UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

x                              QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF l934.

For the quarterly period ended April 30, 2007

OR

o                                 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)

 

(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 x No o

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  x      Accelerated Filer  o      Non-Accelerated Filer  o

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

As of June 5, 2007, there were 73,593,883 shares of the Registrant’s Common Stock outstanding.

 




INDEX

PART I.

 

FINANCIAL INFORMATION

 

3

 

Item 1.

 

Financial Statements

 

3

 

 

 

Condensed Consolidated Balance Sheets

 

3

 

 

 

Condensed Consolidated Statements of Operations

 

4

 

 

 

Condensed Consolidated Statements of Cash Flows

 

5

 

 

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

6

 

Item 2.

 

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

 

14

 

Item 3.

 

Quantitative and Qualitative Disclosures About Market Risk

 

27

 

Item 4.

 

Controls and Procedures

 

28

 

PART II.

 

OTHER INFORMATION

 

28

 

Item 1.

 

Legal Proceedings

 

28

 

Item 1A.

 

Risk Factors

 

28

 

Item 4.

 

Submission of Matters to a Vote of Security Holders

 

30

 

Item 6.

 

Exhibits

 

31

 

 

 

Signatures

 

32

 

 

(All other items in this report are inapplicable)

2




PART I.  FINANCIAL INFORMATION

Item 1.  Financial Statements

TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except per share amounts)

 

 

April 30,

 

October 31,

 

 

 

2007

 

2006

 

 

 

(Unaudited)

 

 

 

ASSETS

 

 

 

 

 

 

 

 

 

Current assets:

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

 

$

108,516

 

 

 

$

132,480

 

 

Accounts receivable, net of allowances of $52,847 and $91,509 at April 30, 2007 and October 31, 2006, respectively

 

 

70,406

 

 

 

143,199

 

 

Inventory, net

 

 

80,228

 

 

 

95,520

 

 

Software development costs and licenses

 

 

117,632

 

 

 

85,207

 

 

Prepaid taxes and taxes receivable

 

 

39,710

 

 

 

60,407

 

 

Prepaid expenses and other

 

 

34,712

 

 

 

28,060

 

 

Total current assets

 

 

451,204

 

 

 

544,873

 

 

Fixed assets, net

 

 

48,784

 

 

 

47,496

 

 

Software development costs and licenses, net of current portion

 

 

37,880

 

 

 

31,354

 

 

Goodwill

 

 

190,693

 

 

 

187,681

 

 

Other intangibles, net

 

 

34,845

 

 

 

43,248

 

 

Other assets

 

 

12,173

 

 

 

14,154

 

 

Total assets

 

 

$

775,579

 

 

 

$

868,806

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

 

 

 

Accounts payable

 

 

$

77,818

 

 

 

$

123,947

 

 

Accrued expenses and other current liabilities

 

 

132,408

 

 

 

128,282

 

 

Deferred revenue

 

 

36,678

 

 

 

11,317

 

 

Total current liabilities

 

 

246,904

 

 

 

263,546

 

 

Deferred revenue

 

 

25,000

 

 

 

50,000

 

 

Other long-term liabilities

 

 

6,437

 

 

 

4,868

 

 

Total liabilities

 

 

278,341

 

 

 

318,414

 

 

Commitments and contingencies

 

 

 

 

 

 

 

 

 

Stockholders’ Equity:

 

 

 

 

 

 

 

 

 

Common Stock, $.01 par value, 100,000 shares authorized; 72,971 and 72,745 shares issued and outstanding at April 30, 2007 and October 31, 2006, respectively

 

 

730

 

 

 

727

 

 

Additional paid-in capital

 

 

494,934

 

 

 

482,104

 

 

Retained earnings (accumulated deficit)

 

 

(12,138

)

 

 

60,659

 

 

Accumulated other comprehensive income

 

 

13,712

 

 

 

6,902

 

 

Total stockholders’ equity

 

 

497,238

 

 

 

550,392

 

 

Total liabilities and stockholders’ equity

 

 

$

775,579

 

 

 

$

868,806

 

 

 

See accompanying Notes.

3




TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)
(in thousands, except per share amounts)

 

 

Three months ended April 30,

 

Six months ended April 30,

 

 

 

         2007        

 

        2006         

 

      2007      

 

      2006      

 

Net revenue

 

 

$

205,436

 

 

 

$

265,122

 

 

 

$

482,776

 

 

$

530,103

 

Cost of goods sold:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Product costs

 

 

105,679

 

 

 

130,940

 

 

 

269,822

 

 

291,793

 

Software development costs and royalties

 

 

53,903

 

 

 

116,410

 

 

 

93,985

 

 

164,871

 

Total cost of goods sold

 

 

159,582

 

 

 

247,350

 

 

 

363,807

 

 

456,664

 

Gross profit

 

 

45,854

 

 

 

17,772

 

 

 

118,969

 

 

73,439

 

Selling and marketing

 

 

28,159

 

 

 

32,194

 

 

 

63,183

 

 

73,838

 

General and administrative

 

 

40,471

 

 

 

33,705

 

 

 

79,085

 

 

72,158

 

Research and development

 

 

11,936

 

 

 

16,097

 

 

 

26,086

 

 

33,806

 

Business reorganization and related

 

 

8,962

 

 

 

 

 

 

8,962

 

 

 

Impairment of long-lived assets

 

 

 

 

 

6,249

 

 

 

 

 

6,249

 

Depreciation and amortization

 

 

7,076

 

 

 

6,695

 

 

 

13,737

 

 

13,346

 

Total operating expenses

 

 

96,604

 

 

 

94,940

 

 

 

191,053

 

 

199,397

 

Loss from operations

 

 

(50,750

)

 

 

(77,168

)

 

 

(72,084

)

 

(125,958

)

Interest income, net

 

 

1,022

 

 

 

4

 

 

 

1,884

 

 

257

 

Loss before income taxes

 

 

(49,728

)

 

 

(77,164

)

 

 

(70,200

)

 

(125,701

)

Provision (benefit) for income taxes

 

 

1,521

 

 

 

(26,791

)

 

 

2,597

 

 

(46,206

)

Net loss

 

 

$

(51,249

)

 

 

$

(50,373

)

 

 

$

(72,797

)

 

$

(79,495

)

Basic and diluted loss per share

 

 

$

(0.71

)

 

 

$

(0.71

)

 

 

$

(1.02

)

 

$

(1.12

)

Basic and diluted weighted average shares outstanding

 

 

71,736

 

 

 

70,979

 

 

 

71,548

 

 

70,890

 

 

See accompanying Notes.

4




TAKE-TWO INTERACTIVE SOFTWARE, INC. and SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(in thousands)

 

 

Six months ended April 30,

 

 

 

2007

 

2006

 

Operating activities:

 

 

 

 

 

Net loss

 

$

(72,797

)

$

(79,495

)

Adjustments to reconcile net loss to net cash provided by (used for) operating activities:

 

 

 

 

 

Amortization and write-off of software development costs, licenses and intellectual property

 

49,688

 

94,007

 

Depreciation and amortization of long-lived assets

 

13,737

 

13,346

 

Impairment of long-lived assets

 

 

6,249

 

Stock-based compensation

 

8,777

 

8,694

 

Benefit for deferred income taxes

 

(135

)

(29,654

)

Provision for price concessions, sales allowances and doubtful accounts

 

38,388

 

94,524

 

Foreign currency transaction gain and other

 

(959

)

(1,252

)

Changes in assets and liabilities, net of effect from purchases of businesses:

 

 

 

 

 

Accounts receivable

 

37,869

 

(24,542

)

Inventory

 

15,292

 

45,348

 

Software development costs and licenses

 

(77,589

)

(74,722

)

Prepaid expenses, other current and other non-current assets

 

16,150

 

(199

)

Accounts payable, accrued expenses, deferred revenue and other liabilities

 

(42,461

)

(9,661

)

Total adjustments

 

58,757

 

122,138

 

Net cash (used for) provided by operating activities

 

(14,040

)

42,643

 

Investing activities:

 

 

 

 

 

Purchase of fixed assets

 

(13,090

)

(13,009

)

Payments for purchases of businesses, net of cash acquired

 

(982

)

(191

)

Net cash used for investing activities

 

(14,072

)

(13,200

)

Financing activities:

 

 

 

 

 

Proceeds from exercise of stock options

 

802

 

1,944

 

Excess tax benefit on exercise of stock options

 

 

124

 

Net cash provided by financing activities

 

802

 

2,068

 

Effects of exchange rates on cash and cash equivalents

 

3,346

 

2,362

 

Net (decrease) increase in cash and cash equivalents

 

(23,964

)

33,873

 

Cash and cash equivalents, beginning of year

 

132,480

 

107,195

 

Cash and cash equivalents, end of period

 

$

108,516

 

$

141,068

 

 

See accompanying Notes.

