10-Q 1 a08-20932_110q.htm 10-Q

Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

FORM 10-Q

 

(Mark one)

 

 

 

 

x

 

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

 

 

 

For the Quarterly Period Ended June 30, 2008

 

 

 

OR

 

 

 

o

 

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                      to                    

 

Commission File Number 1-15839

 

ACTIVISION BLIZZARD, INC.
(Exact name of registrant as specified in its charter)

 

Delaware
(State or other jurisdiction of
incorporation or organization)

 

95-4803544
(I.R.S. Employer Identification No.)

 

 

 

3100 Ocean Park Boulevard, Santa Monica, CA
(Address of principal executive offices)

 

90405
(Zip Code)

 

(310) 255-2000
(Registrant’s telephone number, including area code)

 

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

 

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

 

Large Accelerated Filer x

 

Accelerated Filer o

 

Non-accelerated filer o (Do not check if a smaller reporting company)

Smaller reporting company o

 

 

 

 

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

 

The number of shares of the registrant’s Common Stock outstanding as of August 1, 2008 was 659,219,243.

 

 

 



Table of Contents

 

ACTIVISION, INC. AND SUBSIDIARIES

 

INDEX

 

 

Cautionary Statement

3

 

 

 

PART I.

FINANCIAL INFORMATION

4

 

 

 

Item 1.

Financial Statements

4

 

 

 

 

Consolidated Balance Sheets as of June 30, 2008 (Unaudited) and March 31, 2008

4

 

 

 

 

Consolidated Statements of Operations for the three months ended June 30, 2008 (Unaudited) and June 30, 2007 (Unaudited)

5

 

 

 

 

Consolidated Statements of Cash Flows for the three months ended June 30, 2008 (Unaudited) and June 30, 2007 (Unaudited)

6

 

 

 

 

Consolidated Statement of Changes in Shareholders’ Equity for the three months ended June 30, 2008 (Unaudited)

7

 

 

 

 

Notes to Consolidated Financial Statements

8

 

 

 

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

22

 

 

 

Item 3.

Quantitative and Qualitative Disclosures about Market Risk

44

 

 

 

Item 4.

Controls and Procedures

45

 

 

 

PART II.

OTHER INFORMATION

46

 

 

 

Item 1.

Legal Proceedings

46

 

 

 

Item 1A.

Risk Factors

47

 

 

 

Item 6.

Exhibits

63

 

 

 

SIGNATURES

65

 

 

 

EXHIBIT INDEX

66

 

 

 

CERTIFICATIONS

 

 

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Table of Contents

 

CAUTIONARY STATEMENT

 

This Quarterly Report on Form 10-Q contains, or incorporates by reference, certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements consist of any statement other than a recitation of historical fact and include, but are not limited to, (1) projections of revenues, expenses, income or loss, earnings or loss per share, cash flow projections or other financial items; (2) statements of our plans and objectives, including those relating to product releases; (3) statements of future economic performance; and (4) statements of assumptions underlying such statements. We generally use words such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “forecast,” “future,” “intend,” “may,” “outlook,” “plan,” “positioned,” “potential,” “project,” “remain,” “scheduled,” “set to,” “subject to,” “to be,” “upcoming,” “will,” and other similar expressions to help identify forward-looking statements. These forward-looking statements are subject to business and economic risk, reflect management’s current expectations, estimates and projections about our business, and are inherently uncertain and difficult to predict. Our actual results could differ materially. The forward-looking statements contained herein speak only as of the date on which they were made, and we disclaim any obligation to update any forward-looking statements to reflect events or circumstances after the date of this Quarterly Report. Risks and uncertainties that may affect our future results include, but are not limited to, those discussed under the heading “Risk Factors,” included in Part II, Item 1A of this Quarterly Report . Except as otherwise noted (including in connection with the review and presentation of results of operations for the quarter ended June 30, 2008), all references to “we,” “us,” “our,” “Activision Blizzard” or “the Company” in the following discussion and analysis mean Activision Blizzard, Inc. and its subsidiaries.

 

3



Table of Contents

 

PART I. Financial Information

Item 1. Financial Statements.

 

ACTIVISION, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Amounts in thousands, except share data)

 

 

 

June 30, 2008

 

March 31, 2008

 

 

 

(Unaudited)

 

 

 

Assets

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

1,192,354

 

$

1,396,250

 

Short-term investments

 

60,360

 

52,962

 

Accounts receivable, net of allowances of $137,079 and $129,411 at June 30, 2008 and March 31, 2008, respectively

 

400,989

 

203,420

 

Inventories

 

229,409

 

146,874

 

Software development

 

136,765

 

96,182

 

Intellectual property licenses

 

26,710

 

18,661

 

Deferred income taxes

 

65,538

 

41,242

 

Other current assets

 

30,668

 

23,804

 

 

 

 

 

 

 

Total current assets

 

2,142,793

 

1,979,395

 

 

 

 

 

 

 

Long-term investments

 

88,301

 

91,215

 

Software development

 

17,692

 

13,604

 

Intellectual property licenses

 

63,595

 

64,890

 

Property and equipment, net

 

62,330

 

54,528

 

Deferred income taxes

 

29,997

 

32,825

 

Other assets

 

23,142

 

15,055

 

Goodwill

 

320,706

 

279,161

 

 

 

 

 

 

 

Total assets

 

$

2,748,556

 

$

2,530,673

 

 

 

 

 

 

 

Liabilities and Shareholders’ Equity

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

175,587

 

$

129,896

 

Accrued expenses and other liabilities

 

445,971

 

426,175

 

 

 

 

 

 

 

Total current liabilities

 

621,558

 

556,071

 

 

 

 

 

 

 

Other liabilities

 

24,014

 

26,710

 

 

 

 

 

 

 

Total liabilities

 

645,572

 

582,781

 

 

 

 

 

 

 

Commitments and contingencies (Note 12)

 

 

 

 

 

 

 

 

 

 

 

Shareholders’ equity:

 

 

 

 

 

Preferred stock, $.000001 par value, 3,750,000 shares authorized, no shares issued at June 30, 2008 and March 31, 2008

 

 

 

Series A Junior Preferred stock, $.000001 par value, 1,250,000 shares authorized, no shares issued at June 30, 2008 and March 31, 2008

 

 

 

Common stock, $.000001 par value, 450,000,000 shares authorized, 298,244,105 and 294,651,325 shares issued and outstanding at June 30, 2008 and March 31, 2008, respectively

 

 

 

Additional paid-in capital

 

1,245,982

 

1,148,880

 

Retained earnings

 

831,675

 

772,660

 

Accumulated other comprehensive income

 

25,327

 

26,352

 

 

 

 

 

 

 

Total shareholders’ equity

 

2,102,984

 

1,947,892

 

 

 

 

 

 

 

Total liabilities and shareholders’ equity

 

$

2,748,556

 

$

2,530,673

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

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ACTIVISION, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(Amounts in thousands, except per share data)

 

 

 

For the three months ended June 30,

 

 

 

2008

 

2007

 

 

 

 

 

 

 

Net revenues

 

$

654,203

 

$

495,455

 

 

 

 

 

 

 

Costs and expenses:

 

 

 

 

 

Cost of sales – product costs

 

311,941

 

217,229

 

Cost of sales – software royalties and amortization

 

40,874

 

78,252

 

Cost of sales – intellectual property licenses

 

27,359

 

32,479

 

Product development

 

50,040

 

32,897

 

Sales and marketing

 

86,494

 

68,712

 

General and administrative

 

57,360

 

35,794

 

 

 

 

 

 

 

Total costs and expenses

 

574,068

 

465,363

 

 

 

 

 

 

 

Operating income

 

80,135

 

30,092

 

 

 

 

 

 

 

Investment income, net

 

10,948

 

11,562

 

 

 

 

 

 

 

Income before income tax provision

 

91,083

 

41,654

 

 

 

 

 

 

 

Income tax provision

 

32,068

 

13,828

 

 

 

 

 

 

 

Net income

 

$

59,015

 

$

27,826

 

 

 

 

 

 

 

Basic earnings per share

 

$

0.20

 

$

0.10

 

 

 

 

 

 

 

Weighted-average common shares outstanding

 

296,323

 

283,563

 

 

 

 

 

 

 

Diluted earnings per share

 

$

0.18

 

$

0.09

 

 

 

 

 

 

 

Weighted-average common shares outstanding assuming dilution

 

323,486

 

311,993

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

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ACTIVISION, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(Amounts in thousands)

 

 

 

For the three months ended June 30,

 

 

 

2008

 

2007

 

Cash flows from operating activities:

 

 

 

 

 

Net income

 

$

59,015

 

$

27,826

 

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

 

Deferred income taxes

 

(20,339

)

7,306

 

Depreciation and amortization

 

7,045

 

8,730

 

Realized gain on sale of short-term investments

 

(105

)

 

Amortization of capitalized software development costs and intellectual property licenses (1)

 

23,143

 

77,661

 

Stock-based compensation expense (2)

 

11,944

 

8,160

 

Tax benefit of stock options and warrants exercised

 

17,278

 

400

 

Excess tax benefits from stock option exercises

 

(15,834

)

(370

)

Changes in operating assets and liabilities (net of effects of acquisitions):

 

 

 

 

 

Accounts receivable

 

(197,569

)

(49,165

)

Inventories

 

(82,535

)

(1,298

)

Software development and intellectual property licenses

 

(68,851

)

(42,299

)

Other assets

 

(15,660

)

(2,931

)

Accounts payable

 

45,691

 

(26,731

)

Accrued expenses and other liabilities

 

14,710

 

(783

)

 

 

 

 

 

 

Net cash (used in) provided by operating activities

 

(222,067

)

6,506

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Cash used in business acquisitions (net of cash acquired)

 

 

(3,659

)

Capital expenditures

 

(14,144

)

(7,348

)

Increase in restricted cash

 

(40,298

)

(8,413

)

Purchases of investments

 

 

(187,495

)

Proceeds from sales of investments

 

10,589

 

 

Proceeds from maturities of investments

 

22,440

 

145,864

 

 

 

 

 

 

 

Net cash used in investing activities

 

(21,413

)

(61,051

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Proceeds from issuance of common stock to employees

 

23,163

 

11,182

 

Excess tax benefits from stock option exercises

 

15,834

 

370

 

 

 

 

 

 

 

Net cash provided by financing activities

 

38,997

 

11,552

 

 

 

 

 

 

 

Effect of exchange rate changes on cash

 

587

 

2,565

 

 

 

 

 

 

 

Net decrease in cash and cash equivalents

 

(203,896

)

(40,428

)

 

 

 

 

 

 

Cash and cash equivalents at beginning of period

 

1,396,250

 

384,409

 

 

 

 

 

 

 

Cash and cash equivalents at end of period

 

$

1,192,354

 

$

343,981

 

 


(1) Excludes amortization of stock-based compensation expense.

