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

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All statements, other than statements of historical fact, including statements regarding industry prospects and future results of operations or financial position, made in this Quarterly Report on Form 10-Q are forward looking. We use words such as “anticipates”, “believes”, “expects”, “intends”, “future” and similar expressions to help identify forward-looking statements. These forward-looking statements are subject to business and economic risk and management’s expectations, and are inherently uncertain and difficult to predict. Our actual results could differ materially from management’s expectations due to such risks. We will not necessarily update information if any forward-looking statement later turns out to be inaccurate. Risks and uncertainties that may affect our future results include, but are not limited to, those discussed in this report below under the heading “Risk Factors”, as well as in our Annual Report on Form 10-K for the fiscal year ended March 31, 2004 as filed with the Securities and Exchange Commission (“SEC”) on June 4, 2004 and in other documents we have filed with the SEC.

OVERVIEW

The following overview is a top-level discussion of our operating results as well as the trends and drivers of our business. Management believes that an understanding of these trends and drivers is important in order to understand our results for the quarter ended June 30, 2004, as well as our future prospects. This summary is not intended to be exhaustive, nor is it intended to be a substitute for the detailed discussion and analysis provided elsewhere in this Form 10-Q, including in the remainder of “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, “Risk Factors” or the condensed consolidated financial statements and related notes. Additional information can be found within the “Business” section of our Annual Report on Form 10-K for the fiscal year ended March 31, 2004 as filed with the SEC on June 4, 2004 and in other documents we have filed with the SEC.

About Electronic Arts

Electronic Arts develops, markets, publishes and distributes interactive software games that are playable by consumers on home videogame machines (such as the Sony PlayStation ^® 2, Microsoft Xbox ^® , Nintendo GameCube ^™ consoles), personal computers (PC), hand-held game machines (such as the Game Boy ^® Advance) and online, over the Internet and other proprietary online networks. Many of our games are based on content that we license from others (e.g., Madden NFL Football, Harry Potter and FIFA Soccer), and many of our games are based on intellectual property that is wholly-owned by us (e.g., The Sims ^™ and Medal of Honor ^™ ). Our goal is to develop titles which appeal to the mass markets and as a result, we develop, market, publish and distribute our games in over 100 countries, often translating and localizing them for sale in non-English speaking countries. Our goal is to create software game “franchises” that allow us to publish new titles on a recurring basis that are based on the same property. Examples of this are our annual iterations of our sports-based franchises (e.g., NCAA Football and FIFA Soccer), titles based on long-lived movie properties (e.g., James Bond ^™ ) and wholly-owned properties that can be successfully sequeled (e.g., SimCity ^™ ).

Overview of Financial Results

Net revenue for the three month period ended June 30, 2004 was $432 million, up 22 percent, as compared to the three month period ended June 30, 2003. Our results were driven by strong sales of three new titles, Harry Potter and the Prisoner of Azkaban ^™ , EA SPORTS ^™ Fight Night 2004 , and UEFA Euro 2004 , as well as continued strong sales of Need for Speed ^™ Underground and MVP Baseball ^™ 2004 .

Net income for the quarter was $24 million, a 32 percent increase compared to the same period a year ago. Diluted earnings per share was $0.08 as compared with $0.06 for the prior year.

We used $66 million of cash in operations during the three months ended June 30, 2004 as compared to $34 million in the three month period ended June 30, 2003. The increase in cash used was primarily a result of the timing of sales during the quarter.

Management’s Overview of Historical and Prospective Business Trends

Sales of “Hit” Titles. During fiscal 2004, sales of a number of “hit” titles contributed to our revenue growth, several of which were top sellers across a number of international markets. Continuing this trend, our top-five-selling titles across all platforms

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worldwide during the three months ended June 30, 2004 were the franchise titles Harry Potter and the Prisoner of Azkaban , EA SPORTS Fight Night 2004 , UEFA Euro 2004 , Need for Speed Underground and MVP Baseball 2004 . Hit titles are important to our financial performance because they benefit from overall economies of scale. We have developed, and it is our objective to continue to develop, many of our hit titles to become franchise titles that can be regularly iterated.

Increased Console Installed Base. As consumers purchase the current generation of consoles, either as a first time buyer or by upgrading from a previous generation, this increases the console installed base. As the installed base for a particular console increases, we are generally able to increase our unit volume; however, these unit volumes often begin to decrease as consumers anticipate the next generation of consoles. In the U.S. and Europe, we believe the installed base for the current generation of consoles – the PlayStation2, Xbox and Nintendo GameCube – increased significantly during the period ended June 30, 2004 as compared to June 30, 2003. Accordingly, we believe the significant increase in the installed base for these consoles was a contributing factor to our net revenue growth during the three months ended June 30, 2004. In March 2004, Microsoft reduced the retail price of its Xbox console in the U.S. and in May 2004 Sony did the same with its PlayStation2 console. As price reductions drive sales of consoles and the related installed base of these current generation consoles increases during fiscal 2005, we expect unit sales of current generation titles to remain strong.

Software Prices. As current generation console prices decrease, we expect more value-oriented consumers to become part of the interactive entertainment software market. We experienced this trend several years ago when prices were reduced on previous generation consoles (e.g., Sony PlayStation and Nintendo 64). We believe that hit titles will continue to be launched at premium price points and will maintain those premium price points longer than less popular games. However, as a result of a more value-oriented consumer base, and a greater number of software titles being published, we expect average software prices to gradually come down, which may negatively impact our gross margin.

International Sales Growth. During the first three months of fiscal 2005, net revenue from international sales accounted for approximately 51 percent of our worldwide net revenue, up from 44 percent during the first three months of fiscal 2004. Our first quarter increase in international net revenue was primarily driven by increased sales in Europe, where UEFA Euro 2004 benefited from being released in conjunction with the UEFA Euro 2004 football tournament. For the remainder of fiscal 2005, we anticipate that international net revenue will continue to increase – although not at the same rate as in fiscal 2004 – as we strengthen our presence in new territories, with a particular emphasis on Asia, and as the console installed base expands outside of North America.

Foreign Exchange Impact . Given that a significant portion of our business is conducted internationally in foreign currency, fluctuations in currency prices can have a material impact on our results of operations. For example, the average exchange rate for the Euro, as compared to the U.S. dollar, increased from $1.13 per Euro during the three months ended June 30, 2003 to $1.20 per Euro during the three months ended June 30, 2004. As a result of the fluctuations in currency prices, we had a total foreign exchange benefit on net revenue of approximately $13 million during the three months ended June 30, 2004. Although we intend to continue to utilize foreign exchange forward and option contracts to either mitigate or hedge against some foreign currency exposures, we cannot predict the effect foreign currency fluctuations will have on us in fiscal 2005.

Increasing Cost of Titles. Hit titles have become increasingly more expensive to produce and market as the platforms on which they are played continue to advance technologically and consumers demand continual improvements in the overall gameplay experience. We expect this trend to continue as we require larger production teams to create our titles, the technology needed to develop titles becomes more complex, the number and nature of the platforms for which we develop titles increases and becomes more diverse, the cost of licensing the third-party intellectual property we use in many of our titles potentially increases, we continue to develop additional Internet capabilities included in our products, and we develop new methods to distribute our content via the Internet.

