent, we could incur significant monetary liability and be prevented from using the rights in the future, which could negatively impact our operating results. We may also discover that future opportunities to provide new and innovative modes of game play and game delivery to consumers may be precluded by existing patents that we are unable to license on reasonable terms.

 

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

 

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

 

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

 

We are currently, and from time to time in the future may become, subject to other legal proceedings, claims, litigation and government investigations or inquiries, which could be expensive, lengthy, and disruptive to normal business operations. In addition, the outcome of any legal proceedings, claims, litigation, investigations or inquiries may be difficult to predict and could have a material adverse effect on our business, operating results, or financial condition.

 

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

 

Legislation is continually being introduced that may affect both the content of our products and their distribution. For example, data and consumer protection laws in the United States and Europe impose various restrictions on our web sites. Those rules vary by territory although the Internet recognizes no geographical boundaries. Other countries, such as Germany, have adopted laws regulating content both in packaged games and those transmitted over the Internet that are stricter than current United States laws. In the United States, the federal and several state governments are continually considering content restrictions on products such as ours, as well as restrictions on distribution of such products. For example, recent legislation has been adopted in several states, and could be proposed at the federal level, that prohibits the sale of certain games (e.g., violent games or those with “M (Mature)” or “AO (Adults Only)” ratings) to minors. Any one or more of these factors could harm our business by limiting the products we are able to offer to our customers, by limiting the size of the potential market for our products, and by requiring costly additional differentiation between products for different territories to address varying regulations.

 

If one or more of our titles were found to contain hidden, objectionable content, our business could suffer.

 

Throughout the history of our industry, many video games have been designed to include certain hidden content and gameplay features that are accessible through the use of in-game cheat codes or other technological means that are intended to enhance the gameplay experience. However, in several recent cases, hidden content or features have been found to be included in other publishers’ products by an employee who was not authorized to do so or by an outside developer without the knowledge of the publisher. From time to time, some hidden content and features have contained profanity, graphic violence and sexually explicit or otherwise objectionable material. In a few cases, the Entertainment Software Ratings Board (“ESRB”) has reacted to discoveries of hidden content and features by reviewing the rating that was originally assigned to the product, requiring the publisher to change the game packaging and/or fining the publisher. Retailers have

on occasion reacted to the discovery of such hidden content by removing these games from their shelves, refusing to sell them, and demanding that their publishers accept them as product returns. Likewise, consumers have reacted to the revelation of hidden content by refusing to purchase such games, demanding refunds for games they’ve already purchased, and refraining from buying other games published by the company whose game contained the objectionable material.

 

We have implemented preventative measures designed to reduce the possibility of hidden, objectionable content from appearing in the video games we publish. Nonetheless, these preventative measures are subject to human error, circumvention, overriding, and reasonable resource constraints. If a video game we published were found to contain hidden, objectionable content, the ESRB could demand that we recall a game and change its packaging to reflect a revised rating, retailers could refuse to sell it and demand we accept the return of any unsold copies or returns from customers, and consumers could refuse to buy it or demand that we refund their money. This could have a material negative impact on our operating results and financial condition. In addition, our reputation could be harmed, which could impact sales of other video games we sell. If any of these consequences were to occur, our business and financial performance could be significantly harmed.

 

If we ship defective products, our operating results could suffer.

 

Products such as ours are extremely complex software programs, and are difficult to develop, manufacture and distribute. We have quality controls in place to detect defects in the software, media and packaging of our products before they are released. Nonetheless, these quality controls are subject to human error, overriding, and reasonable resource constraints. Therefore, these quality controls and preventative measures may not be effective in detecting defects in our products before they have been reproduced and released into the marketplace. In such an event, we could be required to recall a product, or we may find it necessary to voluntarily recall a product, and/or scrap defective inventory, which could significantly harm our business and operating results.

 

Our international net revenue is subject to currency fluctuations.

 

For the fiscal year ended March 31, 2007, international net revenue comprised 46 percent of our total net revenue. We expect foreign sales to continue to account for a significant portion of our total net revenue. Such sales may be subject to unexpected regulatory requirements, tariffs and other barriers. Additionally, foreign sales are primarily made in local currencies, which may fluctuate against the U.S. dollar. While we utilize foreign exchange forward contracts to mitigate some foreign currency risk associated with foreign currency denominated assets and liabilities (primarily certain intercompany receivables and payables) and, from time to time, foreign currency option contracts to hedge foreign currency forecasted transactions (primarily related to a portion of the revenue and expenses denominated in foreign currency generated by our operational subsidiaries), our results of operations, including our reported net revenue and net income, and financial condition would be adversely affected by unfavorable foreign currency fluctuations, particularly the Euro, British pound sterling and Canadian dollar.

 

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

 

We are subject to income taxes in the United States and in various foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes, and, in the ordinary course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain.

 

We are also required to estimate what our taxes will be in the future. Although we believe our tax estimates are reasonable, the estimation process and applicable laws are inherently uncertain, and our estimates are not binding on tax authorities. Our effective tax rate could be adversely affected by our profit level, by changes in our business, including the mix of earnings in countries with differing statutory tax rates, changes in the elections we make, changes in applicable tax laws as well as other factors. Further, our tax determinations are regularly subject to audit by tax authorities and developments in those audits could adversely affect our income tax provision. Should our ultimate tax liability exceed our estimates, our income tax provision and net income or loss could be materially affected.

 

We incur certain tax expenses that do not decline proportionately with declines in our consolidated pre-tax income or loss. As a result, in absolute dollar terms, our tax expense will have a greater influence on our effective tax rate at lower levels of pre-tax income or loss than higher levels. In addition, at lower levels of pre-tax income or loss, our effective tax rate will be more volatile.

 

In addition, the rules for tax accounting have recently been changed. In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation (“FIN”) No. 48, “Accounting for Uncertainty in Income Taxes - An Interpretation of FASB Statement No. 109”, which provides new rules for the accounting for uncertainty in income taxes recognized in financial statements in accordance with Statement of Financial Accounting Standard (“SFAS”) No. 109, “Accounting for Income Taxes” (see Note 10 of the Notes to Consolidated Financial Statements). We are evaluating what impact the adoption of FIN No. 48 will have on our Consolidated Financial Statements as it becomes effective in the first quarter of fiscal 2008. This impact could be material and our future effective tax rates could be more volatile.

 

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

 

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

 

As a result of the enactment of the Sarbanes-Oxley Act and the review of accounting policies by the SEC and national and international accounting standards bodies, the frequency of accounting policy changes may accelerate. For example, as discussed above, FIN No. 48 will affect the way we account for income taxes and could have a material impact on our financial results. Similarly, changes in accounting standards relating to stock-based compensation require us to recognize significantly greater expense than we had been recognizing prior to the adoption of the new standard. Likewise, policies affecting software revenue recognition have and could further significantly affect the way we account for revenue related to our products and services. For example, as our industry transitions to new video game hardware systems, we expect a more significant portion of our console and PC games will be online-enabled and, as a result, we will be required to recognize the related revenue over an extended period of time rather than at the time of sale. As we enhance, expand and diversify our business and product offerings, the application of existing or future financial accounting standards, particularly those relating to the way we account for revenue and taxes, could have a significant adverse effect on our reported results although not necessarily on our cash flows.

 

We have begun the implementation of a new set of financial information systems in anticipation of a significant increase in deferred net revenue, which, if not completed in a successful and timely manner, could impede our ability to accurately process, prepare and analyze important financial data.

 

We have begun to implement a new set of financial information systems and processes designed to help us accurately process, prepare and analyze the significant amount of net revenue from online-enabled packaged goods we expect to recognize on a deferred basis beginning in fiscal 2008. The successful implementation of these systems and processes entails a number of risks due to the complexity of the systems, the number of people affected company-wide, and the implementation process itself. While testing of these new systems and processes and training of employees are done in advance of implementation, there are inherent limitations in our ability to simulate a full-scale operating environment in advance of implementation. There can be no assurance that the implementation of these financial information systems and processes will not impede our ability to accurately and timely process, prepare and analyze the financial data we use in making operating decisions and which form the basis of the financial information we include in the periodic reports we file with the SEC.

 

Changes in our worldwide operating structure or the adoption of new products and distribution models could have adverse tax consequences.

 

As we expand our international operations, adopt new products and new distribution models, implement changes to our operating structure or undertake intercompany transactions in light of changing tax laws, expiring rulings, acquisitions and our current and anticipated business and operational requirements, our tax expense could increase. For example, in the fourth quarter of fiscal 2006, we repatriated $375 million under the America Jobs Creation Act of 2004. As a result, we recognized an additional one-time tax expense in fiscal 2006 of $17 million.

