10-Q 1 b413621-10q.htm FORM 10-Q Prepared and Filed by St Ives Financial

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
FORM 10-Q
 
  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF l934.
 
For the quarterly period ended April 30, 2006
 
OR
  TRANSITION REPORT PURSUANT TO SECTION 13 OR SECTION
13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from __________ to __________
 
Commission file number 0-29230
 
TAKE-TWO INTERACTIVE SOFTWARE, INC.
(Exact Name of Registrant as Specified in Its Charter)
 
Delaware
 
51-0350842
(State or Other Jurisdiction
of Incorporation or Organization)
 
(I.R.S. Employer
Identification No.)
 
622 Broadway, New York, New York 10012
(Address of principal executive offices including zip code)
 
Registrant’s Telephone Number, Including Area Code (646) 536-2842
 
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        No   
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act). Large Accelerated Filer        Accelerated Filer        Non-Accelerated Filer   
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).   Yes        No   
 
As of June 2, 2006, there were 72,548,823 shares of the Registrant’s Common Stock outstanding.
 


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INDEX
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


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PART I.    FINANCIAL INFORMATION

Item 1.    Financial Statements

TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES

Condensed Consolidated Balance Sheets (Unaudited)

As of April 30, 2006 and October 31, 2005

(In thousands, except share and per share data)

 


 

 

April 30,
2006

 

October 31,
2005

 

 

 


 


 

ASSETS

 

 

 

 

 

 

 

Current assets

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

141,068

 

$

107,195

 

Accounts receivable, net of allowances of $87,820 and $69,904 at April 30, 2006 and October 31, 2005, respectively

 

 

130,328

 

 

198,068

 

Inventories

 

 

91,820

 

 

136,227

 

Software development costs

 

 

69,431

 

 

88,826

 

Licenses

 

 

4,253

 

 

7,651

 

Prepaid taxes and taxes receivable

 

 

69,854

 

 

40,307

 

Prepaid expenses and other current assets

 

 

27,772

 

 

24,025

 

Deferred tax assets

 

 

38,319

 

 

10,943

 

 

 



 



 

Total current assets

 

 

572,845

 

 

613,242

 

 

 

 

 

 

 

 

 

Fixed assets, net

 

 

49,796

 

 

48,617

 

Software development costs, net of current portion

 

 

27,183

 

 

19,602

 

Licenses, net of current portion

 

 

4,984

 

 

2,330

 

Goodwill

 

 

190,491

 

 

179,893

 

Intangibles, net

 

 

48,916

 

 

58,666

 

Deferred tax assets

 

 

7,784

 

 

5,506

 

Other assets

 

 

4,018

 

 

5,020

 

 

 



 



 

Total assets

 

$

906,017

 

$

932,876

 

 

 



 



 

LIABILITIES and STOCKHOLDERS’ EQUITY

 

 

 

 

 

 

 

Current liabilities

 

 

 

 

 

 

 

Accounts payable

 

$

108,216

 

$

133,353

 

Accrued expenses and other current liabilities

 

 

135,508

 

 

90,702

 

Income taxes payable

 

 

14,361

 

 

10,220

 

 

 



 



 

Total current liabilities

 

 

258,085

 

 

234,275

 

 

 

 

 

 

 

 

 

Other long-term liabilities

 

 

403

 

 

2,467

 

 

 



 



 

Total liabilities

 

 

258,488

 

 

236,742

 

 

 



 



 

Stockholders’ equity

 

 

 

 

 

 

 

Common stock, par value $.01 per share; 100,000,000 shares authorized; 72,515,165 and 70,667,421 shares issued and outstanding at April 30, 2006 and October 31, 2005, respectively

 

 

725

 

 

707

 

Additional paid-in capital

 

 

433,381

 

 

418,053

 

Deferred compensation

 

 

 

 

(11,189

)

Retained earnings

 

 

208,382

 

 

287,877

 

Accumulated other comprehensive income

 

 

5,041

 

 

686

 

 

 



 



 

Total stockholders’ equity

 

 

647,529

 

 

696,134

 

 

 



 



 

Total liabilities and stockholders’ equity

 

$

906,017

 

$

932,876

 

 

 



 



 

The accompanying notes are an integral part of the unaudited condensed consolidated financial statements.

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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES

Condensed Consolidated Statements of Operations (Unaudited)

For the three and six months ended April 30, 2006 and 2005

(In thousands, except per share data)

 


 

 

Three months ended
April 30,

 

Six months ended
April 30,

 

 

 


 


 

 

 

2006

 

2005

 

2006

 

2005

 

 

 


 


 


 


 

Net revenues

 

$

265,122

 

$

222,068

 

$

530,103

 

$

724,542

 

 

 



 



 



 



 

Cost of goods sold

 

 

 

 

 

 

 

 

 

 

 

 

 

Product costs

 

 

130,940

 

 

123,504

 

 

291,793

 

 

360,989

 

Royalties

 

 

82,282

 

 

21,938

 

 

115,149

 

 

102,147

 

Software development costs

 

 

34,128

 

 

4,780

 

 

49,722

 

 

8,985

 

 

 



 



 



 



 

Total cost of goods sold

 

 

247,350

 

 

150,222

 

 

456,664

 

 

472,121

 

 

 



 



 



 



 

Gross profit

 

 

17,772

 

 

71,846

 

 

73,439

 

 

252,421

 

Operating expenses

 

 

 

 

 

 

 

 

 

 

 

 

 

Selling and marketing

 

 

32,194

 

 

36,275

 

 

73,838

 

 

87,206

 

General and administrative

 

 

33,705

 

 

28,705

 

 

72,158

 

 

57,392

 

Research and development

 

 

16,097

 

 

13,785

 

 

33,806

 

 

37,202

 

Depreciation and amortization

 

 

12,944

 

 

5,102

 

 

19,595

 

 

9,888

 

 

 



 



 



 



 

Total operating expenses

 

 

94,940

 

 

83,867

 

 

199,397

 

 

191,688

 

 

 



 



 



 



 

Income (loss) from operations

 

 

(77,168

)

 

(12,021

)

 

(125,958

)

 

60,733

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income, net

 

 

4

 

 

1,164

 

 

257

 

 

1,704

 

 

 



 



 



 



 

Income (loss) before income taxes

 

 

(77,164

)

 

(10,857

)

 

(125,701

)

 

62,437

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Provision (benefit) for income taxes

 

 

(26,791

)

 

(2,671

)

 

(46,206

)

 

15,374

 

 

 



 



 



 



 

Net income (loss)

 

$

(50,373

)

$

(8,186

)

$

(79,495

)

$

47,063

 

 

 



 



 



 



 

Per share data:

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic:

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding

 

 

70,979

 

 

70,112

 

 

70,890

 

 

69,365

 

 

 



 



 



 



 

Net income (loss) per share

 

$

(0.71

)

$

(0.12

)

$

(1.12

)

$

0.68

 

 

 



 



 



 



 

Diluted:

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding

 

 

70,979

 

 

70,112

 

 

70,890

 

 

70,678

 

 

 



 



 



 



 

Net income (loss) per share

 

$

(0.71

)

$

(0.12

)

$

(1.12

)

$

0.67

 

 

 



 



 



 



 

The accompanying notes are an integral part of the unaudited condensed consolidated financial statements.

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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows (Unaudited)

For the six months ended April 30, 2006 and 2005

(In thousands)

 


 

 

Six months ended
April 30,

 

 

 


 

 

 

2006

 

2005

 

 

 


 


 

Cash flows from operating activities:

 

 

 

 

 

 

 

Net income (loss)

 

$

(79,495

)

$

47,063

 

Adjustment to reconcile net income (loss) to net cash provided by operating activities:

 

 

 

 

 

 

 

Depreciation and amortization

 

 

19,595

 

 

9,888

 

Loss on disposal of fixed assets

 

 

 

 

15

 

Amortization of intellectual property and other

 

 

6,563

 

 

6,642

 

Amortization of compensatory restricted stock

 

 

2,032

 

 

9,266

 

Stock-based compensation related to compensatory stock options

 

 

6,662

 

 

 

Amortization of software development costs and licenses

 

 

68,982

 

 

28,327

 

Provision for doubtful accounts and other allowances

 

 

15,712

 

 

14,634

 

Write-off of software development costs and licenses

 

 

18,462

 

 

3,397

 

Tax benefit from exercise of compensatory stock and stock options

 

 

 

 

9,941

 

Foreign currency transaction (gain) loss

 

 

(1,252

)

 

247

 

Changes in operating assets and liabilities, net of effects of acquisitions:

 

 

 

 

 

 

 

Accounts receivable

 

 

54,270

 

 

162,459

 

Inventories

 

 

45,348

 

 

37,847

 

Software development costs

 

 

(67,504

)

 

(70,866

)

Licenses

 

 

(7,218

)

 

(5,556

)

Prepaid taxes and taxes receivable

 

 

(29,547

)

 

(8,900

)

Prepaid expenses and other current assets

 

 

(1,199

)

 

373

 

Non-current assets

 

 

893

 

 

(347

)

Accounts payable

 

 

(26,029

)

 

(76,474

)

Accrued expenses and other liabilities

 

 

11,162

 

 

(66,589

)

Income taxes payable

 

 

5,206

 

 

(2,748

)

 

 



 



 

Net cash provided by operating activities

 

 

42,643

 

 

98,619

 

 

 



 



 

Cash flows from investing activities:

 

 

 

 

 

 

 

Purchase of fixed assets

 

 

(13,009

)

 

(14,610

)

Acquisition of intangible assets

 

 

 

 

(20,000

)

Acquisitions, net of cash acquired

 

 

1,143

 

 

(23,244

)

Escrow payment for settlement

 

 

 

 

(7,500

)

Payments for prior acquisitions

 

 

(1,334

)

 

(965

)

Proceeds from sale of fixed assets and investments

 

 

 

 

73

 

 

 



 



 

Net cash used in investing activities

 

 

(13,200

)

 

(66,246

)

 

 



 



 

Cash flows from financing activities:

 

 

 

 

 

 

 

Proceeds from exercise of stock options

 

 

1,944

 

 

24,445

 

Excess tax benefit from exercise of compensatory stock and stock options

 

 

124

 

 

 

Other financing

 

 

 

 

(52

)

 

 



 



 

Net cash provided by financing activities

 

 

2,068

 

 

24,393

 

 

 



 



 

Effect of foreign exchange rates

 

 

2,362

 

 

(1,620

)

 

 



 



 

Net increase in cash for the period

 

 

33,873

 

 

55,146

 

Cash and cash equivalents, beginning of the period

 

 

107,195

 

 

155,095

 

 

 



 



 

Cash and cash equivalents, end of the period

 

$

141,068

 

$

210,241

 

 

 



 



 

The accompanying notes are an integral part of the unaudited condensed consolidated financial statements.