Expansion of Studio Resources and Technology. During fiscal 2004, as part of our effort to more efficiently utilize our resources and technology, we expanded our studio facilities in Los Angeles and Vancouver, allowing us to consolidate several smaller studios and resources. In fiscal 2005, we expect to devote significant resources primarily to the expansion of our studios in North America and Europe. As we move through the life cycle of current generation consoles, we will devote increased resources to developing selected current generation titles, and increase spending associated with tools and technologies for the next generation of platforms and technology. We expect our studio expansions to enable us to support these investments and allow us to develop new titles. We expect these activities to increase our research and development expenses and decrease our third-party development costs, both as a percentage of net revenue. We anticipate that the decrease in third-party development royalty costs will have a positive impact on our gross margin during fiscal 2005.

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CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Our Condensed Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these Condensed Consolidated Financial Statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, contingent assets and liabilities, and revenue and expenses during the reporting periods. The policies discussed below are considered by management to be critical because they are not only important to the portrayal of our financial condition and results of operations but also because application and interpretation of these policies requires both judgment and estimates of matters that are inherently uncertain and unknown. As a result, actual results may differ materially from our estimates.

Sales returns and allowances and bad debt reserves

We principally derive revenue from sales of packaged interactive software games designed for play on videogame platforms (such as the PlayStation 2, Xbox and Nintendo GameCube), PCs and hand-held game machines (such as the Nintendo Game Boy Advance). Product revenue is recognized net of sales allowances. We also have stock-balancing programs for our PC products, which allow for the exchange of PC products by resellers under certain circumstances. We may decide to provide price protection for both our personal computer and videogame system products. In making this determination, we evaluate inventory remaining in the channel, the rate of inventory sell-through in the channel, and our remaining inventory on hand. It is our general practice to exchange products or give credits, rather than give cash refunds.

We estimate potential future product returns, price protection and stock-balancing programs related to current-period product revenue. We analyze historical returns, current sell-through of distributor and retailer inventory of our products, current trends in the videogame market and the overall economy, changes in customer demand and acceptance of our products and other related factors when evaluating the adequacy of the sales returns and price protection allowances. In addition, management monitors and manages the volume of our sales to retailers and distributors and their inventories, as substantial overstocking in the distribution channel can result in high returns or substantial price protection requirements in subsequent periods. In the past, actual returns have not generally exceeded our reserves. However, actual returns and price protections may materially exceed our estimates as unsold products in the distribution channels are exposed to rapid changes in consumer preferences, market conditions or technological obsolescence due to new platforms, product updates or competing products. For example, the risk of product returns for our products may increase as the PlayStation 2, Xbox and Nintendo GameCube consoles pass the midpoint of their lifecycle and an increasing number and aggregate amount of competitive products heighten pricing and competitive pressures. While management believes it can make reliable estimates regarding these matters, these estimates are inherently subjective. Accordingly, if our estimates changed, our returns reserves would change, which would impact the net revenue we report. For example, if actual returns were significantly greater than the reserves we have established, our actual results would decrease our reported net revenue. Conversely, if actual returns were significantly less than our reserves, this would increase our reported net revenue.

Similarly, significant judgment is required to estimate our allowance for doubtful accounts in any accounting period. We determine our allowance for doubtful accounts by evaluating customer creditworthiness in the context of current economic trends. Depending upon the overall economic climate and the financial condition of our customers, the amount and timing of our bad debt expense and cash collection could change significantly.

We cannot predict customer bankruptcies or an inability of any of our customers to meet their financial obligations to us. Therefore, our estimates could differ materially from actual results.

Royalties & Licenses

Our royalty expenses consist of payments to (1) content licensors, (2) independent software developers and (3) co-publishing and/or distribution affiliates. License royalties consist of payments made to celebrities, professional sports organizations, movie studios and other organizations for our use of their trademark, copyright, personal rights, content and/or other intellectual property. Royalty payments to independent software developers are payments for the development of intellectual property related to our games. Co-publishing and distribution royalties are payments made to third parties for delivery of product.

Royalty-based payments made to content licensors and distribution affiliates are generally capitalized as prepaid royalties and expensed to cost of goods sold at the greater of the contractual or effective royalty rate based on net product sales. With regard to payments made to independent software developers and co-publishing affiliates, these payments are generally in connection

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with the development of a particular product and, therefore, we are generally subject to development risk prior to the general release of the product. Accordingly, payments that are due prior to completion of a product are generally expensed as research and development as the services are incurred. Payments due after completion of the product (primarily royalty-based in nature) are generally expensed as cost of goods sold at the higher of the contractual or effective royalty rate based on net product sales.

Minimum guaranteed royalty obligations are initially recorded as an asset and as a liability at the contractual amount when no significant performance remains with the licensor. When significant performance remains with the licensor, we record royalty payments as an asset when actually paid rather than upon execution of the contract. Minimum royalty payment obligations are classified as current liabilities to the extent such royalty payments are due within the next twelve months. As of June 30, 2004 and March 31, 2004, approximately $57.2 million and $63.4 million, respectively, of minimum guaranteed royalty obligations had been recognized.

Each quarter, we also evaluate the future realization of our royalty-based assets as well as any unrecognized minimum commitments not yet paid to determine amounts we deem unlikely to be realized through product sales. Any impairments determined before the launch of a product are charged to research and development expense. Impairments determined post-launch are charged to cost of goods sold. In either case, we rely on estimated revenue to evaluate the future realization of prepaid royalties. If actual sales or revised revenue estimates fall below the initial revenue estimate, then the actual charge taken may be greater in any given quarter than anticipated. As of June 30, 2004, we had $83.3 million of royalty-based assets and $61.1 million of unrecognized minimum commitments not yet paid that could be impaired if our revenue estimates changed.

Valuation of long-lived assets

We evaluate both purchased intangible assets and other long-lived assets in order to determine if events or changes in circumstances indicate a potential impairment in value exists. This evaluation requires us to estimate, among other things, the remaining useful lives of the assets and future cash flows of the business. These evaluations and estimates require the use of judgment. Our actual results could differ materially from our current estimates.

Under current accounting standards, we make judgments about the remaining useful lives of purchased intangible assets and other long-lived assets whenever events or changes in circumstances indicate a potential impairment in the remaining value of the assets recorded on our consolidated balance sheet. In order to determine if a potential impairment has occurred, management makes various assumptions about the future value of the asset by evaluating future business prospects and estimated cash flows. Our future net cash flows are primarily dependent on the sale of products for play on proprietary videogame consoles, hand-held game machines and PCs (“platforms”). The success of our products is affected by our ability to accurately predict which platforms and which products we develop will be successful. Also, our revenue and earnings are dependent on our ability to meet our product release schedules. Due to product sales shortfalls, we may not realize the future net cash flows necessary to recover our long-lived assets, which may result in an impairment charge being recorded in the future. There were no impairment charges recorded in the three months ended June 30, 2004 or June 30, 2003.

Income taxes

In the ordinary course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. As part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate prior to the completion and filing of tax returns for such periods. This process requires estimating both our geographic mix of income and our current tax exposures in each jurisdiction where we operate. These estimates involve complex issues, require extended periods of time to resolve, and require us to make judgments, such as anticipating the positions that we will take on tax returns prior to our actually preparing the returns and the outcomes of disputes with tax authorities. We are also required to make the determinations of the need to record deferred tax liabilities and the recoverability of deferred tax assets. A valuation allowance is established to the extent recovery of deferred tax assets is not likely based on our estimation of future taxable income in each jurisdiction.

In addition, changes in our business, including acquisitions and the geographic mix of income, as well as changes in valuation allowances, the applicable accounting rules, the applicable tax laws and regulations, rulings and interpretations thereof, developments in tax audit matters, and variations in the estimated and actual level of annual pre-tax income can affect the overall effective income tax rate. For example, in the fourth quarter of fiscal 2004, we resolved certain tax-related matters with the Internal Revenue Service, which lowered our income tax expense by $19.7 million and resulted in a 2.5 percent rate reduction during the fourth quarter of fiscal 2004.