 

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

 

In our fiscal year ended March 31, 2007, over 70 percent of our U.S. sales were made to seven key customers. In Europe, our top ten customers accounted for approximately 31 percent of our sales in that territory during the year ended March 31, 2007. Worldwide, we had direct sales to two customers, Wal-Mart Stores and GameStop Corp., Inc., which represented approximately 13 percent and 12 percent, respectively, of total net revenue in the year ended March 31, 2007. Though our products are available to consumers through a variety of retailers, the concentration of our sales in one, or a few, large customers could lead to a short-term disruption in our sales if one or more of these customers significantly reduced their purchases or ceased to carry our products, and could make us more vulnerable to collection risk if one or more of these large customers became unable to pay for our products. Additionally, our receivables from these large customers increase significantly in the December quarter as they stock up for the holiday selling season. Also, having such a large portion of our total net revenue concentrated in a few customers could reduce our negotiating leverage with these customers.

 

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

 

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

 

 

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

 

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

 

In many countries around the world, more pirated copies of our products are sold than legitimate copies. Though we believe piracy has not had a material impact on our operating results to date, highly organized pirate operations have been expanding globally. In addition, the proliferation of technology designed to circumvent the protection measures we use in our products, the availability of broadband access to the Internet, the ability to download pirated copies of our games from various Internet sites, and the widespread proliferation of Internet cafes using pirated copies of our products, all have contributed to ongoing and expanding piracy. Though we take steps to make the unauthorized copying and distribution of our products more difficult, as do the manufacturers of consoles on which our games are played, these efforts may not be successful in controlling the piracy of our products. This could have a negative effect on our growth and profitability in the future.

 

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

 

The market price of our common stock historically has been, and we expect will continue to be, subject to significant fluctuations. These fluctuations may be due to factors specific to us (including those discussed in the risk factors above as well as others not currently known to us or that we currently do not believe are material), to changes in securities analysts’ earnings estimates or ratings, to our results or future financial guidance falling below our expectations and analysts’ and investors’ expectations, to factors affecting the computer, software, Internet, entertainment, media or electronics industries, or to national or international economic conditions.

 

None.

 

The following diagram depicts the locations of our most significant facilities throughout the world:

 

We currently own a 418,000-square-foot product development studio facility in Burnaby, British Columbia, Canada and a 122,000-square-foot administrative, sales and development facility in Chertsey, England. In addition to the properties we own, we lease approximately 2.7 million square feet of facilities, including significant leases for our headquarters in Redwood City, California, our studios in Los Angeles, California and Orlando, Florida, and our distribution center in Louisville, Kentucky. Our leased space is summarized as follows (in square feet):

 

 

Redwood City Headquarters

 

In February 1995, we entered into a build-to-suit lease (“Phase One Lease”) with a third-party lessor for our headquarters facilities in Redwood City, California (“Phase One Facilities”). The Phase One Facilities comprise a total of approximately 350,000 square feet and provide space for sales, marketing, administration and research and development functions. In July 2001, the lessor refinanced the Phase One Lease with Keybank National Association through July 2006. The Phase One Lease expires in January 2039, subject to early termination in the event the underlying financing between the lessor and its lenders is not extended. Subject to certain terms and conditions, we may purchase the Phase One Facilities or arrange for the sale of the Phase One Facilities to a third party.

 

Pursuant to the terms of the Phase One Lease, we have an option to purchase the Phase One Facilities at any time for a purchase price of $132 million. In the event of a sale to a third party, if the sale price is less than $132 million, we will be obligated to reimburse the difference between the actual sale price and $132 million, up to a maximum of $117 million, subject to certain provisions of the Phase One Lease, as amended.

 

On May 26, 2006, the lessor extended its loan financing underlying the Phase One Lease with its lenders through July 2007, and on May 14, 2007, the lenders extended this financing again for an additional year through July 2008. We may request, on behalf of the lessor and subject to lender approval, an additional one-year extension of the loan financing between the lessor and the lenders. In the event the lessor’s loan financing with the lenders is not extended, we may loan to the lessor approximately 90 percent of the financing, and require the lessor to extend the remainder through July 2009; otherwise the lease will terminate. We account for the Phase One Lease arrangement as an operating lease in accordance with SFAS No. 13, “Accounting for Leases”, as amended.

 

In December 2000, we entered into a second build-to-suit lease (“Phase Two Lease”) with Keybank National Association for a five and one-half year term beginning in December 2000 to expand our Redwood City, California headquarters facilities and develop adjacent property (“Phase Two Facilities”). Construction of the Phase Two Facilities was completed in June 2002. The Phase Two Facilities comprise a total of approximately 310,000 square feet and provide space for sales, marketing, administration and research and development functions. Subject to certain terms and conditions, we may purchase the Phase Two Facilities or arrange for the sale of the Phase Two Facilities to a third party.

 

Pursuant to the terms of the Phase Two Lease, we have an option to purchase the Phase Two Facilities at any time for a purchase price of $115 million. In the event of a sale to a third party, if the sale price is less than $115 million, we will be obligated to reimburse the difference between the actual sale price and $115 million, up to a maximum of $105 million, subject to certain provisions of the Phase Two Lease, as amended.

 

On May 26, 2006, the lessor extended the Phase Two Lease through July 2009 subject to early termination in the event the underlying loan financing between the lessor and its lenders is not extended. Concurrently with the extension of the lease, the lessor extended the loan financing underlying the Phase Two Lease with its

lenders through July 2007. On May 14, 2007 the lenders extended this financing again for an additional year through July 2008. We may request, on behalf of the lessor and subject to lender approval, an additional one-year extension of the loan financing between the lessor and the lenders. In the event the lessor’s loan financing with the lenders is not extended, we may loan to the lessor approximately 90 percent of the financing, and require the lessor to extend the remainder through July 2009, otherwise the lease will terminate. We account for the Phase Two Lease arrangement as an operating lease in accordance with SFAS No. 13, as amended.

 

We believe that, as of March 31, 2007, the estimated fair values of both properties under these operating leases exceeded their respective guaranteed residual values.

 

Guildford, Orlando, Los Angeles and Vancouver Studios; Louisville Distribution Center

 

In February 2006, we entered into an agreement with an independent third party to lease a studio facility in Guildford, Surrey, United Kingdom, which commenced in June 2006 and will expire in May 2016. The facility comprises a total of approximately 95,000 square feet, which we use for research and development functions. Our rental obligation under this agreement is approximately $33 million over the initial ten-year term of the lease.

 

In June 2004, we entered into a lease agreement, amended in December 2005, with an independent third party for a studio facility in Orlando, Florida. The lease commenced in January 2005 and expires in June 2010, with one five-year option to extend the lease term. The campus facilities comprise a total of 140,000 square feet and provide space for research and development functions. Our rental obligation over the initial five-and-a-half year term of the lease is $15 million.

 

In July 2003, we entered into a lease agreement with an independent third party (the “Landlord”) for a studio facility in Los Angeles, California, which commenced in October 2003 and expires in September 2013 with two five-year options to extend the lease term. Additionally, we have options to purchase the property after five and ten years based on the fair market value of the property at the date of sale, a right of first offer to purchase the property upon terms offered by the Landlord, and a right to share in the profits from a sale of the property. Existing campus facilities comprise a total of 243,000 square feet and provide space for research and development functions. Our rental obligation under this agreement is $50 million over the initial ten-year term of the lease. This commitment is offset by expected sublease income of $6 million for a sublease to an affiliate of the Landlord of 18,000 square feet of the Los Angeles facility, which commenced in October 2003 and expires in September 2013, with options of early termination by the affiliate after five years and by us after four and five years.

 

In October 2002, we entered into a lease agreement, with an independent third party for a studio facility in Vancouver, British Columbia, Canada, which commenced in May 2003 and expires in April 2013. We amended the lease in October 2003. The facility comprises a total of approximately 65,000 square feet and provides space for research and development functions. Our rental obligation under this agreement is approximately $16 million over the initial ten-year term of the lease.

 

Our North American distribution is supported by a centralized warehouse facility that we lease in Louisville, Kentucky, occupying 250,000 square feet.

 

In addition to the properties discussed above, we have other properties under lease which have been included in our restructuring costs as discussed in Note 6 of the Notes to Consolidated Financial Statements included in Item 8 of this report. While we continually evaluate our facility requirements, we believe that suitable additional or substitute space will be available as needed to accommodate our future needs.

 

On September 14, 2006, we received an informal inquiry from the Securities and Exchange Commission requesting certain documents and information relating to our stock option grant practices from January 1, 1997 through the date of the letter. We have cooperated to date with all matters related to this request. We most recently provided the SEC with information in December 2006. The SEC has not asked for any further information since that time.

 

We are also subject to claims and litigation arising in the ordinary course of business. We believe that any liability from any reasonably foreseeable disposition of such claims and litigation, individually or in the aggregate, would not have a material adverse effect on our consolidated financial position or results of operations.

 

There were no matters submitted to a vote of our security holders during the quarter ended March 31, 2007.

 

Market Information

 

Our common stock is traded on the NASDAQ Global Select Market under the symbol “ERTS”. The following table sets forth the quarterly high and low sales price per share of our common stock from April 1, 2005 through March 31, 2007.