(2) Includes the net effects of capitalization and amortization of stock-based compensation expense.

 

The accompanying notes are an integral part of these consolidated financial statements.

 

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ACTIVISION, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY

For the three months ended June 30, 2008
(Unaudited)
(Amounts in thousands)

 

 

 

Common Stock

 

Additional
Paid-In

 

Retained

 

Accumulated
Other
Comprehensive

 

Shareholders’

 

 

 

Shares

 

Amounts

 

Capital

 

Earnings

 

Income (Loss)

 

Equity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance as of March 31, 2008

 

294,651

 

$

 

$

1,148,880

 

$

772,660

 

$

26,352

 

$

1,947,892

 

Components of comprehensive income:

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

 

59,015

 

 

59,015

 

Unrealized depreciation on short-term investments, net of taxes

 

 

 

 

 

(1,756

)

(1,756

)

Foreign currency translation adjustment

 

 

 

 

 

731

 

731

 

Total comprehensive income

 

 

 

 

 

 

 

 

 

 

 

57,990

 

Issuance of common stock pursuant to employee stock options, restricted stock rights and employee stock purchase plan

 

2,419

 

 

23,163

 

 

 

23,163

 

Issuance of common stock to effect business combination

 

1,174

 

 

39,000

 

 

 

39,000

 

Stock-based compensation expense related to employee stock options, restricted stock rights, and employee stock purchase plans

 

 

 

17,661

 

 

 

17,661

 

Tax benefit associated with employee stock options

 

 

 

17,278

 

 

 

17,278

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance as of June 30, 2008

 

298,244

 

$

 

$

1,245,982

 

$

831,675

 

$

25,327

 

$

2,102,984

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

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ACTIVISION, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Unaudited)

 

1.             Background and Basis of Presentation

 

The accompanying Consolidated Financial Statements as of June 30, 2008 and for the three month period ended June 30, 2008 include the accounts of Activision, Inc. and its subsidiaries (“Activision” or “we” or the “Company”). The information furnished is unaudited and the adjustments included consist of only normal recurring adjustments that, in the opinion of management, are necessary to provide a fair statement of the results for the interim periods presented. The accompanying unaudited Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements included in our Annual Report on Form 10-K for the fiscal year ended March 31, 2008 as filed with the Securities and Exchange Commission (“SEC”) on May 30, 2008.

 

Certain financial information that is normally included in annual financial statements prepared in accordance with U.S. generally accepted accounting principles (“GAAP”), but is not required for interim reporting purposes, has been condensed or omitted.

 

Management must make estimates and assumptions that affect the Consolidated Financial Statements and the related footnote disclosures. While management makes its best judgment, actual results could differ from those estimates.

 

Significant Transactions

 

Subsequent to the quarter ended June 30, 2008, we consummated our previously announced business combination (the “Business Combination”) pursuant to the Business Combination Agreement (the “Business Combination Agreement”), dated as of December 1, 2007, by and among the Company, Sego Merger Corporation, a wholly-owned subsidiary of the Company, Vivendi S.A. (“Vivendi”), VGAC LLC, a wholly-owned subsidiary of Vivendi (“VGAC”), and Vivendi Games, Inc., a wholly-owned subsidiary of VGAC (“Vivendi Games”). Upon the closing of the Business Combination, which occurred on July 9, 2008, Activision was renamed Activision Blizzard, Inc. (“Activision Blizzard”). Activision Blizzard continues to operate as a public company traded on the NASDAQ under the ticker symbol ATVI. Activision Blizzard now conducts the combined business operations of Activision and Vivendi Games including Blizzard Entertainment, Inc. (“Blizzard”). In connection with the Business Combination, we issued approximately 358 million shares of common stock to VGAC. Following the consummation of the Business Combination, VGAC owned approximately 54% of Activision Blizzard’s issued and outstanding common stock. While we are the surviving entity in this Business Combination, because the transaction is treated as a “reverse acquisition”, Vivendi Games is deemed to be the acquirer for accounting purposes. Accordingly, Activision Blizzard will apply purchase accounting to the assets and liabilities of Activision as of July 9, 2008. Also, for all future Exchange Act filings, the historical financial statements of Activision for periods prior to the consummation of the Business Combination will be those of Vivendi Games. Activision’s businesses will be included in Activision Blizzard’s financial statements for all periods subsequent to the consummation of the Business Combination only.

 

In accordance with the terms of the Business Combination Agreement, on July 16, 2008, Activision Blizzard commenced a tender offer to purchase up to 146.5 million shares of its common stock at a price of $27.50 per share. The tender offer will expire on August 13, 2008 unless extended.

 

Upon consummation of the Business Combination, the senior unsecured credit agreement with Vivendi (as lender) became effective upon terms substantially similar to those previously disclosed in Activision’s Annual Report on Form 10-K for the fiscal year ended March 31, 2008 and Activision Blizzard’s Current Report on Form 8-K dated July 9, 2008. Under that credit agreement, we have access to funds for the tender offer and for general corporate purposes as previously disclosed.

 

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Prior to the closing of the Business Combination, Activision’s fiscal year ended March 31st. Effective July 9, 2008, Activision Blizzard changed its fiscal year end to December 31st. Accordingly, Activision Blizzard’s current fiscal year will end on December 31, 2008.

 

All information included in this report reflects only Activision’s results on a stand alone basis for the relevant periods and does not reflect any impact of the Business Combination.

 

2.             Inventories

 

Inventories are valued at the lower of cost (first-in, first-out) or market. Our inventories consist of the following (amounts in thousands):

 

 

 

June 30, 2008

 

March 31, 2008

 

Finished goods

 

$

208,396

 

$

144,549

 

Purchased parts and components

 

21,013

 

2,325

 

 

 

 

 

 

 

 

 

$

229,409

 

$

146,874

 

 

3.             Goodwill

 

The changes in the carrying amount of goodwill for the three months ended June 30, 2008 are as follows (amounts in thousands):

 

 

 

Publishing

 

Distribution

 

Total

 

 

 

 

 

 

 

 

 

Balance as of March 31, 2008

 

$

273,067

 

$

6,094

 

$

279,161

 

Issuance of contingent consideration

 

41,390

 

 

41,390

 

Effect of foreign currency exchange rates

 

140

 

15

 

155

 

 

 

 

 

 

 

 

 

Balance as of June 30, 2008

 

$

314,597

 

$

6,109

 

$

320,706

 

 

Issuance of contingent consideration consists of additional purchase consideration of approximately $41.4 million related to the acquisition of RedOctane, Inc. (“RedOctane”) which became payable in shares of our common stock, as a result of achievement of targeted net income levels. The additional consideration has been recorded as an accrued liability as of June 30, 2008, and was subsequently paid by the issuance of approximately 1.2 million shares of our common stock to the former shareholders of RedOctane.

 

4.             Income Taxes

 

The income tax provision of $32.1 million for the three months ended June 30, 2008 reflects our effective income tax rate for the quarter ended June 30, 2008 of 35.2%. While our effective income tax rate for the period equals our statutory rate there are certain items that would normally generate a variance between the two rates. Those items are the federal and state research and development tax credits and the impact of foreign tax rate differentials partially offset by state taxes. However, the net effect for this period is approximately zero.

 

The aforementioned effective income tax rate for the three months ended June 30, 2008 of 35.2% differs from our effective income tax rate of 33.2% for the three months ended June 30, 2007 due to the expiration of the federal research and development credit on December 31, 2007.

 

The income tax expense of $13.8 million for the three months ended June 30, 2007 reflects our effective income tax rate for the quarter of 33.2%, which differs from our effective tax rate of 35.0% for the year ended March 31, 2008 due to (1) an increase in the federal research and development credit for the year ended March 31, 2008 over the amount originally anticipated for the quarter ended June 30, 2007 and (2) an increase in the nondeductible portion of annual cash bonuses determined for the full year ended March 31, 2008 under Section 162(m) of the Internal Revenue Code of 1986, as amended, and the establishment of tax reserves for these credits and other deferred tax assets.

 

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5.             Software Development Costs and Intellectual Property Licenses

 

As of June 30, 2008, capitalized software development costs included $127.3 million of internally developed software costs and $27.2 million of payments made to third-party software developers. As of March 31, 2008, capitalized software development costs included $97.8 million of internally developed software costs and $12.0 million of payments made to third-party software developers. Capitalized intellectual property licenses were $90.3 million and $83.6 million as of June 30, 2008 and March 31, 2008, respectively. Amortization of capitalized software development costs and intellectual property licenses were $26.1 million and $77.7 million for the three months ended June 30, 2008 and 2007, respectively.

 

6.             Comprehensive Income (Loss) and Accumulated Other Comprehensive Income (Loss)

 

Comprehensive Income (Loss)

 

The components of comprehensive income (loss) for the three months ended June 30, 2008 and 2007 were as follows (amounts in thousands):

 

 

 

Three months ended June 30,

 

 

 

2008

 

2007

 

 

 

 

 

 

 

Net income

 

$

59,015

 

$

27,826

 

 

 

 

 

 

 

Other comprehensive income (loss)

 

 

 

 

 

Foreign currency translation adjustment

 

731

 

2,722

 

Unrealized depreciation on short-term investments, net of taxes

 

(1,756

)

(407

)

 

 

 

 

 

 

Other comprehensive income (loss)

 

(1,025

)

2,315

 

 

 

 

 

 

 

Comprehensive income

 

$

57,990

 

$

30,141

 

 

Accumulated Other Comprehensive Income (Loss)

 

For the three months ended June 30, 2008, the components of accumulated other comprehensive income (loss) were as follows (amounts in thousands):

 

 

 

Foreign
Currency

 

Unrealized
Depreciation
on Investments

 

Accumulated
Other
Comprehensive
Income

 

 

 

 

 

 

 

 

 

Balance as of March 31, 2008

 

$

29,116

 

$

(2,764

)

$

26,352

 

Other comprehensive income (loss)

 

731

 

(1,756

)

(1,025

)

 

 

 

 

 

 

 

 

Balance as of June 30, 2008

 

$

29,847

 

$

(4,520

)

$

25,327

 

 

Comprehensive income is presented net of taxes of approximately $1.1 million related to unrealized depreciation on investments for the three months ended June 30, 2008. Income taxes were not provided for foreign currency translation items as these are considered indefinite investments in non-U.S. subsidiaries.