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To determine our projected effective income tax rate each quarter prior to the end of a fiscal year, we are required to make a projection of several items, including our projected mix of full-year income in each jurisdiction in which we operate and the related income tax expense in each jurisdiction. The estimated effective income tax rate is also adjusted for taxes related to significant unusual items. The actual results could vary from those projected, and as such, the overall effective income tax rate for a fiscal year could be different from that projected for the full year.

RESULTS OF OPERATIONS

Our fiscal year is reported on a 52/53-week period that ends on the final Saturday of March in each year. The results of operations for fiscal 2005 and 2004 contain 52 weeks. The results of operations for the fiscal quarters ended June 30, 2004 and June 30, 2003 each contain 13 weeks ending on June 26, 2004 and June 28, 2003, respectively. For simplicity of presentation, all fiscal periods are reported as ending on a calendar month end.

Net Revenue

We principally derive net revenue from sales of packaged interactive software games designed for play on videogame consoles (such as the PlayStation 2, Xbox and Nintendo GameCube), PCs and hand-held game machines (such as the Nintendo Game Boy Advance). Additionally, in Europe and Asia we generate a significant portion of net revenue by marketing and selling third-party interactive software games through our established distribution network. We also derive net revenue from selling subscriptions to some of our online games, programming third-party web sites with our game content, allowing other companies to manufacture and sell our products in conjunction with other products, and selling advertisements on our online web pages.

From a geographical perspective, our net revenue for the three months ended June 30, 2004 and 2003 was as follows (in thousands):

North America

For the three months ended June 30, 2004, net revenue in North America increased by 6.2 percent as compared to the three month period ended June 30, 2003. From a franchise perspective, the net revenue increase was primarily driven by higher sales of products in the following four franchises: Fight Night, Harry Potter, Need for Speed and MVP Baseball. Increased sales in these franchises resulted in increased net revenue of $93.6 million for the three months ended June 30, 2004 as compared to the three months ended June 30, 2003. This increase was offset by an $81.7 million decrease in our NBA STREET, Def Jam and The Sims franchises during the three months ended June 30, 2004 as compared to the three months ended June 30, 2003.

Europe

For the three months ended June 30, 2004, net revenue in Europe increased by 48.5 percent as compared to the same period a year ago. We estimate foreign exchange rates (primarily the Euro and the British pound sterling) strengthened reported European net revenue by approximately $11 million or 9 percent for the three months ended June 30, 2004. From a franchise perspective, the net revenue increase was primarily due to (1) higher sales of the Harry Potter franchise, as Harry Potter and the Prisoner of Azkaban was released in conjunction with the blockbuster movie of the same title during the three months ended June 30, 2004, (2) UEFA Euro 2004 , which was released during the three months ended June 30, 2004 in conjunction with the UEFA Euro 2004 football tournament held in Europe, and (3) higher sales of the Fight Night franchise, as EA SPORTS Fight

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Night 2004 was released during the three months ended June 30, 2004, with no corresponding release in fiscal 2004. Together, the three items noted above, increased net revenue by $80.8 million during the three months ended June 30, 2004 as compared to the three months ended June 30, 2003. This increase was partially offset by lower sales of The Sims and F1 franchises, which reduced net revenue by $20.2 million in the three months ended June 30, 2004 as compared to the three month period ended June 30, 2003.

Asia Pacific

For the three months ended June 30, 2004, net revenue from sales in the Asia Pacific region, excluding Japan, increased by 21.6 percent as compared to the three months ended June 30, 2003. The growth in net revenue was primarily due to higher sales in the Harry Potter franchise, partially offset by lower sales in The Sims franchise. We estimate foreign exchange rates strengthened reported Asia Pacific net revenue by approximately $2 million, or 11 percent, for the three months ended June 30, 2004.

Japan

For the three months ended June 30, 2004, net revenue from sales in Japan increased by 6.1 percent as compared to the three months ended June 30, 2003 primarily due to higher sales in the Harry Potter franchise, partially offset by lower sales of The Sims franchise. In addition, we estimate foreign exchange rates strengthened reported Japan net revenue by approximately $1 million or 7 percent, for the three months ended June 30, 2004. Excluding the effect of foreign exchange rates, we estimate that Japan net revenue was relatively flat, decreasing approximately $0.1 million or 1 percent, for the three months ended June 30, 2004.

Our total net revenue by product line for the three months ended June 30, 2004 and 2003 was as follows (in thousands):

PlayStation 2

Net revenue from PlayStation 2 products increased from $118.4 million in the three months ended June 30, 2003 to $162.0 million in the three months ended June 30, 2004. As a percentage of total net revenue, sales of PlayStation 2 products increased by 3.9 percent in the three months ended June 30, 2004 as compared to the three months ended June 30, 2003. The increase in net revenue was primarily due to growth in the installed base and greater demand for our products.

PC

Net revenue from PC-based products decreased from $80.3 million during the three months ended June 30, 2003 to $66.8 million during the three months ended June 30, 2004. As a percentage of total net revenue, sales of PC products decreased by 7.2 percent during the three months ended June 30, 2004. PC net revenue decreased primarily due to lower sales in The Sims franchise as discussed above, which were partially offset by higher sales in the Harry Potter franchise. During the three months ended June 30, 2004, we released three titles as compared to two titles during the three months ended June 30, 2003.

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Xbox

Net revenue from Xbox products increased from $31.5 million in the three months ended June 30, 2003 to $57.2 million in the three months ended June 30, 2004. As a percentage of total net revenue, sales of Xbox products increased by 4.4 percent in the three months ended June 30, 2004. The increase in net revenue was primarily due to growth in the installed base driven by Microsoft’s price reduction in the U.S. in March 2004 and overall greater demand for our products. In addition, we released three titles for the Xbox in the three months ended June 30, 2004 as compared to two titles in the three month period ended June 30, 2003.

Nintendo GameCube

Net revenue from Nintendo GameCube products increased from $21.2 million in the three months ended June 30, 2003 to $26.4 million in the three months ended June 30, 2004. The increase in net revenue was primarily due to growth in the installed base of the Nintendo GameCube driven by Nintendo’s price reduction in the U.S. in September 2003. Although overall Nintendo GameCube net revenue increased, it remained flat as a percentage of total net revenue. During the three months ended June 30, 2004, we released one title as compared to three titles during the three months ended June 30, 2003.

Game Boy Advance

In the three months ended June 30, 2004, net revenue from Game Boy Advance products increased from $2.4 million to $18.0 million as compared to the three months ended June 30, 2003. The increase in net revenue was primarily due to sales of titles in the Harry Potter and The Sims franchises. One title, Harry Potter and the Prisoner of Azkaban, was released during the three months ended June 30, 2004 versus no titles in the three months ended June 30, 2003.

Co-Publishing and Distribution

In the three months ended June 30, 2004, net revenue from co-publishing and distribution products decreased from $71.5 million to $67.2 million as compared to the same period a year ago. The decrease was primarily due to a decline in sales in the Final Fantasy franchise, partially offset by an increase in sales in the Battlefield and Freedom Fighter franchises.

Advertising, Programming, Licensing and Other

In the three months ended June 30, 2004, net revenue from advertising, programming, licensing and other products increased from $14.5 million to $21.7 million as compared to the three months ended June 30, 2003. The increase was primarily due to license revenue related to the Nokia N-Gage in the three months ended June 30, 2004, partially offset by a decrease in net revenue from the Sony PlayStation platform.