 

 

Holders

 

There were approximately 1,722 holders of record of our common stock as of May 24, 2007. In addition, we believe that a significant number of beneficial owners of our common stock hold their shares in street name.

 

Dividends

 

We have not paid any cash dividends and do not anticipate paying cash dividends in the foreseeable future.

Stock Performance Graph

 

The following information shall not be deemed to be “filed” with the Securities and Exchange Commission nor shall this information be incorporated by reference into any future filing under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, except to the extent that we specifically incorporate it by reference into a filing.

 

The following graph shows a five-year comparison of cumulative total returns during the period from March 31, 2002 through March 31, 2007, for our common stock, the NASDAQ Market Composite Index, the S&P 500 Index (to which EA was added in July 2002) and the RDG Technology Index, each of which assumes an initial value of $100. Each measurement point is as of the end of each fiscal year ended March 31. The performance of our stock depicted in the following graph is not necessarily indicative of the future performance of our stock.

 

COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*

Among Electronic Arts Inc., The NASDAQ Composite Index,

The S&P 500 Index and The RDG Technology Composite Index

 

 

* $100 invested on 3/31/02 in stock or index-including reinvestment of dividends. Fiscal year ending March 31.

 

 

ELECTRONIC ARTS INC. AND SUBSIDIARIES

 

SELECTED FIVE-YEAR CONSOLIDATED FINANCIAL DATA
(In millions, except per share data)

 

 

ELECTRONIC ARTS INC. AND SUBSIDIARIES

 

SELECTED FIVE-YEAR CONSOLIDATED FINANCIAL DATA (Continued)
(In millions)

 

 

 

OVERVIEW

 

The following overview is a top-level discussion of our operating results as well as some of the trends and drivers that affect our business. Management believes that an understanding of these trends and drivers is important in order to understand our results for the fiscal year ended March 31, 2007, as well as our future prospects. This summary is not intended to be exhaustive, nor is it intended to be a substitute for the detailed discussion and analysis provided elsewhere in this Form 10-K, including in the “Business” section and the “Risk Factors” above, the remainder of “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, or the Consolidated Financial Statements and related notes.

 

 

We develop, market, publish and distribute interactive software games that are playable by consumers on video game consoles (such as the Sony PlayStation 2 and PLAYSTATION 3, Microsoft Xbox 360 and Nintendo Wii), personal computers, mobile platforms (including cellular handsets and handheld game players such as the PlayStation Portable (“PSP”) and the Nintendo DS) and online (over the Internet and other proprietary online networks). Some of our games are based on content that we license from others (e.g., Madden NFL Football, The Godfather and FIFA Soccer), and some of our games are based on our own wholly-owned intellectual property (e.g., The Sims and Need for Speed). Our goal is to publish titles with mass-market appeal, which often means translating and localizing them for sale in non-English speaking countries. In addition, we also attempt to create software game “franchises” that allow us to publish new titles on a recurring basis that are based on the same property. Examples of this franchise approach are the annual iterations of our sports-based products (e.g., Madden NFL Football, NCAA^® Football and FIFA Soccer), wholly-owned properties that can be successfully sequeled (e.g., The Sims, Need for Speed and Battlefield) and titles based on long-lived literary and/or movie properties (e.g., Lord of the Rings and Harry Potter).

 

 

Total net revenue for the fiscal year ended March 31, 2007 was $3.091 billion, up 5 percent as compared to the fiscal year ended March 31, 2006. Total net revenue for the fiscal year ended March 31, 2007 was driven by sales of Madden NFL 07, Need for Speed Carbon, FIFA 07, The Sims 2 Pets, and NCAA^® Football 07.  Four titles sold more than five million units in the fiscal year ended March 31, 2007 — Madden NFL 07, Need for Speed Carbon, FIFA 07, and The Sims 2 Pets.

 

Net income for the fiscal year ended March 31, 2007 was $76 million as compared to $236 million for the fiscal year ended March 31, 2006. Diluted net income per share for the fiscal year ended March 31, 2007 was $0.24 as compared to $0.75 for the fiscal year ended March 31, 2006. Although net revenue increased in fiscal 2007 as compared to fiscal 2006, net income decreased due to an increase in our operating expenses as a result of our adoption of SFAS No. 123 (revised 2004) (“SFAS No. 123(R)”), “Share Based Payment”, an increase in our annual bonus expense and an increase in additional personnel-related costs due to an increase in headcount. These increases were further mitigated by a decrease in our income tax provision.

 

We generated $397 million of cash from operating activities during the year ended March 31, 2007, as compared to $596 million for fiscal 2006. The decrease in cash generated from operating activities was primarily due to the timing of the collection of our receivables as a result of collecting a greater amount of our receivables during fiscal 2006 as compared to fiscal 2007.

 

Stock-Based Compensation.  Beginning in fiscal 2007, we adopted SFAS No. 123(R) which requires us to recognize the cost resulting from all share-based payment transactions in our financial statements using a fair-value-based method. See Note 12 of the Notes to Consolidated Financial Statements. The following table summarizes our stock-based compensation expense resulting from stock options, restricted stock, restricted

stock units and our employee stock purchase plan included in our Consolidated Statements of Operations for the fiscal years ended March 31, 2007, 2006 and 2005 (in millions):

 

 

As of March 31, 2007, our total unrecognized compensation cost related to stock options was $153 million and is expected to be recognized over a weighted-average service period of 1.6 years. As of March 31, 2007, our total unrecognized compensation cost related to restricted stock and restricted stock units (collectively referred to as “restricted stock rights”) was $82 million and is expected to be recognized over a weighted-average service period of 2.3 years.

 

 

Transition to A New Generation of Consoles.  Video game hardware systems have historically had a life cycle of four to six years, which causes the video game software market to be cyclical as well. Microsoft launched the Xbox 360 in November 2005, while Sony and Nintendo launched the PLAYSTATION 3 and the Wii, respectively, in November 2006. We have continued to develop and market new titles for prior-generation video game systems such as the PlayStation 2 while also making significant investments in products for the new systems. As the prior-generation systems reach the end of their life cycle and the installed base of the new systems continues to grow, our sales of video games for prior-generation systems will continue to decline as (1) we produce fewer titles for prior-generation systems, (2) consumers replace their prior-generation systems with the new systems, and/or (3) consumers reduce game software purchases for certain prior-generation consoles generally, for example, until they are able to purchase a new video game hardware system. This decline in prior-generation product sales could ultimately be greater than we anticipate, and sales of products for the new platforms may be lower than we anticipate. Moreover, we expect development costs for the new video game systems to be greater on a per-title basis than development costs for prior-generation video game systems.

 

We have incurred increased costs during this transition as we have continued to develop and market new titles for certain prior-generation video game platforms while also making significant investments in products for the new generation platforms. As we move through the life cycle of prior-generation consoles, we will continue to devote significant resources to the development of prior-generation titles while at the same time spending more for the new generation of platforms and technology. As a result of these factors, we expect research and development expenses to increase in fiscal 2008.

 

Investment in Online.  Today, we generate net revenue from a variety of online products and services, including casual games and downloadable content marketed under our Pogo brand, persistent state world games such as Ultima Online and Dark Age of Camelot, PC-based downloadable content and online-enabled packaged goods. As the nature of online game offerings expands and evolves, we anticipate long-term opportunities for growth in this area. For example, we expect that consumers will take advantage of the online connectivity of the new generation of consoles at a much higher rate than they have on prior-generation consoles, allowing more consumers to enhance their gameplay experience through multiplayer activity, community-building and downloading content. We plan to increase the amount of content available for download on the PC, consoles and cell phones, increase the number of games with dynamic in-game advertising and to increase the number of PC-based games that can be downloaded digitally. In addition, we plan to expand our casual game offerings internationally and to invest in growing genres such as mid-session

games. To further enhance our online offerings, we acquired Mythic, a developer and publisher of massively multiplayer online role-playing games, in July 2006. We intend to make significant investments in online products, infrastructure and services and believe that online gameplay will become an increasingly important part of our business in the long term.

 

Significantly Increased Deferred Revenue for Online-Enabled Games.  The ubiquity of high-speed Internet access and the integration of network connectivity into new generation game consoles are expected to increase demand for games with online-enabled features. To address this demand, many of our software products are developed with the ability to be connected to and played via the Internet. In order for consumers to participate in online communities and play against one another via the Internet, we (or through outsourced arrangements with third parties) have servers which support the various online services we provide to consumers such as matchmaking, roster updates, tournaments and player rankings. In situations where we do not separately sell these online services, we consider the sale of the software product as a “bundle” sale or multiple element arrangement in which we sell both the software product and the online service for one combined price.