5




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

1.                 BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES

Take-Two Interactive Software, Inc. (“the Company”, “we”, “us”, or similar pronouns) is a leading global publisher, developer and distributor of interactive entertainment software, hardware and accessories. Our publishing segment, which consists of Rockstar Games, 2K Games, 2K Sports and Global Star Software, develops, markets and publishes software titles for the following leading gaming and entertainment hardware platforms:

Sony

 

 

Microsoft

 

 

 

Nintendo

 

PLAYSTATION®3

 

Xbox 360™

 

Wii™

PlayStation®2

 

Xbox®

 

GameCube™

PSP® (PlayStation®Portable)

 

 

 

DS™

 

 

 

Game Boy® Advance

 

We also develop and publish software titles for PCs. Our distribution segment, which primarily includes our Jack of All Games subsidiary, distributes our products as well as third-party software, hardware and accessories to retail outlets primarily in North America.

Basis of Presentation

The accompanying condensed consolidated financial statements include the accounts of the Company and reflect all normal and recurring adjustments necessary for fair presentation of our financial position, results of operations and cash flows. Inter-company accounts and transactions have been eliminated. The preparation of these condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in these condensed consolidated financial statements and accompanying notes. We adhere to the same accounting policies in preparation of interim financial statements. As permitted under generally accepted accounting principles, interim accounting for certain expenses, including income taxes, are based on full year assumptions when appropriate. Actual results could differ materially from those estimates.

Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been omitted pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”), although we believe that the disclosures are adequate to make the information presented not misleading. These condensed consolidated financial statements and accompanying notes should be read in conjunction with our annual consolidated financial statements and the notes thereto, included in our Annual Report on Form 10-K for the year ended October 31, 2006.

Reclassifications

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

Earnings Per Share

Basic earnings per share (“EPS”) is computed by dividing the net income applicable to common stockholders for the period by the weighted average number of common shares outstanding during the same period. Diluted EPS is computed by dividing the net income applicable to common stockholders for the period by the weighted average number of common stock and common stock equivalents, which

6




include common shares issuable upon the exercise of stock options, restricted stock and warrants outstanding during the same period. For the three and six months ended April 30, 2007 and 2006, common stock equivalents are excluded from our computation of diluted weighted average shares outstanding because their effect is antidilutive. The number of common stock equivalents excluded was approximately 7,042,000 for the three and six months ended April 30, 2007 and 8,618,000 for the three and six months ended April 30, 2006. For the three and six months ended April 30, 2007, we issued 829,000 and 905,000, respectively, of shares of common stock in connection with stock option exercises and restricted stock awards.

Recently Issued Accounting Pronouncements

In September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 157, Fair Value Measurements (“SFAS 157”), which clarifies the definition of fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurement. SFAS 157 does not require any new fair value measurements and eliminates inconsistencies in guidance found in various prior accounting pronouncements. SFAS 157 will be effective for us on November 1, 2008. We are currently assessing whether the adoption of SFAS 157 will have an impact on our financial statements.

In September 2006, the SEC released Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”). SAB 108 provides interpretive guidance on the SEC’s views on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. The provisions of SAB 108 will be effective for us on November 1, 2007. We are currently evaluating the impact of applying SAB 108 but do not believe that its application will have a material effect on our financial position, cash flows, or results of operations.

In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of SFAS No. 109 (“FIN 48”), to create a single model to address the accounting for uncertainty in tax positions. FIN 48 clarifies the accounting for income taxes by prescribing the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 will be effective for us beginning November 1, 2007. The cumulative-effect of adopting FIN 48 will be recorded to opening retained earnings. Management is currently evaluating what effect, if any, the adoption of FIN 48 will have on our consolidated financial statements.

2.                 BUSINESS REORGANIZATION AND RELATED CHARGES

At our Annual Stockholders’ Meeting held on March 29, 2007 (the “Annual Meeting”), our stockholders elected to our Board of Directors (the “Board”) five new directors and one incumbent director (the “Alternative Slate”), rather than the six incumbent directors nominated and recommended by our incumbent Board. Immediately following the Annual Meeting, the newly elected Board removed our former President and Chief Executive Officer (“CEO”) and elected a new Chairman and CEO. Our former Chief Financial Officer (“CFO”) resigned shortly thereafter. In April 2007 we entered into separation agreements with our former CEO and CFO. Additionally, we expanded our Board to a total of eight members in the second quarter of 2007.

We entered into a management agreement with ZelnickMedia Corporation (“ZelnickMedia”) on March 30, 2007. ZelnickMedia has agreed to provide financial and management consulting services to us and our Board for an initial term through October 31, 2011. During the term of the agreement, ZelnickMedia will receive an annual management fee of $750 and a bonus of up to $750 per fiscal year

7




based on achieving and exceeding a budgeted earnings level. Also pursuant to the management agreement, we have agreed to award stock options equal to 2.5% of our outstanding common stock on a fully diluted basis, and restricted stock based on a formula utilizing the closing stock price on the issuance date, to ZelnickMedia no earlier than 90 days nor later than 150 days of the effective date of the agreement. No stock-based compensation expense has been recorded in connection with this agreement for the three or six months ended April 30, 2007.

Our newly elected Chairman and CEO are principals of ZelnickMedia and the cost for their services to us is covered by our management agreement with ZelnickMedia. Except for health benefits provided to our CEO and reimbursement of expenses, our newly elected Chairman and CEO are not compensated by the Company.

Prior to our Annual  Meeting, we explored the possibility of presenting alternatives to our stockholders, including the possible sale of the Company, other than the Company’s proposals set forth in its Proxy Statement for the Annual Meeting and the Alternative Slate proposed by a group of the Company’s stockholders, and as a result incurred substantial professional fees, including approximately $2,000 for investment banking services and approximately $1,009 for reimbursement of certain expenses incurred by ZelnickMedia, a related party to the Company.

The table below details the business reorganization and related costs that we incurred for the three and six months ended April 30, 2007. Except for asset impairments, the extent of which we are not currently able to estimate, we expect to incur approximately $15,000 of additional business reorganization and related costs through the remainder of this fiscal year ending October 31, 2007 and into fiscal year 2008.

The components of our business reorganization and related charges are as follows:

 

 

Costs incurred
through

 

Utilization through
April 30, 2007

 

Accrual as of

 

 

 

April 30, 2007

 

Non-cash

 

Cash

 

April 30, 2007(a)

 

Employee termination costs

 

 

$

5,187

 

 

 

$

(1,801

)

 

$

(2,492

)

 

$

894

 

 

Professional fees and other

 

 

3,775

 

 

 

 

 

(3,303

)

 

472

 

 

Total

 

 

$

8,962

 

 

 

$

(1,801

)

 

$

(5,795

)

 

$

1,366

 

 


(a)           Included in accrued expenses and other current liabilities

3.                 COMPREHENSIVE LOSS

Components of comprehensive loss are as follows:

 

 

Six months ended
April 30,

 

 

 

2007

 

2006

 

Net loss

 

$

(72,797

)

$

(79,495

)

Foreign currency translation adjustment

 

6,810

 

4,355

 

Comprehensive loss

 

$

(65,987

)

$

(75,140

)

 

4.                 INVENTORY, NET

Inventory balances by category are as follows:

 

 

April 30,

 

October 31,

 

 

 

2007

 

2006

 

Finished products, net

 

$

75,609

 

 

$

88,337

 

 

Parts and supplies, net

 

4,619

 

 

7,183

 

 

Inventory, net

 

$

80,228

 

 

$

95,520

 

 

 

8




Estimated product returns included in inventory at April 30, 2007 and October 31, 2006 are $8,410 and $8,603, respectively.

5.                 SOFTWARE DEVELOPMENT COSTS AND LICENSES

Details of our software development costs and licenses are as follows:

 

 

April 30, 2007

 

October 31, 2006

 

 

 

Current

 

Non-current

 

Current

 

Non-current

 

Software development costs, internally developed

 

$

94,367

 

 

$

17,116

 

 

$

58,517

 

 

$

17,783

 

 

Software development costs, externally developed

 

15,999

 

 

17,429

 

 

20,731

 

 

11,764

 

 

Licenses

 

7,266

 

 

3,335

 

 

5,959

 

 

1,807

 

 

Software development costs and licenses

 

$

117,632

 

 

$

37,880

 

 

$

85,207

 

 

$

31,354

 

 

 

Amortization and write-off of software development costs and licenses for the three and six months ended April 30, 2007 and 2006 was $23,617 and $59,397, respectively, and $42,997 and $87,444, respectively.

Software development costs and licenses as of April 30, 2007 and October 31, 2006 include $145,159 and $91,248, respectively, related to titles that have not been released.

6.                 ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES

Accrued expenses and other current liabilities consist of the following:

 

 

April 30,

 

October 31,

 

 

 

2007

 

2006

 

Software development costs

 

$

32,233

 

 

$

43,724

 

 

Licenses

 

27,950

 

 

13,725

 

 

Compensation and benefits

 

21,313

 

 

19,054

 

 

Accrued taxes

 

19,440

 

 

19,872

 

 

Rent and deferred rent obligations

 

10,287

 

 

7,233

 

 

Professional fees

 

7,894

 

 

8,399

 

 

Marketing and promotions

 

4,360

 

 

5,042

 

 

Other

 

8,931

 

 

11,233

 

 

Total

 

$

132,408

 

 

$

128,282

 

 

 

7.                 LEGAL AND OTHER PROCEEDINGS

Various lawsuits, claims, proceedings and investigations are pending involving us and certain of our subsidiaries. In accordance with SFAS No. 5, Accounting for Contingencies, we record accruals for such contingencies when it is probable that a liability will be incurred and the amount of loss can be reasonably estimated.