 

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7.             Investment Income, Net

 

Investment income, net is comprised of the following (amounts in thousands):

 

 

 

Three months ended June 30,

 

 

 

2008

 

2007

 

Interest income

 

$

10,859

 

$

11,586

 

Interest expense

 

(16

)

(24

)

Net realized gain on investments

 

105

 

 

 

 

 

 

 

 

Investment income, net

 

$

10,948

 

$

11,562

 

 

8.             Supplemental Cash Flow Information

 

Non-cash investing and financing activities and supplemental cash flow information is as follows (amounts in thousands):

 

 

 

Three months ended June 30,

 

 

 

2008

 

2007

 

 

 

 

 

 

 

Non-cash investing and financing activities:

 

 

 

 

 

Change in unrealized depreciation on investments, net of taxes

 

$

(1,756

)

$

(407

)

Common stock payable related to acquisition

 

41,390

 

22,521

 

 

 

 

 

 

 

Supplemental cash flow information:

 

 

 

 

 

Cash paid for income taxes

 

$

33,332

 

$

3,572

 

Cash paid for interest

 

16

 

24

 

 

9.             Operations by Reportable Segments and Geographic Area

 

Based upon its organizational structure, Activision operated two business segments: (i) publishing of interactive entertainment software and peripherals and (ii) distribution of interactive entertainment software and hardware products.

 

Publishing refers to the development, marketing and sale of products, either directly, by license or through our affiliate label program with certain third-party publishers. During the periods covered by the financial statements included in this report, in the U.S., Activision primarily sold products on a direct basis to mass-market retailers, consumer electronics stores, discount warehouses, and game specialty stores. Activision conducted its international publishing activities through offices in the United Kingdom (“UK”), Germany, France, Italy, Spain, Australia, Sweden, the Netherlands, Norway, Canada, South Korea, and Japan where products were sold on a direct-to-retail basis and through third-party distribution and licensing arrangements and through our wholly owned distribution subsidiaries.

 

Distribution refers to Activision’s operations in the UK, the Netherlands, and Germany that provided logistical and sales services to third-party publishers of interactive entertainment software, Activision’s own publishing operations and manufacturers of interactive entertainment hardware.

 

The accounting policies of these segments are the same as those described in the “Summary of Significant Accounting Policies” in our Annual Report on Form 10-K for the year ended March 31, 2008. Revenue derived from sales between segments is eliminated in consolidation.

 

Information on the reportable segments for the three months ended June 30, 2008 and 2007 is as follows (amounts in thousands):

 

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Three months ended June 30, 2008

 

 

 

Publishing

 

Distribution

 

Total

 

 

 

 

 

 

 

 

 

Total segment revenues

 

$

578,562

 

$

75,641

 

$

654,203

 

Revenues from sales between segments

 

(31,464

)

31,464

 

 

 

 

 

 

 

 

 

 

Revenues from external customers

 

$

547,098

 

$

107,105

 

$

654,203

 

 

 

 

 

 

 

 

 

Operating income

 

$

79,170

 

$

965

 

$

80,135

 

 

 

 

 

 

 

 

 

Total assets

 

$

2,560,845

 

$

187,711

 

$

2,748,556

 

 

 

 

Three months ended June 30, 2007

 

 

 

Publishing

 

Distribution

 

Total

 

 

 

 

 

 

 

 

 

Total segment revenues

 

$

429,222

 

$

66,233

 

$

495,455

 

Revenues from sales between segments

 

(22,847

)

22,847

 

 

 

 

 

 

 

 

 

 

Revenues from external customers

 

$

406,375

 

$

89,080

 

$

495,455

 

 

 

 

 

 

 

 

 

Operating income

 

$

29,117

 

$

975

 

$

30,092

 

 

 

 

 

 

 

 

 

Total assets

 

$

1,700,149

 

$

138,917

 

$

1,839,066

 

 

Geographic information for the three months ended June 30, 2008 and 2007 is based on the location of the selling entity. Revenues from external customers by geographic region were as follows (amounts in thousands):

 

 

 

Three months ended June 30,

 

 

 

2008

 

2007

 

 

 

 

 

 

 

North America

 

$

392,916

 

$

309,536

 

Europe

 

229,381

 

170,014

 

Other

 

31,906

 

15,905

 

 

 

 

 

 

 

Total

 

$

654,203

 

$

495,455

 

 

Revenues by platform were as follows (amounts in thousands):

 

 

 

Three months ended June 30,

 

 

 

2008

 

2007

 

 

 

 

 

 

 

Console

 

$

507,460

 

$

401,874

 

Hand-held

 

119,633

 

75,732

 

PC

 

27,110

 

17,849

 

 

 

 

 

 

 

Total

 

$

654,203

 

$

495,455

 

 

We had two customers, Wal-Mart and GameStop, that each accounted for 11% of consolidated net revenues for the three months ended June 30, 2008, and 14% of consolidated gross accounts receivable at June 30, 2008. We had two customers, Wal-Mart and GameStop, that accounted for 21% and 15% of consolidated net revenues for the three months ended June 30, 2007, and 27% and 10% of consolidated gross accounts receivable at June 30, 2007. These customers were customers of our publishing business.

 

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10.      Computation of Earnings Per Share

 

The following table sets forth the computations of basic and diluted earnings per share (amounts in thousands, except per share data):

 

 

 

Three months ended June 30,

 

 

 

2008

 

2007

 

 

 

 

 

 

 

Numerator:

 

 

 

 

 

Numerator for basic and diluted earnings per share - income available to common shareholders

 

$

59,015

 

$

27,826

 

 

 

 

 

 

 

Denominator:

 

 

 

 

 

Denominator for basic earnings per share - weighted-average common shares outstanding

 

296,323

 

283,563

 

 

 

 

 

 

 

Effect of dilutive securities:

 

 

 

 

 

Employee stock options, employee stock purchase plan, and restricted stock rights

 

24,088

 

24,378

 

Warrants to purchase common stock and other dilutive common stock equivalents

 

3,075

 

4,052

 

 

 

 

 

 

 

Potential dilutive common shares

 

27,163

 

28,430

 

 

 

 

 

 

 

Denominator for diluted earnings per share - weighted-average common shares outstanding plus assumed conversions

 

323,486

 

311,993

 

 

 

 

 

 

 

Basic earnings per share

 

$

0.20

 

$

0.10

 

 

 

 

 

 

 

Diluted earnings per share

 

$

0.18

 

$

0.09

 

 

Equity incentive awards consisting of stock options, restricted stock units and restricted stock with respect to an aggregate of 2.8 million and 1.2 million shares of common stock for the three months ended June 30, 2008 and 2007, respectively, were not included in the calculation of diluted earnings per share because their effect would be antidilutive.

 

In connection with the closing of the Business Combination, the Company’s certificate of incorporation was amended and restated to provide for, among other things, an increase in the authorized number of shares of the Company’s common stock to 1.2 billion shares of common stock. Subsequently, VGAC, as the holder of a majority of the voting power of the Company’s common stock approved an amendment to the Company’s amended and restated certificate of incorporation providing for a further increase in the number of authorized shares of common stock from 1.2 billion to 2.4 billion for the purpose of allowing us to effect the two-for-one stock split announced on July 11, 2008. Activision Blizzard expects the record date for the stock split to be a date shortly after the closing of our previously disclosed tender offer. Pro forma earnings per share figures for the effect of the stock split for the first three months of 2008 and 2007 have been provided below (amounts in thousands, except for per share data):

 

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Three months ended June 30,

 

 

 

2008

 

2007

 

 

 

 

 

 

 

Numerator:

 

 

 

 

 

Numerator for basic and diluted earnings per share - income available to common shareholders

 

$

59,015

 

$

27,826

 

 

 

 

 

 

 

Denominator:

 

 

 

 

 

Denominator for basic earnings per share - weighted-average common shares outstanding

 

592,646

 

567,126

 

 

 

 

 

 

 

Effect of dilutive securities:

 

 

 

 

 

Employee stock options, employee stock purchase plan, and restricted stock rights

 

48,176

 

48,756

 

Warrants to purchase common stock and other dilutive common stock equivalents

 

6,150

 

8,104

 

 

 

 

 

 

 

Potential dilutive common shares

 

54,326

 

56,860

 

 

 

 

 

 

 

Denominator for diluted earnings per share - weighted-average common shares outstanding plus assumed conversions

 

646,972

 

623,986

 

 

 

 

 

 

 

Basic earnings per share

 

$

0.10

 

$

0.05

 

 

 

 

 

 

 

Diluted earnings per share

 

$

0.09

 

$

0.04

 

 

11.      Fair Value Measurements

 

As of April 1, 2008, we adopted Statement of Financial Accounting Standards No. 157 Fair Value Measurements (“SFAS No. 157”) for financial assets and liabilities. SFAS No. 157 establishes a three-level fair value hierarchy that prioritizes the inputs used to measure fair value. This hierarchy requires entities to maximize the use of “observable inputs” and minimize the use of “unobservable inputs.” The three levels of inputs used to measure fair value are as follows:

 

·                 Level 1 — Quoted prices in active markets for identical assets or liabilities.

 

·                 Level 2 — Observable inputs other than quoted prices included in Level 1, such as quoted prices for markets that are not active or other inputs that are observable or can be corroborated by observable market data.

 

·                 Level 3 — Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. This includes certain pricing models, discounted cash flow methodologies and similar techniques that use significant unobservable inputs.

 

The table below segregates all financial assets and liabilities that are measured at fair value on a recurring basis (which, for purposes of SFAS No. 157, means they are so measured at least annually) into the most appropriate level within the fair value hierarchy based on the inputs used to determine the fair value at the measurement date. Financial Statement Position FAS 157-2 delayed the effective date for the application of SFAS No. 157 for all nonfinancial assets and liabilities until January 1, 2009, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis.

 

 

 

June 30,
2008

 

Quoted Prices
in Active
Markets for
Identical Assets
(Level 1)

 

Significant
Other
Observable
Inputs
(Level 2)

 

Significant
Unobservable
Inputs
(Level 3)

 

 

 

(amounts in thousands)

 

Money market funds

 

$

997,467

 

$

997,467

 

$

 

$

 

Asset-backed securities

 

8,517

 

 

8,517

 

 

Auction rate securities

 

88,301

 

 

 

88,301

 

Total financial assets at fair value

 

$

1,094,285

 

$

997,467

 

$

8,517

 

$

88,301

 

 

The following table provides a reconciliation of the beginning and ending balances for our investment in auction rate securities, as these assets are measured at fair value using significant unobservable inputs (Level 3) (amounts in thousands):

 

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Level 3

 

 

 

 

 

Balance as of March 31, 2008

 

$

91,215

 

Transfers in and/or (out) of Level 3

 

 

Total losses realized/unrealized included in earnings

 

 

Total losses included in other comprehensive income (a)

 

(2,668

)

Purchases, sales, issuances and settlements, net

 

 

Interest received

 

(246

)

Balance as of June 30, 2008

 

$

88,301

 

 


(a) Due to uncertainties surrounding the timing of liquidation of our auction rate securities, we continue to classify these instruments as long-term investments in our consolidated balance sheets as of June 30, 2008. Liquidity for these auction rate securities is typically provided by an auction process which allows holders to sell their notes and resets the applicable interest rate at pre-determined intervals, usually every 7 to 35 days. On an industry-wide basis, many auctions have failed, and there is, as yet, no meaningful secondary market for these instruments. Each of the auction rate securities in our investment portfolio as of June 30, 2008 has experienced a failed auction and there is no assurance that future auctions for these securities will succeed. An auction failure means that the parties wishing to sell their securities could not be matched with an adequate volume of buyers. In the event that there is a failed auction, the indenture governing the security requires the issuer to pay interest at a contractually defined rate that is generally above market rates for other types of similar short-term instruments. The securities for which auctions have failed will continue to earn interest at the contractual rate and be auctioned every 7 to 35 days until the auction succeeds, the issuer calls the securities or they mature. As a result, our ability to liquidate and fully recover the carrying value of our auction rate securities in the near term may be limited or not exist.