 

Through fiscal 2007, for accounting purposes, vendor specific objective evidence of fair value existed for the online service. Accordingly, we allocated the revenue collected from the sale of the software product between the online service and the software product and recognized the amounts allocated to each element separately. However, starting in fiscal 2008, for accounting purposes, the required vendor specific objective evidence of fair value will not exist for the online services. This will prevent us from allocating and recognizing revenue related to the software product and the online services separately. Accordingly, we will begin to recognize all of the revenue from the sale of our online-enabled software products related to the PC, PlayStation 2, PLAYSTATION 3 and the PSP platforms over the estimated online service period (currently expected to be recognized over six months after the month of sale). We anticipate that, in fiscal 2008, we will likely defer approximately $400 to $500 million in net revenue from the sale of these online-enabled software products into fiscal 2009. On a quarterly basis, this amount will vary significantly depending upon the timing of the release of the online-enabled software product and the sales volume of such products. In addition, we will expense the cost of goods sold related to these transactions when delivered. As of March 31, 2007, deferred net revenue related to packaged goods and digital content (i.e., content delivered to the consumer via the Internet including (1) digital downloads and (2) certain incremental content related to our core subscription services playable only online, which are types of “micro-transactions”) was $23 million.

 

Expansion of Mobile Platforms.  Advances in mobile technology have resulted in a variety of new and evolving platforms for on-the-go interactive entertainment that appeal to a broader demographic of consumers. Our efforts to capitalize on the growth in mobile interactive entertainment are focused in two broad areas — packaged goods games for handheld game systems and downloadable games for cellular handsets.

 

We have developed and published games for a variety of handheld platforms, including the Nintendo Game Boy and Game Boy Advance, for several years. The introductions of the Sony PSP and the Nintendo DS, with their enhanced graphics, deeper gameplay, and online functionality, provide a richer mobile gaming experience for consumers.

 

We expect sales of games for cellular handsets to continue to be an increasingly important part of our business worldwide. To accelerate our position in this growing segment, in February 2006, we acquired JAMDAT Mobile Inc., a global publisher of wireless games and other wireless entertainment applications. As a result of this acquisition, our net revenue from games for cellular handsets increased significantly in fiscal 2007 as compared to prior years. Likewise, the acquisition, along with the additional investment required to grow this portion of our business globally, resulted in increased license royalties, development and operating expenses in fiscal 2007.

 

As mobile technology continues to evolve and the installed base of both handheld game systems and game-enabled cellular phones continues to expand, we anticipate that sales of our titles for mobile platforms — for both handhelds and cellular handsets — will become an increasingly important part of our business.

 

Acquisitions, Investments and Strategic Transactions.  We have engaged in, evaluated, and expect to continue to engage in and evaluate, a wide array of potential strategic transactions, including (1) acquisitions of

companies, businesses, intellectual properties, and other assets, and (2) investments in new interactive entertainment businesses, such as online and mobile games. In May 2007, we announced that we entered into a licensing agreement with and expect to make a strategic equity investment in The9 Limited, a leading online game operator in China, on or around May 29, 2007. The licensing agreement gives The9 exclusive publishing rights for EA SPORTS FIFA Online in mainland China. In April 2007, we expanded our commercial agreements with and made strategic equity investments in Neowiz Corporation and its online gaming subsidiary, Neowiz Games. Based in Korea, Neowiz is an online media and gaming company with which we partnered in 2006 to launch EA Sports FIFA Online in Korea. In October 2006, the remaining outstanding shares of Digital Illusions C.E. (“DICE”) were purchased, thereby completing the acquisition of the remaining minority interest of DICE. In July 2006, we acquired Mythic as part of our efforts to accelerate our growth in the massively multiplayer online role-playing market. In fiscal 2007, we also acquired SingShot Media, a San Francisco-based online karaoke community, as well as substantially all of the assets of Headgate Studios, a Utah-based developer with which we had partnered since 2000 to develop certain EA franchises, and Phenomic Game Development, a developer of Real Time Strategy games based in Germany. In fiscal 2006, we acquired JAMDAT as part of our efforts to accelerate our growth in mobile gaming.

 

International Expansion.  We expect international sales to remain a fundamental part of our business. As part of our international expansion strategy, we may seek to partner with established local companies through acquisitions, joint ventures, minority investments or other similar arrangements. We are planning to expand our development and business activities internationally. We believe that in order to succeed internationally, it is important to locally develop content that is specifically directed toward local cultures and consumers. As such, we expect to continue to devote resources to hiring local development talent and expanding our infrastructure.

 

Sales of “Hit” Titles.  Sales of “hit” titles, several of which were top sellers in a number of countries, contributed significantly to our net revenue in fiscal 2007. Our top-selling titles across all platforms worldwide during the year ended March 31, 2007 were Madden NFL 07, Need for Speed Carbon, FIFA 07, The Sims 2 Pets and NCAA Football 07. Hit titles are important to our financial performance because they benefit from overall economies of scale. We have developed, and it is our objective to continue to develop, many of our hit titles to become franchise titles that can be regularly iterated.

 

Increasing Licensing Costs.  We generate a significant portion of our net revenue and operating income from games based on licensed content, such as FIFA Soccer. We have recently entered into new licenses and renewed older licenses, some of which may contain higher royalty rates or guarantees than similar license agreements we have entered into in the past. We believe these licenses, and the product franchises they support, will continue to be important to our future operations, but the higher costs of these licenses will negatively impact our gross margins.

 

Foreign Currency Exchange Impact.  Net revenue from international sales accounted for approximately 46 percent of our total net revenue during both fiscal 2007 and 2006. Our international net revenue was primarily driven by sales in Europe and, to a much lesser extent, in Asia. Year-over-year, foreign exchange rates had a favorable impact on our net revenue of $53 million, or 2 percent, for the year ended March 31, 2007.

 

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

 

Our Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these Consolidated Financial Statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, contingent assets and liabilities, and revenue and expenses during the reporting periods. The policies discussed below are considered by management to be critical because they are not only important to the portrayal of our financial condition and results of operations but also because application and interpretation of these policies requires both judgment and estimates of matters that are inherently uncertain and unknown. As a result, actual results may differ materially from our estimates.

 

Revenue Recognition, Sales Returns, Allowances and Bad Debt Reserves

 

We principally derive revenue from sales of interactive software games designed for play on video game consoles (such as the PLAYSTATION 3, Xbox 360 and Wii), PCs and mobile platforms including handheld game players (such as the Sony PSP, Nintendo DS and Nintendo Game Boy Advance) and cellular handsets. We evaluate the recognition of revenue based on the criteria set forth in Statement of Position (“SOP”) 97-2, “Software Revenue Recognition”, as amended by SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions” and Staff Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition”. We evaluate revenue recognition using the following basic criteria and recognize revenue when all four of the following criteria are met:

 

 

Determining whether and when some of these criteria have been satisfied often involves assumptions and judgments that can have a significant impact on the timing and amount of revenue we report. For example, for multiple element arrangements, we must make assumptions and judgments in order to: (1) determine whether and when each element has been delivered; (2) determine whether undelivered products or services are essential to the functionality of the delivered products and services; (3) determine whether vendor-specific objective evidence of fair value (“VSOE”) exists for each undelivered element; and (4) allocate the total price among the various elements we must deliver. Changes to any of these assumptions or judgments, or changes to the elements in a software arrangement, could cause a material increase or decrease in the amount of revenue that we report in a particular period. For example, some of our packaged goods products are sold with online services. Prior to, and through fiscal 2007, we had been able to determine VSOE for the online services to be delivered; therefore, we have been able to allocate the total price received from the combined product and online service sale between these two elements and recognize the related revenue separately. However, starting in fiscal 2008, VSOE will not exist for the online services to be delivered for certain platforms and all revenue from these transactions will be recognized over the estimated online service period. More specifically, we will begin to recognize the revenue from sales of certain online-enabled packaged goods on a straight-line basis over six months after the month of sale. Accordingly, this relatively small change (from having VSOE for online hosting services to no longer having VSOE) will have a significant effect on our reported results.

 

Determining whether a transaction constitutes an online game service transaction or a download of a product requires judgment and can be difficult. The accounting for these transactions is significantly different. Revenue from product downloads is recognized when the download occurs (assuming all other recognition criteria are met). Revenue from online game services is recognized as the services are rendered. If the service period is not defined, we recognize the revenue over the estimated service period. Determining the estimated service period is inherently subjective and is subject to regular revision based on historical online usage.

 

Product revenue, including sales to resellers and distributors (“channel partners”), is recognized when the above criteria are met. We reduce product revenue for estimated future returns, price protection, and other offerings, which may occur with our customers and channel partners. In certain countries, we have stock-balancing programs for our PC and video game system products, which allow for the exchange of these

products by resellers under certain circumstances. It is our general practice to exchange products or give credits rather than to give cash refunds.

 

In certain countries, from time to time, we decide to provide price protection for both our PC and video game system products. When evaluating the adequacy of sales returns and price protection allowances, we analyze historical returns, current sell-through of distributor and retailer inventory of our products, current trends in retail and the video game segment, changes in customer demand and acceptance of our products, and other related factors. In addition, we monitor the volume of sales to our channel partners and their inventories, as substantial overstocking in the distribution channel could result in high returns or higher price protection costs in subsequent periods.