Legal Proceedings

In July 2005, we received four complaints for purported class actions. Two of the four complaints were filed in the United States District Court for the Southern District of New York, one was filed in the United States District Court, Eastern District of Pennsylvania, and one was filed in the Circuit Court in St. Clair County, Illinois. The plaintiffs, alleged purchasers of the Company’s Grand Theft Auto: San Andreas game, assert that we engaged in consumer deception, false advertising and breached an implied warranty of merchantability and were unjustly enriched, as a result of our alleged failure to disclose that Grand Theft Auto: San Andreas contained “hidden” content, which resulted in the game receiving a Mature 17+ (“M”) rating from the Entertainment Software Ratings Board (“ESRB”) rather than

9




an Adults Only 18+ (“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 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. These cases, together with an action commenced against us in the United States District for the Southern District of New York in August 2006, have been consolidated for pretrial proceedings under the caption In re Grand Theft Auto Video Game Consumer Litigation (No. II), 06-MD-1739 (SWK)(MHD). On June 7, 2006, plaintiffs filed a Consolidated and Amended Complaint. On July 31, 2006, we filed a Partial Motion to Dismiss those claims brought under the laws of states other than states where the named plaintiffs reside and were purportedly injured. By an Opinion and Order dated October 25, 2006, the Partial Motion to Dismiss was denied. On November 10, 2006 we filed a Motion to Deny Certification of the proposed nationwide class. On November 17, 2006 we served an answer denying the allegations in the Consolidated and Amended Complaint and asserting various affirmative defenses. On January 24, 2007, the Plaintiffs cross-moved for certification of the proposed nationwide class. Motion practice on the Plaintiffs’ certification motion is proceeding, as are parallel settlement discussions.

In January 2006, the City of Los Angeles filed a complaint against us in the Superior Court of the State of California. The complaint alleges that we violated sections of the California Business and Professions Code prohibiting untrue and misleading statements and unfair competition and that we 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 “AO” rating from the ESRB rather than an “M” rating. The complaint also alleges that we 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 we have moved to dismiss the complaint. The plaintiff has moved to remand the action to state court. The Judicial Panel on Multidistrict Litigation has issued an order transferring the action to the Southern District of New York and the action was consolidated for pre-trial purposes with In re Grand Theft Auto Video Game Consumer Litigation (No. II), 06-MD-1739 (SWK) (MHD).

In February and March 2006, an aggregate of four purported class action complaints were filed against us, our former Chief Executive Officer, our former Chief Financial Officer, our former Chief Global Operating Officer, and four of our former directors in the United States District Court for the Southern District of New York (the ”New York Actions”). A fourth complaint brought in Michigan was voluntarily dismissed. The complaints allege that we violated Sections 10(b), 20(a) and Rule 10b-5 of the Securities Exchange Act of 1934 (“Exchange Act”) by making or causing us 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 ”AO” rating from the ESRB rather than an ”M” rating. The plaintiffs seek to recover unspecified damages and their costs. In July 2006, the court appointed a lead plaintiff. In September 2006, the lead plaintiff filed a consolidated amended complaint which included claims regarding Grand Theft Auto: San Andreas as well as claims relating to the backdating of stock options. This complaint was filed against us, our former Chief Executive Officer, our former Chief Financial Officer, our former Chairman of the Board, and two officers of our Rockstar Games subsidiary. On April 16, 2007, the lead plaintiff filed a second amended complaint which included additional allegations based on an investigation conducted by the Special Litigation Committee of the Board of Directors, currently comprised of Strauss Zelnick, John Levy and Grover Brown (the “Special Litigation Committee”), of options backdating and the Company’s restatement of financial statements relating to options backdating. This complaint was filed against us, our former Chief Executive Officer, our former Chief Financial Officer, our former Chairman of the Board, three of our directors, our Rockstar Games subsidiary, and two officers of Rockstar Games. The Company’s response is due on June 18, 2007.

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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 us, as nominal defendant, and certain of our directors and certain former officers and directors. The factual allegations in this action are similar to the allegations contained in the New York Actions. The plaintiff asserts that certain defendants breached their fiduciary duty by selling their stock while in possession of certain material non-public information and that we violated Section 14(a) and Rule 14a-9 of the Exchange Act by failing to disclose material facts in our 2003, 2004 and 2005 proxy statements in which we solicited approval to increase share availability under our 2002 Stock Option Plan. The 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. In October 2006, the Court issued an order granting our motion to stay this complaint, pending an investigation by the Special Litigation Committee, for a period of 150 days. On January 17, 2007, the plaintiffs moved for an order granting limited relief from the Court’s October 4, 2006 stay of the proceedings in order to file an Amended Derivative and Class Action Complaint. On February 22, 2007, counsel for the Special Litigation Committee advised the Court that the Special Litigation Committee had completed its investigation and rendered a report. On March 23, 2007, counsel for the Special Litigation Committee moved to dismiss the complaint based on, among other things, its conclusion that “future pursuit of this action is not in the best interests of Take-Two or its shareholders.” The plaintiff subsequently served a document demand seeking numerous documents concerning the Special Litigation Committee and its work. The Special Litigation Committee has responded to the document demand, and anticipates that discovery and briefing on its motion to dismiss the complaint will be completed by September 17, 2007.

In July 2006, Richard Lasky filed a purported derivative action complaint in the Southern District of New York against us, as nominal defendant, and certain of our directors and certain former officers and directors. The complaint alleges violations of federal and state law, including breaches of fiduciary duties, abuse of control, gross mismanagement, waste of corporate assets, unjust enrichment and further alleges that defendants breached their fiduciary duties in connection with the granting of stock options between January 1997 and the present. The complaint seeks unspecified damages against all of the individual defendants, reimbursement from certain of the defendants of bonuses or other incentive or equity based compensation paid to them by the Company during our fiscal year ended October 31, 2003, equitable and other relief relating to the proceeds from certain of the defendants’ alleged improper trading activity in Company stock, adoption of certain corporate governance proposals and recovery of litigation costs.

In August 2006, a shareholder derivative complaint was filed by Raeda Karadsheh in the United States District Court of the Southern District of New York against us, as nominal defendant, and certain of our current and former officers and directors. The Karadsheh Complaint asserts claims related to the Company’s stock option granting practices. The Plaintiffs filed a consolidated complaint on January 22, 2007, which focuses exclusively on our historical stock option granting practices. These matters have been referred to the Special Litigation Committee. On June 4, 2007, the Special Litigation Committee moved for a three-month stay of consolidated litigation in order to allow it to conclude its investigation.

In February 2005, the personal representatives of the Estates of Arnold Strickland, James Crump 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 our video games designed, manufactured, marketed and/or supplied to Mr. Moore resulted in “copycat violence” that caused the death of Messrs. Strickland, Crump and Mealer. The suit seeks damages (including punitive damages) against all of the defendants in excess of $600 million. Our motion to dismiss the action was denied and we moved to dismiss for lack of personal jurisdiction (which motion is pending before the Alabama Supreme Court). In April 2006, the plaintiffs amended the complaint to add a claim for civil conspiracy; the Company moved to dismiss that claim and the motion is pending. Under the

11




current Amended Scheduling Order, all fact and expert discovery is to be completed by June 15, 2007, mediation is scheduled for November 8, 2007 and trial, if necessary, to commence no earlier than January 18, 2008. Due to issues that arose in expert discovery, we expect the trial court to issue a further amended scheduling order within the next month, extending all such deadlines by at least 90-120 days. The Company believes that the claims are without merit and that this action is similar to lawsuits brought and uniformly dismissed by courts in other jurisdictions.

In September 2006, personal representatives of the estate of Delbert and Tyrone Posey and Marilea Schmid brought an action against us, Sony and Cody Posey in the Second Judicial District Court of Bernalillo County, New Mexico, alleging that Grand Theft Auto: Vice City resulted in “copycat” violence that caused the deaths of the above named individuals in violation of New Mexico’s product liability statute. The suit seeks damages (including punitive damages) against all of the defendants in excess of $600 million. SCEA and SCA have tendered their defense and requested indemnification from us, and we have accepted such tender. We received copies of the Complaint and Summonses in December 2006; and we moved to dismiss the Complaint on January 19, 2007. We have filed a motion to dismiss for failure to state a claim, as well as a motion to dismiss for lack of personal jurisdiction. Both motions are currently pending. The plaintiffs have requested jurisdictional discovery. The Court has scheduled a hearing on the motions for September 13, 2007. The Company believes that the claims are without merit and that this action is similar to lawsuits brought and uniformly dismissed by courts in other jurisdictions.

We intend to vigorously defend of the above matters and, with respect to the derivative actions, we have been advised that the individual defendants will vigorously defend such actions. However, we cannot predict the outcome of these matters and, if determined adversely to us, 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 our financial condition, cash flows and results of operations.