Cost of Goods Sold

Cost of goods sold for our disk-based and cartridge-based products consists of (1) product costs, (2) certain royalty expenses for celebrities, professional sports and other organizations and independent software developers, (3) manufacturing royalties, net of volume discounts, (4) expenses for defective products, (5) write-off of post-launch prepaid royalty costs, and (6) operations expenses. Cost of goods sold for our online product subscription business consists primarily of data center and bandwidth costs associated with hosting our websites, credit card fees and royalties for use of third party properties. Cost of goods sold for our website advertising business primarily consists of ad serving costs.

Costs of goods sold for the three months ended June 30, 2004 and 2003 were as follows (in thousands):

In the three months ended June 30, 2004, cost of goods sold as a percentage of net revenue decreased by 1.5 percentage points to 40.9 percent from 42.4 percent for the three months ended June 30, 2003. This was primarily due to a 4.8 percentage point

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decrease in royalty costs offset by a 3.0 percentage point increase in product costs, both as a percentage of net revenue, as well as a slight decrease in the average selling price of our titles.

The 4.8 percent decrease in royalty rates was primarily the result of:

	•		Decreased third-party development royalties primarily due to a higher mix of titles developed internally rather than externally in the three months ended June 30, 2004. Two major titles that were released during the three months ended June 30, 2004 were primarily developed internally as compared to the three months ended June 30, 2003 during which all of the major titles released had external development costs. We estimate that lower development royalties spread across multiple platforms increased gross margin by 3.8 percentage points.
	•		Lower co-publishing and distribution royalties as a percentage of net revenue due to the sales of Devil May Cry 2 during the three months ended June 30, 2003 which had a high royalty rate. Also, the lower proportion of co-publishing and distribution net revenue during the three months ended June 30, 2004 compared to the three months ended June 30, 2003 decreased the overall royalty rate as co-publishing and distribution products have higher royalty rates. We estimate that lower co-publishing and distribution royalties as a percentage of net revenue increased gross margin by 2.1 percentage points.
	•		Partially offset by higher license royalty rates as a percentage of net revenue, as Harry Potter and the Prisoner of Azkaban had a higher license royalty rate than major titles released during the three months ended June 30, 2003. We estimate that higher license royalty rates, as a percentage of net revenue, decreased gross margin by 1.1 percentage points.

The above decreases were offset by a 3.0 percent increase in product costs, which were primarily the result of:

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Higher inventory management costs in Europe and a lower proportion of PC net revenue in the three months ended June 30, 2004 compared to the three months ended June 30, 2003 caused an increase in the overall product costs as PC platform products tend to have higher gross margins and lower product costs as a percentage of net revenue.

The above decreases were also partially offset by a slight decrease in average selling prices as a result of:

	•		The release of Harry Potter and the Prisoner of Azkaban in the three months ended June 30, 2004, which had a lower average selling price than prior year franchise titles such as NBA STREET Vol. 2 and Def Jam VENDETTA™.
	•		Decreased average selling prices on PC titles that had been in release for more than nine months.

Cost of goods sold as a percentage of net revenue may increase in fiscal 2005 as compared to fiscal 2004 as a result of (1) a gradual decrease in average selling prices as current generation platforms mature and our industry transitions to next generation technology, (2) overall product mix, and (3) higher license royalties offset by lower development royalties both as a percentage of net revenue.

Marketing and Sales

Marketing and sales expenses consist of personnel-related costs and advertising, marketing and promotional expenses, net of advertising expense reimbursements from third parties.

Marketing and sales expenses for the three months ended June 30, 2004 and 2003 were as follows (in thousands):

Marketing and sales expenses increased by 7.0 percent in the three months ended June 30, 2004 as compared to the three months ended June 30, 2003 primarily due to:

	•		A 12 percent increase in headcount to further support the growth of our marketing and sales functions worldwide, which resulted in an increase to personnel-related costs of approximately $2.6 million.
	•		An increase in our facilities-related expenses of $1.5 million to help support the growth of our marketing and sales functions worldwide.

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As a percentage of net revenue, marketing and sales expenses declined from 16.7 percent during the three months ended June 30, 2003 to 14.6 percent in the three months ended June 30, 2004 primarily due to timing of our marketing and advertising campaigns.

General and Administrative

General and administrative expenses consist of personnel and related expenses of executive and administrative staff, fees for professional services such as legal and accounting, and allowances for bad debts.

General and administrative expenses for the three months ended June 30, 2004 and 2003 were as follows (in thousands):

As a percentage of net revenue, general and administrative expenses declined from 8.7 percent in the three months ended June 30, 2003 to 8.1 percent in the three months ended June 30, 2004 primarily due to a gain on the sale of our Austin property as discussed below. Excluding this sale, general and administrative expenses remained flat as a percentage of net revenue. In total, general and administrative expenses increased by 14.0 percent during the three months ended June 30, 2004 as compared to the three months ended June 30, 2003 primarily due to:

	•		An increase of approximately $3.5 million in professional and contract services.
	•		An increase of approximately 15 percent, or $3.0 million, in personnel-related costs to support the continued growth of our business.

The increase in general and administrative expenses was partially offset by a gain of $2.4 million on the sale of our property in Austin, Texas.

Research and Development

Research and development expenses consist of expenses incurred by our production studios for personnel-related costs, consulting, equipment depreciation and any impairment of prepaid royalties for pre-launch products. Research and development expenses for our online business include expenses incurred by our studios consisting of direct development costs and related overhead costs in connection with the development and production of our online games. Research and development expenses also include expenses associated with development of website content, network infrastructure direct expenses, software licenses and maintenance, and network and management overhead.

Research and development expenses for the three months ended June 30, 2004 and 2003 were as follows (in thousands):

Research and development expenses increased by 43.4 percent, or 4.5 percentage points of net revenue, during the three months ended June 30, 2004 as compared to the three months ended June 30, 2003 primarily due to:

	•		Increases in personnel-related costs of $22.7 million, of which approximately $17.0 million resulted primarily from a 28 percent increase in regular full-time employee headcount.
	•		An overall increase in external development expenses of $14.3 million primarily related to the development of new products with our co-publishing partners.
	•		An increase of $2.2 million in facilities-related expenses to support our studio expansions in North America and Japan.

Research and development expenses increased during the three months ended June 30, 2004 as compared to the three months ended June 30, 2003, as we continued to support the global growth of our research and development capabilities. In recent quarters, we have developed a greater number of titles internally. We expect increased research and development spending to continue in fiscal 2005 as we invest in next-generation tools and technologies,

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products for new platforms, and, to a lesser extent, as we increase spending on titles for the PC and current-generation console products (including the PlayStation 2, Xbox and Nintendo GameCube).

Interest and Other Income, Net

Interest and other income, net, for the three months ended June 30, 2004 and 2003 were as follows (in thousands):

Interest and other income, net, during the three months ended June 30, 2004 increased from the three months ended June 30, 2003 primarily due to:

	•		A net benefit of $2.6 million from our foreign currency activities in the three months ended June 30, 2004 as compared to the three months ended June 30, 2003.
	•		An increase in interest income of $0.8 million as a result of higher average cash, cash equivalents and short-term investments balances in the current year partially offset by a lower average yield.
	•		An increase in other income as we recorded $0.5 million in income related to our equity investment in Digital Illusions, C.E.

Income Taxes

Income taxes for the three months ended June 30, 2004 and 2003 were as follows (in thousands):

Our effective income tax rate reflects tax benefits derived from significant operations outside the U.S., which are generally taxed at rates lower than the U.S. statutory rate of 35 percent. The effective income tax rate was 29 percent for the three months ended June 30, 2004 and 31 percent for the three months ended June 30, 2003. The reduced effective income tax rate in the three months ended June 30, 2004 primarily reflects a change in the geographic mix of taxable income subject to lower tax rates.