 

In the future, actual returns and price protections may materially exceed our estimates as unsold products in the distribution channels are exposed to rapid changes in consumer preferences, market conditions or technological obsolescence due to new platforms, product updates or competing products. For example, the risk of product returns and/or price protection for our products may continue to increase as the PlayStation 2 console moves through its lifecycle. While we believe we can make reliable estimates regarding these matters, these estimates are inherently subjective. Accordingly, if our estimates changed, our returns and price protection reserves would change, which would impact the total net revenue we report. For example, if actual returns and/or price protection were significantly greater than the reserves we have established, our actual results would decrease our reported total net revenue. Conversely, if actual returns and/or price protection were significantly less than our reserves, this would increase our reported total net revenue.

 

Significant judgment is required to estimate our allowance for doubtful accounts in any accounting period. We determine our allowance for doubtful accounts by evaluating customer creditworthiness in the context of current economic trends and historical experience. Depending upon the overall economic climate and the financial condition of our customers, the amount and timing of our bad debt expense and cash collection could change significantly.

 

Royalties and Licenses

 

Our royalty expenses consist of payments to (1) content licensors, (2) independent software developers, and (3) co-publishing and distribution affiliates. License royalties consist of payments made to celebrities, professional sports organizations, movie studios and other organizations for our use of their trademarks, copyrights, personal publicity rights, content and/or other intellectual property. Royalty payments to independent software developers are payments for the development of intellectual property related to our games. Co-publishing and distribution royalties are payments made to third parties for the delivery of product.

 

Royalty-based obligations with content licensors and distribution affiliates are either paid in advance and capitalized as prepaid royalties or are accrued as incurred and subsequently paid. These royalty-based obligations are generally expensed to cost of goods sold generally at the greater of the contractual rate or an effective royalty rate based on expected net product sales. Significant judgment is required to estimate the effective royalty rate for a particular contract. Because the computation of effective royalty rates requires us to project future revenue, it is inherently subjective as our future revenue projections must anticipate a number of factors, including (1) the total number of titles subject to the contract, (2) the timing of the release of these titles, (3) the number of software units we expect to sell which can be impacted by a number of variables, including product quality and competition, and (4) future pricing. Determining the effective royalty rate for our titles is particularly challenging due to the inherent difficulty in predicting the popularity of entertainment products. Accordingly, if our future revenue projections change, our effective royalty rates would change, which could impact the royalty expense we recognize. Prepayments made to thinly capitalized independent software developers and co-publishing affiliates are generally made in connection with the development of a particular product and, therefore, we are generally subject to development risk prior to the release of the product. Accordingly, payments that are due prior to completion of a product are generally amortized to research and development over the development period as the services are incurred. Payments due after completion of the product (primarily royalty-based in nature) are generally expensed as cost of goods sold.

 

Our contracts with some licensors include minimum guaranteed royalty payments which are initially recorded as an asset and as a liability at the contractual amount when no performance remains with the licensor. When performance remains with the licensor, we record guarantee payments as an asset when actually paid and as a liability when incurred, rather than recording the asset and liability upon execution of the contract. Minimum royalty payment obligations are classified as current liabilities to the extent such royalty payments are contractually due within the next twelve months. As of March 31, 2007 and 2006, approximately $9 million of minimum guaranteed royalty obligations had been recognized in each period.

 

Each quarter, we also evaluate the future realization of our royalty-based assets as well as any unrecognized minimum commitments not yet paid to determine amounts we deem unlikely to be realized through product sales. Any impairments determined before the launch of a product are charged to research and development expense. Impairments determined post-launch are charged to cost of goods sold. In either case, we rely on estimated revenue to evaluate the future realization of prepaid royalties and commitments. If actual sales or revised revenue estimates fall below the initial revenue estimate, then the actual charge taken may be greater in any given quarter than anticipated. We had no impairments during fiscal 2007. During fiscal 2006 and 2005, we recorded impairment charges of $16 million and $8 million, respectively.

 

Valuation of Long-Lived Assets, including goodwill and other intangible assets

 

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

 

Under current accounting standards, we make judgments about the recoverability of purchased intangible assets and other long-lived assets whenever events or changes in circumstances indicate a potential impairment in the remaining value of the assets recorded on our Consolidated Balance Sheets. In order to determine if a potential impairment has occurred, management makes various assumptions about the future value of the asset by evaluating future business prospects and estimated cash flows. Our future net cash flows are primarily dependent on the sale of products for play on proprietary video game consoles, handheld game players, PCs, and cellular handsets (“platforms”). The sales of our products are affected by our ability to accurately predict which platforms and which products we develop will be successful. Also, our revenue and earnings are dependent on our ability to meet our product release schedules. Due to product sales shortfalls, we may not realize the future net cash flows necessary to recover our long-lived assets, which may result in an impairment charge being recorded in the future. We recognized an insignificant amount of impairment in fiscal 2007, 2006 and 2005.

 

SFAS No. 142, “Goodwill and Other Intangible Assets” requires at least an annual assessment for impairment of goodwill by applying a fair-value-based test. A two-step approach is required to test goodwill for impairment for each reporting unit. The first step tests for impairment by applying fair value-based tests at the reporting unit level. The second step (if necessary) measures the amount of impairment by applying fair value-based tests to individual assets and liabilities within each reporting unit. Application of the goodwill impairment test requires judgment, including identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. The fair value of each reporting unit is estimated using a discounted cash flow methodology which requires significant judgment to estimate the future cash flows, determine the appropriate discount rates, growth rates and other assumptions. The determination of fair value for each reporting unit could be materially affected by changes in these estimates and assumptions which could trigger impairment. In fiscal 2007, we completed the first step of the annual goodwill impairment testing as of January 1, 2007 and found no indicators of impairment of our recorded goodwill. We did not recognize an impairment loss on goodwill in fiscal 2007, 2006 or 2005. Future impairment tests may result in a charge to earnings and there is a potential for a write-down of goodwill in connection with the annual impairment test.

 

Stock-Based Compensation

 

On April 1, 2006, we adopted SFAS No. 123(R) and applied the provisions of SAB No. 107, “Share-Based Payment”, on our adoption of SFAS No. 123(R). SFAS No. 123(R) requires that the cost resulting from all share-based payment transactions be recognized in the financial statements using a fair-value-based method. We elected to use the modified prospective transition method of adoption. SFAS No. 123(R) requires us to measure compensation cost for all outstanding unvested stock-based awards made to our employees and directors based on estimated fair values and recognize compensation over the service period for awards expected to vest. We recognized $133 million of stock-based compensation related to employee stock options, restricted stock units, restricted stock awards and our employee stock purchase plan (“ESPP”) during the fiscal year ended March 31, 2007. We recognized $3 million of stock-based compensation related to employee restricted stock units, stock options assumed in connection with our acquisition of JAMDAT and non-employee stock options during the fiscal year ended March 31, 2006. We recognized $6 million of stock-based compensation related to stock options assumed in connection with our acquisition of Criterion Software Group Ltd. and non-employee stock options and warrants during the fiscal year ended March 31, 2005.

 

For options and ESPP, we use the Black-Scholes option valuation model to determine the grant date fair value. The Black-Scholes option valuation model requires us to make certain assumptions about the future. The determination of fair value is affected by our stock price as well as assumptions regarding subjective and complex variables such as expected employee exercise behavior and our expected stock price volatility over the term of the award. Generally, our assumptions are based on historical information and judgment is required to determine if historical trends may be indicators of future outcomes. We estimated the following key assumptions for the Black-Scholes valuation calculation:

 

 

As required by SFAS No. 123(R), employee stock-based compensation expense recognized in fiscal 2007 was calculated based on awards ultimately expected to vest and has been reduced for estimated forfeitures. Forfeitures are revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates and an adjustment will be recognized at that time.

 

Changes to our underlying stock price, our assumptions used in the Black-Scholes option valuation calculation and our forfeiture rate as well as future grants of equity could significantly impact compensation expense to be recognized in fiscal 2008 and future periods.

 

Income Taxes

 

In the ordinary course of our business, there are many transactions and calculations where the tax law and ultimate tax determination is uncertain. As part of the process of preparing our Consolidated Financial Statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate prior to the completion and filing of tax returns for such periods. This process requires estimating both our geographic mix of income and our current tax exposures in each jurisdiction where we operate. These estimates involve complex issues, require extended periods of time to resolve, and require us to make judgments, such as anticipating the positions that we will take on tax returns prior to our actually preparing the returns and the outcomes of disputes with tax authorities. We are also required to make determinations of the need to record deferred tax liabilities and the recoverability of deferred tax assets. A valuation allowance is

established to the extent recovery of deferred tax assets is not likely based on our estimation of future taxable income in each jurisdiction.