3


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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows (Unaudited) (continued)

For the six months ended April 30, 2006 and 2005

(In thousands)

 


 

 

 

Six months ended
April,

 

 

 


 

 

 

2006

 

2005

 

 

 


 


 

Supplemental information on businesses acquired:

 

 

 

 

 

 

 

Fair value of assets acquired:

 

 

 

 

Current assets

$

112

 

$

111

 

Non-current assets

421

 

 

1,196

 

Intangible assets

5,644

 

 

7,980

 

Goodwill

11,085

 

 

29,433

 

Less: liabilities assumed

 

 

 

 

Current liabilities

(200

)

 

(3,275

)

Deferred income taxes

(1,620

)

 

(3,192

)

 

 



 



 

Net assets of businesses acquired, excluding cash acquired

$

15,442

 

$

32,253

 

 

 



 



 

Cash paid for businesses acquired

$

857

 

$

24,000

 

Less: cash acquired

(2,000

)

 

(756

)

 

 



 



 

Net cash paid (acquired) for businesses

(1,143

)

 

23,244

 

               

Additional consideration in connection with acquisitions

4,085

 

 

6,416

 

Contingent and deferred consideration

 

 

2,593

 

Issuance of unregistered common stock in connection with acquisitions

12,500

 

 

 

 

 



 



 

Total consideration, net of cash acquired

$

15,442

 

$

32,253

 

 

 



 



 

Supplemental cash flow information:

 

 

 

 

Issuance of warrants to licensor

$

 

$

1,183

 

Cash paid for taxes

9,724

 

 

26,809

 

Cash paid for interest

575

 

 

131

 

The accompanying notes are an integral part of the unaudited condensed consolidated financial statements.

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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES

Condensed Consolidated Statements of Stockholders’ Equity (Unaudited)

For the year ended October 31, 2005 and the six months ended April 30, 2006

(In thousands)

 


 

 

 

Common Stock

 

Additional
Paid-in
Capital

 

 

 

 

 

Accumulated
Other
Comprehensive
Income (loss)

 

 

 

 

 


 

 

 

 

 

 

 

 

 

 

 

Shares

 

Amount

 

 

Deferred
Compensation

 

Retained
Earnings

 

 

Total

 

 

 


 


 


 


 


 


 


 

Balance, October 31, 2004

 

68,159

 

$

682

 

$

381,928

 

$

(3,896

)

$

250,402

 

$

6,354

 

$

635,470

 

Foreign currency translation adjustment

 

 

 

 

 

 

 

 

 

 

 

(5,668

)

 

(5,668

)

Net income

 

 

 

 

 

 

 

 

 

37,475

 

 

 

 

37,475

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



 

Comprehensive income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

31,807

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



 

Purchase of treasury shares, retired

 

(925

)

 

(9

)

 

(24,920

)

 

 

 

 

 

 

 

(24,929

)

Exchange of treasury shares, retired

 

(367

)

 

(4

)

 

(8,307

)

 

 

 

 

 

 

 

(8,311

)

Proceeds from exercise of stock options and warrants

 

2,753

 

 

27

 

 

31,196

 

 

 

 

 

 

 

 

31,223

 

Amortization of deferred compensation

 

 

 

 

 

 

 

14,860

 

 

 

 

 

 

14,860

 

Issuance of common stock in connection with acquisition

 

82

 

 

1

 

 

1,999

 

 

 

 

 

 

 

 

2,000

 

Issuance of compensatory stock and stock options

 

965

 

 

10

 

 

22,688

 

 

(22,153

)

 

 

 

 

 

545

 

Tax benefit in connection with the exercise of compensatory stock and stock options

 

 

 

 

 

12,286

 

 

 

 

 

 

 

 

12,286

 

Issuance of warrants to licensor

 

 

 

 

 

1,183

 

 

 

 

 

 

 

 

1,183

 

 

 


 



 



 



 



 



 



 

Balance, October 31, 2005

 

70,667

 

$

707

 

$

418,053

 

$

(11,189

)

$

287,877

 

$

686

 

$

696,134

 

Foreign currency translation adjustment

 

 

 

 

 

 

 

 

 

 

 

4,355

 

 

4,355

 

Net loss

 

 

 

 

 

 

 

 

 

(79,495

)

 

 

 

(79,495

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



 

Comprehensive loss

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(75,140

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



 

Deferred compensation

 

 

 

 

 

(11,189

)

 

11,189

 

 

 

 

 

 

 

Proceeds from exercise of stock options and warrants

 

174

 

 

1

 

 

1,944

 

 

 

 

 

 

 

 

1,945

 

Stock-based compensation related to compensatory stock options

 

 

 

 

 

9,069

 

 

 

 

 

 

 

 

9,069

 

Amortization of restricted stock

 

 

 

 

 

2,836

 

 

 

 

 

 

 

 

2,836

 

Issuance of common stock in connection with acquisition

 

679

 

 

7

 

 

12,493

 

 

 

 

 

 

 

 

12,500

 

Issuance of compensatory restricted stock, net of forfeitures and cancellations

 

995

 

 

10

 

 

51

 

 

 

 

 

 

 

 

61

 

Tax benefit in connection with the exercise of compensatory stock and stock options

 

 

 

 

 

124

 

 

 

 

 

 

 

 

124

 

 

 


 



 



 



 



 



 



 

Balance, April 30, 2006

 

72,515

$

725

$

433,381

 

$

$

208,382

$

5,041

$

647,529

 

 


 



 



 



 



 



 



 

The accompanying notes are an integral part of the unaudited condensed consolidated financial statements.

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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
Notes to Unaudited Condensed Consolidated Financial Statements
(Dollars in thousands, except per share amounts)

 


1.

ORGANIZATION AND DESCRIPTION OF BUSINESS

Take-Two Interactive Software, Inc. (the “Company”) was incorporated in the State of Delaware in September 1993. The Company develops, publishes and distributes interactive software games designed for personal computers, video game consoles and handheld platforms.

2.

SIGNIFICANT ACCOUNTING POLICIES AND BASIS OF PRESENTATION

Basis of Presentation

The unaudited condensed consolidated financial statements of the Company have been prepared in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, the financial statements do not include all information and disclosures necessary for a presentation of the Company’s financial position, results of operations and cash flows in conformity with generally accepted accounting principles in the United States of America. In the opinion of management, the financial statements reflect all adjustments (consisting only of normal recurring accruals) necessary for a fair statement of the Company’s financial position, results of operations and cash flows. The results of operations for an interim period are not necessarily indicative of the results for the full year. The financial statements should be read in conjunction with the audited financial statements and notes thereto contained in the Company’s Annual Report on Form 10-K for the fiscal year ended October 31, 2005.

Estimates

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reported periods. The most significant estimates and assumptions relate to the adequacy of allowances for returns, price concessions and doubtful accounts; the amortization and recoverability of software development costs, licenses and other intangibles; valuation of inventories, fair value of stock compensation and realization of deferred income taxes. Actual amounts could differ significantly from these estimates.

Stock Split

In April 2005, the Company effected a three-for-two stock split in the form of a stock dividend. Accordingly, all share and per share data in the accompanying unaudited condensed consolidated financial statements and notes thereto give retroactive effect to the stock split.

Financial Instruments

The carrying amounts of the Company’s financial instruments, including cash and cash equivalents, accounts receivable, income tax receivable and payable, accounts payable and accrued liabilities, approximate fair value because of their short maturities. The Company considers all highly liquid instruments purchased with original maturities of three months or less to be cash equivalents.

The Company transacts business in various foreign currencies and has significant sales and purchase transactions denominated in foreign currencies. The Company uses forward exchange contracts to seek to mitigate foreign currency risk associated with foreign currency assets and liabilities, primarily certain intercompany receivables and payables. The Company does not designate foreign currency forward contracts as hedging instruments under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” As a result, the Company marks to market its foreign currency forward contracts each period and any gains and losses are recognized in net income. At April 30, 2006, the Company had no outstanding foreign currency forward contracts.

Reclassifications

Certain prior year amounts have been reclassified to conform to current year presentation.

Recently Issued Accounting Pronouncements

Effective November 1, 2005, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004) (“SFAS 123(R)”), “Share-Based Payment,” which revised Statement of Financial Accounting Standards 123 (“SFAS 123”), “Accounting for Stock-Based Compensation.” Refer to Note 3 to the unaudited condensed consolidated financial statements for further information. There were no other accounting policies adopted during the six months ended April 30, 2006 that had a material effect on the Company’s financial condition and results of operations.

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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
Notes to Unaudited Condensed Consolidated Financial Statements
(Dollars in thousands, except per share amounts)

 


In May 2005, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 154, “Accounting Changes and Error Corrections” (“SFAS 154”), which replaces APB Opinion No. 20, “Accounting Changes” and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statements – An Amendment of APB Opinion No. 28.” SFAS 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes retrospective application, or the latest practicable date, as the required method for reporting a change in accounting principle and the reporting of a correction of an error. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Management does not believe the adoption of SFAS 154 will have a material impact on the Company’s condensed consolidated financial statements.

3.

STOCK-BASED COMPENSATION

Effective November 1, 2005, the Company adopted SFAS 123(R), which revised Statement of Financial Accounting Standard 123. SFAS 123(R) requires all share-based payment transactions with employees, including grants of employee stock options, to be recognized as compensation expense over the requisite service period based on their relative fair values. Prior to the adoption of SFAS 123(R), stock-based compensation expense related to employee stock options was not recognized in the statement of operations if the exercise price was at least equal to the market value of the common stock on the grant date, in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.” Prior to November 1, 2005, the Company had adopted the disclosure-only provisions under SFAS 123.

The Company elected to use the Modified Prospective Application (“MPA”) method for implementing SFAS 123(R). Under the MPA method, prior periods are not restated and new awards are valued and accounted for prospectively upon adoption. Outstanding prior stock option awards that are non-vested as of October 31, 2005 are recognized as compensation expense in the statement of operations over the remaining requisite service period.

The Company has stock-based compensation plans under which directors, officers and other employees are eligible to receive stock options and restricted stock awards. Generally, stock options are granted with an exercise price equal to the market value of a share of common stock on the date of grant, expire within five years and vest over three years. As of April 30, 2006, the Company’s 2002 stock option plan provides for a total of 11.0 million shares of common stock to be issued of which approximately 1.1 million shares were available for grant. As of April 30, 2006, the Company’s Incentive Stock Plan (restricted stock awards) provides for a total of 2.5 million shares of common stock to be issued of which approximately 0.25 million shares were available for grant.