We intend to indefinitely reinvest our international earnings outside the U.S. and, accordingly, have not provided U.S. taxes that would be incurred if such earnings were repatriated back to the U.S.

We are currently projecting an effective income tax rate of approximately 29 percent for fiscal 2005.

Our actual effective income tax rates for fiscal 2005 and future periods can differ from the projected effective income tax rates due to a variety of factors, including changes in our business that were not taken into account in connection with our projection, a variation between the projected and actual mix of income between international and domestic operations, changes or interpretations to applicable tax laws and regulations, changes in the applicable accounting rules or our ability to realize deferred tax assets, or developments in tax audit matters with various tax authorities.

Finally, our projected effective income tax rate for fiscal 2005 does not take into account a new election that is available under the U.S. income tax rules regarding the allocation between U.S. and foreign jurisdictions tax deductions attributable to employee stock option compensation. Although we have not yet determined the impact that the election would have on our reported results, if we were to make the election, it could have a material adverse effect on our effective income tax rate.

Impact of Recently Issued Accounting Standards

In March 2004, the Financial Accounting Standards Board (“FASB”) issued an exposure draft on the Proposed Statement of Financial Accounting Standards, “Share-Based Payment – an amendment of FASB Statements No. 123 and 95 ”. The proposed statement addresses the accounting for share-based payment transactions with employees and other third-parties. The proposed

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standard would eliminate the ability to account for share-based compensation transactions using Accounting Principles Board Opinion (“APB”) No. 25, “ Accounting for Stock Issued to Employees ”, and generally would require that such transactions be accounted for using a fair-value-based method. If the final standard is approved as currently drafted in the exposure draft, it would have a material impact on the amount of earnings we report beginning in fiscal 2006. We have not yet determined the impact that the proposed statement will have on our business.

LIQUIDITY AND CAPITAL RESOURCES

Changes in Cash Flow
During the three months ended June 30, 2004, we used $65.8 million of cash in operating activities as compared to $34.3 million for the three months ended June 30, 2003. The decrease in cash flow was primarily the result of the timing of collection of our sales, which occurred later in the three months ended June 30, 2004 as compared to the three months ended June 30, 2003. We expect this to favorably impact our operating cash flow during the three month period ended September 30, 2004. We expect to generate significant operating cash flow during the remainder of fiscal 2005. For the three months ended June 30, 2004, our primary use of cash in non-operating activities consisted of net purchases of $985.1 million in short-term investments and $26.1 million in capital expenditures, primarily related to the expansions of our Los Angeles and Vancouver studios. These non-operating expenditures were partially offset by $44.3 million in proceeds from the sale of our common stock through stock plans and $15.4 million in proceeds from the sale of property during the three months ended June 30, 2004. We anticipate making continued capital investments in our Vancouver studio during the remainder of fiscal 2005.

Receivables, net
Our gross accounts receivable balance was $291.1 million and $366.6 million as of June 30, 2004 and March 31, 2004, respectively. The decrease in our accounts receivable balance was expected as we traditionally have lower sales during our first quarter as compared to our fourth quarter. We expect our accounts receivable balance to increase during the three months ended September 30, 2004 based on our seasonal product release schedule. Reserves for sales returns, pricing allowances and doubtful accounts decreased from $154.7 million as of March 31, 2004 to $121.5 million as of June 30, 2004. Both the sales return and price protection reserves decreased in absolute dollars and as a percentage of trailing six and nine month net revenue as of June 30, 2004. We believe these reserves are adequate based on historical experience and our current estimate of potential returns and allowances.

Inventories
Inventories decreased slightly to $53.0 million as of June 30, 2004 from $55.1 million as of March 31, 2004 primarily as a result of overall lower activity during the three months ended June 30, 2004 as compared to the three months ended March 31, 2004. We typically have a higher inventory balance, as a percentage of net revenue, on hand in Europe compared to North America, due to the need to provide multiple language versions of each title in that region. No single title represented more than $4.0 million of inventory as of June 30, 2004.

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Other current assets
Other current assets increased slightly to $163.2 million as of June 30, 2004 from $161.9 million as of March 31, 2004 primarily due to an increase in our VAT receivable partially offset by a decrease in other receivables. We expect our VAT receivable to decrease in the three months ended September 30, 2004.

Accounts payable
Accounts payable decreased to $65.6 million as of June 30, 2004 from $114.1 million as of March 31, 2004 primarily due to the lower sales volume we experienced in the first quarter of fiscal 2005 as compared to the fourth quarter of fiscal 2004.

Accrued and other liabilities
Our accrued and other liabilities decreased to $520.4 million as of June 30, 2004 from $630.1 million as of March 31, 2004, primarily as a result of payment of our fiscal 2004 bonus accrual and royalty payments for development. We anticipate our accrued and other liabilities balance will decline following tax payments we anticipate making during the three months ended September 30, 2004.

Financial Condition
We believe the existing cash, cash equivalents, short-term investments, marketable equity securities and cash generated from operations will be sufficient to meet our operating requirements for at least the next twelve months, including working capital requirements, capital expenditures and potential future acquisitions or strategic investments. We may choose at any time to raise additional capital to strengthen our financial position, facilitate expansion, pursue strategic investments or to take advantage of business opportunities as they arise. There can be no guarantee that such additional capital will be available to us on favorable terms, if at all, or that it will not result in substantial dilution to our existing stockholders.

A portion of our cash is generated from operations domiciled in foreign tax jurisdictions (approximately $430.9 million as of June 30, 2004) that is designated as indefinitely reinvested in the respective tax jurisdiction. While we have no plans to repatriate these funds to the United States in the short-term, if we were required to do so to fund our operations in the United States, we would accrue and pay additional taxes in connection with their repatriation.

On January 8, 2004, we filed an amended registration statement on Form S-3 with the SEC. This registration statement, including the base prospectus contained therein, became effective on January 15, 2004 and uses a “shelf” registration process. This shelf registration statement allows us, at any time, to offer any combination of securities described in the prospectus in one or more offerings up to a total amount of $2.0 billion. Unless otherwise specified in a prospectus supplement accompanying the base prospectus, we will use the net proceeds from the sale of any securities offered pursuant to the shelf registration statement for general corporate purposes, including for working capital, financing capital expenditures, research and development, marketing and distribution efforts and, if opportunities arise, for acquisitions or strategic alliances. Pending such uses, we may invest the net proceeds in interest-bearing securities. In addition, we may conduct concurrent or other financings at any time.

Our ability to maintain sufficient liquidity could be affected by various risks and uncertainties including, but not limited to, those related to customer demand and acceptance of our titles on new platforms and new versions of our titles on existing platforms, our ability to collect our accounts receivable as they become due, successfully achieving our product release schedules and attaining our forecasted sales objectives, the impact of competition, domestic and international economic conditions, seasonality in operating results, risks of product returns and the other risks described in the “Risk Factors” section below.

Contractual Obligations and Commercial Commitments

Letters of Credit
In July 2002, we provided an irrevocable standby letter of credit to Nintendo of Europe. The standby letter of credit guarantees performance of our obligations to pay Nintendo of Europe for trade payables of up to €8.0 million. The standby letter of credit expires in July 2005. As of June 30, 2004, we had €0.7 million payable to Nintendo of Europe covered by this standby letter of credit.

In August 2003, we provided an irrevocable standby letter of credit to 300 California Associates II, LLC as a replacement for our security deposit for office space. The standby letter of credit guarantees performance of our obligations to pay our lease commitment up to $1.1 million. The standby letter of credit expires in December 2006. As of June 30, 2004, we did not have a payable balance on this standby letter of credit.

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Development, Celebrity, League and Content Licenses: Payments and Commitments
The products produced by our studios are designed and created by our employee designers, artists, software programmers and by non-employee software developers (“independent artists” or “third-party developers”). We typically advance development funds to the independent artists and third-party developers during development of our games, usually in installment payments made upon the completion of specified development milestones. Contractually, these payments are considered advances against subsequent royalties on the sales of the products. These terms are set forth in written agreements entered into with the independent artists and third-party developers. In addition, we have certain celebrity, league and content license contracts that contain minimum guarantee payments and marketing commitments that are not dependent on any deliverables. Celebrities and organizations with whom we have contracts include: FIFA and UEFA (professional soccer); NASCAR (stock car racing); John Madden (professional football); National Basketball Association (professional basketball); PGA TOUR (professional golf); Tiger Woods (professional golf); National Hockey League and NHLPA (professional hockey); Warner Bros. (Harry Potter, Catwoman and Superman); MGM/Danjaq (James Bond); New Line Productions (The Lord of the Rings); National Football League and Players Inc. (professional football); Collegiate Licensing Company (collegiate football and basketball); ISC (stock car racing); Major League Baseball Properties; MLB Players Association (professional baseball) and Island Def Jam (fighting). These developer and content license commitments represent the sum of (i) the cash payments due under non-royalty-bearing licenses and services agreements, and (ii) the minimum payments and advances against royalties due under royalty-bearing licenses and services agreements that are conditional upon performance by the counterparty. These minimum guarantee payments and marketing commitments are included in the table below.

The following table summarizes our minimum contractual obligations and commercial commitments as of June 30, 2004, and the effect we expect them to have on our liquidity and cash flow in future periods (in thousands):

⁽¹⁾ See discussion on operating leases in the “ Off-Balance Sheet Commitments ” section below and Note 8 in the Notes to Condensed Consolidated Financial Statements, included in Item 1 hereof, for additional information.

⁽²⁾ Developer/licensee commitments include $57.2 million of commitments to developers or licensers that have been included in our Condensed Consolidated Balance Sheet as of June 30, 2004 because the developer does not have any significant performance obligations to us. These commitments are included in both current and long-term assets and liabilities.

The lease commitments disclosed above exclude commitments included in our restructuring activities for contractual rental commitments of $28.4 million under real estate leases for unutilized office space, offset by $17.9 million of estimated future sub-lease income. These amounts were expensed in the periods of the related restructuring and are included in our accrued and other liabilities reported on our Condensed Consolidated Balance Sheet as of June 30, 2004. Please see Note 5 in the Notes to Condensed Consolidated Financial Statements, included in Item 1 hereof, for additional information.

Litigation
We are subject to pending claims and litigation. Management, after review and consultation with legal counsel, considers that any liability from the disposition of such lawsuits would not have a material adverse effect upon our consolidated financial condition or results of operations.

Director Indemnity Agreements
We have entered into an indemnification agreement with the members of our Board of Directors to indemnify our Directors to the extent permitted by law against any and all liabilities, costs, expenses, amounts paid in settlement and damages incurred by the Directors as a result of any lawsuit, or any judicial, administrative or investigative proceeding in which the Directors are sued as a result of their service as a member of our Board of Directors.

Transactions with Related Parties

Transactions with Executive Officers
On June 24, 2002, we hired Warren Jenson and agreed to loan him $4,000,000, to be forgiven over four years based on his continuing employment. The loan does not bear interest. On June 24, 2004, pursuant to the terms of the loan agreement, we forgave two million dollars of the loan and provided Mr. Jenson approximately $1.6 million to offset the tax implications of the forgiveness. As of June 30, 2004, the remaining outstanding loan balance was $2,000,000, which will be forgiven on June 24, 2006, provided that Mr. Jenson has not voluntarily resigned his employment with us or been terminated for cause prior to that time. No additional funds will be provided to offset the tax implications of the forgiveness of the remaining two million dollars.

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OFF-BALANCE SHEET COMMITMENTS

Lease Commitments
We lease certain of our current facilities and certain equipment under non-cancelable operating lease agreements. We are required to pay property taxes, insurance and normal maintenance costs for certain of our facilities and will be required to pay any increases over the base year of these expenses on the remainder of our facilities.

In February 1995, we entered into a build-to-suit lease with a third party for our headquarters facility in Redwood City, California, which was refinanced with Keybank National Association in July 2001 and expires in July 2006. We accounted for this arrangement as an operating lease in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 13, “Accounting for Leases” , as amended. Existing campus facilities developed in phase one comprise a total of 350,000 square feet and provide space for sales, marketing, administration and research and development functions. We have an option to purchase the property (land and facilities) for a maximum of $145.0 million or, at the end of the lease, to arrange for (i) an extension of the lease or (ii) sale of the property to a third party while we retain an obligation to the owner for approximately 90 percent of the difference between the sale price and the guaranteed residual value of up to $128.9 million if the sales price is less than this amount, subject to certain provisions of the lease.

In December 2000, we entered into a second build-to-suit lease with Keybank National Association for a five-year term beginning December 2000 to expand our Redwood City, California headquarters facilities and develop adjacent property adding approximately 310,000 square feet to our campus. Construction was completed in June 2002. We accounted for this arrangement as an operating lease in accordance with SFAS No. 13, as amended. The facilities provide space for marketing, sales and research and development. We have an option to purchase the property for a maximum of $130.0 million or, at the end of the lease, to arrange for (i) an extension of the lease, or (ii) sale of the property to a third party while we retain an obligation to the owner for approximately 90 percent of the difference between the sale price and the guaranteed residual value of up to $118.8 million if the sales price is less than this amount, subject to certain provisions of the lease.

We believe the estimated fair values of both properties under these operating leases are in excess of their respective guaranteed residual values as of June 30, 2004.

For the two lease agreements with Keybank National Association, as described above, the lease rates are based upon the Commercial Paper Rate and require us to maintain certain financial covenants as shown below, all of which we were in compliance with as of June 30, 2004.

In July 2003, we entered into a lease agreement with an independent third party (the “Landlord”) for a studio facility in Los Angeles, California, which commenced in October 2003 and expires in September 2013 with two five-year options to extend the lease term. Additionally, we have options to purchase the property after five and ten years based on the fair market value of the property at the date of sale, a right of first offer to purchase the property upon terms offered by the Landlord, and a right to share in the profits from a sale of the property. We have accounted for this arrangement as an operating lease in accordance with SFAS No. 13, as amended. Existing campus facilities comprise a total of 243,000 square feet and provide space for research and development functions. Our rental obligation under this agreement is $50.2 million over the initial ten-year term of the lease. This commitment is offset by sublease income of $5.8 million for the sublet to an affiliate of the Landlord of 18,000 square feet of the Los Angeles facility, which commenced in October 2003 and expires in September 2013, with options of early termination by the affiliate after five years and by us after four and five years.

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In June 2004, we entered into a lease agreement with an independent third-party for a studio facility in Orlando, Florida, which will commence in January 2005 and expire in June 2010, with one five-year option to extend the lease term. The campus facilities comprise a total of 117,000 square feet, which we intend to use for research and development functions. We have accounted for this arrangement as an operating lease in accordance with SFAS No. 13, as amended. Our rental obligation over the initial five-and-a-half year term of the lease is $13.2 million.

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RISK FACTORS

Our business is subject to many risks and uncertainties, which may affect our future financial performance. The risks and uncertainties discussed below are not the only ones we face. There may be additional risks and uncertainties not currently known to us or that we currently do not believe are material that may harm our business and financial performance. If any of the events or circumstances described below occurs, our business and financial performance could be harmed, our actual results could differ materially from our expectations, and the market value of our securities could decline.

