Electronic Arts Inc.
Q2 2011 Earnings Call Transcript

Published: 3 Nov 2010

[Operator:]

Good afternoon. My name is KC, and I will be your conference operator today. At this time, I would like to welcome everyone to the Second Quarter Fiscal Year 2011 Earnings Conference Call. [Operator Instructions] I will now turn today's call over to Peter Ausnit, Vice President of Investor Relations. Sir, you may begin.

[Peter Ausnit:]

Thank you. Welcome to EA's Fiscal 2011 Second Quarter Earnings Call. Today on the call we have John Riccitiello, our Chief Executive Officer; Eric Brown, our Chief Financial Officer; and John Schappert, our Chief Operating Officer. Please note that our SEC filings and our earnings release are available at investor.ea.com. In addition, we have posted earnings slides to accompany our prepared remarks. Lastly, after the call, we will post our prepared remarks, an audio replay of this call and a transcript. This presentation and our comments include forward-looking statements regarding future events and the future financial performance of the company. Actual events and results may differ materially from our expectation. We refer you to our most recent Form 10-Q for a discussion of risks that could cause actual results to differ materially from those discussed today. Electronic Arts makes these statements as of November 2, 2010, and disclaims any duty to update them. Throughout this call, we will discuss both GAAP and non-GAAP financial measures. Our earnings release and the earnings slides provide a reconciliation of our GAAP to non-GAAP measures. These non-GAAP measures are not intended to be considered in isolation from, as a substitute for, or superior to our GAAP results. We encourage investors to consider all measures before making an investment decision. All comparisons made in the course of this call are against the same period in the prior year unless otherwise stated. Now I'll turn the call over to John Riccitiello. John?

[John Riccitiello:]

Thank you, Peter. We are pleased to report a strong Q2 with revenues and EPS above expectations. This completes a strong first half of fiscal '11. EA continues to focus on three strategic objectives to drive shareholder value

[Eric Brown:]

Thank you, John. Q2 results exceeded our expectations for both non-GAAP revenue and non-GAAP EPS. Non-GAAP revenue of $884 million reflects our efforts to build Digital revenue and drive Packaged Good hits, with notable contributions from the worldwide launch of FIFA 11 and strong catalog sales. Combined with higher gross margins and delayed expense phasing, Q2 revenue upside translated to non-GAAP EPS of $0.10, which was better than our expectations of a non-GAAP loss of $0.15 to $0.10 per share for the quarter. Q2 non-GAAP net revenue is $884 million, down 23% year-over-year as expected on fewer titles. On a GAAP basis, net revenue was $631 million. Non-GAAP revenue was down on a lighter title schedule compared to Q2 last year, which had nine titles, including The Beatles

[John Schappert:]

Thanks, Eric. I'm going to offer some perspective on the sector, then outline EA's retail performance. I'll finish with an update on our progress in mobile and online games and services. The segments of our industry where EA is investing are strong. As Eric mentioned, we expect the total software sector to be up 7% worldwide this year, driven by growth in digital and High-Definition and PC packaged goods. Total Packaged Goods have declined 4% in the calendar year-to-date. However, the High-Definition platforms, the PlayStation 3 and Xbox 360, have grown by 23% in the same period. EA's portfolio strongly favors these growth platforms, and we now command a 25% segment share on HD consoles. Another positive for HD consoles is the introduction of new motion control technology from both Sony and Microsoft. We're encouraged by the early data we're seeing on Move and the prelaunch data on Kinect. EA is launching two titles for Kinect

[John Riccitiello:]

Thanks, John. While we are very proud of our first-half performance, we recognize that a big part of the upside came from bringing all of FIFA into Q2. As a result, we are maintaining our full year guidance. Our Q3 slate is ready to go. Medal of Honor and The Sims 3 console are tracking well. Between now and the holidays, we have a great slate highlighted by Need for Speed Hot Pursuit. EA is executing against our three key strategic objectives. We are outpacing the industry in terms of digital growth, and we are creating meaningful digital revenue streams in our well-positioned Packaged Goods business. And we are proving that our IP is working well, not only on the growing High-Definition platforms, but also on casual platforms from social networks to mobile, helping drive our 35% growth rate on the digital side. We continue to lead in the most attractive segment of a growing game industry. In closing, I'd like to mention one of our most important franchises, Need for Speed. Need for Speed is back in a huge way. So take a day off on November 16 to play Need for Speed Hot Pursuit with Autolog. You're going to love it. With that, we'd be happy to take your questions.