 

Consequently, fair value measurements have been estimated using an income-approach model (discounted cash-flow analysis). When estimating the fair value, we consider both observable market data and non-observable factors, including credit quality, duration, insurance wraps, collateral composition, maximum rate formulas, comparable trading instruments, and likelihood of redemption. Significant assumptions used in the analysis include estimates for interest rates, spreads, cash flow timing and amounts, and holding periods of the securities. Assets measured at fair value using significant unobservable inputs (Level 3) represent approximately 8.1% of our financial assets measured at fair value on a recurring basis.

 

12.      Commitments and Contingencies

 

Credit Facilities

 

We have revolving credit facilities with our Centresoft subsidiary located in the UK (the “UK Facility”) and our NBG subsidiary located in Germany (the “German Facility”). The UK Facility provided Centresoft with the ability to borrow up to Great British Pound (“GBP”) 12.0 million (approximately $23.9 million), including issuing letters of credit, on a revolving basis as of June 30, 2008. The UK Facility bore interest at LIBOR plus 2.0% as of June 30, 2008, is collateralized by substantially all of the assets of the subsidiary and expires in March 2009. The UK Facility also contains various covenants that require the subsidiary to maintain specified financial ratios related to, among others, fixed charges. The German Facility provided for revolving loans up to Euro (“EUR”) 0.5 million (approximately $0.8 million) as of June 30, 2008, bore interest at Eurocurrency rate plus 2.5%, is collateralized by certain of the subsidiary’s property and equipment and has no expiration date. No borrowings were outstanding against the German and the UK Facility as of June 30, 2008.

 

As of June 30, 2008, we also maintained a $50.0 million irrevocable standby letter of credit. The standby letter of credit is required by one of our inventory manufacturers to qualify for payment terms on our inventory purchases. Under the terms of this arrangement, we are required to maintain on deposit with the bank a compensating balance, restricted as to use, of not less than the sum of the available amount of the letter of credit plus the aggregate amount of any drawings under the letter of credit that have been honored thereunder but not reimbursed. At June 30, 2008, the $50.0 million deposit is included in short-term investments as restricted cash. No borrowings were outstanding as of June 30, 2008.

 

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As of June 30, 2008, our publishing subsidiary located in the UK maintained a EUR 12.0 million (approximately $18.9 million) irrevocable standby letter of credit. The standby letter of credit is required by one of our inventory manufacturers to qualify for payment terms on our inventory purchases. The standby letter of credit does not require a compensating balance and is collateralized by substantially all of the assets of the subsidiary and expires in June 2009. No borrowings were outstanding as of June 30, 2008.

 

Upon consummation of the Business Combination, our senior unsecured credit agreement with Vivendi became effective, upon terms substantially similar to those previously disclosed in our Annual Report on Form 10-K for the fiscal year ended March 31, 2008 and Activision Blizzard’s Current Report on Form 8-K dated July 9, 2008.  No borrowings were outstanding as of August 7, 2008.

 

Commitments

 

In the normal course of business, we enter into contractual arrangements with third parties for non-cancelable operating lease agreements for our offices, for the development of products, and as well as for the rights to intellectual property.  Under these agreements, we commit to provide specified payments to a lessor, developer or intellectual property holder, as the case may be, based upon contractual arrangements.  Typically, the payments to third-party developers are conditioned upon the achievement by the developers of contractually specified development milestones.  The payments to third-party developers and intellectual property holders are typically deemed to be advances and are recoupable against future royalties earned by the developer or intellectual property holder based on the sale of the related game.  Additionally, in connection with certain intellectual property right acquisitions and development agreements, we will commit to spend specified amounts for marketing support for the related game(s) which is to be developed or in which the intellectual property will be utilized as applicable.  Assuming all contractual provisions are met, the total future minimum commitments for these and other contractual arrangements in place as of June 30, 2008 are scheduled to be paid as follows (amounts in thousands):

 

 

 

Contractual Obligations(1)

 

 

 

Facility and

 

 

 

 

 

 

 

 

 

Equipment
Leases

 

Developer and
IP

 

Marketing

 

Total

 

Fiscal year ending March 31,

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2009 (remaining nine months)

 

$

17,408

 

$

97,247

 

$

26,394

 

$

141,049

 

2010

 

18,184

 

36,071

 

28,100

 

82,355

 

2011

 

14,915

 

34,086

 

13,100

 

62,101

 

2012

 

10,277

 

16,586

 

 

26,863

 

2013

 

8,793

 

21,586

 

 

30,379

 

Thereafter

 

31,160

 

26,001

 

 

57,161

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

100,737

 

$

231,577

 

$

67,594

 

$

399,908

 

 


(1)  We have omitted Financial Interpretation No. 48, Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109, (“FIN 48”) liabilities from this table due to the inherent uncertainty regarding the timing of potential issue resolution.  Specifically, either (a) the underlying positions have not been fully enough developed under audit to be quantified at this time or, (b) the years relating to the issues for certain jurisdictions are not currently under audit.  As of June 30, 2008, the Company had $74.2 million of unrecognized tax benefits.

 

Legal Proceedings

 

On February 8, 2008, the Wayne County Employees’ Retirement System filed a lawsuit challenging Business Combination. The suit is a putative class action filed against the parties to the Business Combination Agreement as well as certain current and former members of our Board of Directors. The plaintiff alleges,

 

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among other things, that our current and former directors named therein failed to fulfill their fiduciary duties with regard to the Business Combination by “surrendering” the negotiating process to “conflicted management,” that those breaches were aided and abetted by Vivendi and those of its subsidiaries named in the complaint, and that the preliminary proxy statement filed by the Company on January 31, 2008 contains certain statements that the plaintiff alleges are false and misleading. The plaintiff seeks an order from the court that, among other things, certifies the case as a class action, enjoins the Business Combination, requires the defendants to disclose all material information, declares that the Business Combination is in breach of the directors’ fiduciary duties and therefore unlawful and unenforceable, awards the plaintiff and the putative class damages for all profits and special benefits obtained by the defendant in connection with the Business Combination and tender offer, and awards the plaintiff its cost and expense, including attorney’s fees.

 

After various initial motions were filed and ruled upon, on May 8, 2008, the plaintiff filed an amended complaint that, among other things, added allegations relating to a revised preliminary proxy statement filed by the Company on April 30, 2008. Additional motions were then filed, including a motion for preliminary injunction filed by the plaintiff and a motion to dismiss filed by Vivendi and its subsidiaries.  On June 24, 2008, the court granted Vivendi and its subsidiaries’ motion to dismiss as to them.  On July 1, 2008, the court denied plaintiff’s motion for preliminary injunction.  The Company intends to defend itself vigorously.

 

In July 2006, individuals and/or entities claiming to be our stockholders filed derivative lawsuits, purportedly on our behalf, against certain current and former members of our Board of Directors as well as several of our current and former officers. Three derivative actions were filed in Los Angeles Superior Court: Vazquez v. Kotick, et al ., L.A.S.C. Case No. BC355327 (filed July 12, 2006); Greuer v. Kotick, et al. L.A.S.C. Case No. SC090343 (filed July 12, 2006); and Amalgamated Bank v. Baker, et al., L.A.S.C. Case No. BC356454 (filed August 3, 2006). These actions were consolidated by the court under the caption In re Activision Shareholder Derivative Litigation, L.A.S.C. Master File No. SC090343 (West, J.). Four derivative actions were filed in the United States District Court for the Central District of California: Pfeiffer v. Kotick, et al., C.D. Cal. Case No. CV06-4771 MRP (JTLx) (filed July 31, 2006), Hamian v. Kotick, et al., C.D. Cal. Case No. CV06-5375 MRP (JLTx) (filed August 25, 2006) Abdelnur vs. Kotick et al., C.D. Cal. Case No. CV07-3575 AHM (PJWx) (filed June 1, 2007), and Scarborough v. Kotick et al., C.D. Cal. Case No. CV07-4602 SVW (PLAx) (filed July 18, 2007). These actions were also consolidated, under the caption In re Activision, Inc. Shareholder Derivative Litigation, C.D. Cal. Case No. CV06-4771 MRP (JTLx) (Pfaelzer, J.). The consolidated complaints alleged, among other things, purported improprieties in our issuance of stock options. Plaintiffs sought various relief on our behalf, including damages, restitution of benefits obtained from the alleged misconduct, equitable relief, including an accounting and rescission of option contracts; and various corporate governance reforms. We expect that defense expenses associated with the matters will be covered by our directors and officers insurance, subject to the terms and conditions of the applicable policies.

 

Effective as of May 8, 2008, the parties signed a Stipulation of Settlement which was filed in federal court on May 12, 2008 and was preliminarily approved by the U.S. District Court for the Central District of California by order dated May 13, 2008 and entered on May 14, 2008. On July 22, 2008, the District Court entered an order finally approving the Stipulation of Settlement and dismissing all claims with prejudice.  A stipulation of dismissal was filed in the Los Angeles Superior Court and signed by such court on July 28, 2008. In entering into the Stipulation of Settlement, neither we nor any of the settling parties admitted to any liability or wrongdoing. Under the terms of the court-approved Stipulation of Settlement, we will adopt, implement and/or maintain certain corporate governance and internal control measures, relating principally to the following: board composition, structure and practices, director independence standards, stock ownership and compensation, and education; shareholder proposal evaluation process; nomination procedures for shareholder-nominated directors; shareholder meeting procedures; executive compensation policies and procedures; insider trading controls; and stock option granting procedures. We agreed to keep these measures in place for a period of three years, subject to certain exceptions. The Stipulation of Settlement also addresses matters relating to the agreements by certain of our current and former directors and officers to reimburse the Company in connection with the receipt of options that required measurement date corrections. In the case of options already exercised, the agreements allowed reimbursement to be made either by cancellation of vested but unexercised options with a value equivalent to the additional exercise price or by payment of additional exercise price. In the case of options not yet exercised, the exercise price to be paid upon future exercise of those options is increased. In the aggregate, settling defendants have elected to cancel options to acquire approximately 800,000 shares of our common stock and have agreed to increases in the exercise prices of

 

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approximately 16.1 million options. The modification of these options did not result in any incremental compensation expense. In addition, the Stipulation of Settlement provides for us to pay $10,000,000 to plaintiffs’ attorneys for their fees and expenses, subject to court approval of such fees and expenses and subject to our reservation of all rights against our directors and officers insurance carriers, reinsurers and co-insurers. In addition, the Stipulation of Settlement provides that plaintiffs’ attorneys will also be entitled to 15% (up to $750,000) of any payment made by our insurance carriers to us in connection with the settlement. We have not reached agreements with our insurers related to the settlement. The stipulation also provides for the forgiveness of approximately $2.3 million in legal fees previously billed to us by former outside corporate counsel. In anticipation of the settlement, the Company had previously recorded a legal expense accrual of approximately $10.0 million in its consolidated financial statements as of March 31, 2008.

 

On July 24, 2006, we received a letter of informal inquiry from the SEC requesting certain documents and information relating to our historical stock option grant practices. Thereafter, in early June 2007, the SEC issued a formal order of non-public investigation, pursuant to which it subpoenaed documents from us related to the investigation, and testimony and documents from certain current and former directors, officers and employees of ours. The Company has made an offer of settlement to the Staff of the SEC, which the SEC Staff has indicated it is prepared to recommend to the SEC. The tentative settlement of the SEC’s investigation, which would allege violations of various provisions of the Federal securities laws, is subject to agreement on the specific language of the settlement documents, and then to review and approval by the SEC. There can be no assurance that a final settlement will be approved. In connection with the proposed settlement, the Company would not be required to pay a monetary penalty. Under the proposed settlement, the Company would settle this matter without admitting or denying the SEC’s findings.

 

In addition, we are party to other routine claims and suits brought by us and against us in the ordinary course of business, including disputes arising over the ownership of intellectual property rights, contractual claims, employment laws, regulations and relationships, and collection matters. In the opinion of management, after consultation with legal counsel, the outcome of such routine claims and lawsuits will not have a material adverse effect on our business, financial condition, results of operations, or liquidity.

 

13.       Stock-Based Compensation and Employee Benefit Plans

 

Equity Incentive Plans

 

As we previously disclosed, in February 2008, Activision discovered that, due to an error, the record date for the 2007 annual meeting of stockholders was not in technical compliance with Delaware law or our bylaws, which require such record date to be not more than sixty (60) nor less than ten (10) days before the date of such meeting. In accordance with the terms of the Investor Agreement, dated July 9, 2008, by and among Vivendi, VGAC, Vivendi Games, and the Company, VGAC agreed to ratify and re-approve actions and proposals approved by our stockholders at the 2007 annual meeting, and to vote against actions and proposals not approved by our stockholders at such meeting, by written consent as permitted under our bylaws.  In accordance with that Investor Agreement, subsequent to the consummation of the Business Combination, VGAC, as the holder of a majority of the voting power of the Company’s common stock, ratified and re-approved the Activision, Inc. 2007 Plan Equity Incentive Plan (the “2007 Plan”).  We have determined that options and restricted stock units granted under the 2007 Plan have met the definition of a grant date in accordance with Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment, (“SFAS No. 123R”), as we have the ability and intent to grant options and restricted stock units. Further, we have also established a mutual understanding with the employees as to the terms of these grants. Accordingly, stock-based compensation has been recorded for these options and restricted stock units grants.

 

Restricted Stock Units and Restricted Stock (collectively referred to as “restricted stock rights”)

 

During the three months ended June 30, 2008, we issued restricted stock units with respect to approximately 1.1 million shares of our common stock. The value of the shares is based on the closing market price of our common stock on the date of grant. In accordance with SFAS No. 123R, we will recognize compensation expense and increase additional paid in capital related to restricted stock rights over the requisite service

 

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period. For the three months ended June 30, 2008, we recorded expenses related to total restricted stock rights of approximately $3.4 million. For the three months ended June 30, 2007, we recorded expenses related to total restricted stock rights of approximately $0.3 million. As of June 30, 2008, $32.9 million of total unrecognized compensation cost related to restricted stock rights is expected to be recognized over a weighted-average period of 2.12 years.

 

Non-Plan Employee Stock Options

 

In connection with prior employment agreements between the Company and Robert A. Kotick, our Chairman and Chief Executive Officer, and Brian G. Kelly, co-Chairman, Mr. Kotick and Mr. Kelly were granted options to purchase shares of our common stock.  The Board of Directors approved the granting of these options.   As of June 30, 2008, options to purchase approximately 8,304,800 shares under such grants were outstanding with a weighted-average exercise price of $2.05.

 

The following table sets forth the total stock-based compensation expense resulting from stock options, restricted stock rights, and employee stock purchase plans included in our Consolidated Statements of Operations for the three months ended June 30, 2008 and 2007 (amounts in thousands):

 

 

 

Three months ended June 30,

 

 

 

2008

 

2007

 

Cost of sales - software royalties and amortization

 

$

2,991

 

$

1,845

 

Product development

 

1,422

 

1,507

 

Sales and marketing

 

1,700

 

1,771

 

General and administrative

 

5,831

 

3,037

 

 

 

 

 

 

 

Stock-based compensation expense before income taxes

 

11,944

 

8,160

 

Income tax benefit

 

(4,669

)

(3,191

)

 

 

 

 

 

 

Total stock-based compensation expense after income taxes

 

$

7,275

 

$

4,969

 

 

Additionally, stock option expenses are capitalized in accordance with Statement of Financial Accounting Standards No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed. (“SFAS No. 86”)  The following table summarizes stock option expense included in our Consolidated Balance Sheets as a component of software development (amounts in thousands):

 

 

 

Software
Development

 

 

 

 

 

Balance as of March 31, 2008

 

$

9,379

 

Stock option expense capitalized during period

 

8,708

 

Amortization of capitalized stock option expense

 

(2,991

)

Balance as of June 30, 2008

 

$

15,096

 

 

Net cash proceeds from the exercise of stock options were $23.2 million and $11.2 million for the three months ended June 30, 2008 and 2007, respectively. Tax benefits attributable to employee stock option exercises were $20.3 million and $4.0 million and were offset by adjustments to deferred income taxes and additional paid-in capital of $3.0 million and $3.6 million for the three months ended June 30, 2008 and

 

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2007, respectively.  In accordance with SFAS No. 123R, we present excess tax benefits from the exercise of stock options, if any, as financing cash flows rather than operating cash flows.

 

Consistent with SFAS No. 123R, we have attempted to reflect expected future changes in model inputs during the option’s contractual term.  The inputs required by our binomial lattice model include expected volatility, risk-free interest rate, risk-adjusted stock return, dividend yield, contractual term, and vesting schedule, as well as measures of employees’ forfeiture, exercise, and post-vesting termination behavior.   Statistical methods were used to estimate termination rates for specific types of employees.  These termination rates, in turn, were used to model the number of options that are expected to vest and post-vesting termination behavior.  Employee type specific estimates of Expected Time-To-Exercise (“ETTE”) were used to reflect employee exercise behavior.  ETTE was estimated by using statistical procedures to first estimate the conditional probability of exercise occurring during each time period, conditional on the option surviving to that time period.  These probabilities are then used to estimate ETTE.  The model was calibrated by adjusting parameters controlling exercise and post-vesting termination behavior so that the measures output by the model matched values of these measures that were estimated from historical data.  The weighted-average estimated value of employee stock options granted during the three months ended June 30, 2008 and 2007 was $11.93 and $9.05 per share, respectively, using the binomial-lattice model with the following weighted-average assumptions:

 

 

 

Employee and Director Options
and Warrants

 

Employee Stock
Purchase Plan

 

 

 

June 30,
2008

 

June 30,
2007

 

June 30,
2008

 

June 30,
2007

 

Expected Term (in years)

 

5.04

 

5.57

 

0.5

 

0.5

 

Risk-free Interest rate

 

3.97

%

4.77

%

1.53

%

5.07

%

Volatility

 

48.71

%

51.38

%

35.75

%

34.58

%

Dividend yield

 

 

 

 

 

Weighted-average fair value at grant date

 

$

11.93

 

$

9.05

 

$

6.72

 

$

4.58

 

 

To estimate volatility for the binomial-lattice model, we use methods or capabilities that are discussed in SFAS No. 123R and Staff Accounting Bulletin No. 107 (“SAB 107”).  These methods included the implied volatility method based upon the volatilities for exchange-traded options on our stock to estimate short-term volatility, the historical method (annualized standard deviation of the instantaneous returns on Activision’s stock) during the option’s contractual term to estimate long-term volatility and a statistical model to estimate the transition or “mean reversion” from short-term volatility to long-term volatility.  Based on these methods, for options granted during the three months ended June 30, 2008, the expected stock price volatility ranged from 30.67% to 51.56%, with a weighted-average volatility of 48.71% for options granted during the quarter ended June 30, 2008.  For options granted during the three months ended June 30, 2007, the expected stock price volatility ranged from 39.08% to 52.65%, with a weighted-average volatility of 51.38% for options granted during the three months ended June 30, 2007.

 

As was the case for volatility, the risk-free rate is assumed to change during the option’s contractual term.  Consistent with the calculation required by a binomial-lattice model, the risk-free rate reflects the interest from one time period to the next (“forward rate”) as opposed to the interest rate from the grant date to the given time period (“spot rate”).  Since we do not currently pay dividends and are not expected to pay them in the future, we have assumed that the dividend yield is zero.

 

The expected life of employee stock options represents the weighted-average period the stock options are expected to remain outstanding and is, as required by SFAS No. 123R, an output by the binomial-lattice model. The expected life of employee stock options depends on all of the underlying assumptions and calibration of our model. A binomial-lattice model can be viewed as assuming that employees will exercise their options when the stock price equals or exceeds an exercise boundary.  The exercise boundary is not constant but continually declines as one approaches the option’s expiration date.  The exact placement of

 

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the exercise boundary depends on all of the model inputs as well as the measures that are used to calibrate the model to estimated measures of employees’ exercise and termination behavior.

 

Stock-based compensation expense recognized in the Consolidated Statement of Operations is based on awards ultimately expected to vest and has been reduced for estimated forfeitures. SFAS No. 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

 

Accuracy of Fair Value Estimates

 

We developed the assumptions used in the binomial-lattice model, including model inputs and measures of employees’ exercise and post-vesting termination behavior.  Our ability to accurately estimate the fair value of share-based payment awards as of the grant date depends upon the accuracy of the model and our ability to accurately forecast model inputs as long as ten years into the future.  These inputs include, but are not limited to, expected stock price volatility, risk-free rate, dividend yield, and employee termination rates.  Although the fair value of employee stock options is determined in accordance with SFAS No. 123R and SAB 107 using an option-pricing model, the estimates that are produced by this model may not be indicative of the fair value observed between a willing buyer/willing seller.  Unfortunately, it is difficult to determine if this is the case, because markets do not currently exist that permit the active trading of our employee stock option and other share-based instruments.