The success of our business is highly dependent on being able to predict which new videogame platforms will be successful, and on the market acceptance and timely release of those platforms.

We derive most of our revenue from the sale of products for play on videogame platforms manufactured by third parties, such as Sony’s PlayStation 2. Therefore, the success of our products is driven in large part by the success of new videogame hardware systems and our ability to accurately predict which platforms will be most successful in the marketplace. We must make product development decisions and commit significant resources well in advance of the anticipated introduction of a new platform. A new platform for which we are developing products may be delayed, may not succeed or may have a shorter life cycle than anticipated. If the platforms for which we are developing products are not released when anticipated or do not attain wide market acceptance, our revenue growth will suffer, we may be unable to fully recover the resources we have committed, and our financial performance will be harmed.

Our platform licensors set the royalty rates and other fees that we must pay to publish games for their platforms, and therefore have significant influence on our costs. If one or more of the platform licensors adopt a different fee structure for future game consoles or we are unable to obtain such licenses, our profitability will be materially impacted.

In the next few years, we expect our platform licensors to introduce new game machines into the market. In order to publish products for a new game machine, we must take a license from the platform licensor which gives the platform licensor the opportunity to set the fee structure that we must pay in order to publish games for that platform. Similarly, the platform licensors have retained the flexibility to change their fee structures for online gameplay and features for their consoles. The control that platform licensors have over the fee structures for their future platforms and online access makes it difficult for us to predict our costs and profitability in the medium to long term. It is also possible that platform licensors will not renew our licenses. Because publishing products for videogame consoles is the largest portion of our business, any increase in fee structures or failure to secure a license relationship would have a significant negative impact on our business model and profitability.

Our business is both seasonal and cyclical. If we fail to deliver our products at the right times, our sales will suffer.

Our business is highly seasonal, with the highest levels of consumer demand, and a significant percentage of our revenue, occurring in the December quarter. If we miss this key selling period, due to product delays or delayed introduction of a new platform for which we have developed products, our sales will suffer disproportionately. Our industry is also cyclical. Videogame platforms have historically had a life cycle of four to six years. As one group of platforms is reaching the end of its cycle and new platforms are emerging, consumers often defer game software purchases until the new platforms are available, causing sales to decline. This decline may not be offset by increased sales of products for the new platform. For example, following the launch of Sony’s PlayStation2 platform, we experienced a significant decline in revenue from sales of products for Sony’s older PlayStation game console, which was not immediately offset by revenue generated from sales of products for the PlayStation2 platform.

Our business is intensely competitive and increasingly “hit” driven. If we do not continue to deliver “hit” products, our success will be limited.

Competition in our industry is intense, and new products are regularly introduced. A relatively small number of “hit” titles accounts for a significant portion of total sales. For example, during calendar year 2003, approximately 19 percent of the sales of videogames in North America consisted of only 20 “hit” products. If our competitors develop more successful products, or if we do not continue to develop consistently high-quality products, our revenue and profitability will decline.

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If we are unable to maintain or acquire licenses to intellectual property, we will publish fewer hit titles and our revenue, profitability and cash flows will decline. Competition for these licenses may make them more expensive, and increase our costs.

Many of our products are based on or incorporate intellectual property owned by others. For example, our EA SPORTS products include rights licensed from the major sports leagues and players associations. Similarly, many of our hit EA GAMES franchises, such as Bond, Harry Potter and Lord of the Rings, are based on key film and literary licenses. Competition for these licenses is intense. If we are unable to maintain these licenses and obtain additional licenses with significant commercial value, our revenues and profitability will decline significantly. Competition for these licenses may also drive up the advances, guarantees and royalties that we must pay to the licensor, which could significantly increase our costs.

If patent claims continue to be asserted against us, we may be unable to sustain our current business models or profits.

Many patents have been issued that may apply to widely used game technologies. Additionally, infringement claims under many recently issued patents are now being asserted against Internet implementations of existing games. Several such claims have been asserted against us. Such claims can harm our business. We incur substantial expenses in evaluating and defending against such claims, regardless of the merits of the claims. In the event that there is a determination that we have infringed a third-party patent, we could incur significant monetary liability and be prevented from using the rights in the future.

Other intellectual property claims may increase our product costs or require us to cease selling affected products.

Many of our products include extremely realistic graphical images, and we expect that as technology continues to advance, images will become even more realistic. Some of the images and other content are based on real-world examples that may inadvertently infringe upon the intellectual property rights of others. Although we believe that we make reasonable efforts to ensure that our products do not violate the intellectual property rights of others, it is possible that third parties still may claim infringement. From time to time, we receive communications from third parties regarding such claims. Existing or future infringement claims against us, whether valid or not, may be time consuming and expensive to defend. Such claims or litigations could require us to stop selling the affected products, redesign those products to avoid infringement, or obtain a license, all of which would be costly and harm our business.

Our business, our products and our distribution are subject to increasing regulation in key territories of content, consumer privacy and online delivery. If we do not successfully respond to these regulations, our business may suffer.

Legislation is continually being introduced that may affect both the content of our products and their distribution. For example, privacy laws in the United States and Europe impose various restrictions on our web sites. Those rules vary by territory although the Internet recognizes no geographical boundaries. Other countries, such as Germany, have adopted laws regulating content both in packaged goods and those transmitted over the Internet that are stricter than current United States laws. In the United States, the federal and several state governments are considering content restrictions on products such as ours, as well as restrictions on distribution of such products. Any one or more of these factors could harm our business by limiting the products we are able to offer to our customers and by requiring additional differentiation between products for different territories to address varying regulations. This additional product differentiation would be costly.

If we do not consistently meet our product development schedules, we will experience fluctuations in our operating results.

Our ability to meet product development schedules is affected by a number of factors, including the creative processes involved, the coordination of large and sometimes geographically dispersed development teams required by the increasing complexity of our products, and the need to refine and tune our products prior to their release. We have in the past experienced development delays for several of our products. Failure to meet anticipated production or “go live” schedules may cause a shortfall in our revenue and profitability and cause our operating results to be materially different from expectations. Delays that prevent release of our products during peak selling seasons or in conjunction with specific events, such as the release of a related movie or the beginning of a sports season or major sporting event, could adversely affect our financial performance.

Technology changes rapidly in our business, and if we fail to anticipate new technologies, the quality, timeliness and competitiveness of our products will suffer.

Rapid technology changes in our industry require us to anticipate, sometimes years in advance, which technologies our products must take advantage of in order to make them competitive in the market at the time they are released. Therefore, we usually start our product development with a range of technical development goals that we hope to be able to achieve. We may not be able to

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achieve these goals, or our competition may be able to achieve them more quickly than we can. In either case, our products may be technologically inferior to competitive products, or less appealing to consumers, or both. If we cannot achieve our technology goals within the original development schedule of our products, then we may delay products until these technology goals can be achieved, which may delay or reduce revenue and increase our development expenses. Alternatively, we may increase the resources employed in research and development in an attempt to accelerate our development of new technologies, either to preserve our product launch schedule or to keep up with our competition, which would increase our development expenses.

If we do not continue to attract and retain key personnel, we will be unable to effectively conduct our business.

The market for technical, creative, marketing and other personnel essential to the development and marketing of our products and management of our businesses is extremely competitive. Our leading position within the interactive entertainment industry makes us a prime target for recruiting of executives and key creative talent. If we cannot successfully recruit and retain the employees we need, or replace key employees following their departure, our ability to develop and manage our businesses will be impaired.