[Operator:]

[Operator Instructions] Our first question will come from Brian Pitz with UBS.

[Brian Pitz:]

A couple of questions for John. Would you talk about your views on the independent ratings for Medal of Honor? What do you think went wrong there given that the reviews were so low, and how are these ratings impacted your guidance on the title into the quarter? And just separately, quick question on the Facebook announcement to date. What do you believe is the size of the market opportunity for social-based games on Facebook and other social platforms?

[John Riccitiello:]

John Schappert and I will split that. I'll take the MOH one, Medal of Honor. First off, the game is rated mid-70s, almost 20 ratings rated 90 or above. So as an observation, mid-70s is generally perceived to be pretty good. I think ultimately, what happened there and pretty much as we'd expected, the game appeals really well to a mass market, your average gamer. There is a small minority of folks, sometimes well represented by core gamer reviewers or game magazine reviewers, where best I can tell there's been 80 or 90 hours a week playing first person shooters. They are very core to that segment, and some of them didn't like the title. Again, not on the kind of expected. So far, the title has outperformed our sales expectations, continues to outperform our expectations through to week three, which we didn't include in the numbers we just gave you. So it feels very good. As an aside, one of the things that we track very carefully is input to our customer service call-in lines and web question-and-answer from our service personnel. And it's interesting that Medal of Honor is getting some of the strongest positive reviews on fun to play and other positive attributes, more so than other shooters we've shipped in the past. So by and large, it feels like the game that we've got on this one is from an exceptionally narrow demographic of reviewers that gave it a negative review, offset by a more overwhelming majority of people that are buying it and enjoying it. I'll let John to pick up on Facebook.

[John Schappert:]

On Facebook, we are actually bullish on this market. I mean, obviously, we've seen DAUs and MAUs drop as Facebook made some changes to their platform. We think for the most part, that's kind of leveling out. We also think that the on boarding of EA and Playfish with Facebook credits and giving people a unified currency, we think that we'll see more guess turn into purchasers on this platform. So we think that there's upside from that, may be some near-term hiccups as people kind of transition their currency to Facebook credit. But we think long term, that's a win. And with a 0.5 million people there and 250 million of them playing games, we think it's a real market and are happy with our performance and certainly, with the monetization that our teams work on in the past quarter.

[Operator:]

Our next question will come from Arvind Bhatia from Sterne Agee.

[Arvind Bhatia:]

Wanted to just talk about the $180 million restructuring charge one more time, Eric. I didn't quite get the details there. I think you said about $10 million of actual cash outlay. Did I guess that right? And then may be just talk about the benefits, how soon you'll start to see some benefits in fiscal '12, just maybe talk about the magnitude.

[Eric Brown:]

Okay, so first of all, the restructuring itself is oriented around our license agreements and developer contracts. And so you got 95% of the charge that we estimated $180 million or so pertains to those of various contracts. This is not a major personnel-related restructuring. The cash cost of the restructuring is essentially the same as what we otherwise would have paid out over time under existing commitments on license contracts and development agreements. There is essentially a $10 million delta versus the baseline commitments, and that's why we called that out as being nominal. Other than that, I would say that the benefits of the restructuring are expected to begin in fiscal '12. They're designed to improve the long-term profitability of our business and give us the flexibility to manage our franchises as we see fit under current market conditions.

[Operator:]

Our next question will come from Edward Williams from BMO Capital Markets.

[Edward Williams:]

Just a couple of questions on the Digital business for a moment. Can you just talk a little bit about on the PC sales? How much of your PC sales are now occurring via download versus packaged goods? And then also, if you can give us a little bit of color as to what the amount of incremental revenue is on your console Packaged Goods sold that you're getting, if it's reasonably consistent at this point.