 

In addition, changes in our business, including acquisitions, changes in our international corporate structure, changes in the geographic location of business functions or assets, changes in the geographic mix and amount of income, as well as changes in our agreements with tax authorities, valuation allowances, applicable accounting rules, applicable tax laws and regulations, rulings and interpretations thereof, developments in tax audit and other matters, and variations in the estimated and actual level of annual pre-tax income can affect the overall effective income tax rate. As with fiscal 2007, we expect our effective tax rate to be unusually volatile and subject to significant fluctuation.

 

RESULTS OF OPERATIONS

 

Our fiscal year is reported on a 52 or 53-week period that, historically, ended on the final Saturday of March in each year. Beginning with the fiscal year ended March 31, 2006, our fiscal year ends on the Saturday nearest March 31. As a result, fiscal 2006 contained 53 weeks with the first quarter containing 14 weeks. Our results of operations for the fiscal years ended March 31, 2008, 2007, 2006 and 2005 contain the following number of weeks:

 

 

For simplicity of disclosure, all fiscal periods are referred to as ending on a calendar month end.

 

Beginning in fiscal 2007, we adopted SFAS No. 123(R) and applied the provisions of SAB No. 107 to our adoption of SFAS No. 123(R). We elected to use the modified prospective transition method of adoption which requires that compensation expense be recognized in the financial statements for all awards granted after the date of adoption as well as for existing awards for which the requisite service has not been rendered as of the date of adoption. Accordingly, prior periods are not restated for the effect of SFAS No. 123(R). Prior to our adoption of SFAS No. 123(R), we valued our stock options based on the multiple-award valuation method and recognized the expense using the accelerated approach over the requisite service period. In conjunction with our adoption of SFAS No. 123(R), we changed our method of recognizing our stock-based compensation expense to the straight-line approach over the requisite service period; however, we continue to value our stock options based on the multiple-award valuation method.

 

Prior to fiscal 2007, we accounted for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board No. 25, “Accounting for Stock Issued to Employees” and adopted the disclosure-only provisions of SFAS No. 123, “Accounting for Stock-Based Compensation”, as amended. Also, as required by SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure”, we provided pro forma net income and net income per common share disclosures for stock-based awards as if the fair-value-based method defined in SFAS No. 123 had been applied. As a result, prior periods are not restated for the effect of SFAS No. 123(R). Pre-tax stock-based compensation expense for the fiscal years ended March 31, 2007, 2006 and 2005 was $133 million, $3 million and $6 million, respectively.

 

Comparison of Fiscal 2007 to Fiscal 2006

 

Net Revenue

 

We derive net revenue principally from sales of interactive software games designed for play on video game consoles (such as the PlayStation 2, PLAYSTATION 3, Xbox 360 and Wii), PCs and handheld game players (such as the Sony PSP, Nintendo DS and Nintendo Game Boy Advance) and cellular handsets. We also derive net revenue from selling services in connection with some of our online games, programming third-party web

sites with our game content, allowing other companies to manufacture and sell our products in conjunction with other products, and selling advertisements on our online web pages and in our games.

 

From a geographical perspective, our total net revenue for fiscal years ended March 31, 2007 and 2006 was as follows (in millions):

 

 

North America

 

For fiscal 2007, net revenue in North America was $1,666 million, driven primarily by (1) our packaged goods business led by sales of Madden NFL 07, Need for Speed Carbon, and NCAA Football 07, and (2) to a lesser extent, growth in our cellular handset games business resulting from our February 2006 acquisition of JAMDAT. Overall, net revenue increased $82 million, or 5 percent, as compared to fiscal 2006.

 

The increase in net revenue for fiscal 2007, as compared to fiscal 2006 was driven primarily by (1) a $95 million increase in cellular handset net revenue, and (2) a $43 million increase in catalog^(a) net revenue. These increases were partially offset by a $79 million decrease in frontline^(b) net revenue.

 

 

 

Europe

 

For fiscal 2007, net revenue in Europe was $1,261 million, driven primarily by sales of FIFA 07 and Need for Speed Carbon. Overall, net revenue increased $87 million, or 7 percent, as compared to fiscal 2006. We estimate that foreign exchange rates (primarily the Euro and the British pound sterling) increased reported European net revenue by approximately $57 million, or 5 percent, for fiscal 2007 as compared to fiscal 2006. Excluding the effect of foreign exchange rates, we estimate that European net revenue increased by approximately $30 million, or 2 percent, for fiscal 2007.

 

The increase in net revenue for fiscal 2007, as compared to fiscal 2006 was driven primarily by (1) a $64 million increase in catalog net revenue, and (2) a $25 million increase in cellular handset net revenue. These increases were partially offset by a $7 million decrease in frontline net revenue.

 

Asia

 

For fiscal 2007, net revenue in Asia was $164 million, driven primarily by sales of Need for Speed Carbon.  Overall, net revenue decreased by $29 million, or 15 percent, as compared to fiscal 2006. The decrease in net revenue for fiscal 2007 was driven primarily by (1) a $21 million decrease in co-publishing and distribution net revenue, and (2) a $20 million decrease in frontline net revenue. These decreases were partially offset by a $13 million increase in catalog net revenue. We estimate that changes in foreign exchange rates decreased reported net revenue in Asia by approximately $4 million, or 2 percent, for fiscal 2007. Excluding the effect

of foreign exchange rates, we estimate that Asia net revenue decreased by approximately $25 million, or 13 percent, for fiscal 2007 as compared to fiscal 2006.

 

Our total net revenue by platform for fiscal years 2007 and 2006 was as follows (in millions):

 

 

PlayStation 2

 

For fiscal 2007, net revenue from sales of titles for the PlayStation 2 was $886 million, driven primarily by sales of Madden NFL 07, Need for Speed Carbon, and FIFA 07. Overall, PlayStation 2 net revenue decreased $241 million, or 21 percent, compared to fiscal 2006. Although we are unable to specifically quantify the impact, we believe the decrease was primarily due to the transition to new generation consoles.

 

We expect PlayStation 2-related net revenue to continue to decline in fiscal 2008 as consumers increasingly migrate to new platforms, we publish fewer titles (as compared to fiscal 2007) and we defer a greater percentage of our net revenue due to the change in our online-enabled packaged goods business model.

 

Xbox 360

 

The Xbox 360 was launched in North America, Europe and Japan during the three months ended December 31, 2005 and in the rest of Asia during the three months ended March 31, 2006. For fiscal 2007, net revenue from sales of titles for the Xbox 360 was $480 million driven primarily by sales of Madden NFL 07, Need for Speed Carbon, and FIFA 07.

 

We expect net revenue from sales of titles for the Xbox 360 to increase as the installed base grows and we release more titles.

 

Xbox

 

For fiscal 2007, net revenue from sales of titles for the Xbox was $157 million, driven primarily by sales of Madden NFL 07, Need for Speed Carbon, and NCAA Football 07. Overall, Xbox net revenue decreased $243 million, or 61 percent, as compared to fiscal 2006. Although we are unable to specifically quantify the impact, we believe the decrease was primarily due to the transition to new generation consoles.

 

We expect Xbox-related net revenue to continue to decline as consumers increasingly migrate to new platforms and we publish significantly fewer titles (as compared to fiscal 2007).

 

PLAYSTATION 3

 

The PLAYSTATION 3 launched in North America and Japan during the three months ended December 31, 2006 and Europe and the rest of Asia during the three months ended March 31, 2007. Net revenue from sales of titles for the PLAYSTATION 3 was $94 million for fiscal 2007, driven by sales of Need for Speed Carbon, Madden NFL 07, and EA SPORTS^tm Fight Night Round 3.

 

We expect net revenue from sales of titles for the PLAYSTATION 3 to increase as the installed base grows and we release more titles. The increase will be partially offset by our deferral of net revenue resulting from certain online-enabled PLAYSTATION 3 games.

 

Wii

 

The Wii launched in North America, Europe and parts of Asia during the three months ended December 31, 2006. Net revenue from sales of titles for the Wii was $65 million for fiscal 2007, driven by sales of Need for Speed Carbon, Madden NFL 07, and Tiger Woods PGA^® TOUR 07.

 

We expect net revenue from sales of titles for the Wii to increase as the installed base grows and we release more titles.

 

Nintendo GameCube

 

For fiscal 2007, net revenue from sales of titles for the Nintendo GameCube was $60 million, driven primarily by sales of Madden NFL 07, Need for Speed Carbon, and FIFA 07. Overall, Nintendo GameCube net revenue decreased $75 million, or 56 percent, as compared to fiscal 2006. Although we are unable to specifically quantify the impact, we believe the decrease was primarily due to the transition to new generation consoles.

 

We expect Nintendo GameCube-related net revenue to continue to decline as consumers increasingly migrate to new platforms. We will no longer release titles for the Nintendo GameCube, which will also contribute to our expected net revenue decline from this platform.

 

PC

 

For fiscal 2007, net revenue from sales of titles for the PC was $498 million driven primarily by sales of titles from The Sims, Battlefield, and Command and Conquer franchises. Overall, PC net revenue increased $80 million, or 19 percent, as compared to fiscal 2006. The increase was due to a $62 million increase in frontline net revenue and an $18 million increase in catalog net revenue.

