Why did net income fall so sharply despite revenue growth?

Operating expenses rose $395 million, about 27%, while revenue increased only $140 million. Main drivers were $128 million more stock-based compensation from adopting SFAS 123(R), an $83 million increase in annual bonus expense, $75 million in added personnel costs from higher headcount, and higher R&D spending. The effective tax rate also climbed to 48.2%, mostly due to non-deductible stock compensation and acquisition costs.

What does the console cycle mean for EA's near-term revenue?

Sales of PlayStation 2, Xbox and GameCube titles are declining as consumers move to the Xbox 360, PS3 and Wii, and EA is publishing fewer titles for legacy systems. Management expects PS2 revenue to keep falling in fiscal 2008 and Xbox revenue to decline significantly. New-platform revenue is growing but starts from a small installed base, so the transition creates earnings volatility, and development costs per title on new consoles are higher.

How will the online-enabled packaged goods accounting change affect future results?

Beginning in fiscal 2008, EA will lose vendor-specific objective evidence of fair value for online services bundled with certain packaged goods. Revenue from those products will be recognized over an estimated six-month service period instead of at sale, and the related cost of goods sold will be expensed on delivery. Management estimates $400-500 million of net revenue will be deferred from fiscal 2008 into fiscal 2009, so reported revenue and earnings will be less aligned with sales volume.

How concentrated is EA's customer base and supplier base?

Concentration is high. Wal-Mart and GameStop accounted for about 13% and 12% of total net revenue, and over 70% of U.S. sales went to seven key customers. Console makers Sony, Microsoft and Nintendo license their platforms to EA, control manufacturing and approval of EA's titles, and are also among its chief competitors. The company also relies on third-party suppliers for disk components of several platforms.

What strategic moves and risks does the filing disclose beyond core operations?

EA acquired Mythic Entertainment ($76 million), bought the remaining DICE minority interest ($27 million), and made equity investments in Neowiz (about $108 million for roughly 19%) and The9 (about $167 million for roughly 15%, after year-end). It also disclosed an informal SEC inquiry, received September 2006, into its historical stock option grant practices, which it says it has cooperated with, and it reports that the matter has not been escalated since December 2006. Acquisitions and investments carry integration, dilution and impairment risks.

EA 10-K FY2007 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed May 30, 2007. Cited figures are marked; the original filing is the authoritative source.

Electronic Arts' fiscal 2007 10-K (year ended March 31, 2007) shows a company with growing revenue but sharply lower profitability.

Net revenue rose 5% to $3.091 billion^a, driven by Madden NFL 07, Need for Speed Carbon, FIFA 07 and The Sims 2 Pets, while net income fell 68% to $76 million ($0.24 diluted EPS) from $236 million. The decline reflects a $395 million rise in operating expenses, including $133 million of stock-based compensation under the newly adopted SFAS 123(R), an $83 million increase in annual bonus expense, and a 14% increase in headcount. Operating income fell to $39 million from $325 million, and the effective tax rate rose to 48.2%, so interest income of $99 million carried pre-tax income to $138 million.

The filing points to a more difficult near-term earnings outlook. EA is in the early phase of a console cycle (Xbox 360, PLAYSTATION 3 and Wii launched in 2005-2006), so sales of prior-generation titles are declining, and development costs per title are higher. Management expects research and development, marketing and G&A expenses to rise in fiscal 2008, and expects net earnings to decline further.

Starting in fiscal 2008, revenue from online-enabled packaged goods will be deferred over roughly six months, which management estimates at $400^b-500 million of revenue shifted into fiscal 2009. The company also faces a dependence on third-party hardware makers, which are also competitors, and on key retail customers (Wal-Mart and GameStop each represented about 12-13% of revenue). Balance sheet and liquidity remain strong.

Cash, short-term investments and marketable equity securities total $2.98 billion, and stockholders' equity rose to $4.03 billion^c. Operating cash flow fell to $397 million from $596 million, mainly due to receivable collection timing.

Disclosed items include an informal SEC inquiry into stock option grant practices, a planned $108 million^d investment in Neowiz, a planned approximately $167 million investment in The9, and the acquisitions of Mythic Entertainment and the remaining DICE minority interest. The company paid no dividends.

02—Key points

Key Highlights

Net revenue grew 5% to $3.091 billion, with international sales at 46% of the total and North America at $1.666 billion.
Net income fell 68% to $76 million ($0.24 diluted EPS) from $236 million, as operating expenses rose $395 million, largely from stock-based compensation (SFAS 123(R)), higher bonuses and headcount growth.
Operating income dropped to $39 million from $325 million, and the effective tax rate rose to 48.2% from 37.6%.
Console transition is depressing legacy sales: PlayStation 2 revenue fell 21%, Xbox fell 61% and GameCube fell 56%, while Xbox 360, PS3 and Wii contributed $480M, $94M and $65M.
Management guides to lower fiscal 2008 earnings, with higher R&D, marketing and G&A spending, plus $400-500 million of revenue deferred into fiscal 2009 under the new online-enabled packaged goods accounting.
Mobile growth continued: cellular handset revenue rose to $140 million from $19 million after the JAMDAT acquisition, and total mobility revenue reached $540 million.
Liquidity is solid, with $2.98 billion in cash, short-term investments and marketable equity securities and $4.03 billion in stockholders' equity, though operating cash flow fell to $397 million.

03—Questions

Frequently Asked Questions

Why did net income fall so sharply despite revenue growth?
Operating expenses rose $395 million, about 27%, while revenue increased only $140 million. Main drivers were $128 million more stock-based compensation from adopting SFAS 123(R), an $83 million increase in annual bonus expense, $75 million in added personnel costs from higher headcount, and higher R&D spending. The effective tax rate also climbed to 48.2%, mostly due to non-deductible stock compensation and acquisition costs.
What does the console cycle mean for EA's near-term revenue?
Sales of PlayStation 2, Xbox and GameCube titles are declining as consumers move to the Xbox 360, PS3 and Wii, and EA is publishing fewer titles for legacy systems. Management expects PS2 revenue to keep falling in fiscal 2008 and Xbox revenue to decline significantly. New-platform revenue is growing but starts from a small installed base, so the transition creates earnings volatility, and development costs per title on new consoles are higher.
How will the online-enabled packaged goods accounting change affect future results?
Beginning in fiscal 2008, EA will lose vendor-specific objective evidence of fair value for online services bundled with certain packaged goods. Revenue from those products will be recognized over an estimated six-month service period instead of at sale, and the related cost of goods sold will be expensed on delivery. Management estimates $400-500 million of net revenue will be deferred from fiscal 2008 into fiscal 2009, so reported revenue and earnings will be less aligned with sales volume.
How concentrated is EA's customer base and supplier base?
Concentration is high. Wal-Mart and GameStop accounted for about 13% and 12% of total net revenue, and over 70% of U.S. sales went to seven key customers. Console makers Sony, Microsoft and Nintendo license their platforms to EA, control manufacturing and approval of EA's titles, and are also among its chief competitors. The company also relies on third-party suppliers for disk components of several platforms.
What strategic moves and risks does the filing disclose beyond core operations?
EA acquired Mythic Entertainment ($76 million), bought the remaining DICE minority interest ($27 million), and made equity investments in Neowiz (about $108 million for roughly 19%) and The9 (about $167 million for roughly 15%, after year-end). It also disclosed an informal SEC inquiry, received September 2006, into its historical stock option grant practices, which it says it has cooperated with, and it reports that the matter has not been escalated since December 2006. Acquisitions and investments carry integration, dilution and impairment risks.

04—Continue

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