Our platform licensors are our chief competitors and frequently control the manufacturing of and/or access to our videogame products. If they do not approve our products, we will be unable to ship to our customers.

Our agreements with hardware licensors (such as Sony for the PlayStation 2, Microsoft for the Xbox and Nintendo for the Nintendo GameCube) typically give significant control to the licensor over the approval and manufacturing of our products, which could, in certain circumstances, leave us unable to get our products approved, manufactured and shipped to customers. These hardware licensors are also our chief competitors. In most events, control of the approval and manufacturing process by the platform licensors increases both our manufacturing lead times and costs as compared to those we can achieve independently. While we believe that our relationships with our hardware licensors are currently good, the potential for these licensors to delay or refuse to approve or manufacture our products exists. Such occurrences would harm our business and our financial performance.

We compete directly with Microsoft and Sony for sales of products with online capabilities. We also require compatibility code and the consent of each in order to include online capabilities in our products for their respective platforms. As online capabilities for videogame platforms become more significant, Microsoft and Sony could restrict our ability to provide online capabilities for our console platform products. If Microsoft or Sony refused to approve our products with online capabilities or significantly impacted the financial terms on which these services are offered to our customers, our business could be harmed.

Our international net revenue is subject to currency fluctuations.

For the three months ended June 30, 2004, international net revenue comprised 51 percent of our total net revenue. For the three months ended June 30, 2003, international net revenue comprised 44 percent of total net revenue. We expect foreign sales to continue to account for a significant portion of our net revenue. Such sales are subject to unexpected regulatory requirements, tariffs and other barriers. Additionally, foreign sales are primarily made in local currencies, which may fluctuate against the dollar. While we utilize foreign exchange forward contracts to mitigate foreign currency risk associated with foreign currency denominated assets and liabilities (primarily certain intercompany receivables and payables) and foreign currency option contracts to hedge foreign currency forecasted transactions (primarily related to revenue generated by our operational subsidiaries), our results of operations and financial condition may, nonetheless, be adversely affected by foreign currency fluctuations.

Our reported financial results could be affected if significant changes in current accounting principles are adopted.

Recent actions and public comments from the SEC have focused on the integrity of financial reporting generally. Similarly, Congress has considered a variety of bills that could affect certain accounting principles. The FASB and other regulatory accounting agencies have recently introduced several new or proposed accounting standards, such as accounting for stock options, some of which represent a significant change from current practices. For example, changes in our accounting for stock options could materially increase our reported expenses.

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The majority of our sales are made to a relatively small number of key customers. If these customers reduce their purchases of our products or become unable to pay for them, our business could be harmed.

In the U.S. in the three months ended June 30, 2004, over 65 percent of our sales were made to six key customers. In Europe, our top ten customers accounted for over 35 percent of our sales in that territory in the three months ended June 30, 2004. Worldwide, we had direct sales to one customer, Wal-Mart Stores, Inc., which represented 12 percent of total net revenue during the three months ended June 30, 2004. Though our products are available to consumers through a variety of retailers, the concentration of our sales in one, or a few, large customers could lead to short-term disruption in our sales if one or more of these customers significantly reduced their purchases or ceased to carry our products, and could make us more vulnerable to collection risk if one or more of these large customers became unable to pay for our products. Additionally, our receivables from these large customers increase significantly in the December quarter as they stock up for the holiday selling season. Also, having such a large portion of our total net revenue concentrated in a few customers reduces our negotiating leverage with these customers.

Acquisitions, investments and other strategic transactions could result in operating difficulties, dilution to our investors and other negative consequences.

We have evaluated, and expect to continue to evaluate, a wide array of potential strategic transactions, including (1) acquisitions of companies, businesses, intellectual properties, and other assets, and (2) investments in new interactive entertainment businesses (for example, online and mobile games). Any of these strategic transactions could be material to our financial condition and results of operations. Although we regularly search for opportunities to engage in strategic transactions, we may not be successful in identifying suitable opportunities. We may not be able to consummate potential acquisitions or investments or an acquisition or investment may not enhance our business or may decrease rather than increase our earnings. In addition, the process of integrating an acquired company or business, or successfully exploiting acquired intellectual property or other assets, could divert a significant amount of our management’s time and focus and may create unforeseen operating difficulties and expenditures. Additional risks we face include:

	•		The need to implement or remediate controls, procedures and policies appropriate for a public company in an acquired company that, prior to the acquisition, lacked these controls, procedures and policies,
	•		Cultural challenges associated with integrating employees from an acquired company or business into our organization,
	•		Retaining employees from the businesses we acquire,
	•		The need to integrate an acquired company’s accounting, management information, human resource and other administrative systems to permit effective management, and
	•		To the extent that we engage in strategic transactions outside of the United States, we face additional risks, including risks related to integration of operations across different cultures and languages, currency risks and the particular economic, political and regulatory risks associated with specific countries.

Future acquisitions and investments could involve the issuance of our equity securities, potentially diluting our existing stockholders, the incurrence of debt, contingent liabilities or amortization expenses, or write-offs of goodwill, any of which could harm our financial condition. Our stockholders may not have the opportunity to review, vote on or evaluate future acquisitions or investments.

We have begun the implementation of a common set of financial information systems throughout our worldwide organization, which, if not completed in a successful and timely manner, could impede our ability to accurately process, prepare and analyze important financial data.

As part of our effort to improve efficiencies throughout our worldwide organization, we have begun the implementation of a common set of practices, processes and financial information systems. The successful conversion from our current financial information systems to new financial information systems entails a number of risks due to the complexity of the conversion and implementation process. Such risks include verifying the accuracy of the business data and information prior to conversion, the actual conversion of that data and information to the new systems and then using that business data and information in the new systems after the conversion. In addition, because the implementation is company-wide, there is a need for substantial and comprehensive company-wide employee training. While testing of these new systems and processes and training of employees are done in advance of implementation, there are inherent limitations in our ability to simulate a full-scale operating environment in advance of implementation. Finally, there can be no assurance that the conversion to, and the implementation of, the new financial information systems will not impede our ability to accurately and timely process, prepare and analyze the financial data

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we use in making operating decisions and which form the basis of the financial information we include in the periodic reports we file with the SEC.

Our products are subject to the threat of piracy by a variety of organizations and individuals. If we are not successful in combating and preventing piracy, our sales and profitability could be harmed significantly.

In many countries around the world, more pirated copies of our products are sold than legitimate copies. Though piracy has not had a material impact on our operating results to date, highly organized pirate operations have been expanding globally. In addition, the proliferation of technology designed to circumvent the protection measures we use in our products, the availability of broadband access to the Internet, the ability to download pirated copies of our games from various Internet sites, and the widespread proliferation of Internet cafes using pirated copies of our products, all have contributed to ongoing and expanding piracy. Though we take steps to make the unauthorized copying and distribution of our products more difficult, as do the manufacturers of consoles on which our games are played, neither our efforts nor those of the console manufacturers may be successful in controlling the piracy of our products. This could have a negative effect on our growth and profitability in the future.

Our stock price has been volatile and may continue to fluctuate significantly.

As a result of the factors discussed in this report and other factors that may arise in the future, the market price of our common stock historically has been, and we expect will continue to be, subject to significant fluctuations. These fluctuations may be due to factors specific to us, to changes in analysts’ earnings estimates, to factors affecting the computer, software, Internet, entertainment, media or electronics businesses, or to national and international economic conditions.

average contractual foreign currency exchange rates and fair value. The fair value of our forward and option contracts are recorded in other current assets on our Condensed Consolidated Balance Sheets.