Other Matters

We have received grand jury subpoenas issued by the District Attorney of the County of New York requesting production of documents covering various periods beginning on January 1, 1997, including those relating to, among other things: the so-called “Hot Coffee” scenes in Grand Theft Auto: San Andreas; the work of our Board of Directors, all Board Committees, and the Special Litigation Committee; certain acquisitions entered into by us; billing and payment records relating to PricewaterhouseCoopers LLC (“PWC”) and the termination of PWC as the Company’s auditors; communications to financial analysts and stockholders about acquisitions and financial results; compensation and human resources documents of certain of the Company’s directors and employees and former directors and employees; stock-based compensation; the SEC’s July 2006 inquiry; legal services performed for employees; corporate credit card and expense records of certain individuals; the SEC bar of the our former Chief Executive Officer, Ryan Brant; the resolution to amend our Incentive Stock Plan; and ethics, securities, and conflict of interest policies and questionnaires. We are fully cooperating and providing the documents and information called for by the subpoenas.

In July 2006, we received notice from the SEC that it was conducting an informal non-public investigation of certain stock option grants made from January 1997 to present and in April 2007 we received notice from the SEC that it was conducting a formal investigation of such stock option grants. As a result of the Special Litigation Committee’s internal review of our option grants, in February 2007 we restated our financial statements for prior periods in our Annual Report on Form 10-K for the year ended October 31, 2006. The Company also received a request for information from the IRS for records relating to the grant and exercise of options and tax deductions taken by the Company from October 2000 to October 2004.

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In connection with its investigation, the Special Litigation Committee determined that certain stock options issued by the Company to certain former members of its Board of Directors (“Independent Directors”), were improperly dated. As a result, and in connection with our remedial measures, we entered into an agreement (the “Agreement”) with each of the relevant Independent Directors whereby the Independent Directors agreed to remit to the Company any after-tax gains that they realized as a result of the improper grant dates. In the event that certain grants remained unexercised, we re-priced such stock options to reflect an appropriate price for which such stock options should have been deemed granted. The Agreement was entered into voluntarily by the Company and the Independent Directors, none of whom served on the Special Litigation Committee. In addition, the Company has subsequently entered into similar agreements with certain former employees who received improperly dated stock options.

We are also involved in other routine litigation in the ordinary course of business, which in our opinion will not have a material adverse effect on our financial condition, cash flows or results of operations.

8.                 SEGMENT AND GEOGRAPHIC INFORMATION

We are a publisher and distributor of interactive software games designed for personal computers, video game consoles and handheld platforms. Revenue earned by our publishing segment is primarily derived from the sale of internally developed software titles, software titles developed on our behalf by third parties and the sale of certain video game accessories and peripherals. Revenue earned by our distribution segment is derived from the sale of third-party software titles, accessories and hardware.

Our Chief Executive Officer is our chief operating decision maker (“CODM”). We are centrally managed and the CODM 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.

Our CODM is presented with financial information that contains information that separately identifies our publishing and distribution operations, including gross margin information. Accordingly, we consider our publishing and distribution businesses to be distinct reportable segments.

Our operating segments do not record inter-segment revenue and therefore none has been reported. We do not allocate operating expenses, interest and other income, interest expense or income taxes to operating segments. Our accounting policies for segment reporting are the same as for the Company as a whole.

Information about our reportable segments is as follows:

 

 

Three months ended April 30,

 

Six months ended April 30,

 

Net revenue:

 

        2007        

 

       2006       

 

      2007      

 

      2006      

 

Publishing

 

 

$

153,931

 

 

 

$

200,060

 

 

 

$

315,919

 

 

 

$

358,349

 

 

Distribution

 

 

51,505

 

 

 

65,062

 

 

 

166,857

 

 

 

171,754

 

 

Total net revenue

 

 

$

205,436

 

 

 

$

265,122

 

 

 

$

482,776

 

 

 

$

530,103

 

 

 

 

 

Three months ended April 30,

 

Six months ended April 30,

 

Gross profit:

 

        2007        

 

        2006        

 

      2007      

 

      2006      

 

Publishing

 

 

$

41,551

 

 

 

$

11,104

 

 

 

$

104,371

 

 

 

$

59,254

 

 

Distribution

 

 

4,303

 

 

 

6,668

 

 

 

14,598

 

 

 

14,185

 

 

Total gross profit

 

 

$

45,854

 

 

 

$

17,772

 

 

 

$

118,969

 

 

 

$

73,439

 

 

 

 

 

April 30, 2007

 

October 31, 2006

 

 

 

Publishing

 

Distribution

 

Total

 

Publishing

 

Distribution

 

Total

 

Accounts receivable, net

 

$

51,924

 

 

$

18,482

 

 

$

70,406

 

$

109,974

 

 

$

33,225

 

 

$

143,199

 

Inventory, net

 

30,827

 

 

49,401

 

 

80,228

 

35,068

 

 

60,452

 

 

95,520

 

Total assets

 

648,835

 

 

126,744

 

 

775,579

 

710,467

 

 

158,339

 

 

868,806

 

 

13




 

We attribute net revenue to geographic regions based on product destination. Net revenue by geographic region is as follows:

 

 

Three months ended April 30,

 

Six months ended April 30,

 

Net revenue by geographic region:

 

       2007      

 

       2006      

 

     2007     

 

       2006       

 

United States

 

 

$

138,456

 

 

 

$

172,896

 

 

$

335,403

 

 

$

329,823

 

 

Canada

 

 

10,551

 

 

 

19,084

 

 

27,714

 

 

51,757

 

 

North America

 

 

149,007

 

 

 

191,980

 

 

363,117

 

 

381,580

 

 

United Kingdom

 

 

17,528

 

 

 

18,848

 

 

33,556

 

 

39,036

 

 

Continental Europe

 

 

31,013

 

 

 

46,013

 

 

65,577

 

 

93,654

 

 

Asia Pacific and other

 

 

7,888

 

 

 

8,281

 

 

20,526

 

 

15,833

 

 

Total net revenue

 

 

$

205,436

 

 

 

$

265,122

 

 

$

482,776

 

 

$

530,103

 

 

 

Net revenue by product platform for our reportable segments is as follows:

 

 

Three months ended April 30,

 

Six months ended April 30,

 

Net revenue by product platform:

 

        2007        

 

        2006        

 

      2007      

 

      2006      

 

Publishing:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sony PlayStation 2 and PlayStation

 

 

$

59,187

 

 

 

$

40,279

 

 

 

$

117,779

 

 

 

$

87,177

 

 

Microsoft Xbox 360

 

 

31,618

 

 

 

78,145

 

 

 

56,252

 

 

 

94,470

 

 

PC

 

 

18,992

 

 

 

41,861

 

 

 

38,002

 

 

 

60,953

 

 

Sony PSP

 

 

16,832

 

 

 

15,719

 

 

 

49,922

 

 

 

68,146

 

 

Sony PlayStation 3

 

 

16,057

 

 

 

 

 

 

26,191

 

 

 

 

 

Peripherals and other

 

 

4,732

 

 

 

6,398

 

 

 

12,878

 

 

 

15,016

 

 

Microsoft Xbox

 

 

3,945

 

 

 

11,774

 

 

 

10,210

 

 

 

22,888

 

 

Nintendo handheld devices

 

 

2,536

 

 

 

5,059

 

 

 

4,323

 

 

 

7,841

 

 

Nintendo GameCube

 

 

32

 

 

 

825

 

 

 

363

 

 

 

1,858

 

 

Total publishing

 

 

153,931

 

 

 

200,060

 

 

 

315,920

 

 

 

358,349

 

 

Distribution:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Hardware and peripherals

 

 

22,322

 

 

 

24,811

 

 

 

67,237

 

 

 

60,431

 

 

Software:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

PC

 

 

10,463

 

 

 

15,035

 

 

 

23,805

 

 

 

27,990

 

 

Sony PlayStation 2 and PlayStation

 

 

6,186

 

 

 

8,343

 

 

 

22,723

 

 

 

26,221

 

 

Nintendo handheld devices

 

 

5,812

 

 

 

8,312

 

 

 

30,941

 

 

 

33,020

 

 

Microsoft Xbox 360

 

 

1,845

 

 

 

1,908

 

 

 

6,157

 

 

 

3,695

 

 

Nintendo Wii

 

 

1,385

 

 

 

 

 

 

4,191

 

 

 

 

 

Sony PSP

 

 

1,067

 

 

 

2,021

 

 

 

2,504

 

 

 

3,507

 

 

Nintendo GameCube

 

 

863

 

 

 

1,881

 

 

 

2,909

 

 

 

7,013

 

 

Sony PlayStation 3

 

 

787

 

 

 

 

 

 

1,687

 

 

 

 

 

Microsoft Xbox

 

 

775

 

 

 

2,751

 

 

 

4,702

 

 

 

9,877

 

 

Total distribution

 

 

51,505

 

 

 

65,062

 

 

 

166,856

 

 

 

171,754

 

 

Total net revenue

 

 

$

205,436

 

 

 

$

265,122

 

 

 

$

482,776

 

 

 

$

530,103

 

 

 

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

Our Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is provided in addition to the accompanying condensed consolidated financial statements and footnotes to assist readers in understanding our results of operations, financial condition and cash flows. The following discussion should be read in conjunction with the MD&A included in our annual consolidated financial

14




statements and the notes thereto, included in our Annual Report on Form 10-K for the year ended October 31, 2006.