 

Mobile Platforms

 

Net revenue from mobile products, which consist of packaged goods games for handheld systems and downloadable games for cellular handsets, increased from $393 million in fiscal 2006 to $540 million in fiscal 2007. The increase was primarily due to a $121 million year-over-year growth in our cellular handset games business resulting from our acquisition of JAMDAT and an increase of $37 million in net revenue from sales of titles for the Nintendo DS.

 

We expect sales of games for cellular handsets to continue to be an increasingly important part of our business worldwide.

 

Co-Publishing and Distribution

 

Net revenue from co-publishing and distribution products, which consists of packaged goods games we co-develop and co-publish with as well as distribute on behalf of other companies and revenue generated from our Switzerland distribution business, decreased from $213 million in fiscal 2006 to $175 million in fiscal 2007. The decrease was primarily due to a decline in sales from two titles which were released in fiscal 2006 but had no corresponding releases in fiscal 2007: (1) Half-Life 2, sales of which decreased by $19 million and (2) Black & White 2^tm, sales of which decreased by $15 million.

 

We expect sales of titles for co-publishing products to increase in fiscal 2008.

 

Cost of Goods Sold

 

Cost of goods sold for our packaged-goods business consists of (1) product costs, (2) certain royalty expenses for celebrities, professional sports and other organizations and independent software developers, (3) manufacturing royalties, net of volume discounts and other vendor reimbursements, (4) expenses for defective products, (5) write-offs of post-launch prepaid royalty costs, (6) amortization of certain intangible assets, and (7) operational expenses. We generally recognize volume discounts when they are earned from the manufacturer (typically in connection with the achievement of unit-based milestones), whereas other vendor reimbursements are generally recognized as the related revenue is recognized. Cost of goods sold for our online products consists primarily of data center and bandwidth costs associated with hosting our web sites, credit card fees and royalties for use of third-party properties. Cost of goods sold for our web site advertising business primarily consists of ad-serving costs.

 

Cost of goods sold for fiscal years 2007 and 2006 were as follows (in millions):

 

 

In fiscal 2007, cost of goods sold decreased by 0.8 percentage points as a percentage of total net revenue as compared to fiscal 2006. This decrease was primarily due to lower average product costs as a percentage of total net revenue primarily driven by (1) fewer returns and lower pricing actions taken, or expected to be taken, in fiscal 2007 as compared to fiscal 2006 and (2) improved inventory management. As a result, we estimate average product costs as a percentage of total net revenue decreased by approximately 2 percent in fiscal 2007 as compared to fiscal 2006.

 

As a percentage of total net revenue, the decrease in average product costs was partially offset by an estimated 1 percent increase in license royalties during fiscal 2007 as compared to fiscal 2006 primarily due to (1) license agreements associated with our EA SPORTS titles and (2) from our acquisition of JAMDAT. This was partially offset by lower license royalties from movie-based titles in fiscal 2007.

 

Although there can be no assurance, and our actual results could differ materially, in the short-term we expect our gross margin to decline as a result of (1) increased deferred net revenue related to certain online-enabled packaged goods (we will expense the cost of goods sold related to these transactions when delivered), (2) a higher mix of co-publishing and distribution net revenue that has a lower gross margin, and (3) higher license royalty rates.

 

Marketing and Sales

 

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

 

Marketing and sales expenses for fiscal years 2007 and 2006 were as follows (in millions):

 

Marketing and sales expenses increased by $35 million, or 8 percent, in fiscal 2007 as compared to fiscal 2006. The increase was primarily due to (1) an increase of $17 million in stock-based compensation expense recognized as a result of our adoption of SFAS No. 123(R), (2) an increase of $10 million in our annual bonus expense, and (3) $10 million in additional personnel-related costs primarily resulting from an increase in headcount. These increases were partially offset by a decrease of $9 million in our marketing, advertising, promotional and related services as a result of higher advertising in the prior year to support our product releases, primarily from our Harry Potter and BLACK franchises.

 

Marketing and sales expenses included vendor reimbursements for advertising expenses of $28 million and $41 million in fiscal 2007 and 2006, respectively.

 

We expect marketing and sales expenses to increase in absolute dollars in fiscal 2008 primarily to support our titles.

 

General and Administrative

 

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

 

General and administrative expenses for fiscal years 2007 and 2006 were as follows (in millions):

 

 

General and administrative expenses increased by $73 million, or 34 percent, in fiscal 2007 as compared to fiscal 2006 primarily due to (1) an increase of $36 million in stock-based compensation expense recognized as a result of our adoption of SFAS No. 123(R), (2) a $14 million increase in our annual bonus expense, (3) an $11 million increase in additional personnel-related costs to help support our administrative functions worldwide, and (4) an increase of $11 million in professional and contracted services in support of our technology infrastructure.

 

We expect general and administrative expenses to increase in absolute dollars in fiscal 2008 primarily due to an increase in personnel-related costs.

 

Research and Development

 

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

 

Research and development expenses for fiscal years 2007 and 2006 were as follows (in millions):

 

 

Research and development expenses increased by $283 million, or 37 percent, in fiscal 2007 as compared to fiscal 2006. The increase was primarily due to (1) an increase of $75 million in stock-based compensation expense recognized as a result of our adoption of SFAS No. 123(R), (2) a $59 million increase in our annual bonus expense, (3) $54 million in additional personnel-related costs, primarily due to a 14 percent increase in headcount related in part to our acquisitions of JAMDAT and Mythic, and partially to support development of games for the new generation of consoles, (4) an increase of $50 million in external development expenses primarily due to a greater number of projects in development as compared to the prior year as well as

expenses in our cellular handset business resulting from our acquisition of JAMDAT, and (5) an increase of $45 million in facilities-related expenses in support of our research and development functions worldwide.

 

We expect research and development expenses to increase in absolute dollars in fiscal 2008 primarily to support our development of titles for the new generation of consoles.

 

Amortization of Intangibles

 

Amortization of intangibles for fiscal years 2007 and 2006 were as follows (in millions):

 

 

For fiscal 2007, amortization of intangibles resulted from our acquisitions of JAMDAT, Mythic and others. For fiscal 2006, amortization of intangibles resulted from our acquisitions of JAMDAT, Criterion and others. Amortization of intangibles increased by $20 million, or 286 percent, in fiscal 2007 as compared to fiscal 2006 primarily due to the amortization of intangibles related to our acquisitions of JAMDAT and Mythic. See Note 4 of the Notes to Consolidated Financial Statements included in Item 8 of this report.

 

We expect amortization of intangible expenses to increase slightly in fiscal 2008 primarily due to the amortization of intangibles related to our acquisition of Mythic, which will be included in our results for a full year in fiscal 2008.

 

Acquired In-process Technology

 

Acquired in-process technology charges for fiscal years 2007 and 2006 were as follows (in millions):

 

 

The acquired in-process technology charge we incurred in fiscal 2007 resulted from our acquisitions of Mythic and the remaining minority interest in DICE. The acquired in-process technology charge we incurred in fiscal 2006 resulted primarily from our acquisition of JAMDAT. Acquired in-process technology includes the value of products in the development stage that are not considered to have reached technological feasibility or have an alternative future use. Accordingly, upon consummation of these acquisitions, we incurred a charge for the acquired in-process technology, as reflected in our Consolidated Statement of Operations. See Note 4 of the Notes to Consolidated Financial Statements included in Item 8 of this report.

 

Restructuring Charges

 

Restructuring charges for fiscal years 2007 and 2006 were as follows (in millions):

 

 

During the fourth quarter of fiscal 2006, we recorded a total pre-tax restructuring charge of $10 million, consisting entirely of one-time benefits related to headcount reductions, which is included in restructuring charges in our Consolidated Statement of Operations. These headcount reductions related to our decision in the fourth quarter of fiscal 2006 to realign our resources with our product plan for fiscal 2007 and strategic opportunities for the new generation of consoles, online and mobile platforms.

 

During fiscal 2006, restructuring charges related to the establishment of our international publishing headquarters in Geneva, Switzerland were approximately $14 million, of which $8 million was for the closure of certain United Kingdom facilities. During fiscal 2007, restructuring charges related to the establishment of our international publishing headquarters in Geneva, Switzerland were approximately $15 million, of which $10 million was for employee-related expenses.

 

In connection with our fiscal 2006 international publishing reorganization, in fiscal 2008, we expect to incur between $5 million and $10 million of restructuring costs. Overall, including charges incurred through March 31, 2007, we expect to incur between $50 million and $55 million of restructuring costs in connection with our fiscal 2006 international publishing reorganization, substantially all of which will result in cash expenditures by 2017. These restructuring costs will consist primarily of employee-related relocation assistance (approximately $30 million), facility exit costs (approximately $15 million), as well as other reorganization costs (approximately $7 million).