The following table summarizes the activity in options under the Company’s stock based compensation plans:

 

 

 

Shares
(in thousands)

 

Weighted Average
Exercise Price

 

 

 


 


 

Options outstanding at October 31, 2005

 

7,495

 

$

20.47

 

Granted-exercise price equal to fair value

 

65

 

 

18.13

 

Exercised

 

(86

)

 

12.87

 

Forfeited

 

(65

)

 

19.56

 

 

 


 



 

Options outstanding at January 31, 2006

 

7,409

 

$

20.55

 

Granted-exercise price equal to fair value

 

116

 

 

16.77

 

Exercised

 

(98

)

 

10.37

 

Forfeited

 

(296

)

 

20.87

 

 

 


 



 

Options outstanding at April 30, 2006

 

7,131

 

$

20.61

 

 

 


 



 

Options exercisable at April 30, 2006

 

4,341

 

$

19.12

 

 

 


 



 

As of April 30, 2006, the weighted average remaining contractual term of the Company’s options outstanding and exercisable is 3.0 years and 2.5 years, respectively. As of April 30, 2006, due to the Company’s stock price, there is no aggregate intrinsic value related to options outstanding or exercisable. As of April 30, 2006, the total future unrecognized compensation cost related to outstanding unvested options is $29.4 million which will be recognized as compensation expense over the remaining vesting period.

7


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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
Notes to Unaudited Condensed Consolidated Financial Statements
(Dollars in thousands, except per share amounts)

 


The weighted average per share fair values of options granted were $7.43 and $14.85 for the three months ended April 30, 2006 and 2005, respectively, and $7.86 and $13.81 for the six months ended April 30, 2006 and 2005, respectively. The fair value of the Company’s options was estimated using the Black-Scholes option-pricing model. This model requires the input of assumptions regarding a number of complex and subjective variables that will usually have a significant impact on the fair value estimate. These variables include, but are not limited to, the volatility of the Company’s stock price and employee stock option exercise behaviors. The assumptions and variables used for the current period grants were developed based on SFAS 123(R) and SEC guidance contained in Staff Accounting Bulletin (SAB) No. 107, “Share-Based Payment.” The following table summarizes the assumptions and variables used by the Company to compute the weighted average fair value of stock option grants:

 

 

 

Three months ended
April 30,

 

Six months ended
April 30,

 

 

 


 


 

 

 

2006

 

2005

 

2006

 

2005

 

 

 


 


 


 


 

Risk free interest rate

 

4.7

%

4.0

%

4.6

%

3.8

%

Expected stock price volatility

 

55.0

%

66.1

%

55.0

%

66.8

%

Expected term until exercise (years)

 

3.5

 

5.0

 

3.7

 

4.8

 

Dividends

 

None

 

None

 

None

 

None

 

For the three and six months ended April 30, 2006, the Company used a combination of historical volatility and the implied volatility for publicly traded options on the Company’s stock as the expected volatility assumption required in the Black-Scholes option-pricing model consistent with SFAS 123(R) and SAB 107. Prior to fiscal 2006, the Company had used its historical stock price volatility in accordance with SFAS 123 for purposes of its pro forma information. The selection of the implied volatility approach was based upon the availability of actively traded options on the Company’s stock and the Company’s assessment that implied volatility is more representative of future stock price trends than historical volatility.

SFAS 123(R) requires the recognition of stock-based compensation for the number of awards that are ultimately expected to vest. As a result, for most awards, recognized stock compensation was reduced for estimated forfeitures prior to vesting primarily based on a historical annual forfeiture rate of approximately 7%. Estimated forfeitures will be reassessed at each balance sheet date and may change based on new facts and circumstances. Prior to October 31, 2005, actual forfeitures were accounted for as they occurred for purposes of required pro forma stock compensation disclosures.

Restricted stock awards are expensed on a straight-line basis over the vesting period, which typically ranges from one to four years. The following table summarizes the activity in non-vested restricted stock under the Company’s stock based compensation plans:

 

 

 

Shares
(in thousands)

 

Weighted Average
Grant Date Fair Value

 

 

 


 


 

Non-vested restricted stock at October 31, 2005

 

600

 

$

23.03

 

Granted

 

45

 

 

19.24

 

Vested

 

(52

)

 

22.35

 

Forfeited

 

(6

)

 

19.00

 

 

 


 



 

Non-vested restricted stock at January 31, 2006

 

587

 

$

22.84

 

 

 


 



 

 

 

 

 

 

 

 

Granted

 

962

 

 

15.59

 

Vested

 

(57

)

 

22.25

 

Forfeited

 

(5

)

 

22.78

 

 

 


 



 

Non-vested restricted stock at April 30, 2006

 

1,487

 

$

18.17

 

 

 


 



 

8


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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
Notes to Unaudited Condensed Consolidated Financial Statements
(Dollars in thousands, except per share amounts)

 


The following table summarizes the components and classification of stock-based compensation expense in the Company’s condensed consolidated statements of operations:

 

 

 

Three months ended
April 30,

 

Six months ended
April 30,

 

 

 


 


 

 

 

2006

 

2005

 

2006

 

2005

 

 

 


 


 


 


 

Stock options

 

$

2,134

 

$

 

$

6,662

 

$

 

Restricted stock

 

 

1,727

 

 

4,464

 

 

2,032

 

 

9,266

 

 

 



 



 



 



 

Total stock-based compensation expense

 

$

3,861

 

$

4,464

 

$

8,694

 

$

9,266

 

 

 



 



 



 



 

Selling and marketing

 

$

517

 

$

1,126

 

$

1,224

 

$

2,259

 

General and administrative

 

 

2,211

 

 

1,186

 

 

5,404

 

 

2,130

 

Research and development

 

 

1,133

 

 

2,152

 

 

2,066

 

 

4,877

 

 

 



 



 



 



 

Total stock-based compensation expense

 

$

3,861

 

$

4,464

 

$

8,694

 

$

9,266

 

 

 



 



 



 



 

Effective November 1, 2005, in connection with the adoption of SFAS 123(R), the Company capitalizes a portion of its stock-based compensation costs as software development costs. Stock-based compensation expense for the three and six months ended April 30, 2006 excludes approximately $1.9 million and $3.2 million, respectively, in stock-based compensation costs which were capitalized as software development costs in connection with the development of software titles. In prior periods, the Company’s disclosures regarding the pro forma impact on net income of stock-based compensation do not reflect the capitalization of these costs. For the three and six months ended April 30, 2005, stock-based compensation expense of approximately $1.3 million and $2.2 million, respectively, would have been capitalized.

Amortization of such capitalized costs as a component of costs of goods sold is recorded on a title-by-title basis based on the greater of the proportion of current year sales to the total of current and estimated future sales for the title or the straight-line method over the remaining estimated useful life of the title. At each balance sheet date, the Company evaluates the recoverability of capitalized software costs based on undiscounted future cash flows and charges to cost of goods sold any amounts that are deemed unrecoverable.

For the three and six months ended April 30, 2005, had the compensation cost for the Company’s stock option plans been determined based on the fair value at the grant date for awards consistent with the provisions of SFAS 123, the Company’s net income and net income per share would have been adjusted to the pro forma amounts indicated below:

 

 

 

Three months
ended
April 30, 2005

 

Six months
ended
April 30, 2005

 

 

 


 


 

Net income (loss), as reported

 

$

(8,186

)

$

47,063

 

Add: Stock-based employee compensation expense included in reported net income (loss), net of related tax effects

 

 

2,727

 

 

5,661

 

Deduct: Total stock-based employee compensation expense determined under the fair value based method for all awards, net of related tax effects

 

 

(7,530

)

 

(14,371

)

 

 



 



 

Pro forma net income (loss)

 

$

(12,989

)

$

38,353

 

 

 



 



 

Earnings (loss) per share:

 

 

 

 

 

 

 

Basic – as reported

 

$

(.12

)

$

.68

 

 

 



 



 

Basic – pro forma

 

$

(.19

)

$

.55

 

 

 



 



 

Diluted – as reported

 

$

(.12

)

$

.67

 

 

 



 



 

Diluted – pro forma

 

$

(.19

)

$

.54

 

 

 



 



 

9


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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
Notes to Unaudited Condensed Consolidated Financial Statements
(Dollars in thousands, except per share amounts)

 


4.

BUSINESS ACQUISITIONS

The acquisitions described below have been accounted for as purchase transactions. Accordingly, the results of operations and financial position of the acquired businesses are included in the Company’s condensed consolidated financial statements from the respective dates of acquisition. To the extent that the purchase price allocation for these acquisitions is preliminary, the Company does not expect that the final purchase price allocation will be materially different. Pro forma information has not been provided as the impact of these acquisitions was not material.

In November 2005, the Company acquired all of the outstanding capital stock of Firaxis Games, Inc. (“Firaxis”), a developer of PC and strategy titles, including the Civilization franchise. The purchase price of approximately $15,442 consisted of $12,500 of unregistered common stock and $4,085 of development advances previously paid to Firaxis reduced by net cash acquired of $1,143. In connection with the acquisition, the Company recorded $5,644 of identifiable intangible assets, comprised of $1,130 of non-competition agreements and $4,514 of intellectual property, $11,085 of goodwill, which is not deductible for tax purposes, $333 of net assets and $1,620 of deferred tax liabilities, on a preliminary basis. The Company also agreed to make additional payments up to $11,250 based on future product sales, of which approximately $10,000 will be recorded as additional purchase price when the conditions requiring their payment are met and $1,250 will be recorded as employee compensation expense.

In August 2005, the Company acquired all of the outstanding membership interests in Irrational Studios (“Irrational”), the developer of certain of the Company’s titles. The purchase price consisted of $4,212 in cash and $2,000 of unregistered common stock, which was payable at closing, $1,550 of development advances previously paid to Irrational and $2,000 of deferred consideration which is payable in equal amounts on the first and second anniversary of the acquisition. In connection with the acquisition, the Company recorded $2,250 of identifiable intangible assets, $7,665 of goodwill, which is deductible for tax purposes, $187 of non-current assets and $340 of net current liabilities, on a preliminary basis. The Company also agreed to make additional payments of $2,000 based on the delivery of products which will be recorded as additional purchase price when the conditions requiring their payment are met.