Overview

We are a global publisher, developer and distributor of interactive entertainment software, hardware and accessories. Our publishing segment, which consists of Rockstar Games, 2K Games, 2K Sports and Global Star Software, develops, markets and publishes software titles for the following leading gaming and entertainment hardware platforms: Sony’s PLAYSTATION®3 (“PS3”) and PlayStation®2 (“PS2”) computer entertainment systems; Sony’s PSP® (PlayStation®Portable) (“PSP”) system; Microsoft’s Xbox 360™ (“Xbox 360”) and Xbox® (“Xbox”) video game and entertainment systems; Nintendo’s Wii™ (“Wii”) , GameCube™, DS™ (“DS”) and Game Boy® Advance (“GBA”) ; and for PCs. Our distribution segment, which includes our Jack of All Games subsidiary, distributes our products as well as third-party software, hardware and accessories to retail outlets primarily in North America.

Our strategy is to capitalize on the growth of the interactive entertainment market, particularly the expanding demographics of video game players. We have established a portfolio of successful proprietary software content for the major hardware platforms. We expect Rockstar Games, the publisher of our Grand Theft Auto franchise, to continue to be a leader in the action product category by leveraging our existing titles and developing new brands.

Revenue in our publishing segment is primarily derived from the sale of internally developed software titles, software titles developed on our behalf by third parties and the sale of video game accessories and peripherals. 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 acquisitions and software product development. We develop most of our frontline products internally, and we own major intellectual properties, which we believe best positions us financially and competitively. Operating margins associated with our externally developed titles, or titles for which we do not own the intellectual property are generally lower because they require us to acquire licenses and provide minimum development guarantees.

Revenue in our distribution segment is 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. Software product sales generally yield higher margins than hardware.

Management Reorganization

During the second quarter of 2007, our stockholders elected 5 new directors to our Board of Directors (the “Board”) and one incumbent director rather than the six incumbent directors nominated for election by the incumbent Board. The newly elected Board elected a new Chairman and Chief Executive Officer of the Company, and on March 30, 2007, we entered into an agreement with  ZelnickMedia Corporation (“ZelnickMedia”) for executive management services. The Board and ZelnickMedia immediately began to implement a plan to restructure our executive management team, which included entering into separation agreements with our former Chief Executive Officer and Chief Financial Officer. Additionally, we expanded our Board to a total of eight members in the second quarter of 2007.

Our newly elected Chairman and CEO are principals of ZelnickMedia and the cost for their services to us is covered by our management agreement with ZelnickMedia. Except for health benefits provided to our CEO and reimbursement of expenses, our newly elected Chairman and CEO are not compensated by the Company.

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ZelnickMedia has agreed to provide financial and management consulting services to us and our Board for an initial term through October 31, 2011. In the second quarter of 2007, ZelnickMedia began to assist us in developing a business reorganization plan. We have broadly defined the priorities of such plan as follows:

·       Review and optimize our management and organizational structure.

·       Assess our business units and develop strategic alternatives for any business that is determined to be non-core.

·       Maximize the value of our critical external relationships such as those with hardware and intellectual property licensors.

·       Establish a disciplined approval process for software titles and develop only those with adequate market potential.

·       Pursue swift and appropriate resolution of our outstanding legal and regulatory matters.

In consideration for their services, we have agreed to pay ZelnickMedia an annual management fee of $0.8 million and a bonus of up to $0.8 million per fiscal year based on achieving and exceeding a budgeted earnings level. We have also agreed to grant to ZelnickMedia options to purchase approximately 2.5% of our outstanding common stock on a fully diluted basis, and issue shares of restricted stock based on a formula utilizing the closing stock price on the issuance date. As of April 30, 2007, no stock based compensation had been granted to ZelnickMedia and no stock-based compensation expense has been recorded in connection with this agreement for the three or six months then ended.

We have recorded approximately $1.0 million of professional fees in the second quarter of 2007 to reimburse certain expenses incurred by ZelnickMedia, a related party to the Company.

Product Pipeline

We have announced expected release dates for the following titles:

Title

 

 

 

Platform

 

Expected Release (Fiscal Period)

Manhunt 2

 

Wii, PS2, PSP

 

Third quarter 2007

The BIGS

 

Xbox 360, PS3, Wii, PS2, PSP

 

Third quarter 2007

The Darkness

 

Xbox 360, PS3

 

Third quarter 2007

Fantastic 4: Rise of the Silver Surfer

 

Xbox 360, PS3, Wii, PS2, DS

 

Third quarter 2007

All-Pro Football 2K8

 

Xbox 360, PS3

 

Third quarter 2007

Grand Theft Auto IV

 

Xbox 360, PS3

 

Fourth quarter 2007

BioShock

 

Xbox 360, PC

 

Fourth quarter 2007

Carnival Games

 

Wii

 

Fourth quarter 2007

NBA 2K8

 

Xbox 360, PS3, PS2

 

Fourth quarter 2008

NHL 2K8

 

Xbox 360, PS3, PS2

 

Fourth quarter 2008

Midnight Club: Los Angeles

 

Xbox 360, PS3

 

Fiscal year 2008

L.A. Noire

 

PS3

 

Fiscal year 2008

Grand Theft Auto IV episodic content

 

Xbox 360

 

Fiscal year 2008

College Hoops 2K8

 

Xbox 360, PS3, PS2

 

Fiscal year 2008

Beaterator

 

PSP

 

Fiscal year 2008

Major League Baseball 2K8

 

Multiple Platforms

 

Fiscal year 2008

NBA 2K9

 

Multiple Platforms

 

Fiscal year 2008

NHL 2K9

 

Multiple Platforms

 

Fiscal year 2008

 

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Critical Accounting Policies and Estimates

Our most critical accounting policies, which are those that require significant judgment, include: valuation of goodwill, long-lived assets and stock-based compensation; allowances for returns and price concessions; capitalization and recognition of software development costs and licenses; revenue recognition; and income taxes. In-depth descriptions of these can be found in our Annual Report on Form 10-K for the fiscal year ended October 31, 2006 (the “2006 Form 10-K”). Although there have been no material changes in the accounting policies that we disclosed in our 2006 Form 10-K, we are reiterating our policy on software development costs to provide expanded disclosure about how we determine technological feasibility for our products.

Software Development Costs

We utilize both internal development teams and third-party software developers to develop the titles we publish.

We capitalize internal software development costs (including stock-based compensation, specifically identifiable employee payroll expense and incentive compensation costs related to the completion and release of titles), third-party production and other content costs, subsequent to establishing technological feasibility of a software title. Technological feasibility of a product includes the completion of both technical design documentation and game design documentation. Amortization of such capitalized costs is recorded on a title-by-title basis in cost of goods sold (software development costs) using (1) the proportion of current period revenues to the total revenues expected to be recorded over the life of the title or (2) the straight-line method over the remaining estimated useful life of the title, whichever is greater.

We have established an internal royalty program that allows certain of our employees to participate in the success of software titles that they assist in developing. Royalties earned by employees under this program are recorded to cost of goods sold as they are incurred.

We frequently enter into agreements with third-party developers that require us to make advance payments for game development and production services. In exchange for our advance payments, we receive the exclusive publishing and distribution rights to the finished game title as well as, in some cases, the underlying intellectual property rights. Such agreements allow us to fully recover the advance payments to the developers at an agreed royalty rate earned on the subsequent retail sales of such software, net of any agreed costs. We capitalize all advance payments to developers as software development. On a product-by-product basis, we reduce software development costs and record a corresponding amount of research and development expense for any costs incurred by third-party developers prior to establishing technological feasibility of a product. We typically enter into agreements with third-party developers after completing the technical design documentation for our products and therefore record the design costs leading up to a signed developer contract as research and development expense. We also generally contract with third party developers that have proven technology and experience in the genre of the software being developed, which often allows for the establishment of technological feasibility early in the development cycle. In instances where design and technology are not in place prior to an executed contract, we monitor the software development process and require our third-party developers to adhere to the same technological feasibility standards that apply to our internally developed products.

We capitalize advance payments as software development costs subsequent to establishing technological feasibility of a software title and amortize them, on a title-by-title basis, as royalties in cost of goods sold. Royalty amortization is recorded using (1) the proportion of current period revenues to the total revenues expected to be recorded over the life of the title or (2) the contractual, revenue based royalty rate defined in the respective agreement, whichever is greater. At each balance sheet date, we evaluate the recoverability of advanced development payments and any other unrecognized minimum commitments

17




that have not been paid. To the extent that advance payments are deemed unrecoverable, they are charged to cost of goods sold in the period in which such determination is made.

At each balance sheet date, or earlier if an indicator of impairment exists, we evaluate the recoverability of capitalized software costs using an undiscounted future cash flow analysis, and charge any amounts that are deemed unrecoverable to cost of goods sold. We use various measures to estimate future revenues for our software titles, including past performance of similar titles and orders for titles prior to their release. For sequels, the performance of predecessor titles is also taken into consideration.

Recently Issued Accounting Pronouncements

In September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 157, Fair Value Measurements (“SFAS 157”), which clarifies the definition of fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurement. SFAS 157 does not require any new fair value measurements and eliminates inconsistencies in guidance found in various prior accounting pronouncements. SFAS 157 will be effective for us on November 1, 2008. We are currently assessing whether the adoption of SFAS 157 will have an impact on our financial statements.