 

Stock option activity for the three months ended June 30, 2008 is as follows (amounts in thousands, except per share amounts):

 

 

 

Shares

 

Weighted-Average
Exercise Price

 

Weighted-
Average
Remaining
Contractual
Term

 

Aggregate
Intrinsic Value

 

Outstanding at March 31, 2008

 

48,655

 

$

10.67

 

 

 

 

 

Granted

 

212

 

33.49

 

 

 

 

 

Exercised

 

(2,440

)

9.83

 

 

 

 

 

Forfeiture

 

(134

)

15.61

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Outstanding at June 30, 2008

 

46,293

 

$

10.81

 

5.68

 

$

1,076,830

 

 

 

 

 

 

 

 

 

 

 

Exercisable at June 30, 2008

 

28,284

 

$

6.76

 

4.02

 

$

772,469

 

 

The aggregate intrinsic value in the table above represents the total pretax intrinsic value (i.e., the difference between our closing stock price on the last trading day of the quarter ended June 30, 2008 and the exercise price, times the number of shares) that would have been received by the option holders had all option holders exercised their options on June 30, 2008.  This amount changes based on the fair market value of our stock.  Total intrinsic value of options exercised is $52.3 million for the three months ended June 30, 2008.

 

As of June 30, 2008, $59.0 million of total unrecognized compensation cost related to stock options is expected to be recognized over a weighted-average period of 1.6 years.

 

14.       Recently Issued Accounting Standards

 

In September 2006, the FASB issued SFAS No. 157.  SFAS No. 157 defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures

 

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about fair value measurements. SFAS No. 157 applies to other accounting pronouncements that require or permit fair value measurements and does not require any new fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007 for financial assets and liabilities and is effective for fiscal years beginning after November 15, 2008 for non-financial assets and liabilities. The adoption of SFAS No. 157 for financial assets did not have a material effect on our financial position or results of operations.  We do not expect the adoption of SFAS No. 157 for non-financial assets to have a material effect on our financial position or results of operations.

 

In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115 (“SFAS No. 159”).  SFAS No. 159 permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. Subsequent unrealized gains and losses on items for which the fair value option has been elected will be reported in earnings. The provisions of SFAS No. 159 are effective for financial statements issued for fiscal years beginning after November 15, 2007. The adoption of SFAS No. 159 did not have a material effect on our financial position or results of operations because the Company did not elect to measure any items at fair value that are not already required to be reported at fair value.

 

In June 2007, the FASB ratified the Emerging Issues Task Force’s (“EITF”) consensus conclusion on EITF Issue 07-03, Accounting for Advance Payments for Goods or Services to Be Used in Future Research and Development (“EITF 07-03”). EITF 07-03 addresses the diversity which exists with respect to the accounting for the non-refundable portion of a payment made by a research and development entity for future research and development activities. Under this conclusion, an entity is required to defer and capitalize non-refundable advance payments made for research and development activities until the related goods are delivered or the related services are performed. EITF 07-03 is effective for interim or annual reporting periods in fiscal years beginning after December 15, 2007 and requires prospective application for new contracts entered into after the effective date. The adoption of EITF 07-03 did not have a material impact on our Consolidated Financial Statements.

 

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

 

Overview

 

Business Combination with Vivendi Games

 

Subsequent to the quarter ended June 30, 2008, we consummated our previously announced Business Combination pursuant to the Business Combination Agreement, dated as of December 1, 2007, by and among the Company, Sego Merger Corporation, Vivendi, VGAC and Vivendi Games. Upon the closing of the Business Combination, which occurred on July 9, 2008, Activision was renamed Activision Blizzard. Activision Blizzard continues to operate as a public company traded on NASDAQ under the ticker symbol ATVI.  The Financial Statements, Management’s Discussion and Analysis and other Items of Part I and Part II in this quarterly report on Form 10-Q covering the three months ended June 30, 2008 reflect exclusively Activision’s stand-alone operations as they existed as of and for the period ended June 30, 2008 prior to the consummation of the Business Combination. Activision Blizzard now conducts the combined business operations of Activision and Vivendi Games. In connection with the Business Combination, we issued approximately 358 million shares of common stock to VGAC. Following the consummation of the Business Combination, VGAC owned approximately 54% of Activision Blizzard’s issued and outstanding common stock. While we are the surviving entity in this Business Combination, because the transaction is treated as a “reverse acquisition”, Vivendi Games is deemed to be the acquirer for accounting purposes. Accordingly, for all future Exchange Act filings, the historical financial statements of Activision for periods prior to the consummation of the Business Combination will be those of Vivendi Games. Activision’s businesses will be included in Activision Blizzard’s financial statements for all periods subsequent to the consummation of the Business Combination only. See Note 1 to the Consolidated Financial Statements for further information.

 

All information included in this report reflects only Activision’s results for the relevant periods, and does not reflect any impact of the Business Combination. The forward looking statements noted throughout this quarterly report on Form 10-Q will likely change as a result of the Business Combination.

 

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Our Business

 

We are a leading international publisher of interactive entertainment software products. We have built a company with a diverse portfolio of products that spans a wide range of categories and target markets and that are used on a variety of game hardware platforms and operating systems. We have created, licensed, and acquired a group of highly recognizable franchises, which we market to a variety of consumer demographics.  During the three months ended June 30, 2008, we published Guitar Hero: On Tour for the Nintendo Dual Screen (“NDS”); Guitar Hero: Aerosmith and Kung Fu Panda across multiple platforms. During calendar 2008, we plan to release Guitar Hero World Tour, Call of Duty: World at War, and continue to expand our licensed titles such as Madagascar: Escape 2 Africa, Spider-Man: Web of Shadows, our first James Bond title, Quantum of Solace, and several other titles. We are currently in development of Wolfenstein from id Software, Marvel Ultimate Alliance 2: Fusion from Vicarious Visions and Singularity from Raven Software among other titles.

 

Our products cover diverse game categories including action/adventure, action sports, racing, role-playing, simulation, first-person action, music-based gaming, and strategy. Our target customer base ranges from casual players to game enthusiasts, children to adults, and mass-market consumers to “value” buyers. We currently offer our products primarily in versions that operate on the Sony PlayStation 2 (“PS2”), the Sony PlayStation 3 (“PS3”), the Nintendo Wii (“Wii”), and the Microsoft Xbox360 (“Xbox360”) console systems, the NDS, and the Sony PlayStation Portable (“PSP”) hand-held devices, and the personal computer (“PC”). The installed base for the previous generation of hardware platforms (e.g., the PS2) is significant and the fiscal 2006 release of the Xbox360 and the fiscal 2007 releases of the PS3 and the Wii have further expanded the software market. Our plan is to continue to build a significant presence on the PS3, the Wii, and the Xbox360 (“the next-generation platforms”) by continuing to expand the number of titles released on the next-generation and hand-held platforms while continuing to market to the PS2 platform as long as economically attractive given its large installed base.

 

Our publishing business involves the development, marketing, and sale of products directly, by license, or through our affiliate label program with certain third-party publishers. In the U.S., we primarily sell our products on a direct basis to mass-market retailers, consumer electronics stores, discount warehouses, and game specialty stores. We conduct our international publishing activities through offices in the UK, Germany, France, Italy, Spain, the Netherlands, Norway, Sweden, Australia, Canada, South Korea, and Japan. Our products are sold internationally on a direct-to-retail basis, through third-party distribution and licensing arrangements, and through our wholly owned European distribution subsidiaries. Our distribution business consists of operations located in the UK, the Netherlands, and Germany that provide logistical and sales services to third-party publishers of interactive entertainment software, our own publishing operations, and manufacturers of interactive entertainment hardware.

 

Our profitability is directly affected by the mix of revenues from our publishing and distribution businesses. Operating margins realized from our publishing business are typically substantially higher than margins realized from our distribution business. Operating margins in our publishing business are affected by our ability to release highly successful or “hit” titles. Though many of these titles have substantial production or acquisition costs and marketing budgets, once a title recoups these costs, incremental net revenues directly and positively impact our operating margin. Operating margins in our distribution business are affected by the mix of hardware and software sales, with software typically producing higher margins than hardware.

 

Our Focus

 

With respect to future game development, we will continue to focus on our “big propositions” products that are backed by strong franchises and high quality development, for which we will provide significant marketing support.

 

We have focused on establishing and maintaining relationships with talented and experienced software development and publishing teams.  We will continue to invest in the future development of the Guitar Hero franchise published by RedOctane across a variety of platforms.  During the quarter ended June 30, 2008, we released Guitar Hero: Aerosmith on the next-generation platforms and the PS2, and Guitar Hero: On Tour on the NDS.  We will release Guitar Hero World Tour across multiple platforms in the fall of 2008.  We have also been successful and continued the momentum in the quarter ended June 30, 2008 in the first

 

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person action categories through our originally developed Call of Duty franchise, and in accordance with our plan to continue it as a successful long-term franchise, we will release Call of Duty: World at War in calendar 2008.  We also plan on entering the racing category through the development of a new title by Bizarre Creations Limited (“Bizarre Creations”).  Bizarre Creations will play a role in our growth strategy as we develop new intellectual property for the racing category, expand our development capability and capacity for other genres and utilize Bizarre Creations’ proprietary development technology. We also have development agreements with other top-level, third-party developers such as id Software, Inc., Splash Damage, Ltd., and Next Level Games.

 

Our releases include well-established franchises, which are backed by high-profile intellectual property and/or highly anticipated motion picture releases. We license from intellectual property owners, such as DreamWorks Animation LLC (“DreamWorks”), Harrah’s Entertainment, Inc. (“Harrah”), Hasbro Properties Group (“Hasbro”), MGM Interactive and EON Productions Ltd. (“MGM & EON”), Mattel, Inc. (“Mattel”), Marvel Entertainment, Inc. (“Marvel”), and professional skateboarder Tony Hawk, to develop video games based on their intellectual property.  We plan to release future titles under these licensing agreements.  For example, we plan to release Spider-Man: Web of Shadows, Marvel Ultimate Alliance 2: Fusion, our first James Bond title, Quantum of Solace, Monsters vs. Aliens, and Madagascar: Escape 2 Africa.  In the quarter ended June, 30, 2008, we released Kung Fu Panda based on the DreamWorks movie “Kung Fu Panda”.

 

We are utilizing these developer relationships, new intellectual property acquisitions, new original intellectual property creations, and our existing library of intellectual property to further focus our game development on product lines that will deliver significant, lasting, and recurring revenues and operating profits.

 

Critical Accounting Policies and Estimates

 

We have identified the policies below as critical to our business operations and the understanding of our financial results. The impact and any associated risks related to these policies on our business operations are discussed throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations where such policies affect our reported and expected financial results. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

 

Revenue Recognition.  We recognize revenue from the sale of our products upon the transfer of title and risk of loss to our customers, and once any performance obligations have been completed. Certain products are sold to customers with a street date (the earliest date these products may be sold by retailers). For these products we recognize revenue on the later of the street date or the sale date. Revenue from product sales is recognized after deducting the estimated allowance for returns and price protection. With respect to license agreements that provide customers the right to make multiple copies in exchange for guaranteed amounts, revenue is recognized upon delivery of a master copy. Per copy royalties on sales that exceed the guarantee are recognized as earned.

 

Some of our software products provide limited online features at no additional cost to the consumer. Historically, such features have been incidental to the overall product offering and an inconsequential deliverable. Accordingly, we recognize revenue related to products containing these limited online features upon the transfer of title and risk of loss to our customer. In instances where online features or additional functionality is considered a substantive deliverable in addition to the software product, we take this into account when applying our revenue recognition policy. This evaluation is performed for each software product when it is released. When our software products contain online functionality that constitutes a more-than-inconsequential separate service deliverable in addition to the product, principally because of its importance to game play, we consider our performance obligations for these software products extend beyond the sale of the game. Vendor-specific objective evidence of fair value (“VSOE”) does not exist for the online functionality, as we do not separately charge for this component of the title. As a result, we recognize all of the revenue from the sale of these software products title ratably over an estimated service period, which is currently estimated to be six months beginning the month after shipment. In addition, we defer the costs of sales for these software products. Cost of sales includes: manufacturing costs, software royalties and amortization, and intellectual property licenses.

 

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Based on our current assessment of obligations with respect to the online functionality for certain titles anticipated to be released prior to December 31, 2008, we expect that certain titles will contain online functionality that constitutes a more-than-inconsequential separate service deliverable in addition to the product, and that our performance obligations for these titles will extend beyond the sale of the game. VSOE of fair value does not exist for these online features, as we do not plan to separately charge for this component of these titles. As a result, we expect to recognize all of the revenue from the sale of these titles ratably over an estimated service period, which is currently estimated to be six months beginning the month after shipment. In addition, we expect to defer the costs of sales of these titles.

 

With respect to online transactions, such as electronic downloads of titles or product add-ons, revenue has historically been recognized when the fee is paid by the online customer to purchase online content and we are notified by the online retailer that the product has been downloaded. In instances where online features or additional functionality is considered a substantive deliverable in addition to the software product, revenue from online transactions, such as product add-ons for these titles, will be recognized ratably over the estimated service period. In addition, in order to recognize revenue for both product sales and licensing transactions, persuasive evidence of an arrangement must exist and collection of the related receivable must be probable.

 

Sales incentives or other consideration given by us to our customers is accounted for in accordance with EITF Issue 01-9, Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products) (“EITF 01-9”). In accordance with EITF 01-9, sales incentives and other consideration that are considered adjustments of the selling price of our products, such as rebates and product placement fees, are reflected as reductions of revenue. Sales incentives and other consideration that represent costs incurred by us for assets or services received, such as the appearance of our products in a customer’s national circular advertisement, are reflected as sales and marketing expenses.

 

Allowances for Returns, Price Protection, Doubtful Accounts, and Inventory Obsolescence.  We closely monitor and analyze the historical performance of our various titles, the performance of products released by other publishers and the anticipated timing of other releases in order to assess future demands of current and upcoming titles. Initial volumes shipped upon title launch and subsequent reorders are evaluated to ensure that quantities are sufficient to meet the demands from the retail markets but at the same time are controlled to prevent excess inventory in the channel. We benchmark our units to be shipped to our customers using historical and industry data.

 

We may permit product returns from, or grant price protection to, our customers under certain conditions. In general, price protection refers to the circumstances when we elect to decrease the wholesale price of a product by a certain amount and, when granted and applicable, allows customers a credit against amounts owed by such customers to us with respect to open and/or future invoices. The conditions our customers must meet to be granted the right to return products or price protection are, among other things, compliance with applicable payment terms and consistent delivery to us of inventory and sell-through reports. We may also consider other factors, including the facilitation of slow-moving inventory and other market factors. Management must make estimates of potential future product returns and price protection related to current period product revenue. We estimate the amount of future returns and price protection for current period product revenue utilizing historical experience and information regarding inventory levels and the demand and acceptance of our products by the end consumer. The following factors are used to estimate the amount of future returns and price protection for a particular title: historical performance of titles in similar genres, historical performance of the hardware platform, historical performance of the franchise, console hardware life cycle, our sales force and retail customer feedback, industry pricing, weeks of on-hand retail channel inventory, absolute quantity of on-hand retail channel inventory, our warehouse on-hand inventory levels, the title’s recent sell-through history (if available), marketing trade programs, and competing titles. The relative importance of these factors varies among titles depending upon, among other items, genre, platform, seasonality, and sales strategy. Significant management judgments and estimates must be made and used in connection with establishing the allowance for returns and price protection in any accounting period. Based upon historical experience we believe our estimates are reasonable. However, actual returns and price protection could vary materially from our allowance estimates due to a number of reasons including, among others, a lack of consumer acceptance of a title, the release in the same period of a similarly themed title by a competitor, or technological obsolescence due to the emergence of new hardware platforms. Material differences may result in the amount and timing of our revenue for any period if factors or market conditions change or if management makes different judgments or utilizes different estimates in determining the allowances for returns and price

 

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protection. For example, a 1% change in our June 30, 2008 allowance for returns and price protection and doubtful accounts would impact net revenues by $1.4 million.

 

Similarly, management must make estimates of the uncollectibility of our accounts receivable. In estimating the allowance for doubtful accounts, we analyze the age of current outstanding account balances, historical bad debts, customer concentrations, customer creditworthiness, current economic trends, and changes in our customers’ payment terms and their economic condition, as well as whether we can obtain sufficient credit insurance. Any significant changes in any of these criteria would affect management’s estimates in establishing our allowance for doubtful accounts.

 

We value inventory at the lower of cost or market. We regularly review inventory quantities on hand and in the retail channel and record a provision for excess or obsolete inventory based on the future expected demand for our products. Significant changes in demand for our products would impact management’s estimates in establishing our inventory provision.

 

Software Development Costs and Intellectual Property Licenses.  Software development costs include payments made to independent software developers under development agreements, as well as direct costs incurred for internally developed products.

 

We account for software development costs in accordance with SFAS No. 86. Software development costs are capitalized once the technological feasibility of a product is established and such costs are determined to be recoverable. Technological feasibility of a product encompasses both technical design documentation and game design documentation. Significant management judgments and estimates are utilized in the assessment of when technological feasibility is established. For products where proven technology exists, this may occur early in the development cycle. Technological feasibility is evaluated on a product-by-product basis. Prior to a product’s release, we expense, as part of “cost of sales—software royalties and amortization,” capitalized costs when we believe such amounts are not recoverable. Capitalized costs for those products that are cancelled or abandoned are charged to product development expense in the period of cancellation. Amounts related to software development which are not capitalized are charged immediately to product development expense.

 

Commencing upon product release, capitalized software development costs are amortized to “cost of sales—software royalties and amortization” based on the ratio of current revenues to total projected revenues for the specific product, generally resulting in an amortization period of six months or less.

 

Intellectual property license costs represent license fees paid to intellectual property rights holders for use of their trademarks, copyrights, software, technology, music or other intellectual property or proprietary rights in the development of our products. Depending upon the agreement with the rights holder, we may obtain the rights to use acquired intellectual property in multiple products over multiple years, or alternatively, for a single product. Prior to the related product’s release, we expense, as part of “cost of sales—intellectual property licenses,” capitalized intellectual property costs when we believe such amounts are not recoverable. Capitalized intellectual property costs for those products that are cancelled or abandoned are charged to product development expense in the period of cancellation.

 

Commencing upon the related product’s release, capitalized intellectual property license costs are amortized to “cost of sales—intellectual property licenses” based on the ratio of current revenues for the specific product to total projected revenues for all products in which the licensed property will be utilized. As intellectual property license contracts may extend for multiple years, the amortization of capitalized intellectual property license costs relating to such contracts may extend beyond one year.

 

We evaluate the future recoverability of capitalized software development costs and intellectual property licenses on a quarterly basis. For products that have been released in prior periods, the primary evaluation criterion is actual title performance. For products that are scheduled to be released in future periods, the recoverability of capitalized software development costs is evaluated based on the expected performance of the specific products to which the costs relate or in which the licensed trademark or copyright is to be used. Criteria used to evaluate expected product performance include: historical performance of comparable products developed with comparable technology; orders for the product prior to its release; and for any sequel product, estimated performance based on the performance of the product on which the sequel is based. As many of our intellectual property licenses extend for multiple products over multiple years, we also assess the recoverability

 

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of capitalized intellectual property license costs based on certain qualitative factors, such as the success of other products and/or entertainment vehicles utilizing the intellectual property, whether there are any future planned theatrical releases or television series based on the intellectual property, and the rights holder’s continued promotion and exploitation of the intellectual property.

 

Significant management judgments and estimates are utilized in the assessment of the recoverability of capitalized costs. In evaluating the recoverability of capitalized costs, the assessment of expected product performance utilizes forecasted sales amounts and estimates of additional costs to be incurred. If revised forecasted or actual product sales are less than, and/or revised forecasted or actual costs are greater than, the original forecasted amounts utilized in the initial recoverability analysis, the net realizable value may be lower than originally estimated in any given quarter, which could result in an impairment charge. Additionally, as noted above, as many of our intellectual property licenses extend for multiple products over multiple years, we also assess the recoverability of capitalized intellectual property license costs based on certain qualitative factors such as the success of other products and/or entertainment vehicles utilizing the intellectual property, whether there are any future planned theatrical releases or television series based on the intellectual property and the rights holder’s continued promotion and exploitation of the intellectual property. Material differences may result in the amount and timing of charges for any period if management makes different judgments or utilizes different estimates in evaluating these qualitative factors.

 

Stock-based Compensation Expense.  On April 1, 2006, we adopted SFAS No. 123R which requires the measurement and recognition of compensation expense for all share-based payment awards made to our employees and directors, including employee stock options and employee stock purchases made pursuant to the Employee Stock Purchase Plan based on estimated fair values.

 

We estimate the value of employee stock options on the date of grant using a binomial-lattice model. The fair value of a share-based payment as of the grant date estimated in accordance with this option pricing model depends upon our future stock price as well as assumptions concerning expected volatility, risk-free interest rate, and risk-adjusted stock return, and measures of employees’ forfeiture, exercise, and post-vesting termination behavior. Statistical methods were used to estimate employee rank specific termination rates. These termination rates, in turn, were used to model the number of options that are expected to vest and employees’ post-vesting termination behavior. Employee rank specific estimates of ETTE were used to reflect employee exercise behavior. ETTE was estimated by using statistical procedures to first estimate the conditional probability of exercise occurring during each time period, conditional on the option surviving to that time period and then using those probabilities to estimate ETTE. The model was calibrated by adjusting parameters controlling exercise and post-vesting termination behavior so that the measures output by the model matched values of these measures that were estimated from historical data. The weighted-average estimated value of employee stock options granted for the three months ended June 30, 2008 and 2007 was $11.93 and $9.05, respectively, per share using the binomial-lattice model with the following weighted-average assumptions:

 

 

 

Three Months Ended
June 30, 2008

 

Expected life (in years)

 

5.04

 

Risk-free interest rate

 

3.97

%

Expected volatility

 

48.71

%

Dividend yield

 

 

 

To estimate volatility for the binomial-lattice model, we use methods or capabilities that are discussed in SFAS No. 123R and SAB No. 107.  These methods included the implied volatility method based upon the volatilities for exchange-traded options on our stock to estimate short-term volatility, the historical method (annualized standard deviation of the instantaneous returns on Activision’s stock) during the option’s contractual term to estimate long-term volatility and a statistical model to estimate the transition or “mean reversion” from short-term volatility to long-term volatility.  Based on these methods, for options granted during the quarter ended June 30, 2008, the expected stock price volatility ranged from 30.67% to 51.56%, with a weighted-average volatility of 48.71% for options granted during the quarter ended June 30, 2008.  For options granted during the three months ended June 30, 2007, the expected stock price volatility ranged from

 

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39.08% to 52.65%, with a weighted-average volatility of 51.38% for options granted during the quarter ended June 30, 2007.

 

As was the case for volatility, the risk-free rate is assumed to change during the option’s contractual period.  As required by a binomial-lattice model, the risk-free rate reflects the interest from one time period to the next (“forward rate”) as opposed to the interest rate from the grant date to the given time period (“spot rate”).  Since we do not currently pay dividends and are not expected to pay them in the future, we have assumed that the dividend yield is zero.

 

The expected life of employee stock options represents the weighted-average period the stock options are expected to remain outstanding and is, as required by SFAS No. 123R, output by the binomial-lattice model. The expected life of employee stock options depends on all of the underlying assumptions and calibration of our model. The binomial-lattice model assumes that employees will exercise options when the stock price equals or exceeds an exercise boundary.  The exercise boundary is not constant but continually declines as one approaches the option’s expiration date.  The exact placement of the exercise boundary depends on all of the model inputs as well as the measures that were used to calibrate the model to estimated measures of employees’ exercise and termination behavior.

 

Stock-based compensation expense recognized in the Consolidated Statement of Operations is based on awards ultimately expected to vest and has been reduced for estimated forfeitures. SFAS No. 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

 

If factors change and we employ different assumptions in the application of SFAS No. 123R in future periods, the compensation expense that we record under SFAS No. 123R may differ significantly from what we have recorded in the current period.

 

Income Taxes.  We record a tax provision for the anticipated tax consequences of the reported results of operations. In accordance with Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes, the provision for income taxes is computed using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. We record a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. Effective at the beginning of fiscal 2008, we adopted FIN 48.

 

Management believes it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with the tax effects of the deferred tax liabilities, will be sufficient to fully recover the remaining deferred tax assets. In the event that all or part of the net deferred tax assets are determined not to be realizable in the future, an adjustment to the valuation allowance would be charged to earnings in the period such determination is made. In addition, the calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of FIN 48 and other complex tax laws. Resolution of these uncertainties in a manner inconsistent with management’s expectations could have a material impact on our financial condition and operating results.

 

Selected Consolidated Statements of Operations Data

 

The following table sets forth certain consolidated statements of operations data for the periods indicated as a percentage of total net revenues as well as net revenues by territory, business segment and platform and operating income by business segment (amounts in thousands):

 

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Table of Contents

 

 

 

Three months ended June 30,

 

 

 

2008

 

2007

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

$

654,203

 

100

%

$

495,455

 

100

%

 

 

 

 

 

 

 

 

 

 

Costs and expenses:

 

 

 

 

 

 

 

 

 

Cost of sales – product costs

 

311,941

 

48

 

217,229

 

44

 

Cost of sales – software royalties and amortization

 

40,874

 

6

 

78,252

 

16

 

Cost of sales – intellectual property licenses

 

27,359

 

4

 

32,479

 

6

 

Product development

 

50,040

 

8

 

32,897

 

7

 

Sales and marketing

 

86,494

 

13

 

68,712

 

14

 

General and administrative

 

57,360

 

9

 

35,794

 

7

 

 

 

 

 

 

 

 

 

 

 

Total costs and expenses

 

574,068

 

88

 

465,363

 

94

 

 

 

 

 

 

 

 

 

 

 

Operating income

 

80,135

 

12

 

30,092

 

6

 

 

 

 

 

 

 

 

 

 

 

Investment income, net

 

10,948

 

2

 

11,562

 

2

 

 

 

 

 

 

 

 

 

 

 

Income before income tax provision

 

91,083

 

14

 

41,654

 

8

 

 

 

 

 

 

 

 

 

 

 

Income tax provision

 

32,068

 

5

 

13,828

 

2

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

59,015

 

9

%

$

27,826

 

6

%

 

 

 

 

 

 

 

 

 

 

Net Revenues by Territory:

 

 

 

 

 

 

 

 

 

North America

 

$

392,916

 

60

%

$

309,536

 

62

%

Europe

 

229,381

 

35

 

170,014

 

35

 

Other

 

31,906

 

5

 

15,905

 

3

 

 

 

 

 

 

 

 

 

 

 

Total net revenues

 

$

654,203

 

100

%

$

495,455

 

100

%

 

 

 

 

 

 

 

 

 

 

Net Revenues by Segment/Platform Mix:

 

 

 

 

 

 

 

 

 

Publishing:

 

 

 

 

 

 

 

 

 

Console

 

$

450,099

 

69

%

$

358,773

 

72

%

Hand-held

 

103,747

 

16

 

56,616

 

12

 

PC

 

24,716

 

3

 

13,833

 

3

 

 

 

 

 

 

 

 

 

 

 

Total publishing net revenues

 

578,562

 

88

 

429,222

 

87

 

 

 

 

 

 

 

 

 

 

 

Distribution:

 

 

 

 

 

 

 

 

 

Console

 

57,361

 

9

 

43,101

 

8

 

Hand-held

 

15,886

 

3

 

19,116

 

4

 

PC

 

2,394

 

 

4,016

 

1

 

Total distribution net revenues

 

75,641

 

12

 

66,233

 

13

 

 

 

 

 

 

 

 

 

 

 

Total net revenues

 

$

654,203

 

100

%

$

495,455

 

100

%

 

 

 

 

 

 

 

 

 

 

Operating Income by Segment and as a Percentage of Total Segment Net Revenues:

 

 

 

 

 

 

 

 

 

Publishing

 

$

79,170

 

14

%

$

29,117

 

7

%

Distribution

 

965

 

1

 

975

 

1

 

 

 

 

 

 

 

 

 

 

 

Total operating income

 

$

80,135

 

12

%

$

30,092

 

6

%

 

Results of Operations – Three Months Ended June 30, 2008 and 2007

 

Net Revenues

 

We primarily derive revenue from sales of packaged interactive software games designed for play on video game consoles (such as the PS2, PS3, Xbox360 and Wii), PCs and hand-held game devices (such as the NDS and PSP).  We also derive revenue from our distribution business in Europe that provides logistical and sales services to third-party publishers of interactive entertainment software, our own publishing operations, and third-party manufacturers of interactive entertainment hardware.

 

The following table details our consolidated net revenues by business segment and our publishing net revenues by territory for the three months ended June 30, 2008 and 2007 (amounts in thousands):

 

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Table of Contents

 

 

 

Three Months Ended June 30,

 

Increase/

 

Percent

 

 

 

2008

 

2007

 

(Decrease)

 

Change

 

Publishing Net Revenues

 

 

 

 

 

 

 

 

 

North America

 

$

392,916

 

$

309,536

 

$

83,380

 

27

%

Europe

 

153,740

 

103,781

 

49,959

 

48

%

Other

 

31,906

 

15,905

 

16,001

 

101

%

Total International

 

185,646

 

119,686

 

65,960

 

55

%

 

 

 

 

 

 

 

 

 

 

Total Publishing Net Revenues

 

578,562

 

429,222

 

149,340

 

35

%

Distribution Net Revenues

 

75,641

 

66,233

 

9,408

 

14

%

Consolidated Net Revenues

 

$

654,203

 

$

495,455

 

$

158,748

 

32

%

 

Consolidated net revenues increased 32% from $495.5 million for the three months ended June 30, 2007 to $654.2 million for the three months ended June 30, 2008.  This increase primarily resulted from the growth of our publishing business, the net revenues of which increased by 35% as compared to the first quarter of the prior fiscal year.  Our financial performance was also driven by the following:

 

·                  The increase in our publishing net revenues of $149.3 million was attributable to continued growth of the Guitar Hero and Call of Duty franchises in the quarter ended June 30, 2008 and our increased presence on multiple platforms for the titles released during the quarter.  We released Guitar Hero: Aerosmith on the next-generation platforms and the PS2 in North America and Europe and Guitar Hero: On Tour for the NDS in North America and Asia Pacific in the first quarter of 2009. This compares to the first quarter of fiscal 2008 worldwide release of Guitar Hero II only on Xbox360.  The continued momentum from Call of Duty: Modern Warfare and Guitar Hero III: Legends of Rock across all platforms also contributed to the increase in net revenues. Additionally, contributing to the increase in net revenue was the publication of Kung Fu Panda worldwide concurrent with the movie release, and the LucasArt’s title Lego: Indiana Jones the Original Adventures in the three months ended June 30, 2008 in Europe and Asia. According to The NPD Group, Activision was the #1 third-party Wii and NDS publisher by dollars in the U.S. for the quarter ended June 30, 2008.  We also released Enemy Territory: Quake Wars on the PS3 and the Xbox360 during the three months ended June 30, 2008. In the first quarter of fiscal 2008, we released Spider-Man 3 and Shrek the Third worldwide, and in North America and Asia Pacific we released TRANSFORMERS: The Game.

 

·                  International net revenues were impacted by a year over year weakening of the U.S. Dollar in relation to GBP, EUR and AUD.  We estimate that foreign exchange rates increased reported consolidated net revenues by approximately $9.5 million.  Excluding the impact of changing foreign currency rates, our consolidated net revenues increased 30% year over year.

 

North America Publishing Net Revenues (amounts in thousands)

 

Three Months
Ended
June 30,

 

% of
Consolidated

 

Three Months
Ended
June 30,

 

% of
Consolidated

 

Increase/

 

Percent

 

2008

 

Net Revenues

 

2007

 

Net Revenues

 

(Decrease)

 

Change

 

 

 

 

 

 

 

 

 

 

 

 

 

$

 392,916

 

60

%

$

309,536

 

62

%

$

83,380

 

27

%

 

North America publishing net revenues increased 27% from $309.5 million for the three months ended June 30, 2007 to $392.9 million for the three months ended June 30, 2008.  The increase primarily resulted from the releases of Guitar Hero: Aerosmith on the next-generation platforms and the PS2 and Guitar Hero: On Tour for the NDS in North America during the three months ended June 30, 2008. This compares to the first quarter

 

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