In June 2005, the Company acquired all of the outstanding capital stock of Gaia Capital Group and its wholly-owned subsidiaries (“Gaia”), the developers of certain of the Company’s titles for console and handheld platforms. The purchase price consisted of $5,748 in cash, $4,055 of development advances previously paid to Gaia and deferred consideration of $1,597. In connection with the acquisition, the Company recorded $3,940 of identifiable intangible assets, $7,918 of goodwill, which is deductible for tax purposes, $528 of non-current assets, and $986 of net current liabilities, on a preliminary basis.

In January 2005, the Company acquired from SEGA all of the outstanding capital stock of Visual Concepts Entertainment and its wholly-owned subsidiary, Kush Games, the developers of certain of the Company’s sports titles, and certain intellectual property rights associated with these products. The purchase price consisted of $27,794 in cash, $1,866 of prepaid royalties previously advanced to SEGA and contingent consideration of $2,593 based on the release of certain titles. In connection with the acquisition, the Company recorded $7,980 of identifiable intangible assets, $29,433 of goodwill, which is not deductible for tax purposes, $1,196 of non-current assets, $3,164 of net current liabilities and $3,192 of deferred tax liabilities related to identifiable intangible assets.

5.

INCOME TAXES

The provision (benefit) for income taxes for the three and six months ended April 30, 2006 and 2005 are based on the Company’s estimated annualized effective tax rates for the respective years. The estimated annualized effective tax rate for the six months ended April 30, 2006 is a benefit of 36.8% compared to an estimated annualized effective tax rate for the comparable period in fiscal 2005, which was an expense of 24.6%. The higher estimated annual effective tax rate in fiscal 2006 is primarily attributable to forecasted losses in higher tax rate jurisdictions. The lower effective tax rate for the comparable period in fiscal 2005 was primarily attributable to a higher proportion of forecasted earnings in lower tax rate jurisdictions.

The realization of deferred tax assets, including deferred tax assets attributable to net operating losses carried forward to future years, depends on whether the Company generates future taxable income of the appropriate type. In addition, the Company may adopt tax planning strategies to realize these assets. If future taxable income does not materialize or tax planning strategies are not effective, the Company may be required to record a valuation allowance, in whole or in part, if the Company determines that it is more likely than not that the future benefit of the deferred tax assets will not be realized.

10


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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
Notes to Unaudited Condensed Consolidated Financial Statements
(Dollars in thousands, except per share amounts)

 


At each balance sheet date, the Company evaluates its estimated annual effective tax rate based on updated information on forecasted income generated in each of its jurisdictions. Any revisions to the rates are recorded in the current period to reflect management’s current best estimate of the annual effective tax rate.

Recent tax legislation replaced the extraterritorial income (“ETI”) exclusion, subject to a phase-out of the exclusion. The Company currently derives benefits from the ETI exclusion, which is limited to 80% and 60% of the otherwise allowable exclusion in calendar years 2005 and 2006, respectively. There will be no ETI deduction available after calendar year 2006. This recent legislation replaces the ETI with a deduction from taxable income based on certain qualified income from domestic production activities. The Company does not expect to benefit from this deduction in fiscal 2006.

This legislation also provides for a one-time 85% dividends received deduction on repatriation of foreign earnings, which was applicable to the Company if utilized by December 31, 2005. Historically, the Company has considered undistributed earnings of its foreign subsidiaries to be indefinitely reinvested and, accordingly, no incremental taxes have been provided thereon. The Company did not repatriate any foreign earnings under this provision. The total amount of undistributed earnings of foreign subsidiaries was approximately $174,000 as of April 30, 2006.

The Company adopted FAS 123(R) on November 1, 2005, which requires, among other items, the recognition of stock option expense in the results of operations. As a result of the adoption of SFAS 123(R), the income tax effects of compensatory stock options are included in the computation of the income tax expense (benefit), and deferred tax assets and liabilities, subject to certain prospective adjustments to stockholders’ equity for the differences between the income tax effects of expenses recognized in the results of operations and the related amounts deducted for income tax purposes. Prior to the Company’s adoption of SFAS 123(R), the tax benefits relating to the income tax deductions for compensatory stock options were recorded directly to stockholders’ equity.

6.

NET INCOME (LOSS) PER SHARE

The following table provides a reconciliation of basic net income (loss) per share to diluted net income (loss) per share for the three and six months ended April 30, 2006 and 2005:

 

 

 

Net
Income (loss)

 

Shares
(in thousands)

 

Per Share
Amount

 

 

 


 


 


 

Three Months Ended April 30, 2006:

 

 

 

 

 

 

 

 

 

Basic and Diluted

 

$

(50,373

)

70,979

 

$

(0.71

)

 

 



 


 



 

Three Months Ended April 30, 2005:

 

 

 

 

 

 

 

 

 

Basic and Diluted

 

$

(8,186

)

70,112

 

$

(0.12

)

 

 



 


 



 

Six Months Ended April 30, 2006:

 

 

 

 

 

 

 

 

 

Basic and Diluted

 

$

(79,495

)

70,890

 

$

(1.12

)

 

 



 


 



 

Six Months Ended April 30, 2005:

 

 

 

 

 

 

 

 

 

Basic

 

$

47,063

 

69,365

 

$

0.68

 

Effect of dilutive securities – Stock options, restricted stock and warrants

 

 

 

1,313

 

 

 

 

 

 



 


 



 

Diluted

 

$

47,063

 

70,678

 

$

0.67

 

 

 



 


 



 


The computation of diluted number of shares excludes unexercised stock options, warrants and non-vested restricted shares which are antidilutive. A net loss was reported for the three and six months ended April 30, 2006, therefore, the diluted number of shares excludes 8,618 of unexercised stock options, warrants and non-vested restricted shares, which are antidilutive due to the net loss. The computation of diluted number of shares excludes 7,824 and 948 of unexercised stock options and warrants for the three and six months ended April 30, 2005, which are antidilutive.

11


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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
Notes to Unaudited Condensed Consolidated Financial Statements
(Dollars in thousands, except per share amounts)

 


7.

INVENTORIES

 

     
As of April 30, 2006 and October 31, 2005, inventories consist of:

 

 

April 30,
2006

 

October 31,
2005

 

 

 


 


 

Finished products

 

$

82,198

 

$

128,753

 

Parts and supplies

 

 

9,622

 

 

7,474

 

 

 



 



 

Total

 

$

91,820

 

$

136,227

 

 

 



 



 

Estimated product returns included in the inventory balance were $10,753 and $8,857 at April 30, 2006 and October 31, 2005, respectively.

8.

SOFTWARE DEVELOPMENT COSTS

The Company utilizes both internal development teams and third-party software developers to develop the Company’s products and the titles it publishes.

The Company capitalizes internal software development costs (including stock-based compensation, specific employee payroll and incentive compensation costs related to the completion and release of titles), as well as film production and other content costs, subsequent to establishing technological feasibility of a title. Amortization of such costs as a component of cost of goods sold (software development costs) is recorded on a title-by-title basis based on the greater of the proportion of current year net revenues to the total of current and estimated future net revenues for the title or the straight-line method over the remaining estimated useful life of the title. At each balance sheet date, the Company evaluates the recoverability of capitalized software costs based on undiscounted future cash flows and charges to cost of goods sold any amounts that are deemed unrecoverable. The amount of internally developed software included in software development costs was $54,196 and $60,324 at April 30, 2006 and October 31, 2005, respectively. Royalties earned under the Company’s internal royalty program continue to be expensed as incurred as a component of cost of goods sold (royalties).

Agreements with third-party developers generally provide the Company with exclusive publishing and distribution rights and require the Company to make advance payments that are recouped against royalties due to the developer based on the contractual amounts of product sales, adjusted for certain costs. Advance payments are capitalized subsequent to establishing technological feasibility and amortized as royalties in cost of goods sold on a title-by-title basis based on the greater of the proportion of current year net revenues to the total of current and estimated future net revenues for that title or the contractual royalty rate based on actual product net revenues as defined in the respective agreements. At each balance sheet date, the Company evaluates the recoverability of advanced development payments and unrecognized minimum commitments not yet paid to determine the amounts unlikely to be realized through product sales. Advance payments are charged to cost of goods sold in the amount that management determines is unrecoverable in the period in which such determination is made or if management determines that it will cancel a development project. Criteria used to evaluate expected product performance and to estimate future net revenues for a title include historical performance of comparable titles, orders for titles prior to release and the estimated performance of a sequel title based on the performance of the title on which the sequel is based.

The amount of software development costs resulting from advance payments and guarantees to third-party developers was $42,418 and $48,104 at April 30, 2006 and October 31, 2005, respectively.

The following table provides the details of software development costs:

 

 

Fiscal
2006

 

Fiscal
2005

 

 

 


 


 

Balance, November 1

 

$

108,428

 

$

64,322

 

Additions

 

 

32,268

 

 

39,510

 

Amortization

 

 

(22,583

)

 

(13,358

)

Write down

 

 

(520

)

 

(2,964

)

Foreign exchange

 

 

337

 

 

498

 

 

 



 



 

Balance, January 31

 

 

117,930

 

 

88,008

 

Additions

 

 

34,354

 

 

23,066

 

Amortization

 

 

(38,437

)

 

(12,779

)

Write down

 

 

(17,942

)

 

(33

)

Foreign exchange

 

 

709

 

 

(37

)

 

 



 



 

Balance, April 30

 

 

96,614

 

 

98,225

 

 

 

 

 

 

 

 

 

Less: current portion

 

 

69,431

 

 

50,802

 

 

 



 



 

Non-current portion

 

$

27,183

 

$

47,423

 

 

 



 



 

12


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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
Notes to Unaudited Condensed Consolidated Financial Statements
(Dollars in thousands, except per share amounts)

 


Software development costs at April 30, 2006 and October 31, 2005 included amounts of $88,405 and $77,544, respectively, related to titles that have not yet been released.

The increase in write-downs for the three months ended April 30, 2006 was due to impairment charges related to several titles in development. The impairment charges were based on an assessment of the future recoverability of capitalized software balances related to these titles and the determination that these titles were unlikely to recover capitalized costs given a change in sales expectations as a result of weaker market conditions, the closure and anticipated closure of development studios, uncertainty involved in the console transition and historical performance of the titles.

9.

LICENSES

Licenses consist of payments and guarantees made to licensors of intellectual property rights. The Company’s agreements with certain licensors provide for minimum guaranteed payments for intellectual property and other licensing rights which may be recouped against amounts due to the licensor based on product net revenues. Minimum guaranteed payments are initially recorded as an asset (licenses) and as a liability (accrued licenses) at the contractual amount upon execution of the contract when no significant performance remains with the licensor. When significant performance remains with the licensor, the Company records payments when actually due.

