01—Abstract
Summary
Summary of the 10-K filed June 7, 2005. Cited figures are marked; the original filing is the authoritative source.
Electronic Arts' fiscal 2005 10-K (year ended March 31, 2005) shows a company still growing revenue but facing margin and earnings pressure as it prepares for the next console cycle.
Net revenue rose 5.8% to $3.129 billiona, while net income fell 12.7% to $504 million and diluted EPS declined to $1.59 from $1.87. Operating income dropped to $669 million from $776 million, driven mainly by a 24% increase in research and development spending to $633 million, which management attributes to next-generation technology investment and a 30% rise in headcount. Management signaled that the company is entering a transition period.
It expects Sony, Microsoft and Nintendo to launch next-generation consoles within roughly eighteen months, which it says will raise development costs per title, may cause current-generation sales to decline, and will make operating results more volatile and harder to predict. Price pressure on current-generation titles, rising licensing costs for sports and film properties, and concentration of sales in a few retailers (Wal-Mart alone was 14%b of revenue) are additional risks. Management guided to higher sales and gross profit in fiscal 2006 but flagged continued cost increases.
The balance sheet remains strong, with cash, short-term investments and marketable equity securities of about $3.1 billionc and stockholders' equity of $3.5 billion, and no cash dividends are paid. However, the filing discloses several pending lawsuits: two employment misclassification class actions in California and a securities class action filed in March 2005 with related shareholder derivative suits, following a reported returns and price-protection shortfall in the March 2005 quarter. Investors should weigh the strong franchise position and cash generation against near-term margin pressure, legal exposure and the uncertainty of the console transition.
02—Key points
Key Highlights
- Net revenue grew 5.8% to $3.129 billion, with international sales at 47% of the total and Need for Speed Underground 2 representing about 11% of revenue.
- Net income declined 12.7% to $504 million; diluted EPS fell to $1.59 from $1.87 as R&D rose 24% to $633 million.
- Operating income fell to $669 million from $776 million, and operating margin narrowed as costs grew faster than revenue.
- Operating cash flow was $634 million, down from $669 million, reflecting higher receivables and cash tax payments.
- Cash, short-term investments and marketable equity securities totaled about $3.1 billion, with stockholders' equity of $3.5 billion; the company has never paid cash dividends.
- A $750 million share repurchase program was authorized in October 2004, with about $709 million remaining at March 31, 2005.
- Management expects a volatile transition to next-generation consoles over the next eighteen months, with higher development costs and possible declines in current-generation sales.
- Securities class action and shareholder derivative suits were filed in March–May 2005, alongside two California employee misclassification class actions.
03—Questions
Frequently Asked Questions
Why did net income fall even though revenue grew?
Revenue rose 5.8% to $3.129 billion, but operating expenses grew about 17% to $1.263 billion. Research and development rose $122 million to $633 million, as the company hired heavily (headcount up about 30%) and invested in next-generation tools and technologies. Cost of goods sold also rose as a share of revenue, from 37.3% to 38.2%, because of channel price actions, rebates and costs for Nintendo DS and PSP titles. Net income fell 12.7% to $504 million.
How dependent is EA on a few products and customers?
Dependence is significant. Need for Speed Underground 2 accounted for about 11% of fiscal 2005 revenue, and 31 titles sold over one million units. Wal-Mart represented 14% of total net revenue, and over 80% of U.S. sales went to six key customers, two of which had announced a merger. Roughly 80% of revenue depends on hardware platforms controlled by Sony, Microsoft and Nintendo, which are also EA's chief competitors.
What is the biggest risk to investors over the next 18 months?
The console transition. Management warned that next-generation launches could cause current-generation sales to decline and consumers may defer purchases. Development costs per title are expected to be higher, and the company expects operating results to be more volatile and harder to predict, which could cause the stock price to fluctuate significantly. Platform licensors also set royalty rates and control approval and manufacturing, and could change fee structures.
What legal issues does the filing disclose?
There are three categories. Two California class actions (Kirschenbaum, filed July 2004, and Hasty, filed February 2005) allege improper classification of employees as exempt from overtime. A purported securities class action filed March 24, 2005 alleges false and misleading statements under Sections 10(b) and 20(a), with additional suits following. Shareholder derivative actions were filed in April and May 2005. Management said it has not yet responded to the securities complaints and believes other claims would not be materially adverse.
Is the company's cash position strong enough to fund its plans?
Yes, according to management. Cash, short-term investments and marketable equity securities totaled about $3.1 billion, and management believes existing resources and operating cash flow are sufficient for at least the next twelve months. Capital spending was $126 million, mainly for studio expansions. The company also made acquisitions (Criterion and a majority of DICE, about $81 million net of cash), bought a 19.9% stake in Ubisoft for $90 million, and repurchased $41 million of stock.
04—Continue