 

Interest and Other Income, Net

 

Interest and other income, net, for fiscal years 2007 and 2006 was as follows (in millions):

 

 

For fiscal 2007, interest and other income, net, increased by $35 million, or 55 percent, as compared to fiscal 2006 primarily due to an increase of $30 million in interest income as a result of higher yields on our cash, cash equivalent and short-term investment balances and a $7 million decrease in realized net losses recognized on investments.

 

Income Taxes

 

Income taxes for fiscal years 2007 and 2006 were as follows (in millions):

 

 

Our effective income tax rates were 48.2 percent and 37.6 percent for fiscal 2007 and fiscal 2006, respectively. For fiscal 2007, our effective income tax rate was higher than the U.S. statutory rate of 35.0 percent due to a number of factors, including certain non-deductible stock based compensation expenses related to SFAS No. 123(R) and additional charges resulting from certain non-deductible acquisition-related costs during the fourth quarter of fiscal 2007. For fiscal 2006, our effective income tax rate is higher than the U.S. statutory rate of 35.0 percent for fiscal 2006 due to a number of factors, including the repatriation of foreign earnings in connection with the American Jobs Creation Act of 2004 (the “Jobs Act”), as discussed below, and additional charges resulting from certain non-deductible acquisition-related costs during the second and fourth quarters of fiscal 2006, which were partially offset by other items.

 

Our effective income tax rates for fiscal 2008 and future periods will depend on a variety of factors. For example, changes in our business such as acquisitions and intercompany transactions (for example, the acquisition of and intercompany transactions related to Mythic and DICE), changes in our international structure, changes in the geographic location of business functions or assets, changes in the geographic mix of income, as well as changes in, or termination of, our agreements with tax authorities, valuation allowances, applicable accounting rules, applicable tax laws and regulations, rulings and interpretations thereof, developments in tax audit and other matters. Also, variations in the estimated and actual level of annual pre-tax income can affect the overall effective income tax rate for future fiscal years. We incur certain tax expenses that do not decline proportionately with declines in our consolidated income or increase in consolidated loss. As a result, in absolute dollar terms, our tax expense will have a greater influence on our effective tax rate at lower levels of pre-tax income than higher levels. In addition, at lower levels of pre-tax income, our effective tax rate will be more volatile.

 

We historically have considered undistributed earnings of our foreign subsidiaries to be indefinitely reinvested and, accordingly, no U.S. taxes have been provided thereon. With the exception of taking advantage of the one-time opportunity afforded to us by the Jobs Act, we currently intend to continue to indefinitely reinvest the undistributed earnings of our foreign subsidiaries.

 

In July 2006, FASB issued FIN No. 48 which clarifies the accounting for uncertainty in income taxes recognized in financial statements in accordance with SFAS No. 109. FIN No. 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return and provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. Under FIN No. 48, the evaluation of a tax position is a two-step process. The first step is a recognition process where we are required to determine whether it is more likely than not that a tax position will be sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position. In evaluating whether a tax position has met the more-likely-than-not recognition threshold, it is presumed that the position will be examined by the appropriate taxing authority that has full knowledge of all relevant information. The second step is a measurement process whereby a tax position that meets the more-likely-than-not recognition threshold is calculated to determine the amount of benefit to recognize in the financial statements. FIN No. 48 also requires new tabular reconciliation of the total amounts of unrecognized tax benefits at the beginning and end of the reporting period. The provisions of FIN No. 48 are effective for fiscal years beginning after December 15, 2006. As such, we are required to adopt it in our first quarter of fiscal year 2008. Any changes to our income taxes due to the adoption of FIN No. 48 are treated as the cumulative effect of a change in accounting principle. We are evaluating what impact the adoption of FIN No. 48 will have on our Consolidated Financial Statements. This impact could be material and our future effective tax rates could be more volatile.

 

Net Income

 

Net income for fiscal years 2007 and 2006 was as follows (in millions):

 

 

Net income decreased by $160 million, or 68 percent, in fiscal 2007 as compared to fiscal 2006. The decrease was due to a $395 million increase in our operating expenses primarily due to (1) an increase of $128 million in stock-based compensation expense recognized as a result of our adoption of SFAS No. 123(R), (2) an $83 million increase in our annual bonus expense, and (3) a $75 million increase in additional personnel-related costs due to an increase in headcount (related in part to our acquisitions and growth in our EA Mobile business). These increases in operating expenses were mitigated by (1) a $140 million increase in net revenue and (2) an $81 million decrease in our income tax provision.

 

We expect net earnings to decrease in fiscal 2008 primarily as a result of (1) the fact that during fiscal 2008, we expect to recognize the cost of goods sold and direct marketing and selling costs related to certain online-enabled packaged goods for which a portion of the corresponding net revenue will be deferred and not recognized until fiscal 2009, and (2) an increase in our research and development expense.

 

Comparison of Fiscal 2006 to Fiscal 2005

 

Net Revenue

 

From a geographical perspective, our total net revenue for the fiscal years ended March 31, 2006 and 2005 was as follows (in millions):

 

North America

 

For fiscal 2006, net revenue in North America was $1,584 million, driven primarily by sales of (1) Madden NFL 06, Need for Speed Most Wanted, NBA LIVE 06, NCAA^® Football 06 and The Sims 2, (2) titles for the PSP, which was launched in North America in March 2005, and (3) titles for the Xbox 360, which launched in November 2005. Overall, net revenue decreased $81 million, or 5 percent, as compared to fiscal 2005. Our net revenue was adversely impacted by the transition to next-generation consoles in fiscal 2006 as overall net revenue from sales of our titles for the PlayStation 2, Xbox and Nintendo GameCube decreased. While sales of titles for the PSP and the Xbox 360 helped to mitigate the impact of the transition in fiscal 2006, they were not enough to offset the overall decrease in net revenue in North America.

 

From a title and franchise perspective, the decrease in net revenue was primarily due to (1) lower sales from our NFL Street, NBA Street, Def Jam and The Urbz^tm franchises as there were no corresponding titles released during fiscal 2006, and (2) lower sales from our Lord of the Rings franchise which was released on multiple platforms during fiscal 2005 as compared to two platforms, the PSP and PC, during fiscal 2006. The overall decrease in net revenue was mitigated by (1) sales of Battlefield 2^tm on the PC which was released during the first quarter of fiscal 2006 and Battlefield 2: Modern Combat^tm on the PlayStation 2 and Xbox released during the third quarter of fiscal 2006, (2) increased net revenue from our Madden franchise primarily resulting from the release of Madden NFL 06 on the Xbox 360 and PSP in fiscal 2006, and (3) increased net revenue from our Burnout franchise primarily resulting from the release of Burnout^tm Revenge on the Xbox 360 and Burnout^tm Legends on the PSP in fiscal 2006.

 

Europe

 

For fiscal 2006, net revenue in Europe was $1,174 million, driven primarily by sales of Need for Speed Most Wanted, FIFA 06, The Sims 2, Harry Potter and the Goblet of Fire, as well as sales of titles for the PSP and Xbox 360 which were both introduced in Europe during fiscal 2006. Overall, net revenue declined $110 million, or 9 percent, as compared to fiscal 2005. We estimate that foreign exchange rates (primarily the Euro and the British pound sterling) decreased reported European net revenue by approximately $36 million, or 3 percent, net of realized gains from hedging activities, for the fiscal 2006 as compared to fiscal 2005. Excluding the effect of foreign exchange rates, we estimate that European net revenue decreased by approximately $74 million, or 6 percent, for fiscal 2006. Our net revenue in Europe was adversely impacted by the transition to next-generation consoles in fiscal 2006 as overall net revenue from sales of our titles for the PlayStation 2, Xbox and Nintendo GameCube decreased. Sales of titles for the PSP, Nintendo DS, and the Xbox 360, however, were enough to offset the overall decrease in net revenue from sales of titles for current-generation consoles.

 

From a title and franchise perspective, the overall decrease in net revenue was primarily due to (1) lower sales from our Lord of the Rings and The Sims franchises, (2) the release of The Urbz^tm: Sims in the City^tm during the three months ended December 31, 2004 as there was no corresponding title released during fiscal 2006, and (3) higher fiscal 2005 sales of UEFA Euro 2004^tm, which was released in the three months ended June 30, 2004 in conjunction with the UEFA Euro 2004 football tournament held in Europe. The overall decrease in net revenue was mitigated by increased net revenue from our Battlefield franchise due to the release of multiple titles during fiscal 2006 and our FIFA Street franchise due to the initial release of FIFA Street late in the fourth quarter of fiscal 2005 which benefited fiscal 2006 and the release of FIFA Street 2 earlier in the fourth quarter of fiscal 2006.

 

Asia

 

For fiscal 2006, net revenue in Asia increased by $13 million, or 7 percent, as compared to fiscal 2005. The increase in net revenue for fiscal 2006 was driven primarily by sales of titles for the PSP, which launched in the fourth quarter of fiscal 2005. We estimate that the foreign exchange rate impact on Asia net revenue was not material for fiscal 2006 as compared to fiscal 2005.

 

Our total net revenue by product line for fiscal years 2006 and 2005 was as follows (in millions):