Licenses are amortized as royalties in cost of goods sold on a title-by-title basis based on the greater of the proportion of current year net revenues to the total of current and estimated future net revenues for that title or the contractual royalty rate based on actual net product sales as defined in the respective agreements. At each balance sheet date, the Company evaluates licenses as well as any unrecognized minimum commitments not yet paid to determine the amounts unlikely to be realized through product sales. License-based assets are charged to cost of goods sold in the amount that management determines is not probable of being recouped at the contractual royalty rate based on current and future net revenues in the period in which such determination is made. Criteria used to evaluate expected product performance and to estimate future sales for a title include historical performance of comparable titles, orders for titles prior to release and the estimated performance of a sequel title based on the performance of the title on which the sequel is based.

The following table provides the details of licenses:

 

 

 

Fiscal
2006

 

Fiscal
2005

 

 

 


 


 

Balance, November 1

 

$

9,981

 

$

5,665

 

Additions

 

 

6,096

 

 

4,480

 

Amortization

 

 

(4,943

)

 

(1,256

)

Write down

 

 

 

 

(400

)

 

 



 



 

Balance, January 31

 

 

11,134

 

 

8,489

 

 

 

 

 

 

 

 

 

Additions

 

 

1,122

 

 

1,076

 

Amortization

 

 

(3,019

)

 

(934

)

Write down

 

 

 

 

 

 

 



 



 

Balance, April 30

 

 

9,237

 

 

8,631

 

 

 

 

 

 

 

 

 

Less: current portion

 

 

4,253

 

 

5,981

 

 

 



 



 

Non-current portion

 

$

4,984

 

$

2,650

 

 

 



 



 

13


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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
Notes to Unaudited Condensed Consolidated Financial Statements
(Dollars in thousands, except per share amounts)

 


Included in licenses at April 30, 2006 and October 31, 2005 are $8,066 and $5,466, respectively, related to titles that have not yet been released.

10.

FIXED ASSETS, NET

As of April 30, 2006 and October 31, 2005, fixed assets consist of:

 

 

 

April 30,
2006

 

October 31,
2005

 

 

 


 


 

Computer equipment

 

$

27,174

 

$

22,893

 

Office equipment

 

 

15,707

 

 

13,940

 

Computer software

 

 

31,239

 

 

26,411

 

Furniture and fixtures

 

 

6,667

 

 

6,338

 

Leasehold improvements

 

 

19,635

 

 

19,031

 

Capital leases

 

 

398

 

 

398

 

   

 

 

 

 

 

100,820

 

 

89,011

 

Less: accumulated depreciation and amortization

 

 

51,024

 

 

40,394

 

   

 

 

Total

 

$

49,796

 

$

48,617

 

   

 

 


Depreciation expense for the three and six months ended April 30, 2006 and 2005 was $5,479 and $3,876, respectively, and $10,656 and $7,325, respectively.

11.

INTANGIBLES, NET

Intangible assets consist of trademarks, customer lists and relationships, intellectual property, non-competition agreements and acquired technology in connection with acquisitions. Intangible assets are amortized under the straight-line method over the period of expected benefit ranging from three to ten years or amortized based on the expected revenue stream.

 

 

 

 

 

April 30, 2006

 

October 31, 2005

 

 

 

 

 


 


 

 

 

Range of
Useful Life
(Years)

 

Gross
Carrying
Amount

 

Accumulated
Amortization

 

Net

 

Gross
Carrying
Amount

 

Amortization
Accumulated

 

Net

 

 

 


 


 


 


 


 


 


 

Trademarks

 

7-10 years

 

$

17,716

 

$

(7,780

)

$

9,936

 

$

29,365

 

$

(14,145

)

$

15,220

 

Customer lists and relationships

 

5-10 years

 

 

4,673

 

 

(3,420

)

 

1,253

 

 

4,673

 

 

(3,282

)

 

1,391

 

Intellectual property

 

2-6 years

 

 

70,393

 

 

(40,375

)

 

30,018

 

 

69,927

 

 

(36,371

)

 

33,556

 

Non-competition agreements

 

3-6 years

 

 

7,700

 

 

(4,579

)

 

3,121

 

 

8,738

 

 

(4,472

)

 

4,266

 

Technology

 

3 years

 

 

11,509

 

 

(6,921

)

 

4,588

 

 

9,032

 

 

(4,799

)

 

4,233

 

 

 

 

 



 



 



 



 



 



 

Total

 

 

 

$

111,991

 

$

(63,075

)

$

48,916

 

$

121,735

 

$

(63,069

)

$

58,666

 

 

 

 

 



 



 



 



 



 



 

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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements

(Dollars in thousands, except per share amounts)

 


Amortization expense for the three and six months ended April 30, 2006 and 2005 is as follows:

 

 

 

Three months ended
April 30,

 

Six months ended
April 30,

 

 


 


 

 

2006

 

2005

 

2006

 

2005

 

 


 


 


 


Included in:

 

 

 

 

 

 

 

 

 

 

 

 

Cost of goods sold – product costs

 

$

4,233

 

$

3,238

 

$

6,310

 

$

5,909

Depreciation and amortization

 

 

1,371

 

 

1,226

 

 

2,845

 

 

2,563

 

 



 



 



 



Total amortization expense

 

$

5,604

 

$

4,464

 

$

9,155

 

$

8,472

 

 



 



 



 



Estimated amortization expense for the fiscal years ending October 31, is as follows:

 

Remainder of 2006

 

$

6,637

2007

 

 

12,117

2008

 

 

11,239

2009

 

 

10,252

2010

 

 

4,164

Thereafter

 

 

4,507

 

 



Total

 

$

48,916

 

 



For the six months ended April 30, 2006, the decrease in intangible assets is primarily due to impairment charges of approximately $6.3 million related to the write-off of certain trademarks and acquired intangibles in the three months ended April 30, 2006 offset by an increase in trademarks and other intangibles in connection with the acquisition of Firaxis (See Note 4).

12.

LINES OF CREDIT

In August 2005, the Company entered into a new credit agreement with JPMorgan Chase Bank, N.A. (“JPMorgan”), and terminated its credit agreement with Bank of America, N.A. The JPMorgan credit agreement provides for borrowings of up to $50,000 through the expiration of the agreement on August 23, 2006. Advances under the credit agreement bear interest at a rate of 0.25% to 0.75% over the bank’s prime rate, or at the Eurodollar rate plus 1.25% to 1.75% depending on the Company’s consolidated leverage ratio. The Company is required to pay a commitment fee to the bank equal to 0.25% of the unused loan balance and borrowings under the agreement are collateralized by certain of the Company’s assets. The credit agreement also contains financial and other covenants (including a consolidated asset coverage ratio) and limits or prohibits the Company from paying cash dividends, merging or consolidating with another corporation, selling or acquiring assets (other than in the ordinary course of business), creating liens and incurring additional indebtedness. Available borrowings under the agreement are reduced by the amount of any outstanding stand-by letters of credit, which is $1,560 at April 30, 2006. The Company had no borrowings under the credit agreement and was in compliance with all financial and other covenants at April 30, 2006.

In May 2006, the Company’s United Kingdom subsidiary renewed its credit facility agreement with Lloyds TSB Bank plc (“Lloyds”) under which Lloyds agreed to make available borrowings of up to approximately $23,000. Advances under the credit facility bear interest at the rate of 1.25% per annum over the bank’s base rate, and are guaranteed by the Company. Available borrowings under the agreement are reduced by the amount of outstanding guarantees. The facility expires on March 31, 2007. The Company had no outstanding guarantees and no borrowings under this facility as of April 30, 2006.

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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements

(Dollars in thousands, except per share amounts)

 


13.

ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES

Accrued expenses and other current liabilities as of April 30, 2006 and October 31, 2005 consist of:

 

 

 

April 30,
2006

 

October 31,
2005

 

 


 


Royalties

 

$

57,635

 

$

17,940

Compensation and benefits

 

 

15,544

 

 

23,729

Licenses

 

 

25,891

 

 

9,743

Deferred revenue

 

 

6,882

 

 

6,414

Rent and deferred rent obligations

 

 

7,352

 

 

6,484

Co-op advertising

 

 

4,523

 

 

3,802

Professional fees

 

 

3,906

 

 

7,219

Freight

 

 

1,261

 

 

2,321

Other

 

 

12,514

 

 

13,050

 

 



 



Total

 

$

135,508

 

$

90,702

 

 



 



14.

LEGAL AND OTHER PROCEEDINGS

The Federal Trade Commission (“FTC”) has concluded its previously reported inquiry regarding the advertising claims for Grand Theft Auto: San Andreas following the re-rating of the title by the Entertainment Software Rating Board (“ESRB”). In June 2006, the Company entered into an agreement with the FTC containing a Consent Order under which the Company agreed to settle all outstanding matters pending before the FTC. The proposed consent agreement with the FTC requires Take-Two and Rockstar Games to clearly and prominently disclose on product packaging and in any promotion or advertisement for electronic games, content relevant to the rating, unless that content had been disclosed sufficiently in prior submissions to the rating authority. In addition, the companies cannot misrepresent the rating or content descriptors for an electronic game and the companies must establish, implement, and maintain a comprehensive system reasonably designed to ensure that all content in an electronic game is considered and reviewed in preparing submissions to a rating authority. The Consent Order, under which no penalties or fines have been assessed, and an accompanying Complaint are subject to a 30-day period for public comment.

In July 2005, the Company received three purported class action complaints against the Company and its subsidiary, Rockstar Games, two of which were filed in the United States District Court for the Southern District of New York and one such complaint which was filed in the United States District Court, Eastern District of Pennsylvania. On September 8, 2005, another similar complaint was filed in the Circuit Court for the Twentieth Judicial District, St. Clair County, Illinois and then removed to United States District Court for the Southern District of Illinois. The plaintiffs, alleged purchasers of the Company’s Grand Theft Auto: San Andreas game, allege that the Company and Rockstar Games engaged in consumer deception, false advertising and common law fraud and were unjustly enriched as a result of the alleged failure of the Company and Rockstar Games to disclose that Grand Theft Auto: San Andreas contained “hidden” content, which resulted in the game receiving an “M” rating from the ESRB rather than an “AO” rating. The complaints seek unspecified damages, declarations of various violations of law and litigation costs. The New York and Pennsylvania actions have been consolidated in the Southern District of New York under the caption In re Grand Theft Auto Video Game Consumer Litigation, (05-CV-6734 (BSJ)) and the Illinois action has been transferred to the Southern District of New York for coordinated pretrial proceedings pursuant to an Order of Judicial Panel on Multidistrict Litigation. The plantiffs must now file an Amended Consolidated Complaint.