In September 2006, the SEC released Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”). SAB 108 provides interpretive guidance on the SEC’s views on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. The provisions of SAB 108 will be effective for us on November 1, 2007. We are currently evaluating the impact of applying SAB 108 but do not believe that its application will have a material effect on our financial position, cash flows, or results of operations.

In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of SFAS No. 109 (“FIN 48”), to create a single model to address the accounting for uncertainty in tax positions. FIN 48 clarifies the accounting for income taxes by prescribing the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 will be effective for us beginning November 1, 2007. The cumulative-effect of adopting FIN 48 will be recorded to opening retained earnings. Management is currently evaluating what effect, if any, the adoption of FIN 48 will have on our consolidated financial statements.

18




Results of Operations

Consolidated operating results, revenue by geographic region and publishing revenue by platform as a percent of revenue are as follows:

 

 

Three months ended
April 30,

 

Six months ended
April 30,

 

 

 

   2007   

 

   2006   

 

   2007   

 

   2006   

 

Net revenue:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Publishing

 

 

74.9

%

 

 

75.5

%

 

 

65.4

%

 

 

67.6

%

 

Distribution

 

 

25.1

%

 

 

24.5

%

 

 

34.6

%

 

 

32.4

%

 

Net revenue

 

 

100.0

%

 

 

100.0

%

 

 

100.0

%

 

 

100.0

%

 

Cost of goods sold:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Product costs

 

 

51.4

%

 

 

49.4

%

 

 

55.9

%

 

 

55.0

%

 

Software development costs and royalties

 

 

26.2

%

 

 

43.9

%

 

 

19.5

%

 

 

31.1

%

 

Total cost of goods sold

 

 

77.7

%

 

 

93.3

%

 

 

75.4

%

 

 

86.1

%

 

Gross profit

 

 

22.3

%

 

 

6.7

%

 

 

24.6

%

 

 

13.9

%

 

Selling and marketing

 

 

13.7

%

 

 

12.1

%

 

 

13.1

%

 

 

13.9

%

 

General and administrative

 

 

19.7

%

 

 

12.7

%

 

 

16.4

%

 

 

13.6

%

 

Research and development

 

 

5.8

%

 

 

6.1

%

 

 

5.4

%

 

 

6.4

%

 

Business reorganization

 

 

4.4

%

 

 

0.0

%

 

 

1.9

%

 

 

0.0

%

 

Impairment of long-lived assets

 

 

0.0

%

 

 

2.4

%

 

 

0.0

%

 

 

1.2

%

 

Depreciation and amortization

 

 

3.4

%

 

 

2.5

%

 

 

2.8

%

 

 

2.5

%

 

Total operating expenses

 

 

47.0

%

 

 

35.8

%

 

 

39.6

%

 

 

37.6

%

 

Loss from operations

 

 

(24.7

)%

 

 

(29.1

)%

 

 

(14.9

)%

 

 

(23.8

)%

 

Interest income, net

 

 

0.5

%

 

 

0.0

%

 

 

0.4

%

 

 

0.0

%

 

Loss before income taxes

 

 

(24.2

)%

 

 

(29.1

)%

 

 

(14.5

)%

 

 

(23.7

)%

 

Income taxes

 

 

0.7

%

 

 

(10.1

)%

 

 

0.5

%

 

 

(8.7

)%

 

Net loss

 

 

(24.9

)%

 

 

(19.0

)%

 

 

(15.1

)%

 

 

(15.0

)%

 

Net revenue by geographic region:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

United States and Canada

 

 

72.5

%

 

 

72.4

%

 

 

75.2

%

 

 

72.0

%

 

Europe, Asia-Pacific and Other

 

 

27.5

%

 

 

27.6

%

 

 

24.8

%

 

 

28.0

%

 

Publishing revenue by platform:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Console

 

 

72.0

%

 

 

65.5

%

 

 

66.7

%

 

 

57.6

%

 

PC

 

 

12.3

%

 

 

20.9

%

 

 

12.0

%

 

 

17.0

%

 

Handheld

 

 

12.6

%

 

 

10.4

%

 

 

17.2

%

 

 

21.2

%

 

Accessories

 

 

3.1

%

 

 

3.2

%

 

 

4.1

%

 

 

4.2

%

 

 

Three Months ended April 30, 2007 compared to April 30, 2006

Publishing

(thousands of dollars)

 

2007

 

%

 

2006

 

%

 

Increase/
(decrease)

 

%
Increase/
(decrease)

 

Net revenue

 

$

153,931

 

100.0

%

$

200,060

 

100.0

%

$

(46,129

)

 

(23.1

)%

 

Cost of goods sold

 

112,380

 

73.0

%

188,956

 

94.4

%

(76,576

)

 

(40.5

)%

 

Gross profit

 

$

41,551

 

27.0

%

$

11,104

 

5.6

%

$

30,447

 

 

274.2

%

 

 

Our decrease in net revenue in 2007 primarily reflects the sales of The Elder Scrolls IV: Oblivion for Xbox 360 and PC, which were $70.3 million higher in the 2006 period. Offsetting the decreased sales of The Elder

19




Scrolls IV: Oblivion were strong sales of our Grand Theft Auto titles and Major League Baseball 2K7, which increased revenue $19.3 million and $7.9 million, respectively, when compared to the prior period. Major League Baseball 2K7 was also released approximately one month earlier in 2007 than in 2006.

Net revenue earned on titles for the PS2 platform continued to remain strong due to its large installed base. We recognized an $18.9 million or 47.1% increase in net revenue on the PS2 in 2007 compared to the prior period, mainly due to the releases of Grand Theft Auto: Vice City Stories and Ghost Rider in the second quarter of 2007 and the continued success of Grand Theft Auto: San Andreas almost two and a half years after its release. Xbox 360 and PC sales declined $46.5 million or 59.5% and $22.9 million or 54.6%, respectively, again reflecting the stronger sales of The Elder Scrolls IV: Oblivion in the 2006 period. Although consumer demand for the PS3 system has not increased as quickly as anticipated, these sales accounted for $16.1 million of our net publishing revenue in the 2007 period, and we expect the PS3 to continue to gain momentum through the rest of the year and into the holiday selling season. Nintendo’s Wii system has sold at a stronger than expected rate in 2007, although we have not yet published software on the Wii system. We have four titles for the Wii, which are expected to be released in the third and fourth quarters. Sales on the Xbox system decreased $7.8 million due to the continuing hardware transition and increased availability of the Xbox 360 system. We have continued to reduce pricing on software titles for the PS2 and Xbox platforms as the next generation hardware installed base grows.

Above average external royalty costs for The Elder Scrolls IV: Oblivion and approximately $18.2 million of impairment charges related to software development contributed to the unusually low gross profit margin in the 2006 period. We also recorded a $5.2 million impairment charge related to intellectual property in the second quarter of 2007, which slightly offset the increase in gross profit margin. However, we realized a significant increase in the gross profit margin of our sports products, particularly Major League Baseball 2K7, NBA 2K7 and College Hoops 2K7, each of which had higher revenues than their predecessor games on comparable amounts of software development costs. Licensing costs were also lower as a percentage of net revenue in 2007, particularly for our baseball titles where we have a greater number of products planned for release than in the prior year. We expect to realize increasing gross profit margins toward the end of fiscal 2007 and into fiscal 2008 with the releases of our internally developed, non-licensed titles such as Grand Theft Auto IV, BioShock and Midnight Club: Los Angeles.

Revenue earned from licensing our intellectual property to third parties increased to $5.9 million in the second quarter of 2007 from $2.7 million in the 2006 period, primarily related to our January 2007 release of Grand Theft Auto: San Andreas for the PS2 in Japan. We recognize substantially higher gross profit margins on revenue earned in connection with licensing our products.

Revenue earned outside of North America accounted for approximately $56.4 million in the second quarter of 2007 compared to $73.1 million in the 2006 period. The year-over-year decrease was primarily attributable to strong sales of The Elder Scrolls IV: Oblivion in the prior period. Foreign exchange rates benefited revenue by approximately $5.1 million in the second quarter of 2007.

Distribution

(thousands of dollars)

 

2007

 

%

 

2006

 

%

 

Increase/
(decrease)

 

%
Increase/
(decrease)

 

Net revenue

 

$

51,505

 

100.0

%

$

65,062

 

100.0

%

$

(13,557

)

 

(20.8

)%

 

Cost of goods sold

 

47,202

 

91.6

%

58,394

 

89.8

%

(11,192

)

 

(19.2

)%

 

Gross profit

 

$

4,303

 

8.4

%

$

6,668

 

10.2

%

$

(2,365

)

 

(35.5

)%

 

 

Net revenue associated with software on current generation platforms decreased $4.7 million or 37.4% compared to the 2006 period, resulting from the continued decline in sales volume and average selling

20




price of value and frontline software titles as the gaming industry transitions to next generation platforms. We also continue to see increased competition in the value software market. In addition, we experienced a decline in sales of our PC products of $4.6 million and Nintendo handhelds of $2.5 million. Lower net revenue was partially offset by an increase in next generation software sales of $2.1 million, which includes PS3, Xbox 360 and Wii, all of which were sold at higher price points than their predecessor products. We expect to see increases in sales for next generation platforms, especially the PS3 system, as the installed base of the hardware continually grows through the transition period. We recognized a slight decrease in gross profit margin as our sales of PC products declined, which typically realize higher margins.