[Eric Brown:]

This is Eric. I'll take the second question first. The console deals, the attach rate, it varies by franchise. I can tell you that the Ultimate Team modes that we've introduced for FIFA and is now extended across other sports products is very popular. We've seen gross revenues in excess of $30 million at FIFA 10 for the Ultimate Team mode. Ultimate Team for FIFA 11 is just recently been announced, and we expect that that's going to track well in the future. In regards to the PC business, packaged sales versus full-game PC digital download, we're seeing that increase over time. So it's not yet at the 50-50 mark, but what we're finding is that certainly, in certain genres like Battlefield

[John Riccitiello:]

This is John. Just to add a little color. A couple of years ago, we really didn't focus on either of those revenue streams, which are, frankly, high-profit margin, ARPU drivers for our business. We focused on both of them, and we're seeing great results from both fronts. It's very pleasing to see that there are really -- in an interesting way to think about it, our Digital business is really two very related businesses. One of them is pure digital, what we do on the social networks such as in mobile, what we do at Pogo. But then there's also a sizable business that starts with a disc and is pure digital ARPU-driving, revenue-driving, margin driver. And we're seeing success in both sides of the fronts.

[Operator:]

Our next question will come from Mike Hickey from Janco Partners.

[Michael Hickey:]

Eric, just a couple of housekeeping. The R&D headcount quarter end and catalog sales for the period?

[Eric Brown:]

Our catalog sales were 16% for the quarter. And of the total headcount of 7,820, the R&D headcount was 5,640.

[Michael Hickey:]

And then John, I was just curious if you could share with us how you see the Internet TV game market taking shape over the next several years?

[John Riccitiello:]

Well, the next several years for Internet TV, we'll get the crystal ball out. But I think that there's absolutely no question that Internet TV is here to stay. It's a big story. And with CPU prices reasonable as they are for powerful CPUs and hard drive are priced as cheap as they are, you're going to see the equivalent of the mini computer under the TV in the form of a device from Apple or Google or Samsung built in. I think the long-term opportunity there is significant. I think we'll ultimately move to be more-than-just-casual games. And I think it bodes well as we go from a world where, if you think about it, a minority of consumers around the world have got a game-ready device connected to their plasma or otherwise High-Definition television to that being sort of a universal standard. What I like about EA is I think it's going to really present itself to the consumer in two ways. One is stuff that looks a lot like what we do in EAI with our more casual offerings, and I think a big part of it is going to feel more traditional. And I think we can participate in both. It's likely to promote more direct-to-consumer digital models, which, as we've indicated up until now, leave more of the money in our pockets of business than they do of various folks taking a piece out of the middle. So I think it's a long-term positive. I think it supports both core and more casual offerings. I think it's a growth driver, and I think navigating the specifics is going to be tricky and interesting to watch.

[Operator:]

Our next question will come from Jess Lubert from Wells Fargo Securities.

[Jess Lubert:]

Two questions actually. First, can you provide some incremental color regarding what's driving the shift of expenses into the second half of the year? I didn't catch your comments there.

[Eric Brown:]

Certainly, this is Eric. The expense shift that we were able to do pertain to marketing and personnel and contract-related expenses out of Q2 into the second half.

[Jess Lubert:]

And then another question on Medal of Honor. It looks like it sold through a little less than Battlefield did in its first two weeks. Can you update us on how Medal of Honor has performed through week three relative to Battlefield and how you expect the game to track relative to Battlefield going forward?

[John Riccitiello:]

Yes, this is John again. So one observation and a comment I should have made earlier with respect to Medal of Honor. The game has exceeded our plan and expectations sell-through and sell-in, and those expectations were they went up as they went from planned to forecast and as we updated our forecast through for the year. So in every possible gate of opportunity to increase the forecast we did, and then we exceeded those forecast based on strong selling numbers. So it is absolutely clear success as a business for us. And consumer feedback has been strong to suggest that we've got a franchise now, once again, that we could successfully and effectively sequel in the future. Now I think it's the first step with this franchise, sort of back into the marketplace where Battlefield

[Operator:]

Our next question will come from Colin Sebastian from Lazard Capital Markets.

[Colin Sebastian:]

Just wanted to first follow up in the Digital segment given the doubling in the core registered user account over the past year. But overall, Digital revenue growth decelerated a bit presumably on the mobile and social segments, if you could address that may be in a little more detail. And then what gives you visibility that the Digital segment will rebound in terms of growth over the remaining part of the year?

[Eric Brown:]

Colin, this is Eric. I think it's important to recall what we said last quarter in regards to our Digital results. And we reported about $188 million to $189 million of Digital revenue, and we specifically called out approximately $20 million of that as being very favorable in terms of timing, phasing and being nonrecurring. And so please keep that in mind as we look at the current quarter Q2 results. We had revenue in Q1 that could possibly have fallen in Q2 per se. So the relevant comparison or I think an important comparison is what does the first half looked like this year versus last year? The first half Digital all-in is up 35%, and we're seeing particularly strong growth in disk-related console DLC. That number in the quarter doubled year-over-year in terms of Digital revenue.

[Colin Sebastian:]

And where did Madden end up for the quarter versus last year on the unit sales basis?

[John Schappert:]

Madden is actually roughly flat with last year, but Madden is seeing great growth in the Digital side. So we launched Madden Ultimate Team about a month ago. And today, Madden Ultimate Team has done almost as much in revenue as last year's Madden Ultimate Team has done. Not to mention, we launched Madden NFL Superstars on Facebook, and Madden also launched on iPad and iPhone day and date with Madden console title, and it's the first title on the App Store to be number one top grossing in both the iPhone and iPad. So Madden has great upside in Digital side and is doing well on consoles.

[John Riccitiello:]

And just an added piece on Madden. One of the things I think that's easy to miss is the shift in the shape of the revenue curve for Madden. Three, four years ago, with so many people to track the business were used to, Madden used to do the dominant portion of its business in the month of August and early September. Basically, it was a get out immediately and buy the franchise. As the franchise grew and went from a couple of million units to 4 million, 5 million and 6 million units, one of the things that's happened is we picked up a more sizable holiday business with Madden, which is part of the growth. One of the comparison points that I think we suffered from last year, and I don't think we've pointed it out as well, is that folks were looking for that same portion of the business in August and September when it was in fact delivered August through, actually, last year through January. So we're looking forward for a Madden holiday.

[Operator:]

Our next question will come from Eric Handler from MKM Partners.

[Eric Handler:]

First, what are you seeing in terms of digital attach rates for digital content? And also, what kind of price point tends to work best for you there? And then secondly, the M&A landscape right now, where do you see you might need to or may want to do some type of tuck-in acquisitions and what's sort of out there right now?

[Eric Brown:]

So I'll take the first half of it. The Digital attach rate for console DLC, it varies by franchises. We noted earlier that the Ultimate Team mode initiated, the FIFA team has been quite successful. On FIFA 10, we're north of $30 million gross revenue on that. Battlefield

[John Schappert:]

And I'll just add a little bit more color to -- we talked to you about launching Madden Ultimate Team. We just launched FIFA Ultimate Team today. We've launched NHL Ultimate Team as well. So all of those get a fairly robust user base, and they're pretty active users once they've kind of go on. Once they spend some money, they stay pretty attached to that. With respect to your second part about any tuck-in acquisition, we are still tucking in Chillingo as we speak and very happy with that acquisition and welcome Joe [Wee] and Chris [Byatte] to the team. And of course, we're going to always be looking out for the right companies that can fit into the fold and fit in nicely with EA. But we have nothing to announce right now.

[Operator:]

Our next question will come from Tony Gikas with Piper Jaffray.

[Anthony Gikas:]

Can you talk a little bit about the margins on some of these new digital revenue streams, let's say, [indiscernible] social gaming.

[John Riccitiello:]

I think the question, which we'll try to answer, which was margins on new digital revenue streams? I'll let Eric go a little bit deeper on this. But in general, we see significantly better margin structure and across-the-board on Digital, whether that digital starts with the disc where it doesn't.

[Eric Brown:]

Yes, what we've been doing, again, the core franchise teams is doing -- they're doing a great job creating digital extensions, whether it's Ultimate Team in sports or DLC in the games label and so on. The marginal cost to market and sell, another $10, $15, $20 piece of DLC to an incremental customer is effectively zero. And so we find ourselves recouping the dev [development] cost quite quickly on DLC, and then going at 90-plus percent margins thereafter on the incremental sales. And this is, of course, net of the fee that we have paid to the first party to transmit the DLC. So as the console DLC in some ways very high incremental margins, we've been very encouraged by it. And again, year-over-year, we've seen that business double.

[Anthony Gikas:]

Second part of my question then was do you know what the growth rate of social gaming will be this year and potentially next year? And then, the last question, just any thoughts on 3D. When does that become a real material or meaningful business, how big can that be and what platforms will that be on?

[John Schappert:]

This is John Schappert. I can take the social gaming. I don't think we're going to provide any predictions for what we think the growth rate will be, although we are seeing nice growth in that business. And I think there were some changes that happened earlier in the year. I think we hopefully are seeing that kind of stabilized. And with the addition of Facebook credits, we actually hope that we will see some good growth there. And of course, Facebook continues to onboard new users, too. So you've got that growth happening hopefully twofold, both from new users and for making it easier to purchase content on that site. And Facebook still seems to be moving along pretty strong, so we're happy with our agreement with them. With respect to 3D, John, did you...

[John Riccitiello:]

Just one thought on Facebook for social. While we're not -- John is appropriately not giving you a specific forecast for social since we haven't put that out there and we're very careful about guiding specific sectors. I would say not inconsistent with what we see across the board with Digital. So it's definitely a growth story.

[John Schappert:]

And with respect to 3D, we think 3D is interesting. We think it's still kind of early. People are buying their televisions now this holiday that feature 3D. We think it's something that will continue to grow and mature. But probably a little early right now, a little bit more interesting next year. Certainly, very interesting on 3Ds, which has 3D built in to it. And what's nice for us is our content is all 3D-ready. So it's relatively easy for us to flip that 3D switch on and make our content 3D as opposed to having to remaster it or reshoot all of the content to make it 3D. We have 3D content. So when the market is there, we're ready.

[John Riccitiello:]

And as regard to 3D, just one additional thing. There's a question earlier about IPTV. If I had to pick between IPTV and 3D and which one would be more important for gaming, not necessarily for installed base for homes, because I'm sure that people are definitely going to want to watch Shrek in 3D at home. But for us, I actually think it's probably more potential in terms of new revenue and business model for us. What derives from the IPTV side, we're watching that very carefully. So it's a priority that's high for us.

[Operator:]

Our next question will come from Justin Post with Bank of America.

[Justin Post:]

John, your sports franchises has really been a real strength for the company and a real source of competitive advantage. When you think about that business and including the Digital piece and may be some of these contract negotiations, do you see two to three years a top line growth story or a margin improvement story? And then also, any help with may be what percent of profits the Sports business contribute. I know you last updated to that on the analyst day, but I don't know if you have any update you want to provide on that.

[John Riccitiello:]

Well, first off, sports has been a strong growth story for us this year. We've gotten it off the World Cup. We've got it on FIFA. We've built an exercise business in EA SPORTS Active. We've added nice line of products in the form, martial arts and boxing, and we've been growing Digital. I would say that one of the things that is true is we've been focused very much on making sure that they're not just a representation of what we are on the front of the magazine, but they are also have been in the front of the annual report, but they are big contributor in the back of the annual report relative to the profit contribution. We're not giving you the specifics. It's a substantially profitable business comparable to our other businesses. It can do better over the years to come, which is why we've addressed some of the structural issues. This is not our first cut at some of those structural issue. We took some steps a few years ago to allow these businesses to be as profitable as the best of any packaged goods and digital business for us. I particularly see an opportunity in sports, in the EA SPORTS brand as it by casual and social and mobile continues to grow. It might be a stretch for imagining some franchises whether they be core RPG or RTS, sort of reaching 30 million or 40 million people in the United States. But sports is interesting to almost everybody. I live in San Francisco last night. And you could frankly hear the cheer rising out of the city at about 8

[Operator:]

Our next question will come from Atul Bagga with ThinkEquity.

[Atul Bagga:]

I was wondering if you can share any update on Star Wars development. Is it still on track for launch spring of 2011? And second, on Facebook, with this agreement, I understand there are two dynamics. One, you're expecting better retention, higher acquisition of customers and better conversion. But at the same time, you're also going to share 30% revenue with Facebook. So all-in-all, in the near term, what kind of impact do you see on Facebook games because of this Facebook credit agreement you signed today?

[Eric Brown:]

This is Eric. I'll take the first half of the question. In regards to Star Wars, we're not providing any update in regards to timing. The only thing that we're here to confirm today is that it is not shipping in fiscal '11, and that we continue to incur development costs. Second half of the question...

[John Schappert:]

Second half of the question was Facebook and margins. And you are right, there is a margin share with -- revenue share with Facebook as we transition the Facebook credits. So the thing to keep in mind though is there is a margin share right now with our current payment provider. So we're going from one vendor to another vendor. In fact, we're going to a vendor where everyone on Facebook now actually can have Facebook credits and they can be used to purchase virtual items on all of their games. So what we think will happen is rather than pay one vendor, we're going to pay Facebook. And we're going to see a lot more of the 250 million gamers actually have Facebook credits in their account. In fact, I think they all may have Facebook credits in their account now as Facebook ceded them with Facebook credits to turn them into spenders. So we actually think it's going to be a benefit for us. But you're right, there is a share of revenue. But frankly, we have that before us.

[John Riccitiello:]

So just a couple of thoughts before we take your last question. First, with regard to the big MMO we've been talking a lot about, we're not trying to avoid your question on the call. But the fact is when we make our announcements for a consumer franchise like that, we'll make a consumer announcement as opposed to sort of a release through a financial review as we are doing today. Secondly, in my prepared comments, just one thing I wanted to highlight for you, I finished by encouraging you to take a look at Need for Speed. There was a reason I encourage that. I think Autolog can do for driving and/or for Need for Speed what superior forms of multiplayer game play did for shooters a few short years ago. It's the first truly compelling online feature set for a driving game, and it's worth paying attention to. If you're looking for innovation-driving outcomes, it's a place to look for innovation.

[Operator:]

Our next question will come from Andrey Glukhov from Brean Murray.

[Andrey Glukhov:]

As you think about the racing genre worldwide, in light of the new platforms that are available for you, do you think that the racing genre is structurally still a growth genre or is it going to be stable kind of how do you think about the growth outlook there?

[John Riccitiello:]

I think without doubt, the racing genre is a growth genre. But I think what's really going to prove it out is comping Q3 -- calendar Q4, but our Q3 FY '11, with Q3 FY '10. We have the same products in the marketplace and let's see how we do. What bodes well, I think, for both the sector and the franchise is innovation and quality. This innovation is going to drive online play like we haven't seen in driving with [indiscernible]. That's still to be proven, but I'm pretty confident that it should work. I think the second thing to remember is this holiday is fairly crowded with products that appeal quite richly to a very core audience. With the exception of The Sims and what we have with Need for Speed, there's precious little that appeals outside of folks that probably got their first name and their gamer tag confused. And so against that more broad audience, I think we've got the right offering.

[Andrey Glukhov:]

And then the second question, if I can ask one on Star Wars. As we get a little bit closer to the launch, are you guys in a position to over time trim sort of the development expenses? And on a related note, as you get closer to the launch, do you need to ramp up expenses related to kind of post-game operation and what that impact might be?

[John Riccitiello:]

So I don't think you should expect any significant ramp up as we get towards launch. And then secondly, of course, we will disclose all that is appropriate around that franchise as we get towards it. I would offer this. I've had a chance to get a colorful look at it quite recently in fact. The game development is going very well. We're very pleased with it, and we're looking forward to an opportunity to introduce the franchise more formally to the consumer. And when we do so, we'll certainly talk to all the folks who track the stock. Thanks, everybody. With that, we'll close the call.

[Operator:]

Ladies and gentlemen, that does conclude today's conference call. Thank you for your participation. You may now disconnect.