In January 2006, the City Attorney for the City of Los Angeles filed a complaint against the Company and Rockstar Games in the Superior Court of the State of California. The complaint alleges that the Company and Rockstar Games violated sections of the California Business and Professions Code prohibiting untrue and misleading statements and unfair competition and that the Company and Rockstar Games were unjustly enriched as a result of the alleged failure to disclose that Grand Theft Auto: San Andreas contained “hidden” content which should have resulted in the game receiving an Adults Only (“AO”) rating from the ESRB rather than a Mature (“M”) rating. The complaint also alleges that the Company made misleading statements as to the origin of the “hidden” content. The complaint seeks injunctive relief, restitution for purchasers of the game and civil fines. The action has been removed to the United States District Court, Central District of California and the Company has moved to dismiss the complaint. The plaintiff has moved to remand the action to state court and the Judicial Panel on Multidistrict Litigation has issued an order transferring the action to the Southern District of New York. The Company has also received requests for documents and information from the Attorneys General of the States of North Carolina and Connecticut relating to Grand Theft Auto: San Andreas. These matters have remained dormant.

16


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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements

(Dollars in thousands, except per share amounts)

 


In February and March 2006, an aggregate of four purported class action complaints were filed against the Company, its Chief Executive Officer, Chief Financial Officer and former Chief Global Operating Officer in the United States District Court for the Southern District of New York (the “New York Actions”) and one such purported class action was filed in the United States District Court for the Eastern District of Michigan (the “Michigan Action”). The New York plaintiffs are Max Kaplan, John Fenninger, David Andrews and David Toth and the Michigan plaintiff was The City of Flint and Daniel J. Hall on behalf of The City of Flint Employees’ Retirement Pension Fund. The complaints allege that the defendants violated Sections 10(b), 20(a) and Rule 10b-5 of the Securities Exchange Act of 1934 (“Exchange Act”) by making or causing the Company to make untrue statements or failing to disclose in certain press releases and SEC periodic reports that, among other things: Grand Theft Auto: San Andreas contained “hidden” content which should have resulted in the game receiving an Adults Only (“AO”) rating from the ESRB rather than a Mature (“M”) rating; the defendants attempted to bolster sales of Grand Theft Auto: San Andreas by concealing the “adult content” from retailers who refused to carry AO material; the Company’s management failed to keep the Board of Directors informed of important issues or failed to do so in a timely fashion; and the Company was misstating capitalized software development costs and amortization expense and had inadequate internal controls and procedures to ensure accuracy in its reported financial results. The plaintiffs seek to recover unspecified damages and their costs. The plaintiffs in the Michigan Action voluntarily dismissed their complaint without prejudice. A motion to consolidate the New York Actions and appoint a lead plaintiff is pending.

In January 2006, the St. Clair Shores General Employees Retirement System filed a purported class and derivative action complaint in the Southern District of New York against the Company, as nominal defendant, and certain of the Company’s officers and directors and certain former officers and directors. The factual allegations in this action are similar to the allegations contained in the New York Actions. Plaintiff asserts that certain defendants breached their fiduciary duty by selling Company stock while in possession of certain material non-public information and breached their fiduciary duty and violated Section 14(a) and Rule 14a-9 of the Exchange Act by failing to disclose material facts in the Company’s 2003, 2004 and 2005 proxy statements in which the Company solicited approval to increase share availability under its 2002 Stock Option Plan. Plaintiff seeks the return of all profits from the alleged insider trading conducted by the individual defendants who sold Company stock, unspecified compensatory damages with interest and their costs in the action. A motion to stay the action pending the determination of an investigation by a Special Litigation Committee of the Board is pending.

In January 2006, Todd Veeck filed a complaint in the Court of Chancery of the State of Delaware against the Company pursuant to the 8 Del. C. § 220 to compel inspection of the Company’s books and records in order to “investigate” possible breaches of fiduciary duties with regard to the creation, development, marketing and sale of the Company’s Grand Theft Auto line of products.

In February 2005, the personal representatives of the Estates of Arnold Strickland and Ace Mealer brought an action in the Circuit Court of Fayette County, Alabama against the Company, Sony Computer Entertainment America Inc. (“SCEA”), Sony Corporation of America (“SCA”), Wal-Mart, GameStop and Devin Moore alleging under Alabama’s manufacturers’ liability and wrongful death statutes that the Company’s video games designed, manufactured, marketed and/or supplied to Mr. Moore resulted in “copycat violence” that caused the death of Messrs. Strickland and Mealer. The suit seeks damages (including punitive damages) against all of the defendants in excess of $600 million. Wal-Mart, SCEA and SCA have tendered their defense and requested indemnification from the Company, and the Company has accepted such tender. The Company’s motion to dismiss the action was denied and the Company moved to have certain issues certified for an immediate interlocutory appeal before the Alabama Supreme Court. The Company also separately pursued a petition to dismiss claims against it and its subsidiary, Rockstar Games, for lack of personal jurisdiction. The Alabama Supreme Court declined to accept the interlocutory appeal, but agreed to hear the petition to dismiss the action for lack of personal jurisdiction. Briefing has been completed on such petition, and the matter is now pending before the Supreme Court. In April 2006, the plaintiffs filed a Third Amended Complaint to add a claim for civil conspiracy; the Company and its co-defendants have moved to dismiss that claim and the motion is scheduled for hearing before the trial court. In April 2006, the trial court entered a Scheduling Order that set (a) a hearing on the admissibility of Plaintiffs’ expert opinions for October 5, 2006; (b) completion of all fact and expert discovery by May 15, 2007; (c) mediation for June 1, 2007; and (d) trial (if necessary) to commence on July 1, 2007.

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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements

(Dollars in thousands, except per share amounts)

 


The Company intends to vigorously defend and seek dismissal of these matters and, with respect to the derivative actions, the Company has been advised that the individual defendants will vigorously defend such actions. However, the Company cannot predict the outcome of these matters and, if determined adversely to the Company, such matters, either singly or in the aggregate, could result in the imposition of significant judgments, fines and/or penalties which could have a material adverse effect on the Company’s financial condition, cash flows or results of operations.

The Company is also involved in routine litigation in the ordinary course of its business, which in management’s opinion will not have a material adverse effect on the Company’s financial condition, cash flows or results of operations.

15.

COMMITMENTS AND CONTINGENCIES

A summary of annual minimum contractual obligations and commitments as of April 30, 2006 is as follows:

Fiscal Years Ending October 31,

 

Licensing and
Marketing
Agreements

 

Software
Development
Agreements

 

Leases

 

Distribution
Agreements

 

Total


 


 


 


 


 


Remainder of 2006

 

$

46,138

 

$

25,822

 

$

8,743

 

$

4,042

 

$

84,745

2007

 

 

60,602

 

 

26,807

 

 

16,506

 

 

 

 

103,915

2008

 

 

54,826

 

 

13,075

 

 

15,124

 

 

 

 

83,025

2009

 

 

55,634

 

 

39

 

 

14,809

 

 

 

 

70,482

2010

 

 

55,692

 

 

 

 

13,079

 

 

 

 

68,771

Thereafter

 

 

102,655

 

 

 

 

34,793

 

 

 

 

137,448

 

 



 



 



 



 



 

$

375,547

 

$

65,743

 

$

103,054

 

$

4,042

 

$

548,386

 

 



 



 



 



 



Licensing and Marketing Agreements: The Company’s license expense consists primarily of payments made to licensors for intellectual property rights under agreements which expire at various times through December 2012. As of April 30, 2006, the Company has minimum guaranteed licensing and marketing commitments of $375,547 outstanding, of which $3,328 are recorded in the Company’s condensed consolidated balance sheet as the licensor does not have any significant performance obligation to the Company. Minimum guaranteed licensing and marketing commitments primarily reflect the Company’s agreements with major sports leagues and players’ associations.

Software Development Agreements: The Company’s payments made to third-party software developers include contractual advances and royalties under agreements which expire at various times through November 2008. Assuming performance by third-party developers, the Company has aggregate outstanding commitments of $65,743 under various software development agreements at April 30, 2006. The Company has also established an internal royalty program pursuant to which it pays royalties to certain of its development personnel based on product sales. Royalties earned under the Company’s internal royalty program continue to be expensed as incurred.

Lease Commitments: The Company’s offices and warehouse facilities are occupied under non-cancelable operating leases expiring at various times from June 2006 to July 2015. The Company also leases certain furniture, equipment and automobiles under non-cancelable leases expiring through April 2010. Future minimum rental payments for fiscal 2006 are $8,743 and aggregate minimum rental payments through applicable lease expirations are $103,054.

Distribution Agreements: The Company periodically enters into distribution agreements to purchase various software games. These agreements, which expire at various dates through January 2007, require remaining aggregate minimum guaranteed payments of $4,042 at April 30, 2006.

Contingent Consideration: In November 2005, in connection with the acquisition of Firaxis, the Company agreed to make additional payments of $11,250 based on future product sales, of which approximately $10,000 will be recorded as additional purchase price and $1,250 will be recorded as employee compensation expense.

In fiscal 2005, in connection with the acquisition of Irrational, the Company agreed to make additional payments of $2,000 to the former owners of Irrational based on the delivery of products. The Company does not anticipate making these contingent payments within the next twelve months due to the expected timing of product releases. Additionally, in fiscal 2005, in connection with the acquisition of Visual Concepts and Kush Games, the Company agreed to make additional payments of approximately $1,400 to SEGA based on the commercial release of products. The additional payments to SEGA are expected to be made in fiscal 2006.

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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements

(Dollars in thousands, except per share amounts)

 


In March 2005, the Company renegotiated a $6,000 contingent obligation due upon delivery of the final PC version of Duke Nukem Forever through the payment of $4,250 and issuance of a promissory note in the principal amount of $500. The payment of the promissory note is contingent upon the commercial release of such product prior to December 31, 2006.

In fiscal 2004, in connection with the acquisition of Mobius Entertainment Limited (“Mobius”), the Company agreed to make additional contingent payments of approximately $2,000 based on the delivery of products. In fiscal 2003, the Company also agreed to make additional payments of up to $2,500 to the former owners of Cat Daddy Games LLC (“Cat Daddy”) based on a percentage of Cat Daddy’s future profits for the first three years after acquisition. The Company does not anticipate making these contingent payments within the next twelve months.

16.

SEGMENT REPORTING

The Company is a publisher and distributor of interactive software games designed for personal computers, video game consoles and handheld platforms. The Company’s operations involve similar products and customers worldwide and include products which are developed and sold domestically and internationally. Publishing revenues are derived from the sale of internally developed software titles and software titles developed by third parties. Distribution revenues are derived from the sale of third-party software titles, accessories and hardware to retail outlets in North America. Generally, publishing activities generate higher margins than distribution activities, with sales of PC software titles resulting in higher margins than sales of product designed for video game consoles and handheld platforms.

The Company’s chief operating decision maker is considered to be the Chief Executive Officer. The Company continues to be centrally managed and the chief operating decision maker primarily uses consolidated financial information supplemented by sales information by product category, major product title and platform for making operational decisions and assessing financial performance.

Beginning February 1, 2006, the Company’s chief operating decision maker has been presented with financial information that contains additional information that separately identifies the Company’s publishing and distribution activities, including gross margin information. Accordingly, the Company currently considers its publishing and distribution activities as two separate reportable segments. The Company is presenting prior period financial information to reflect this change and to conform to current year presentation.

The Company’s view and reporting of business segments may change due to variations in the underlying business facts and circumstances and the evolution of the reporting to its chief operating decision maker.

Information about the Company’s reportable segments as of April 30, 2006 and October 31, 2005 and for the three and six months ended April 30, 2006 and 2005 is as follows:

 

 

 

As of April 30, 2006

 

As of October 31, 2005

 

 

 


 


 

 

 

Publishing

 

Distribution

 

Total

 

Publishing

 

Distribution

 

Total

 

 

 


 


 


 


 


 


 

Accounts receivable

 

$

43,323

$

87,005

$

130,328

 

$

133,966

 

$

64,102

 

$

198,068

 

Inventory

 

47,162

44,658

91,820

 

 

55,119

 

 

81,108

 

 

136,227

 

Long-term assets

 

302,587

30,585

333,172

 

 

289,190

 

 

30,444

 

 

319,634

 

Total assets

 

693,097

212,920

906,017

 

 

735,975

 

 

196,901

 

 

932,876

 

 

 

 

Three months ended April 30, 2006

 

Three months ended April 30, 2005

 

 

 


 


 

 

 

Publishing

 

Distribution

 

Total

 

Publishing

 

Distribution

 

Total

 

 

 


 


 


 


 


 


 

Net revenues

 

$

200,060

$

65,062

$

265,122

 

$

146,923

 

$

75,145

 

$

222,068

 

Gross profit

 

11,104

6,668

17,772

 

 

70,375

 

 

1,471

 

 

71,846

 

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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements

(Dollars in thousands, except per share amounts)

 


 

 

 

Six months ended April 30, 2006

 

Six months ended April 30, 2005

 

 

 


 


 

 

 

Publishing

 

Distribution

 

Total

 

Publishing

 

Distribution

 

Total

 

 

 


 


 


 


 


 


 

Net revenues

 

$

358,349

$

171,754

$

530,103

 

$

502,307

 

$

222,235

 

$

724,542

 

Gross profit

 

59,254

14,185

73,439

 

 

238,973

 

 

13,448

 

 

252,421

 

The publishing segment gross profit for the three and six months ended April 30, 2006 included impairment charges of approximately $17.9 million and $18.5 million, respectively, due to the write-down of several titles.

Information about the Company’s total non-current assets in the United States, Canada and international areas as of April 30, 2006 and October 31, 2005 is presented below:

 

 

 

April 30,
2006

 

October 31,
2005

 

 

 


 


 

Non-current assets:

 

 

 

 

 

 

 

United States

$

236,775

 

$

208,947

 

Canada

10,946

 

 

13,353

 

International:

 

 

 

 

United Kingdom

36,648

 

 

28,013

 

Switzerland

14,511

 

 

29,410

 

All other Europe

23,566

 

 

29,749

 

Other

10,726

 

 

10,162

 

 

 



 



 

Total

$

333,172

 

$

319,634

 

 

 



 



 

Information about the Company’s net revenues in the United States, Canada and international areas for the three and six months ended April 30, 2006 and 2005 is presented below (net revenues are attributed to geographic areas based on product destination):

 

 

 

Three months ended April 30,

 

Six months ended April 30,

 

 

 


 


 

 

 

2006

 

2005

 

2006

 

2005

 

 

 


 


 


 


 

Net revenues:

 

 

 

 

 

 

 

 

 

 

 

 

 

United States

$

172,896

 

$

136,937

$

329,823

 

$

433,104

 

Canada

19,084

 

 

17,919

51,757

 

 

52,095

 

International:

 

 

 

 

 

 

 

United Kingdom

18,848

 

 

18,397

39,036

 

 

83,373

 

All other Europe

46,013

 

 

41,110

93,654

 

 

135,460

 

Asia Pacific

7,512

 

 

6,752

13,524

 

 

18,289

 

Other

769

 

 

953

2,309

 

 

2,221

 

 

 



 



 



 



 

Total

$

265,122

 

$

222,068

$

530,103

 

$

724,542

 

 

 



 



 



 



 

North America

72.4

%

 

69.7

%

72.0

%

 

67.0

%

International

27.6

%

 

30.3

%

28.0

%

 

33.0

%

20


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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements

(Dollars in thousands, except per share amounts)

 


Information about the Company’s net revenues by product platforms for the three and six months ended April 30, 2006 and 2005 is presented below:

 

 

 

Three months ended April 30,

 

Six months ended April 30,

 

 

 


 


 

 

 

2006

 

2005

 

2006

 

2005

 

 

 


 


 


 


 

Platforms:

 

 

 

 

 

 

 

 

 

 

 

 

 

Sony PlayStation 2

 

$

48,109

 

$

100,660

 

$

112,312

 

$

453,272

 

Microsoft Xbox 360

 

 

80,053

 

 

 

 

98,166

 

 

 

Sony PSP

 

 

17,740

 

 

3,334

 

 

71,653

 

 

3,334

 

Microsoft Xbox

 

 

14,525

 

 

46,389

 

 

32,765

 

 

88,762

 

PC

 

 

56,896

 

 

31,111

 

 

88,943

 

 

53,751

 

Nintendo Handhelds

 

 

13,372

 

 

15,369

 

 

40,859

 

 

41,914

 

Nintendo GameCube

 

 

2,706

 

 

5,118

 

 

8,870

 

 

18,635

 

Hardware

 

 

19,971

 

 

10,283

 

 

49,511

 

 

34,803

 

Accessories and other

 

 

11,750

 

 

9,804

 

 

27,024

 

 

30,071

 

 

 



 



 



 



 

Total

 

$

265,122

 

$

222,068

 

$

530,103

 

$

724,542

 

 

 



 



 



 



 

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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES

(Dollars in thousands, except per share amounts)

 


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

Overview

We are a leading global publisher of interactive software games designed for personal computers, and video game consoles and handheld platforms manufactured by Sony, Microsoft and Nintendo. We also distribute our products as well as third-party software, hardware and accessories to retail outlets in North America through our Jack of All Games subsidiary, and we have sales, marketing and publishing operations in Australia, Austria, Canada, China, France, Germany, Italy, Japan, The Netherlands, New Zealand, Spain, Switzerland and the United Kingdom.

Our principal sources of revenue are derived from publishing and distribution operations. Publishing revenues are derived from the sale of internally developed software titles and software titles developed by third parties. Operating margins in our publishing business are dependent in part upon our ability to continually release new, commercially successful products and to manage costs associated with business and product acquisitions and software product development. We develop most of our frontline products internally, and we own major intellectual properties, which we believe positions us to maximize profitability. Operating margins for titles developed by third parties, or for which we do not own the intellectual property, are affected by costs to acquire licenses and amounts due to developers.

Our distribution revenues are derived from the sale of third-party software titles, accessories and hardware. Operating margins in our distribution business are dependent in part on the mix of software and hardware sales, with software generating higher margins than hardware. Publishing activities generate significantly higher margins than distribution activities, with sales of PC software titles resulting in higher margins than sales of products designed for video game consoles and handheld platforms.

We have pursued a growth strategy by capitalizing on the widespread market acceptance of video game consoles, as well as the growing popularity of innovative action games that appeal to mature audiences. We have established a portfolio of successful proprietary software content for the major hardware platforms. We expect to continue to be a leader in the mature, action product category by leveraging our existing franchises and developing new brands.

We have diversified our product offerings by capitalizing on significant growth opportunities in the market for sports and other licensed action and strategy titles. During fiscal 2005 and the six months ended April 30, 2006, we made several strategic acquisitions of leading sports and strategy game development studios and entered into license agreements with major sports leagues to develop sports titles. We also entered into license agreements for several popular entertainment properties, acquired well-known intellectual property rights, and entered into distribution and publishing arrangements for major action and strategy PC titles.

The video game industry is currently undergoing a transition due to the introduction of next generation hardware platforms and new software for these platforms. In 2005, Sony introduced the PlayStation Portable (PSP), a new handheld gaming system, followed by Microsoft’s release of the Xbox 360, a next generation console platform. Sony is expected to introduce the PlayStation 3 and Nintendo is planning the launch of the Wii console system during 2006. During the transition to next generation hardware platforms, our operating results may become more volatile and more difficult to predict. Additionally, our publishing and distribution net revenues may slow or decline during the transition period, due to downward pressure on software pricing on current generation platforms, limited initial availability of new hardware platforms and a decline in consumer purchases in anticipation of next generation platforms becoming available. See Part II-Item 1A. “Risk Factors.”

In response to the current business environment during the industry transition and our assessment of market conditions, we have taken steps to streamline our operations by implementing cost saving initiatives including the closure of two underperforming development studios. In the second quarter of fiscal 2006, we recorded non-cash impairment charges of approximately $24.3 million related to several titles, certain trademarks and acquired intangibles, and incurred severance and other costs of approximately $2.0 million associated with development studio closings. We expect to incur additional costs in connection with the closure of a third studio in May 2006.

Estimates

The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of net revenues and expenses during the reporting periods. The most significant estimates and assumptions relate to the adequacy of allowances for returns, price concessions and doubtful accounts; the amortization and recoverability of capitalized software development costs, licenses and other intangibles; valuation of inventories, fair value of stock compensation and realization of deferred income taxes. Actual amounts could differ significantly from these estimates.

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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES

(Dollars in thousands, except per share amounts)

 


Stock Split

In April 2005, we effected a three-for-two stock split in the form of a stock dividend. Accordingly, all share and per-share data in the accompanying unaudited condensed consolidated financial statements and notes thereto give retroactive effect to the stock split.

Critical Accounting Policies

Revenue Recognition

We recognize revenue upon the transfer of title and risk of loss to our customers. We apply the provisions of Statement of Position 97-2, “Software Revenue Recognition” in conjunction with the applicable provisions of Staff Accounting Bulletin No. 104, “Revenue Recognition.” Accordingly, we recognize revenue for software when there is (1) persuasive evidence that an arrangement with our customer exists, which is generally a customer purchase order, (2) the software is delivered, (3) the selling price is fixed or determinable and (4) collection of the customer receivable is deemed probable. Our payment arrangements with customers typically provide net 30 and 60-day terms.

Revenue is recognized after deducting estimated reserves for returns and price concessions. In specific circumstances when we do not have a reliable basis to estimate returns and price concessions or are unable to determine that collection of receivables is probable, we defer the revenue until such time as we can reliably estimate any related returns and allowances and determine that collection of the receivables is probable.

Allowances for Returns and Price Concessions

We accept returns and grant price concessions in connection with our publishing arrangements. Following reductions in the price of our products, we grant price concessions to permit customers to take credits against amounts they owe us with respect to merchandise unsold by them. Our customers must satisfy certain conditions to entitle them to return products or receive price concessions, including compliance with applicable payment terms and confirmation of field inventory levels.

Our distribution arrangements with customers do not give them the right to return titles or to cancel firm orders. However, we sometimes accept returns from our distribution customers for stock balancing and make accommodations to customers, which include credits and returns, when demand for specific titles falls below expectations.

We make estimates of future product returns and price concessions related to current period product revenue. We estimate the amount of future returns and price concessions for published titles based upon, among other factors, historical experience and performance of the titles in similar genres, historical performance of the hardware platform, customer inventory levels, analysis of sell-through rates, sales force and retail customer feedback, industry pricing, market conditions and changes in demand and acceptance of our products by consumers.

Significant management judgments and estimates must be made and used in connection with establishing the allowance for returns and price concessions in any accounting period. We believe we can make reliable estimates of returns and price concessions. However, actual results may differ from initial estimates as a result of changes in circumstances, market conditions and assumptions. Adjustments to estimates are recorded in the period in which they become known.

Software Development Costs

We utilize both internal development teams and third-party software developers to develop our products. We capitalize internal software development costs (including stock-based compensation, specific employee payroll and incentive compensation costs related to the completion and release of titles), as well as film production and other content costs, subsequent to establishing technological feasibility of a title. Amortization of such costs as a component of cost of goods sold (software development costs) is recorded on a title-by-title basis based on the greater of the proportion of current year sales to the total of current and estimated future sales for the title or the straight-line method over the remaining estimated useful life of the title. At each balance sheet date, we evaluate the recoverability of capitalized software costs based on undiscounted future cash flows and charge to cost of goods sold any amounts that are deemed unrecoverable. Royalties earned under our internal royalty program continue to be expensed as incurred as a component of cost of goods sold (royalties).

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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES

(Dollars in thousands, except per share amounts)

 


Our agreements with third-party developers generally provide us with exclusive publishing and distribution rights and require us to make advance payments that are recouped against royalties due to the developer based on the contractual amounts of product sales, adjusted for certain costs. Advance payments are capitalized subsequent to establishing technological feasibility and amortized as royalties in cost of goods sold on a title-by-title basis based on the greater of the proportion of current year sales to the total of current and estimated future sales for that title or the contractual royalty rate based on actual net product sales as defined in the respective agreements. At each balance sheet date, we evaluate the recoverability of advanced development payments and unrecognized minimum commitments not yet paid to determine the amounts unlikely to be realized through product sales. Advance payments are charged to cost of goods sold in the amount that management determines is unrecoverable in the period in which such determination is made or if management determines that it will cancel a development project. Criteria used to evaluate expected product performance and to estimate future sales for a title include historical performance of comparable titles, orders for titles prior to release and the estimated performance of a sequel title based on the performance of the title on which the sequel is based.

Licenses

Licenses consist of payments and guarantees made to licensors of intellectual property rights. Our agreements with certain licensors provide for minimum guaranteed payments for intellectual property licenses and other licensing rights which may be recouped against amounts due to the licensor or developer based on product sales. Minimum guaranteed payments are initially recorded as an asset (licenses) and as a liability (accrued licenses) at the contractual amount upon execution of the contract when no significant performance remains with the licensor. When significant performance remains with the licensor, we record payments when actually due.

Licenses are amortized as royalties in cost of goods sold on a title-by-title basis based on the greater of the proportion of current year sales to the total of current and estimated future sales for that title or the contractual royalty rate based on actual net product sales as defined in the respective agreements. At each balance sheet date, we evaluate licenses as well as any unrecognized minimum commitments not yet paid to determine the amounts unlikely to be realized through product sales. License-based assets are charged to cost of goods sold in the amount that management determines is not probable of being recouped at the contractual royalty rate based on current and future sales in the period in which such determination is made. Criteria used to evaluate expected product performance and to estimate future sales for a title include historical performance of comparable titles, orders for titles prior to release and the estimated performance of a sequel title based on the performance of the title on which the sequel is based.

Income Taxes

Income tax assets and liabilities are determined by taxable jurisdiction. We do not provide taxes on undistributed earnings of our international subsidiaries. The total amount of undistributed earnings of foreign subsidiaries was approximately $174,000 as of April 30, 2006. It is currently our intention to reinvest undistributed earnings of our foreign subsidiaries and thereby indefinitely postpone their remittance. Accordingly, no provision has been made for foreign withholding taxes or United States income taxes which may become payable if undistributed earnings of foreign subsidiaries are paid as dividends. The realization of deferred tax assets depends on whether we generate future taxable income of the appropriate type. In addition, we may adopt tax planning strategies to realize these assets. If future taxable income does not materialize or tax planning strategies are not effective, we may be required to record a valuation allowance.

Recent tax legislation currently in place is intended to replace the extraterritorial income (“ETI”) exclusion. We currently derive benefits from the ETI exclusion, which is limited to 80% and 60% of the otherwise allowable exclusion for calendar years 2005 and 2006, respectively. There will be no ETI deduction available after calendar year 2006. The recent legislation permits a deduction from taxable income based on certain qualified income from domestic production activities. We do not expect to generate any taxable benefits from this deduction in fiscal 2006.

This recent legislation also provides for a one-time 85% dividends received deduction on repatriation of foreign earnings, which was applicable to us if utilized by December 31, 2005. Historically, we have considered undistributed earnings of our foreign subsidiaries to be indefinitely reinvested and, accordingly, no incremental taxes have been provided thereon. We did not repatriate foreign earnings under this provision.

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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES

(Dollars in thousands, except per share amounts)

 


The provision (benefit) for income taxes for the three and six months ended April 30, 2006 and 2005 are based on our estimated annualized effective tax rates for the respective years. The estimated annualized effective tax rate for fiscal 2006 is a benefit of 36.8% compared to an estimated annualized effective tax rate for fiscal 2005, which was an expense of 24.6%. The higher estimated annualized effective tax rate in fiscal 2006 is primarily attributable to forecasted losses in higher tax rate jurisdictions and the U.S. tax benefit from the extraterritorial income exclusion. The lower effective tax rate for the comparable period in fiscal 2005 was primarily attributable to a higher proportion of forecasted earnings in lower tax rate jurisdictions.

At each balance sheet date, we evaluate the estimated annualized effective tax rate based on updated information regarding forecasted income in each of our jurisdictions. Any revisions to the tax rate are recorded in the current period to reflect our current best estimate of the annualized effective tax rate.

We adopted FAS 123(R) on November 1, 2005, which requires, among other items, the recognition of stock option expense in the results of operations. As a result of the adoption of SFAS 123(R), the income tax effects of compensatory stock options are included in the computation of the income tax expense (benefit), and deferred tax assets and liabilities, subject to certain prospective adjustments to stockholders’ equity for the differences between the income tax effects of expenses recognized in the results of operations and the related amounts deducted for income tax purposes. Prior to our adoption of SFAS 123(R) the tax benefits relating to the income tax deductions for compensatory stock options were recorded directly to stockholders’ equity.

Recently Issued and Adopted Accounting Pronouncements

Effective November 1, 2005, we adopted Statement of Financial Accounting Standards No. 123 (revised 2004) (“SFAS 123(R)”), “Share-Based Payment,” which revised Statement of Financial Accounting Standards 123 (“SFAS 123”), “Accounting for Stock-Based Compensation.” SFAS 123(R) requires all share-based payment transactions with employees, including grants of employee stock options, to be recognized as compensation expense over the requisite service period based on their relative fair values. Prior to the adoption of SFAS 123(R), stock-based compensation expense related to employee stock options was not recognized in the statement of operations if the exercise price was at least equal to the market value of the common stock on the grant date, in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.” Prior to November 1, 2005, we had adopted the disclosure-only provisions under SFAS 123. In the six months ended April 30, 2006, stock-based compensation expense of approximately $8.7 million, which excludes capitalizable costs of $3.2 million, was recorded in the condensed consolidated statement of operations in connection with adoption of SFAS 123(R). There was no cumulative effect of adoption. Refer to Note 3 to our unaudited condensed consolidated financial statements for further information. There were no other new accounting pronouncements adopted during the six months ended April 30, 2006.

In May 2005, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 154, “Accounting Changes and Error Corrections” (“SFAS 154”), which replaces APB Opinion No. 20, “Accounting Changes” and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statements – An Amendment of APB Opinion No. 28”. SFAS 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes retrospective application, or the latest practicable date, as the required method for reporting a change in accounting principle and the reporting of a correction of an error. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. We do not believe the adoption of SFAS 154 will have a material impact on our condensed consolidated financial statements.

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TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES

(Dollars in thousands, except per share amounts)

 


Results of Operations

The following table sets forth for the periods indicated the percentage of net revenues represented by certain items reflected in our statement of operations, and sets forth net revenues by territory, sales mix, platform and principal products:

 

 

 

Three months ended
April 30,

 

Six months ended
April 30,

 

 

 


 


 

Operating data:

 

2006

 

2005

 

2006

 

2005

 


 


 



 


 

Net revenues

 

100.0

%

100.0

%

100.0

%

100.0

%

Cost of goods sold

 

 

 

 

 

 

 

 

Product costs

 

49.4

 

55.6

55.0

 

49.8

 

Royalties

 

31.0

 

9.9