Operating Expenses

(thousands of dollars)

 

2007

 

% of net
revenue

 

2006

 

% of net
revenue

 

Increase/
(decrease)

 

%
Increase/
(decrease)

 

Selling and marketing

 

$

28,159

 

 

13.7

%

 

$

32,194

 

 

12.1

%

 

 

$

(4,035

)

 

 

(12.5

)%

 

General and administrative

 

40,471

 

 

19.7

%

 

33,705

 

 

12.7

%

 

 

6,766

 

 

 

20.1

%

 

Research and development

 

11,936

 

 

5.8

%

 

16,097

 

 

6.1

%

 

 

(4,161

)

 

 

(25.8

)%

 

Business reorganization

 

8,962

 

 

4.4

%

 

 

 

0.0

%

 

 

8,962

 

 

 

N/M

 

 

Impairment of long-lived assets

 

 

 

0.0

%

 

6,249

 

 

2.4

%

 

 

(6,249

)

 

 

N/M

 

 

Depreciation and amortization

 

7,076

 

 

3.4

%

 

6,695

 

 

2.5

%

 

 

381

 

 

 

5.7

%

 

Total operating expenses(1)

 

$

96,604

 

 

47.0

%

 

$

94,940

 

 

35.8

%

 

 

$

1,664

 

 

 

1.8

%

 


(1)          Includes stock-based compensation expense, which was allocated as follows:

Selling and marketing

 

$

312

 

 

 

 

 

$

517

 

 

 

 

 

 

 

 

 

 

 

 

 

General and administrative

 

2,154

 

 

 

 

 

2,211

 

 

 

 

 

 

 

 

 

 

 

 

 

Research and development

 

1,070

 

 

 

 

 

1,133

 

 

 

 

 

 

 

 

 

 

 

 

 

Business reorganization

 

1,801

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

We ran significant marketing campaigns in conjunction with our March 2006 launch of The Elder Scrolls IV: Oblivion, which caused selling and marketing expense to be substantially higher in the 2006 period.

General and administrative expenses increased as a result of higher professional fees associated with regulatory matters, including our stock options investigation and New York County District Attorney’s subpoenas, which were $2.0 million for the three months ended April 30, 2007. In addition, we had higher salaries and related expenses of $2.6 million, primarily in our European territories in the 2007 period resulting from the relocation of our international publishing headquarters to Geneva, Switzerland. General and administrative expenses for the quarters ended April 30, 2007 and 2006 also include occupancy expenses (primarily rent, utilities and office expenses) of $3.9 million and $3.7 million, respectively, related to our development studios.

Our 2006 studio closings resulted in a reduced number of development personnel, improved software capitalization rates and a corresponding reduction in research and development expense in the second quarter of 2007. In addition, there was approximately $1.6 million of severance expense recorded in the second quarter of 2006 as a result of the studio closures.

Business reorganization and related expenses include severance of $5.2 million for the termination of employment agreements with our former Chief Executive Officer and Chief Financial Officer in April 2007. In total, we spent $3.8 million on professional fees related to the change in a majority of the members of our Board at our Annual Meeting and the subsequent replacement of prior management, $2.0 million of which was investment banking fees incurred by prior management to consider the possibility of

21




presenting alternative proposals to our stockholders, including a potential sale of the Company. We expect to continue to incur reorganization expenses through the remainder of 2007 and in fiscal 2008.

In the second quarter of 2006, we recorded approximately $6.2 million of impairment charges related to the write-off of certain trademarks and acquired intangibles.

Provision (benefit) for income taxes.   For the three months ended April 30, 2007, income tax expense was $1.5 million, primarily attributable to foreign jurisdictions, compared to an income tax benefit of $26.8 million in the second quarter of 2006. We did not record an income tax benefit on our pre-tax loss in 2007 due to uncertainty regarding the realization of our deferred tax assets, primarily those attributable to U.S. net operating loss carryforwards. As a result, we increased our valuation allowance by approximately $18.9 million in the second quarter of 2007.

Consequently, our effective tax rate was -3.1% for the three months ended April 30, 2007, compared to an effective tax benefit of 34.7% for the comparable period in fiscal 2006.

We are regularly audited by domestic and foreign taxing authorities. Audits may result in tax assessments in excess of amounts claimed and the payment of additional taxes. We believe that our tax positions comply with applicable tax law, and that we have adequately provided for reasonably foreseeable tax assessments.

Net loss and loss per share.   For the three months ended April 30, 2007, net loss was $51.2 million, compared to $50.4 million in the 2006 period. Net loss per share for the three months ended April 30, 2007 and April 30, 2006 was $0.71.  Weighted average shares outstanding were relatively flat compared to the prior period and did not have a significant impact on our loss per share.

Six Months ended April 30, 2007 compared to April 30, 2006

Publishing

(thousands of dollars)

 

2007

 

%

 

2006

 

%

 

Increase/
(decrease)

 

%
Increase/
(decrease)

 

Net revenue

 

$

315,919

 

100.0

%

$

358,349

 

100.0

%

$

(42,430

)

 

(11.8

)%

 

Cost of goods sold

 

211,548

 

67.0

%

299,095

 

83.5

%

(87,547

)

 

(29.3

)%

 

Gross profit

 

$

104,371

 

33.0

%

$

59,254

 

16.5

%

$

45,117

 

 

76.1

%

 

 

Sales of The Elder Scrolls IV: Oblivion for Xbox 360 and PC, which we released in the second quarter of 2006, accounted for approximately $62.0 million of the decrease in our net revenue in 2007. Offsetting the decrease were the strong sales of our sports titles (Major League Baseball 2K7, NBA 2K7, NHL 2K7, and College Hoops 2K7), which sold an additional $23.3 million compared to their respective predecessor titles in the prior year.

Net revenue earned on titles for the PS2 platform continued to remain strong due to its large installed base, with a $30.7 million or 35.2% increase due to the release of Grand Theft Auto: Vice City Stories and Ghost Rider in the second quarter of 2007 and the continued success of Grand Theft Auto: San Andreas almost two and a half years after its release. Software sales on the Xbox 360 and PC declined $38.2 million or 40.5% and $23.0 million or 37.7%, respectively, again reflecting the strong sales of The Elder Scrolls IV: Oblivion in the 2006 period. Although consumer demand for the PS3 system has not increased as quickly as anticipated, these sales accounted for $26.2 million or 8.3% of our net publishing revenue in the 2007 period, and we expect the PS3 to continue to gain momentum through the rest of the year and into the holiday selling season. Nintendo’s Wii system has sold at a stronger than expected rate in 2007, although we have not yet published software on the Wii system. We have four titles in development for the Wii which are expected to be released in the third and fourth quarters. Sales on the PSP system have decreased

22




$18.2 million primarily due to the strong sales of Grand Theft Auto: Liberty City Stories in the 2006 period. Sales on the Xbox system have decreased $12.7 million due to the continuing hardware transition and increased availability of the Xbox 360 system. We have continued to reduce pricing on software titles for the PS2 and Xbox platforms as the next generation hardware installed base grows.

Above average external royalty costs for The Elder Scrolls IV: Oblivion and approximately $18.2 million of impairment charges related to software development contributed to the unusually low gross profit margin in the 2006 period. In the 2007 period, we recorded a $5.2 million impairment charge related to intellectual property, which slightly offset the increase in gross profit margin. However, we were able to realize a significant increase in our gross profit margin of our sports products,  particularly Major League Baseball 2K7, NBA 2K7 and College Hoops 2K7, which had significantly higher revenues than their predecessor games on a comparable amount of software development costs. Licensing costs were also lower as a percentage of net revenue, particularly for our baseball titles where we have a greater number of products planned for release than in the prior year. We expect to realize increasing margins toward the end of fiscal 2007 and into fiscal 2008 with the release of internally developed, non-licensed titles such as Grand Theft Auto IV, BioShock and Midnight Club: Los Angeles.

Revenue earned from licensing our intellectual property to third parties increased to $15.2 million in the six months ended April 30, 2007 from $5.8 million in 2006, primarily related to our January 2007 release of Grand Theft Auto: San Andreas for the PS2 in Japan. We recognize substantially higher gross profit margins on revenue earned in connection with our licensing our products.

Revenue earned outside of North America accounted for approximately $119.7 million in the six months ended April 30, 2007 compared to $148.5 million in 2006. The year-over-year decrease was primarily attributable to strong sales of The Elder Scrolls IV: Oblivion in the prior period. Foreign exchange rates benefited revenue by approximately $9.7 million in the six months ended April 30, 2007.

Distribution

(thousands of dollars)

 

2007

 

%

 

2006

 

%

 

Increase/
(decrease)

 

%
Increase/
(decrease)

 

Net revenue

 

$

166,857

 

100.0

%

$

171,754

 

100.0

%

 

$

(4,897

)

 

 

(2.9

)%

 

Cost of goods sold

 

152,259

 

91.3

%

157,569

 

91.7

%

 

(5,310

)

 

 

(3.4

)%

 

Gross profit

 

$

14,598

 

8.7

%

$

14,185

 

8.3

%

 

$

413

 

 

 

2.9

%

 

 

Distribution revenue associated with software sales on current generation platforms decreased $11.8 million in 2007 as a result of the continued decline in sales volume and average selling price of value and frontline software titles as the gaming industry transitions to next generation platforms. We also continue to see increased competition in the value software market. In addition, we experienced a decline in sales of our PC products of $4.2 million or 15.0%. The decrease in net revenue was partially offset by an increase in next generation hardware sales, including Xbox 360, Wii and PS3, along with software titles for those platforms, all of which were sold at higher price points than their predecessor products. Software sales for next generation consoles increased $8.3 million compared to 2006. We expect to see increases in sales for next generation platforms, especially the PS3 system, as the installed base of the hardware continually grows through the transition period.

Gross profit margins remained relatively unchanged compared to the prior year, although our software sales for next generation titles in 2007 realized higher gross margins than those in the prior period. Offsetting the increase in gross margin was lower sales of PC products, which typically realize higher margins than console products.

23




Operating Expenses

 

 

 

 

 

 

 

 

 

 

 

 

%

 

 

 

 

 

% of net

 

 

 

% of net

 

Increase/

 

Increase/

 

(thousands of dollars)

 

2007

 

revenue

 

2006

 

revenue

 

(decrease)

 

(decrease)

 

Selling and marketing

 

$

63,183

 

 

13.1

%

 

$

73,838

 

 

13.9

%

 

$

(10,655

)

 

(14.4

)%

 

General and administrative

 

79,085

 

 

16.4

%

 

72,158

 

 

13.6

%

 

6,927

 

 

9.6

%

 

Research and development

 

26,086

 

 

5.4

%

 

33,806

 

 

6.4

%

 

(7,720

)

 

(22.8

)%

 

Business reorganization

 

8,962

 

 

1.9

%

 

 

 

0.0

%

 

8,962

 

 

N/M

 

 

Impairment of long-lived assets

 

 

 

0.0

%

 

6,249

 

 

1.2

%

 

(6,249

)

 

N/M

 

 

Depreciation and amortization

 

13,737

 

 

2.8

%

 

13,346

 

 

2.5

%

 

391

 

 

2.9

%

 

Total operating expenses(1)

 

$

191,053

 

 

39.6

%

 

$

199,397

 

 

37.6

%

 

$

(8,344

)

 

(4.2

)%

 


(1)          Includes stock-based compensation expense, which was allocated as follows:

Selling and marketing

 

$

619

 

 

 

 

 

$

1,224

 

 

 

 

 

 

 

 

 

 

 

General and administrative

 

4,100

 

 

 

 

 

5,404

 

 

 

 

 

 

 

 

 

 

 

Research and development

 

2,257

 

 

 

 

 

2,066

 

 

 

 

 

 

 

 

 

 

 

Business reorganization

 

1,801

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

We ran significant marketing campaigns in conjunction with our launches on the Xbox 360 platform of The Elder Scrolls IV: Oblivion, NBA 2K6 and NHL 2K6 in the 2006 period. We released NBA 2K7 and NHL 2K7 for the Xbox 360 in the fourth quarter of our 2006 fiscal year and as a result, the 2007 period does not include a comparable amount of selling and marketing expense.

General and administrative expenses increased as a result of higher professional fees associated with regulatory matters, including our stock options investigation and New York County District Attorney’s subpoenas, which were $9.2 million for the six months ended April 30, 2007. General and administrative expenses for the six months ended April 30, 2007 and 2006 also include occupancy expenses (primarily rent, utilities and office expenses) of $7.6 million and $7.3 million, respectively, related to our development studios.

Our 2006 studio closings resulted in a reduced number of development personnel, improved software capitalization rates and a corresponding reduction in research and development expense in the six months ended April 30, 2007. In addition, there was approximately $1.6 million of severance expense recorded in the six months ended April 30, 2006 as a result of the studio closures.

Business reorganization and related expenses include severance of $5.2 million for the termination of employment agreements with our former Chief Executive Officer and Chief Financial Officer in April 2007. In total, we spent $3.8 million on professional fees related to the replacement of prior management and the election of five new directors to our board of directors at our annual stockholders’ meeting (rather than the six incumbent directors nominated and recommended by our incumbent board of directors), $2.0 million of which was investment banking fees incurred by prior management to consider the possibility of presenting alternative proposals to our stockholders, including a potential sale of the Company. We expect to continue to incur reorganization expenses through the remainder of 2007 and in fiscal 2008.

In the second quarter of 2006, we recorded approximately $6.2 million of impairment charges related to the write-off of certain trademarks and acquired intangibles.

Provision (benefit) for income taxes.   Income tax expense was $2.6 million, primarily attributable to foreign jurisdictions, for the six months ended April 30, 2007 as compared to an income tax benefit of $46.2 million in the six months ended April 30, 2006. We did not record an income tax benefit on our pre-tax loss in 2007

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due to uncertainty regarding the realization of our deferred tax assets, primarily those attributable to U.S. net operating loss carryforwards. As a result, we increased our valuation allowance by approximately $25.3 million in the six months ended April 30, 2007.

Consequently, our effective tax rate was -3.7% for the six months ended April 30, 2007, compared to an effective tax benefit of 36.8% for the comparable period in fiscal 2006.

We are regularly audited by domestic and foreign taxing authorities. Audits may result in tax assessments in excess of amounts claimed and the payment of additional taxes. We believe that our tax positions comply with applicable tax law, and that we have adequately provided for reasonably foreseeable tax assessments.

Net loss and loss per share.   For the six months ended April 30, 2007, net loss was $72.8 million, compared to $79.5 million in the 2006 period. Net loss per share for the six months ended April 30, 2007 was $1.02, compared to $1.12 in the 2006 period. Weighted average shares outstanding were relatively flat compared to the prior period and did not have a significant impact on our loss per share.

Liquidity and Capital Resources

Our primary cash requirements have been to fund (i) the development, manufacturing and marketing of our published products (ii) working capital (iii) acquisitions and (iv) capital expenditures. In addition, we expect to incur further cash obligations as part of our business reorganization initiatives. Historically, we relied on funds provided by operating activities and short and long-term borrowings to satisfy our working capital needs.

We are subject to credit risks, particularly in the event that any of the receivables represent a limited number of retailers or are concentrated in foreign markets. If we are unable to collect our accounts receivable as they become due, it could adversely affect our liquidity and working capital position and we would be required to increase our provision for doubtful accounts.

As of April 30, 2007 and October 31, 2006, amounts due from our five largest customers comprised approximately 65.5% and 45.4%, respectively, of our gross accounts receivable balance with our significant customers (those that individually comprise more than 10% of our gross accounts receivable balance) accounting for 51.6% and 36.4% of such balance at April 30, 2007 and October 31, 2006, respectively. We believe that the receivable balances from these largest customers do not represent a significant credit risk based on past collection experience.

Generally, we collect our accounts receivable in the ordinary course of business. We do not hold any collateral to secure payment from customers and our receivables are generally not covered by insurance. However, from time to time we purchase insurance from financial institutions on our accounts receivable, with certain limits, to help protect us from loss in the event of a customer’s bankruptcy or insolvency.

We have approximately $75 million of license and marketing commitments due within one year and approximately $325 million of such commitments over the next six years. We entered into significant long-term agreements, primarily with major sports leagues and players’ associations, for intellectual properties including trademarks, player likenesses and player stats for use in the publishing, marketing and distribution of certain of our software titles. We acquired non-exclusive licenses for National Basketball Association (“NBA”) and National Hockey League (“NHL”) themed titles, and a third-party exclusive license for Major League Baseball (“MLB”) themed titles. For certain of these agreements, in addition to the license and marketing commitments, we are subject to certain penalties based on minimum product requirements and release schedules. We also occasionally enter into agreements to license, publish, market and distribute titles based on major motion pictures and other popular entertainment properties such as Fantastic 4: Rise of the Silver Surfer, Ghost Rider, The Da Vinci Code and Charlie and the Chocolate Factory.

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Generally our licensing agreements require significant cash commitments by us, including, in some cases, marketing commitments in support of these titles.

We have approximately $50 million of commitments with several third-party software development studios expiring at various times through November 2008. These commitments require us to make advance payments to such developers, which we later have the ability to recover as pre-agreed sales thresholds are met.

In the second quarter of 2007, we also entered into a distribution agreement which requires us to purchase a minimum of approximately $19 million in inventory through the remainder of 2007. In addition we have operating lease commitments, primarily for office space, which total nearly $100 million over the next seven years and generally range between $15 million and $18 million per year.

We believe that our current cash and cash equivalents and projected cash flow from operations will provide us with sufficient liquidity to satisfy our cash requirements for working capital, capital expenditures and commitments through at least the next twelve months. If our projected cash flow and available cash is insufficient to fund our operations, or if our plans and assumptions change or prove to be inaccurate, we may be required to seek additional financing.

Our changes in cash and cash equivalents are as follows: