Activision Blizzard
Annual Report 2006

Plain-text annual report

growing our balanced portfolio forging key strategic alliances extending our global reach A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T 14 consecutive years of revenue growth $1.47 BILLION 5 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 N E T R E V E N U E S A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T To Our Shareholders: Activision’s fiscal year 2006 net revenues totaled $1.47 billion, marking 14 consecutive years of growth. During the year, we diversified our brand portfolio, established an early leadership presence on the next-generation platforms, forged several key alliances and expanded into new geographies. We ended the fiscal year as the #2 U.S. software publisher overall and had the #1 game on the Xbox 360™ platform with Call of Duty® 2 , according to the NPD Group. We strengthened our market position, although our operating results were negatively impacted by the beginning of a new console transition including a shift in consumer demand away from current-generation software in anticipation of the new hardware consoles. We ended the fiscal year with nearly $1 billion in cash and short-term investments and $1.2 billion in shareholders’ equity. Over the long term, we remain focused on increasing revenue and operating margin by growing our balanced franchise portfolio, increasing our international presence and improving our operating efficiencies worldwide, all of which will help us take full advantage of the new hardware cycle. 6 We continue to have confidence in the long-term positive fundamentals of the video game industry which are being driven by significant technical advancements in console hardware that should appeal to a new generation of consumers. For the first time, the three console platforms are well differentiated from each other, as well as from prior-generation hardware. Microsoft®’s Xbox 360’s online capabilities, Sony®’s PlayStation® 3’s high-definition graphics and the Nintendo® Wii™’s new interface present unique opportunities to further broaden the appeal of gaming. These new platforms are expected to usher in a new era of market growth which traditionally follows hardware launches. We believe that the potential revenue opportunities created by these new platforms, coupled with our focus to increase operating margin over the long term should enable us to capitalize on what we hope to be one of the greatest growth periods in our industry’s history. Growing our balanced franchise portfolio During fiscal 2006, Activision forged a number of alliances that should facilitate future growth and value building for our shareholders. We expanded our alliance with Marvel Enterprises for the Spider-Man™ and X-Men™ franchises and our agreement with Spider-Man Merchandising L.P. for Spider-Man® motion pictures through 2017. We signed a multi-year agreement with DreamWorks Animation® for the exclusive video game rights for certain platforms to four upcoming feature films and also extended our rights beyond “Shrek the Third”™ to include potential future films in the “Shrek”® franchise. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T We entered into an agreement with The Hasbro Properties Group to develop and publish console, hand-held and PC games based on Hasbro’s renowned “Transformers” brand, one of the best-selling boys’ action brands since its launch as a global property in 1984. In April 2006, we were awarded the rights to develop and publish interactive entertainment games based on the James Bond license through 2014. Bond is one of the most successful franchises in film history. The franchise continues to have popular global appeal with approximately 30 million units of video games having sold to date. Lastly, in June 2006, we acquired video game publisher RedOctane, Inc., and the popular Guitar Hero™ franchise. The acquisition provides Activision with an early leadership position in music-based gaming, which the company expects will be one of the fastest growing genres in the coming years. We remain focused on growing and diversifying our franchises and reinventing our core brands through innovative gameplay and top-notch development talent. Our production strategy centers around creating games based on well-recognized brands that have a strong track record of performance. We believe that the strength of these brands, coupled with our proven development capabilities will allow us to build our market leadership position in the years to come. 7 Increasing our international market position In fiscal 2006, our European publishing net revenues grew 18% to more than $400 million. We sell direct to retail in the seven largest European markets—UK, France, Germany, Benelux, Sweden, Spain and Italy and more recently we have added Denmark, Norway and Austria. Through our direct model, we are increasing volume, market share, retail presence and customer relationships with the objective of generating financial efficiencies. Growing our international presence remains a key priority for us. We have seen the benefit of our initia- tives to date and we will continue to strengthen our international competitive position. Today, we have more salespeople on the ground selling direct in more countries than ever before and although we still have room for growth, our efforts this fiscal year drove strong in-market performance and revenue increases. Improving operational efficiency Over the long term, Activision continues to focus on increasing its operating margin through inno- vation and operational efficiency. We view the console transition as an opportunity to align our expenses with our revenues. We will continue to identify cost efficiencies that will help us take advantage of the long-term opportunities in the marketplace and remain committed to finding ways to optimize our product development costs and variable marketing expenditure. We have taken a number of steps to help A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T offset increases in next-generation production budgets, including the creation of a number of shared tools and technologies that are designed to generate process efficiencies across our development studios. In addition, we have begun to increase our development schedules in order to facilitate a longer pre-production phase and more predictable workflow timelines. We also completed a targeted reduction in our workforce that has enabled us to better align our headcount against our strategic targets. Over the next few years, we will also focus on optimizing our variable marketing expendi- tures and returning them to proven spending levels as a percentage of revenue. Looking ahead The next-generation console devices are poised to revolutionize the way video games are played and the proliferation of devices that can play games will continue to expand the demand for interactive entertainment. We believe that over the long term, industry growth will be driven by: • Microsoft’s Xbox Live® and Live Anywhere online services which will continue to add a social community-driven experience to the already compelling single-player experience. 8 • Sony’s PlayStation 3’s feature film quality production values that deliver gaming experiences that rival motion pictures and television. • The Nintendo Wii’s revolutionary controller which should expand the number of consumers who play video games. • Increased investment, competition and growth in the hand-held market with Sony’s PSP™ and Nintendo’s DS™. • Emerging market segments such as online gaming, wireless gaming and in-game advertising that will create ancillary revenue streams for video games. Microsoft’s Xbox 360 online service, Xbox Live, and its new cross-platform Live Anywhere service will continue to enhance gaming from a solitary interaction to a more social and community-driven experience. Using Xbox Live, consumers can join message boards, talk to and see other members and play games against other players anywhere in the world. Live Anywhere will allow players to communicate with and interact between games played on cell phones, the Xbox 360 consoles and the upcoming Windows® Vista operating system. More than just a gaming console, the PlayStation 3 is designed as an entertainment platform. The platform’s Blu-ray high-definition DVD player and Sony’s plans for an online service will allow consumers to watch high-definition DVDs, listen to music, connect to the Internet at high speeds and play games with high-quality production values that rival feature films. The incorporation of the BD (Blu-ray Disc™) specification should allow publishers to deliver games at an unparalleled level of image quality through high-definition 3D video that is rendered in real time with results that in the past were only achievable in off-line rendering. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Nintendo’s Wii lets players manipulate actions on their televisions through the precise, lifelike motion of the system’s wireless controller that can be used to simulate everything from fishing to conducting music to firing a gun. The introduction of the controller will allow developers to create compelling experiences that have never before been possible in video games. The Sony PSP and Nintendo DS offer more attractive operating models than previous hand-held systems. These platforms are bringing console-like production values to portable gaming and appeal to an older demographic than the traditional 6- to 11-year-old hand-held gamer. As production and marketing costs increase and access to high-quality development talent and intellectual property remains limited, the barriers to enter the video game industry continue to rise. With its established product portfolio, proven development capabilities, worldwide distribution operations and deep financial resources, Activision is well positioned to benefit from the market opportunities afforded by the new console era. In addition, emerging market segments such as online gaming, wireless gaming and in-game advertising should offer ancillary revenue streams that never existed in our industry before. The new console era is ushering in a period of profound change that will pose new challenges, but offer greater opportunities than ever before for both Activision and the industry. We believe that by continuing to focus on the fundamentals of our business, we have built a framework that will allow us to enhance our leadership position and shareholder value for years to come. 9 We remain steadfast in our commitment to continually search for new ways to serve our customers, strategic partners, shareholders and community and to operate a highly disciplined company that makes the necessary investments and takes selective creative risks. Our dedication and determina- tion to live out these beliefs and make them a part of our everyday operations will drive our future success. Thanks to our talented employees around the world who develop, market and distribute our products and invest their abilities, artistry and time to make Activision a premier company, we are confident of our ability to realize this goal. Sincerely, Robert A. Kotick Chairman and Chief Executive Officer Brian G. Kelly Co-Chairman Michael Griffith President and Chief Executive Officer, Activision Publishing, Inc. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T CONTINUED LEADERSHIP THROUGH GREAT BRANDS Activision has a strong track record of developing video games that span a variety of popular gaming genres including action, adventure, action sports, racing, role-playing, simulation and strategy. We remain focused on building and growing our balanced brand portfolio which includes well-recognized licensed properties that have a history of performance such as Tony Hawk®, Spider-Man, Shrek®, Transformers®, X-Men and James Bond, as well as a select number of original properties that the com- pany owns. In fiscal 2006, we successfully launched our third game based on an original concept, GUN ™, which marks the third consecutive year that Activision has created the #1 new intellectual property in the marketplace. 10 In fiscal 2006, we also extended our successful multi-platform strategy by releasing two unique Call of Duty games—Call of Duty 2 for the PC and Xbox 360, and Call of Duty 2: Big Red One™ for the PlayStation 2, Xbox and Nintendo GameCube. This strategy enabled us to grow the brand’s overall market share by releasing a state-of-the-art game targeted toward early adopters and a more immersive story-driven title for the mass-market audience. Additionally, we realized marketing synergies by maximizing consumer and trade activities that allowed us to more effectively reach our target audiences. In fiscal 2007, we will further broaden our portfolio by creating a brand extension to our popular Tony Hawk franchise. Tony Hawk’s Project 8™, which is targeted toward 13- to 24-year-olds, immerses players in the definitive skateboarding experience and is being developed to leverage the power of the PlayStation 3 and Xbox 360. Tony Hawk’s Downhill Jam™, which is aimed at 8- to 12-year-olds, allows players to experience the breakneck speed of downhill skateboard racing through an intuitive game experience designed for younger and casual audiences. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T LEVERAGING EMERGING MARKET SEGMENTS Activision’s ability to understand its audience and reach them through virtually every medium with brands that set quality standards in entertainment is the impetus for its future growth. We believe that there are three trends—online gaming, wireless gaming and in-game advertising—that will play significant roles in driving our company’s and industry’s long-term performance. Currently, the opportunity in these segments is limited. Therefore, we continue to take a prudent and disciplined approach to the way we invest in them. However, we believe that by the end of the decade, these trends should create substantial ancillary revenue streams that will enable us to build shareholder value in the future. 11 Today, there are more ways for consumers to access video games and content than ever before. The proliferation of broadband is facilitating sales of games and game-related content directly to consumers at an unprecedented rate. Worldwide, more than 46 million people had broadband connections in 2005, according to a recent report from In-Stat. By the end of 2010, the market research firm expects that total to reach 413 million. Mass-market penetration of high-speed connected computers and next-generation consoles should enable publishers to extend the shelf life of products. Concurrent with the potential of online gaming, the wireless space is coming of age. Advanced next-gen handsets are beginning to deliver compelling gaming experiences driven by 3D-enabled smart phones. These sophisticated devices allow for high-quality video on color screens, connectiv- ity with computers, client-side memory that lets consumers download information directly on their handsets and increased frame rates that deliver faster, smoother mobile gaming experiences. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T As video games become an ever-increasing part of consumers’ leisure time, interest from the adver- tising community about in-game product placement targeted toward the elusive 12- to 34-year-old male demographic continues to grow. Technological advances such as personal video recorders, audience fragmentation and the declining popularity of the 30-second television spot have led major advertisers to focus more of their dollars on product placement. 12 While in-game product placement is not new, it’s a trend that is rapidly turning from a novelty into a serious business. According to Nielsen Entertainment, in-game advertising is expected to be a $75 million market in the U.S. this year and could grow to $1 billion by 2010. We believe that in-game advertising can be additive to our current business model without any degradation to the consumer experience. Substantial revenue generated by in-game advertising is likely to be five or more years away, as it will take that long to build the installed console base and test business models. While we believe that the future growth derived from the above trends can be substantial, it is important to remember that trends alone don’t guarantee results. Their impact can only be realized by those companies with the talent and imagination necessary to anticipate change. At Activision, we have laid a strong foundation to take advantage of these emerging opportunities as the market segments mature, and we are well positioned to capitalize on these trends to propel our competitive leadership in the future. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Selected Consolidated Financial Data The following table summarizes certain selected consolidated financial data, which should be read in conjunc- tion with our Consolidated Financial Statements and Notes thereto and with Management’s Discussion and Analysis of Financial Condition and Results of Operations included elsewhere herein. The selected consolidated financial data presented below as of and for each of the fiscal years in the five-year period ended March 31, 2006 are derived from our audited consolidated financial statements except basic and diluted earnings per share and basic and diluted weighted average shares outstanding which have been restated for the effect of our stock splits. The Consolidated Balance Sheets as of March 31, 2006 and 2005 and the Consolidated Statements of Operations and Consolidated Statements of Cash Flows for each of the fiscal years in the three-year period ended March 31, 2006, and the report thereon, are included elsewhere in this report (in thousands, except per share data). For the years ended March 31, 2006 2005 2004 2003 2002 Statement of Operations Data: Net revenues Cost of sales—product costs Cost of sales—intellectual property licenses and software royalties and amortization Income from operations Income before income tax provision Net income Basic earnings per share(1) Diluted earnings per share(1) Basic weighted average common shares outstanding(1) Diluted weighted average $ 1,468,000 734,874 $ 1,405,857 658,949 $ 947,656 475,541 $ 864,116 440,977 $ 786,434 435,725 205,488 17,957 48,587 41,899 0.15 0.14 185,997 184,571 197,663 138,335 0.55 0.50 91,606 109,817 115,992 77,715 0.33 0.30 124,196 94,847 103,407 66,180 0.26 0.24 99,006 80,574 83,120 52,238 0.26 0.22 273,177 250,023 236,887 256,639 202,607 13 common shares outstanding(1) 299,437 278,860 257,588 276,413 237,821 Net Cash Provided by (Used In): Operating activities Investing activities Financing activities 86,007 (85,796) 45,088 215,309 (143,896) 72,654 67,403 (170,155) 117,569 90,975 (301,547) 64,090 111,792 (8,701) 50,402 As of March 31, 2006 2005 2004 2003 2002 Balance Sheet Data: Working capital Cash, cash equivalents and short-term investments Capitalized software development and intellectual property licenses Goodwill Total assets Long-term debt Shareholders’ equity $ 923,892 $ 915,413 $ 675,796 $ 422,500 $ 333,199 944,960 840,864 587,649 406,954 279,007 147,665 100,446 1,419,523 — 1,225,584 127,340 91,661 1,306,963 — 1,099,912 135,201 76,493 968,817 — 832,738 107,921 68,019 704,816 2,671 597,740 56,742 35,992 556,887 3,122 430,091 (1) Consolidated financial information for fiscal years 2005–2002 has been restated for the effect of our four-for-three stock split effected in the form of a 331⁄ 3% stock dividend to shareholders of record as of October 10, 2005, paid October 24, 2005. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T 14 Management’s Discussion and Analysis of Financial Condition and Results of Operations Overview Our Business We are a leading international publisher of interactive entertainment software products. We have built a com- pany with a diverse portfolio of products that spans a wide range of categories and target markets and that is used on a variety of game hardware platforms and operating systems. We have created, licensed, and acquired a group of highly recognizable brands, which we market to a variety of consumer demographics. Our fiscal 2006 product portfolio included such best-selling products as Call of Duty 2, Call of Duty 2: Big Red One, Tony Hawk’s American Wasteland (“THAW”), Madagascar, Ultimate Spider-Man, Quake IV, GUN, True Crime: New York City, and X-Men Legends II. Our products cover diverse game categories including action/adventure, action sports, racing, role-playing, simulation, first-person action, and strategy. Our target customer base ranges from casual players to game enthusiasts, children to adults, and mass-market consumers to “value” buyers. We currently offer our prod- ucts primarily in versions that operate on the PS2, GameCube, Xbox, and Xbox360 console systems, GBA, PSP, and NDS hand-held devices, and the PC. The installed base for this current-generation of hardware platforms is significant and the fiscal 2006 release of the Xbox360 and the upcoming calendar 2006 releases of the PS3 and Wii, will further expand the software market. We successfully executed our strategy of having a high-quality product presence at the launch of the Xbox360, releasing four titles concurrent with the con- sole launch, and are currently developing additional titles for the Xbox360. We are also currently developing three launch titles for the PS3, Call of Duty 3, Marvel: Ultimate Alliance, and Tony Hawk’s Project 8, and three launch titles for the Wii, Call of Duty 3, Marvel: Ultimate Alliance, and Tony Hawk’s Downhill Jam. Our plan is to have a significant presence at the launch of both the PS3 and the Wii while marketing to current- generation platforms as long as economically attractive given their large installed base. Our publishing business involves the development, marketing, and sale of products directly, by license or through our affiliate label program with certain third-party publishers. In the United States and Canada, we primarily sell our products on a direct basis to mass-market retailers, consumer electronics stores, discount warehouses, and game specialty stores. We conduct our international publishing activities through offices in the United Kingdom (“UK”), Germany, France, Italy, Spain, the Netherlands, Australia, Sweden, Canada, and Japan. Our products are sold internationally on a direct-to-retail basis, through third-party distribution and licensing arrangements and through our wholly-owned European distribution subsidiaries. Our distribu- tion business consists of operations located in the UK, the Netherlands, and Germany that provide logistical and sales services to third-party publishers of interactive entertainment software, our own publishing opera- tions, and manufacturers of interactive entertainment hardware. Our profitability is directly affected by the mix of revenues from our publishing and distribution businesses. Operating margins realized from our publishing business are typically substantially higher than margins real- ized from our distribution business. Operating margins in our publishing business are affected by our ability to release highly successful or “hit” titles. Though many of these titles have substantial production or acquisition costs and marketing budgets, once a title recoups these costs, incremental net revenues directly and positively impact our operating margin. Operating margins in our distribution business are affected by the mix of hard- ware and software sales, with software producing higher margins than hardware. Our Focus With respect to future game development, we will continue to focus on our “big propositions,” products that are backed by strong brands and high quality development, for which we will provide significant marketing support. Our fiscal 2006 “big proposition” releases included well-established brands, which were backed by high-profile intellectual property and/or highly anticipated motion picture releases. For example, we have a long-term relationship with Marvel Enterprises through an exclusive licensing agreement. During the third quarter of fiscal 2006, we further extended our exclusive licensing agreement with Marvel Enterprises by signing a multi-year extension to our current video game licensing agreement for the Spider-Man and X-Men franchises through 2017. This agreement grants us the exclusive rights to develop and publish video games based on A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Marvel’s comic book franchises Spider-Man and X-Men. Through fiscal 2006, games based on the Spider-Man and X-Men franchises have generated more than $785.7 million in net revenue worldwide. Our fiscal 2006 release schedule included titles based on Marvel’s Spider-Man, X-Men, and Fantastic 4, which was part of our previous licensing agreement. In the first quarter of fiscal 2006 we released the video game, Fantastic 4, just prior to the theatrical release of “Fantastic 4.” We also released Ultimate Spider-Man and X-Men Legends II: Rise of the Apocalypse (“X-Men Legends II”) in the second quarter of fiscal 2006 in North America and in the third quarter of fiscal 2006 internationally. In fiscal 2007, under this agreement, we plan to release X-Men: The Official Game around the theatrical release of “X-Men: The Last Stand” and Marvel: Ultimate Alliance. In addition, through our licensing agreement with Spider-Man Merchandising, LP, we will be developing and publishing video games based on Columbia Pictures/Marvel Enterprises, Inc.’s upcoming feature film “Spider-Man 3,” which is expected to be released in May 2007. In addition, during the third quarter of fiscal 2006, we signed an agreement with Spider-Man Merchandising, LP to extend our exclusive worldwide publishing rights to publish entertainment software products based on subsequent Spider- Man movie sequels or new television series through 2017. We also have an exclusive licensing agreement with professional skateboarder Tony Hawk. The agreement grants us exclusive rights to develop and publish video games through 2015 using Tony Hawk’s name and likeness. Through fiscal 2006, we have released seven successful titles in the Tony Hawk franchise with cumulative net revenues of $1.1 billion, including the most recent, THAW, which was released in the third quarter of fiscal 2006. We will continue to build on the Tony Hawk franchise in fiscal 2007 with the release of Tony Hawk’s Project 8 and Tony Hawk’s Downhill Jam. We continue to develop a number of original intellectual properties which are developed and owned by Activision. For example, in the third quarter of fiscal 2006 we released Call of Duty 2 on the PC and Xbox360 and Call of Duty 2: Big Red One, on the GameCube, PS2, and Xbox. According to NPD Funworld, Call of Duty 2 was the top selling Xbox360 title of the year. These titles were the fourth and fifth releases based upon this original intellectual property following two other PC titles, Call of Duty and Call of Duty: United Offensive, and one other console title, Call of Duty: Finest Hour. In the third quarter of fiscal 2006, we also released True Crime: New York City, which was based upon our fiscal 2004 original intellectual property True Crime: Streets of LA, and GUN, a new original intellectual property. According to NPD Funworld, we have developed the number one new original intellectual property title in each of the past three years which included True Crime: Streets of LA in calendar 2003, Call of Duty: Finest Hour in calendar 2004, and GUN in calendar 2005. We expect to develop a variety of games on multiple platforms based on these original properties as well as continue to invest in developing other original intellectual properties. 15 We will also continue to evaluate and exploit emerging brands that we believe have potential to become suc- cessful game franchises. For example, we have a multi-year, multi-property, publishing agreement with DreamWorks LLC that grants us the exclusive rights to publish video games based on DreamWorks Animation SKG’s theatrical release “Shrek 2,” which was released in the first quarter of fiscal 2005, “Shark Tale,” which was released in the second quarter of fiscal 2005, “Madagascar,” which was released in the first quarter of fiscal 2006, “Over the Hedge,” which was released in the first quarter of fiscal 2007, and all of their respec- tive sequels, including “Shrek the Third” and “Madagascar 2.” In addition, during the third quarter of fiscal 2006, we further enhanced our agreement with DreamWorks Animation SKG by signing a multi-year agree- ment which grants us the exclusive video game rights to four upcoming feature films, “Bee Movie,” “Kung Fu Panda,” “Rex Havoc,” and “How to Train Your Dragon,” as well as potential future films in the “Shrek” franchise beyond the upcoming “Shrek the Third.” Additionally, we have a strategic alliance with Harrah’s Entertainment, Inc. that grants us the exclusive, worldwide interactive rights to develop and publish “World Series of Poker” video games based on the popular World Series of Poker Tournament. In the second quarter of fiscal 2006, we released our first title under this alliance, World Series of Poker, which became the number one poker title of calendar 2005. In fiscal 2007, we plan on releasing our second title under this alliance, World Series of Poker: Tournament of Champions. We also continue to build on our portfolio of licensed intellectual property. In February 2006, we signed an agreement with Hasbro Properties Group granting us the global rights, excluding Japan, to develop console, A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Management’s Discussion and Analysis of Financial Condition and Results of Operations hand-held, and PC games based on Hasbro’s “Transformers” brand. We anticipate releasing the first game concurrently with the July 2007 movie release of the live action “Transformers” film from DreamWorks Pictures and Paramount Pictures. In May 2006 we signed an agreement with MGM Interactive and EON Productions Ltd. granting us the rights to develop and publish interactive entertainment games based on the James Bond license through 2014. In addition to acquiring or creating high profile intellectual property, we have also continued our focus on establishing and maintaining relationships with talented and experienced software development teams. We have strengthened our internal development capabilities through the acquisition of several development com- panies with talented and experienced teams including the acquisitions of developers Toys For Bob, Inc. in April 2005 and Beenox, Inc. in May 2005. Additionally, in May 2006 we entered into an agreement to acquire video game publisher RedOctane Inc., the publisher of the popular Guitar Hero franchise. We have development agreements with other top-level, third-party developers such as id Software, Inc., Edge of Reality, Ltd., and Splash Damage, Ltd. We are utilizing these developer relationships, new intellectual property acquisitions, new original intellectual property creations, and our existing library of intellectual property to further focus our game development on product lines that will deliver significant, lasting, and recurring revenues and operating profits. Critical Accounting Policies We have identified the policies below as critical to our business operations and the understanding of our financial results. The impact and any associated risks related to these policies on our business operations is discussed throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations where such policies affect our reported and expected financial results. For a detailed discussion on the appli- cation of these and other accounting policies, see Note 1 to the Notes to the Consolidated Financial Statements included in Item 8. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. 16 Revenue Recognition. We recognize revenue from the sale of our products upon the transfer of title and risk of loss to our customers. Certain products are sold to customers with a street date (the date that products are made widely available for sale by retailers). For these products we recognize revenue no earlier than the street date. Revenue from product sales is recognized after deducting the estimated allowance for returns and price protection. With respect to license agreements that provide customers the right to make multiple copies in exchange for guaranteed amounts, revenue is recognized upon delivery of such copies. Per copy royalties on sales that exceed the guarantee are recognized as earned. In addition, in order to recognize revenue for both product sales and licensing transactions, persuasive evidence of an arrangement must exist and collection of the related receivable must be probable. Revenue recognition also determines the timing of certain expenses, including cost of sales—intellectual property licenses and cost of sales—software royalties and amortization. Sales incentives or other consideration given by us to our customers is accounted for in accordance with the Financial Accounting Standards Board’s Emerging Issues Task Force (“EITF”) Issue 01-9, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products).” In accordance with EITF Issue 01-9, sales incentives and other consideration that are considered adjustments of the selling price of our products, such as rebates and product placement fees, are reflected as reductions of revenue. Sales incentives and other consideration that represent costs incurred by us for assets or services received, such as the appearance of our products in a customer’s national circular ad, are reflected as sales and marketing expenses. Allowances for Returns, Price Protection, Doubtful Accounts, and Inventory Obsolescence. In determining the appropriate unit shipments to our customers, we benchmark our titles using historical and industry data. We closely monitor and analyze the historical performance of our various titles, the performance of products released by other publishers, and the anticipated timing of other releases in order to assess future demands of current and upcoming titles. Initial volumes shipped upon title launch and subsequent reorders are evaluated A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T to ensure that quantities are sufficient to meet the demands from the retail markets but at the same time, are controlled to prevent excess inventory in the channel. We may permit product returns from, or grant price protection to, our customers under certain conditions. In general, price protection refers to the circumstances when we elect to decrease the wholesale price of a product by a certain amount and, when granted and applicable, allow customers a credit against amounts owed by such customers to Activision with respect to open and/or future invoices. The conditions our customers must meet to be granted the right to return products or price protection are, among other things, compliance with applicable payment terms, delivery to us of weekly inventory and sell-through reports, and consistent participa- tion in the launches of our premium title releases. We may also consider other factors, including the facilitation of slow-moving inventory and other market factors. Management must make estimates of potential future product returns and price protection related to current period product revenue. We estimate the amount of future returns and price protection for current period product revenue utilizing historical experience and information regarding inventory levels and the demand and acceptance of our products by the end consumer. The following factors are used to estimate the amount of future returns and price protection for a particular title: historical performance of titles in similar genres, historical performance of the hardware platform, historical performance of the brand, console hardware life cycle, Activision sales force and retail customer feedback, industry pricing, weeks of on-hand retail channel inventory, absolute quantity of on-hand retail channel inventory, our warehouse on-hand inventory levels, the title’s recent sell-through history (if available), marketing trade programs, and competing titles. The relative importance of these factors varies among titles depending upon, among other items, genre, platform, seasonality, and sales strategy. Significant management judgments and estimates must be made and used in connection with establishing the allowance for returns and price protection in any accounting period. Based upon historical experience we believe our estimates are reasonable. However, actual returns and price protection could vary materially from our allowance estimates due to a number of reasons including, among others, a lack of consumer acceptance of a title, the release in the same period of a similarly themed title by a competitor, or technological obsolescence due to the emer- gence of new hardware platforms. Material differences may result in the amount and timing of our revenue for any period if management makes different judgments or utilizes different estimates in determining the allowances for returns and price protection. For example, a 1% change in our March 31, 2006 allowance for returns and price protection would impact net revenues by approximately $1.0 million. Similarly, management must make estimates of the uncollectibility of our accounts receivable. In estimating the allowance for doubtful accounts, we analyze the age of current outstanding account balances, historical bad debts, customer concentrations, customer creditworthiness, current economic trends, and changes in our customers’ payment terms and their economic condition, as well as whether we can obtain sufficient credit insurance. Any significant changes in any of these criteria would impact management’s estimates in establish- ing our allowance for doubtful accounts. We value inventory at the lower of cost or market. We regularly review inventory quantities on hand and in the retail channel and record a provision for excess or obsolete inventory based on the future expected demand for our products. Significant changes in demand for our products would impact management’s estimates in establishing our inventory provision. Software Development Costs. Software development costs include payments made to independent software developers under development agreements, as well as direct costs incurred for internally developed products. We account for software development costs in accordance with Statement of Financial Accounting Standard (“SFAS”) No. 86, “Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed.” Software development costs are capitalized once technological feasibility of a product is established and such costs are determined to be recoverable. Technological feasibility of a product encompasses both technical design documentation and game design documentation. For products where proven technology exists, this may occur early in the development cycle. Technological feasibility is evaluated on a product-by-product basis. Prior to a product’s release, we expense, as part of cost of sales—software royalties and amortization, capitalized costs when we believe such amounts are not recoverable. Capitalized costs for those products that are cancelled or abandoned are charged to product development expense in the period of cancellation. Amounts related to 17 A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Management’s Discussion and Analysis of Financial Condition and Results of Operations software development which are not capitalized are charged immediately to product development expense. We evaluate the future recoverability of capitalized amounts on a quarterly basis. The recoverability of capitalized software development costs is evaluated based on the expected performance of the specific products for which the costs relate. Criteria used to evaluate expected product performance include: historical performance of comparable products using comparable technology; orders for the product prior to its release; and estimated performance of a sequel product based on the performance of the product on which the sequel is based. Commencing upon product release, capitalized software development costs are amortized to cost of sales— software royalties and amortization based on the ratio of current revenues to total projected revenues, generally resulting in an amortization period of six months or less. For products that have been released in prior periods, we evaluate the future recoverability of capitalized amounts on a quarterly basis. The primary evaluation criterion is actual title performance. Significant management judgments and estimates are utilized in the assessment of when technological feasibil- ity is established, as well as in the ongoing assessment of the recoverability of capitalized costs. In evaluating the recoverability of capitalized costs, the assessment of expected product performance utilizes forecasted sales amounts and estimates of additional costs to be incurred. If revised forecasted or actual product sales are less than and/or revised forecasted or actual costs are greater than the original forecasted amounts utilized in the initial recoverability analysis, the net realizable value may be lower than originally estimated in any given quarter, which could result in an impairment charge. Intellectual Property Licenses. Intellectual property license costs represent license fees paid to intellectual prop- erty rights holders for use of their trademarks, copyrights, software, technology, or other intellectual property or proprietary rights in the development of our products. Depending upon the agreement with the rights holder, we may obtain the rights to use acquired intellectual property in multiple products over multiple years, or alternatively, for a single product. 18 We evaluate the future recoverability of capitalized intellectual property licenses on a quarterly basis. The recoverability of capitalized intellectual property license costs is evaluated based on the expected performance of the specific products in which the licensed trademark or copyright is to be used. As many of our intellec- tual property licenses extend for multiple products over multiple years, we also assess the recoverability of capitalized intellectual property license costs based on certain qualitative factors such as the success of other products and/or entertainment vehicles utilizing the intellectual property, whether there are any future planned theatrical releases or television series based on the intellectual property, and the rights holder’s con- tinued promotion and exploitation of the intellectual property. Prior to the related product’s release, we expense, as part of cost of sales—intellectual property licenses, capitalized intellectual property costs when we believe such amounts are not recoverable. Capitalized intellectual property costs for those products that are cancelled or abandoned are charged to product development expense in the period of cancellation. Criteria used to evaluate expected product performance include: historical performance of comparable products using comparable technology; orders for the product prior to its release; and estimated performance of a sequel product based on the performance of the product on which the sequel is based. Commencing upon the related product’s release, capitalized intellectual property license costs are amortized to cost of sales—intellectual property licenses based on the ratio of current revenues for the specific product to total projected revenues for all products in which the licensed property will be utilized. As intellectual property license contracts may extend for multiple years, the amortization of capitalized intellectual property license costs relating to such contracts may extend beyond one year. For intellectual property included in products that have been released and unreleased products, we evaluate the future recoverability of capitalized amounts on a quarterly basis. The primary evaluation criterion is actual and expected title performance. Significant management judgments and estimates are utilized in the assessment of the recoverability of capi- talized costs. In evaluating the recoverability of capitalized costs, the assessment of expected product perfor- mance utilizes forecasted sales amounts and estimates of additional costs to be incurred. If revised forecasted or actual product sales are less than, and/or revised forecasted or actual costs are greater than, the original forecasted amounts utilized in the initial recoverability analysis, the net realizable value may be lower than originally estimated in any given quarter, which could result in an impairment charge. Additionally, as noted A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T above, as many of our intellectual property licenses extend for multiple products over multiple years, we also assess the recoverability of capitalized intellectual property license costs based on certain qualitative factors such as the success of other products and/or entertainment vehicles utilizing the intellectual property, whether there are any future planned theatrical releases or television series based on the intellectual property and the rights holder’s continued promotion and exploitation of the intellectual property. Material differences may result in the amount and timing of charges for any period if management makes different judgments or uti- lizes different estimates in evaluating these qualitative factors. Selected Consolidated Statements of Operations Data The following table sets forth certain consolidated statements of operations data for the periods indicated as a percentage of consolidated net revenues and also breaks down net revenues by territory, business segment, and platform, as well as operating income by business segment (in thousands): Year ended March 31, Net revenues Costs and expenses: Cost of sales—product costs Cost of sales—software royalties and amortization Cost of sales—intellectual property licenses Product development Sales and marketing General and administrative Total costs and expenses Income from operations Investment income, net Income before income tax provision Income tax provision Net income Net Revenues by Territory: North America Europe Other 2006 2005 2004 $ 1,468,000 100% $ 1,405,857 100% $ 947,656 100% 734,874 147,822 57,666 131,782 283,220 94,679 1,450,043 17,957 30,630 50 10 4 9 19 7 99 1 2 48,587 3 6,688 — 658,949 123,800 62,197 86,543 230,058 59,739 1,221,286 184,571 13,092 197,663 59,328 47 9 5 6 16 4 87 13 1 14 4 475,541 59,744 31,862 97,859 128,221 44,612 837,839 50 6 3 10 14 5 88 109,817 12 6,175 — 115,992 38,277 12 4 $ 41,899 3% $ 138,335 10% $ 77,715 8% $ 710,040 717,494 40,466 48% $ 696,325 675,074 49 34,458 3 50% $ 446,812 479,224 48 21,620 2 47% 51 2 19 Total net revenues $ 1,468,000 100% $ 1,405,857 100% $ 947,656 100% Net Revenues by Segment/Platform Mix: Publishing: Console Hand-held PC $ 812,345 158,861 183,457 55% $ 713,947 138,695 11 220,087 13 51% $ 508,418 10 24,945 132,369 15 54% 2 14 Total publishing net revenues 1,154,663 79 1,072,729 76 665,732 70 Distribution: Console Hand-held PC Total distribution net revenues 196,413 76,973 39,951 313,337 13 5 3 21 256,452 23,282 53,394 333,128 18 2 4 24 223,802 18,361 39,761 281,924 24 2 4 30 Total net revenues $ 1,468,000 100% $ 1,405,857 100% $ 947,656 100% Operating Income (Loss) by Segment: Publishing Distribution $ (3,984) 21,941 —% $ 160,826 23,745 1 11% $ 93,223 16,594 2 Total operating income $ 17,957 1% $ 184,571 13% $ 109,817 10% 2 12% A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Management’s Discussion and Analysis of Financial Condition and Results of Operations Results of Operations—Fiscal Years Ended March 31, 2006 and 2005 Net Revenues We primarily derive revenue from sales of packaged interactive software games designed for play on video game consoles (such as the PS2, Xbox, Xbox360, and GameCube), PCs, and hand-held game devices (such as the GBA, NDS, and PSP). We also derive revenue from our distribution business in Europe that provides logistical and sales services to third-party publishers of interactive entertainment software, our own publishing operations and third-party manufacturers of interactive entertainment hardware. The following table details our consolidated net revenues by business segment and our publishing net revenues by territory for the years ended March 31, 2006 and 2005 (in thousands): For the years ended March 31, 2006 2005 Increase/ (Decrease) Percent Change Publishing net revenues North America Europe Other Total international Total publishing net revenues Distribution net revenues Consolidated net revenues $ 710,040 $ 696,325 $ 13,715 404,157 40,466 444,623 341,946 34,458 376,404 1,154,663 313,337 1,072,729 333,128 62,211 6,008 68,219 81,934 (19,791) $ 1,468,000 $ 1,405,857 $ 62,143 2% 18% 17% 18% 8% (6%) 4% 20 Consolidated net revenues increased 4% from $1,405.9 million for the year ended March 31, 2005 to $1,468.0 million for the year ended March 31, 2006. This increase in consolidated net revenues was solely generated by our publishing business and was driven by the following: • An increase year over year in the number of titles released. Our fiscal 2006 launch schedule included the largest slate of new releases in our history. In fiscal 2006, we released seventeen major titles including the following major releases: Doom 3 for the Xbox, Madagascar, Fantastic Four, Ultimate Spider-Man, X-Men Legends II, THAW, Call of Duty 2, Call of Duty 2: Big Red One, GUN, True Crime: New York City, Quake 4, Shrek SuperSlam, The Movies, Cabela’s Dangerous Hunts 2, and World Series of Poker. In addition, four of these titles, Call of Duty 2, THAW, Quake 4, and GUN, were released concurrently with the release of the Xbox360 platform at a premium retail price of $59.99. This compares to fourteen titles in fiscal 2005, which included the following major releases: Spider-Man 2, Call of Duty: Finest Hour, Tony Hawk’s Underground 2 (“THUG 2”), Shrek 2, X-Men Legends, Doom 3, Lemony Snicket’s A Series of Unfortunate Events, Shark Tale, Cabela’s Big Game Hunter 2005, and Rome: Total War. Additionally in fiscal 2006, we achieved our goal of increasing the number of million and multi-million unit selling titles. • An increase in our hand-held platform presence growing publishing hand-held revenues by $20.2 million or 15% from $138.7 million for the year ended March 31, 2005 to $158.9 million for the year ended March 31, 2006. This was driven by an increase in the number of hand-held titles released combined with titles being released across more hand-held platforms with the fiscal 2005 introductions of the PSP and NDS. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Partially offset by: • An increase in provision for return and price protection throughout fiscal 2006 from 12% of net reve- nues in fiscal 2005 to 18% of net revenues in fiscal 2006, due to challenging market conditions and the ongoing console transition. • A decrease in net revenues from our distribution business due mostly to the effect of year over year weakening of the Euro (“EUR”) and Great Britain Pound (“GBP”) in relation to the United States Dollar (“USD”). Foreign exchange rates decreased reported distribution net revenues by approximately $14.9 million for the year ended March 31, 2006. Excluding the impact of changing foreign currency rates, our distribution net revenues decreased 1% year over year. Due to uncertainty with regard to the market, software pricing, and first-party hardware plans for current and next-generation consoles, we plan on releasing a more focused slate of titles in fiscal 2007. As a result, we anticipate revenue will decrease in fiscal 2007 in comparison to the record net revenues achieved in fiscal 2006. North America Publishing Net Revenues (in thousands) March 31, 2006 $710,040 % of Consolidated Net Revenues 48% March 31, 2005 $696,325 % of Consolidated Net Revenues 50% Increase/ (Decrease) $13,715 Percent Change 2% North America publishing net revenues increased 2% from $696.3 million for the year ended March 31, 2005 to $710.0 million for the year ended March 31, 2006. The increase reflects our largest slate of releases in company history and expansion of our hand-held presence with products for PSP, NDS, and GBA. This was offset by weaker market conditions resulting in higher provisions for returns and price protection. North America publishing net revenues decreased as a percentage of consolidated net revenues from 50% for the year ended March 31, 2005 to 48% for the year ended March 31, 2006. The decrease is due to a larger increase in our international publishing net revenues due to successful expansion efforts into new territories and the strong performance of our affiliate titles in Europe. 21 International Publishing Net Revenues (in thousands) March 31, 2006 $444,623 % of Consolidated Net Revenues 31% March 31, 2005 $376,404 % of Consolidated Net Revenues 26% Increase/ (Decrease) $68,219 Percent Change 18% International publishing net revenues increased by 18% from $376.4 million for the year ended March 31, 2005 to $444.6 million for the year ended March 31, 2006. Additionally, international publishing net revenues as a percentage of consolidated net revenues increased from 26% for the year ended March 31, 2005 to 31% for the year ended March 31, 2006. The increases were due mainly to our successful expansion efforts into new territories combined with strong performance from our affiliate label products which included the successful LucasArts’ titles, Star Wars: Revenge of the Sith and Star Wars Battlefront II. The increase in international publishing net revenues was partially offset by a weakening of the EUR and the GBP in relation to the USD of approximately $14.5 million. Excluding the impact of changing foreign currency rates, our international publishing net revenues increased 22% year over year. In the coming year, we will continue to focus on expanding our international publishing capabilities and direct-selling efforts in both the European and Asia- Pacific markets. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Management’s Discussion and Analysis of Financial Condition and Results of Operations Publishing Net Revenues by Platform Publishing net revenues increased 8% from $1,072.7 million for the year ended March 31, 2005 to $1,154.7 million for the year ended March 31, 2006. The following table details our publishing net revenues by platform and as a percentage of total publishing net revenues for the years ended March 31, 2006 and 2005 (in thousands): Publishing Net Revenues PC Console Sony PlayStation 2 Microsoft Xbox Microsoft Xbox360 Nintendo GameCube Other Total console Hand-held Game Boy Advance PlayStation Portable Nintendo Dual Screen 22 Total hand-held Total publishing net revenues Year Ended March 31, 2006 % of Publishing Net Revs Year Ended March 31, 2005 % of Publishing Net Revs Increase/ (Decrease) Percent Change $ 183,457 16% $ 220,087 21% $ (36,630) (17%) 422,239 205,864 102,809 80,964 469 812,345 79,738 52,016 27,107 158,861 36% 18% 9% 7% —% 70% 7% 5% 2% 14% 417,310 196,894 — 96,936 2,807 713,947 101,796 19,200 17,699 138,695 39% 18% —% 9% —% 66% 9% 2% 2% 13% 4,929 8,970 102,809 (15,972) (2,338) 98,398 (22,058) 32,816 9,408 20,166 1% 5% —% (16%) (83%) 14% (22%) 171% 53% 15% $ 1,154,663 100% $ 1,072,729 100% $ 81,934 8% Personal Computer Net Revenues (in thousands) March 31, 2006 $183,457 % of Publishing Net Revenues 16% March 31, 2005 $220,087 % of Publishing Net Revenues 21% Increase/ (Decrease) $(36,630) Percent Change (17%) Net revenues from sales of titles for the PC decreased 17% from $220.1 million and 21% of publishing net revenues for the year ended March 31, 2005 to $183.5 million and 16% of publishing net revenues for the year ended March 31, 2006. The decrease in both absolute dollars and as a percentage of publishing revenue was due to the slate of PC titles released in fiscal 2005 in comparison to fiscal 2006. In fiscal 2005, we released the highly successful PC titles Doom 3 and Rome: Total War and also had strong continued sell through of our catalog title, Call of Duty. Although we had strong sales from our fiscal 2006 PC titles, Call of Duty 2, The Movies, and Quake 4, in fiscal 2005, according to NPD Funworld, we were the only publisher to have three top-ten PC titles for calendar year 2004. We expect fiscal 2007 PC publishing net revenues to decrease in absolute dollars due to a more focused slate of titles in fiscal 2007 which includes only one PC exclusive title, Enemy Territory: Quake Wars and one expansion pack, The Movies: Stunts and Effects. We expect fiscal 2007 PC publishing net revenues as a percentage of total publishing net revenues to remain consistent with fiscal 2006. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Sony PlayStation 2 Net Revenues (in thousands) March 31, 2006 $422,239 % of Publishing Net Revenues 36% March 31, 2005 $417,310 % of Publishing Net Revenues 39% Increase/ (Decrease) $4,929 Percent Change 1% Net revenues from sales of titles for the PS2 increased 1% from $417.3 million for the year ended March 31, 2005 to $422.2 million for the year ended March 31, 2006. The slight increase was primarily due to an increase in the number of major titles released for the PS2 from seven major titles in fiscal 2005 to nine major titles in fiscal 2006. This increase was offset by an increase in the provision for returns and price protection on new releases due to weaker market conditions. In addition, Madagascar, which was our fifth best selling PS2 title for fiscal 2006 in terms of units sold, was released at a lower initial retail pricing point of $39.99 compared to $49.99 for comparable children’s titles in fiscal 2005. As a percentage of publishing net revenues, net revenues from sales of titles for the PS2 decreased from 39% for the year ended March 31, 2005 to 36% for the year ended March 31, 2006. The decrease is due to a change in our platform revenue mix due to the introduction of the Xbox360. We expect the installed base of PS2 to continue to grow in fiscal 2007, although at a slower rate than in previous years, due to the anticipated release of the next-generation PS3 console sys- tem in calendar 2006. However, due to the market uncertainty involving the transition to the next-generation console systems, we plan on releasing a more focused slate in fiscal 2007 resulting in a significant decrease in PS2 titles from fiscal 2006 where we had the largest slate of titles in our history. As a result, we expect net revenues from sales of titles for the PS2 to decrease in fiscal 2007 in comparison to fiscal 2006. We expect the release of the PS3 to have a small impact on fiscal 2007 net revenues given the initially low installed base. Microsoft Xbox Net Revenues % of Publishing Net Revenues (in thousands) March 31, 2006 $205,864 18% March 31, 2005 $196,894 % of Publishing Net Revenues 18% Increase/ (Decrease) $8,970 Percent Change 5% 23 Net revenues from sales of titles for the Xbox increased 5% from $196.9 million for the year ended March 31, 2005 to $205.9 million for the year ended March 31, 2006 and held steady as a percentage of publishing net revenues at 18%. The increase was primarily attributable to the strong performance of our first quarter fiscal 2006 Xbox exclusive release of Doom 3 which had no comparable Xbox exclusive title released in fiscal 2005. This increase was offset by increased provisions for returns and price protection in anticipation of quicker required pricing actions as a result of the introduction of the Xbox360, which is expected to result in a gradual slowdown in sales for the Xbox as customers upgrade or anticipate upgrading to the next-generation platform. We expect our fiscal 2007 net revenues from sales of titles for the Xbox to decrease versus fiscal 2006 due to fewer anticipated title releases for the Xbox in fiscal 2007 combined with a declining customer base as the Xbox360 hardware becomes more readily available and its installed base grows. Microsoft Xbox360 Net Revenues (in thousands) March 31, 2006 $102,809 % of Publishing Net Revenues 9% March 31, 2005 $— % of Publishing Net Revenues —% Increase/ (Decrease) $102,809 Percent Change — % The Xbox360 was released in November 2005 and was the first of the next-generation hardware to be released. Consistent with our goal of having a significant presence at the launch of each new platform, we released four titles concurrently with the release of the Xbox360, Call of Duty 2, THAW, Quake 4, and GUN. All of these A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Management’s Discussion and Analysis of Financial Condition and Results of Operations titles were released at premium retail pricing of $59.99. Although limited by hardware availability in fiscal 2006, we experienced strong sales of these four titles, and, according to NPD Funworld, Call of Duty 2 was the number one title on the Xbox360 and had the highest attach rate of any console launch in video game history. We expect the Xbox360 to provide significant opportunity for us in the upcoming fiscal years. In fiscal 2007, we expect net revenues from sales of titles for the Xbox360 to continue to increase over what we achieved in fiscal 2006. Nintendo GameCube Net Revenues (in thousands) March 31, 2006 $80,964 % of Publishing Net Revenues 7% March 31, 2005 $96,936 % of Publishing Net Revenues 9% Increase/ (Decrease) $(15,972) Percent Change (16%) Net revenues from sales of titles for the Nintendo GameCube decreased 16% from $96.9 million for the year ended March 31, 2005 to $81.0 million for the year ended March 31, 2006. Despite an increase in the number of titles released for the GameCube from seven major titles for the year ended March 31, 2005 to nine major titles for the year ended March 31, 2006, the releases in fiscal 2006, which included GUN, Call of Duty 2: Big Red One, THAW, and True Crime: New York City, were less geared toward the demographics of the GameCube audience as compared to our fiscal 2005 title releases, which included Spider-Man 2 and Shrek 2. Additionally, Madagascar, which was our top selling title on the GameCube in fiscal 2006, was released at a lower initial retail pricing of $39.99 as compared to Spider-Man 2 and Shrek 2, which were both released at an initial retail price of $49.99. Madagascar was our top selling title on the GameCube for fiscal 2006 and although it performed strongly, it compares to fiscal 2005 where our top two selling titles on the GameCube were Spider-Man 2 and Shrek 2, each of which outperformed Madagascar. We expect fiscal 2007 net revenues for the GameCube to decrease over fiscal 2006 due to our more focused fiscal 2007 title slate and the next- generation platforms gaining market share over current-generation platforms such as the GameCube. It is anticipated that Nintendo will release their next-generation console, the Wii, in calendar 2006. Given the initially low installed base, we expect the release of the Wii to have little initial impact on our net revenues. 24 Hand-held (in thousands) March 31, 2006 $158,861 % of Publishing Net Revenues 14% March 31, 2005 $138,695 % of Publishing Net Revenues 13% Increase/ (Decrease) $20,166 Percent Change 15% Net revenues from sales of titles for the hand-held for the year ended March 31, 2006 increased 15% from the prior fiscal year, from $138.7 million to $158.9 million. Additionally, hand-held net revenues as a percentage of publishing net revenues increased from 13% for the year ended March 31, 2005 to 14% for the year ended March 31, 2006. The increases were due to the worldwide introductions of the NDS and PSP hand-held plat- forms in late fiscal 2005 and the continued growth of their installed base throughout fiscal 2006, which resulted in hand-held titles being sold across more platforms. In addition, compared to the other hand-held platforms, titles for the PSP have a higher retail pricing point of $49.99. The major titles driving hand-held net revenues in fiscal 2006 were Madagascar, Madagascar: Operation Penguin, Fantastic Four, Ultimate Spider-Man, and Shrek SuperSlam for the GBA; Madagascar, Ultimate Spider-Man, Tony Hawk’s American Sk8land, and Shrek SuperSlam for the NDS; and THUG 2, Spider-Man 2, X-Men Legends II, and LucasArts’ Star Wars Battlefront II for the PSP. This compares to fiscal 2005 where the main titles driving hand-held net revenues were Shrek 2, Spider-Man 2, and DreamWorks’ Shark Tale for the GBA; Spider-Man 2 for the NDS; and THUG 2 and Spider-Man 2 for the PSP. With the installed base of the PSP, NDS, and GBA continuing to increase and the PSP expanding the demographic of the hand-held gamer, we expect that fiscal 2007 hand- held net revenues to continue to increase year over year. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Overall The platform mix of our future publishing net revenues will likely be impacted by a number of factors, includ- ing the ability of hardware manufacturers to continue to increase their installed hardware base and the intro- duction of new hardware platforms, as well as the performance of key product releases from our product release schedule. We expect that net revenues from console titles will continue to represent the largest component of our publishing net revenues with PS2 having the largest percentage of that business due to its larger installed hardware base. However, during fiscal 2007, we expect the introduction of the PS3 and Wii next-generation console systems and a higher installed base of the Xbox360 will continue to decrease the percentage of PS2 business throughout the year. With the installed base of the NDS and PSP platforms continuing to increase, we also expect to see a continued increase in our hand-held business in line with the growth in the installed base in comparison to prior periods. Our net revenues from PC titles will be primarily driven by our product release schedule. A significant portion of our revenues and profits are derived from a relatively small number of popular titles and brands each year as revenues and profits are significantly affected by our ability to release highly success- ful titles. For example, for the year ended March 31, 2006, 20% of our consolidated net revenues and 26% of worldwide publishing net revenues were derived from net revenues from our Call of Duty 2, THAW, and Call of Duty 2: Big Red One titles. Though many of these titles have substantial production or acquisition costs and marketing budgets, once a title recoups these costs, incremental net revenues directly and positively impact operating profits resulting in a disproportionate amount of operating income being derived from these select titles. We expect that a limited number of titles and brands will continue to produce a disproportionately large amount of our net revenues and profits. Three key factors that could affect future publishing and distribution net revenue performance are console hardware pricing, software pricing, and transitions in console platforms. As console hardware moves through its life cycle, hardware manufacturers typically enact price reductions. Reductions in the price of console hardware typically result in an increase in the installed base of hardware owned by consumers. Historically, we have also seen that lower console hardware prices put downward pressure on software pricing. While we expect console software launch pricing for the Xbox360 to hold at $59.99, we have noticed downward pressure on the prices of current-generation software. Additionally, when new console platforms are announced or introduced into the market, such as the upcoming 2006 calendar year releases of the PS3 and Wii and the November 2005 release of the Xbox360, consumers typically reduce their purchases of game console entertain- ment software products for current console platforms in anticipation of new platforms becoming available. During these periods, sales of our game console entertainment software products may be expected to slow or even decline until new platforms are introduced and achieve wide consumer acceptance. 25 Distribution Net Revenues % of Consolidated Net Revenues (in thousands) March 31, 2006 $313,337 21% March 31, 2005 $333,128 % of Consolidated Net Revenues 24% Increase/ (Decrease) $(19,791) Percent Change (6%) Distribution net revenues for the year ended March 31, 2006 decreased 6% from the prior fiscal year, from $333.1 million to $313.3 million. Foreign exchange rates decreased reported distribution net revenues by approximately $14.9 million for the year ended March 31, 2006. Excluding the impact of the changing foreign currency rates, our distribution net revenues decreased $4.9 million or 1% year over year. The remaining year over year decrease was primarily due to the termination of relationships with unprofitable publishers and stronger third-party releases in fiscal 2005. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Management’s Discussion and Analysis of Financial Condition and Results of Operations The mix of distribution net revenues between hardware and software sales varied year over year with approx- imately 20% of distribution net revenues from hardware sales in the year ended March 31, 2006 as compared to 13% in the prior fiscal year. This was mainly attributed to the release of the PSP in Europe in the second quarter of fiscal 2006 and the release of the Xbox360 in November 2005. In both fiscal years, hardware sales were principally comprised of sales of console hardware. The mix of future distribution net revenues will be driven by a number of factors including the occurrence of further hardware price reductions instituted by hardware manufacturers, the introduction of new hardware platforms, and our ability to establish and main- tain distribution agreements with hardware manufacturers and third-party software publishers. We expect our fiscal 2007 distribution net revenues to decrease when compared with fiscal 2006 due to uncertainty with regard to the software market as a result of the transition from current-generation console system to the next- generation Xbox360, PS3, and Wii and a more focused slate of Activision titles. Costs and Expenses Cost of Sales—Product Costs % of Consolidated Net Revenues (in thousands) March 31, 2006 $734,874 50% March 31, 2005 $658,949 % of Consolidated Net Revenues 47% Increase/ (Decrease) $75,925 Percent Change 12% Cost of sales—product costs represented 50% and 47% of consolidated net revenues for the years ended March 31, 2006 and 2005, respectively. In absolute dollars, cost of sales—product costs increased 12% from $658.9 million for the year ended March 31, 2005 to $734.9 million for the year ended March 31, 2006. The primary factors affecting the increase in cost of sales—product costs in absolute dollars and as a percentage of consolidated net revenues were: 26 • Volume growth in our European territories of LucasArts’ Star Wars: Episode III Revenge of the Sith, and Star Wars Battlefront II. LucasArts’ titles are part of our affiliate label program and carry a significantly higher product cost than Activision developed titles. • Write-downs of inventory costs for certain titles in fiscal 2006 in the amount of $14.5 million due to the high level of inventory for certain titles at the end of our third quarter of fiscal 2006. At the end of the third quarter of fiscal 2006 we reviewed the levels of inventory and determined that, due to lower than expected re-orders caused by weaker market conditions and the ongoing console transition, we anticipated that certain titles in our inventory would likely be sold below its original cost. • A decrease in our PC net revenues as a percentage of publishing net revenues from 21% in fiscal 2005 to 16% in fiscal 2006. Products for PC typically have lower costs of sales—product costs associated with them as they do not require royalty payments to hardware manufacturers. • An increase in provision for returns and price protection throughout fiscal 2006 from 12% of net revenues in fiscal 2005 compared to 18% of net revenues in fiscal 2006, due to challenging market conditions and the ongoing console transition. • An increase in consolidated net revenues of 4% from $1,405.9 million for the year ended March 31, 2005 to $1,468.0 million for the year ended March 31, 2006. • Reduced pricing on a number of catalog titles as well as new releases in our kids genre. We expect cost of sales—product costs as a percentage of net revenues to remain relatively flat as a percentage of revenue in fiscal 2007 as compared to fiscal 2006. This is primarily due to slightly higher product costs related to next-generation titles offset by higher retail pricing on next-generation titles which are anticipated to retail for $59.99. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Cost of Sales—Software Royalties and Amortization % of Publishing Net Revenues (in thousands) March 31, 2006 March 31, 2005 % of Publishing Net Revenues $147,822 13% $123,800 12% Increase/ (Decrease) $24,022 Percent Change 19% Cost of sales—software royalties and amortization for the year ended March 31, 2006 increased as a percent- age of publishing net revenues from the prior fiscal year, from 12% to 13%. In absolute dollars, cost of sales —software royalties and amortization for the year ended March 31, 2006 also increased from the prior fiscal year, from $123.8 million to $147.8 million. The increases in cost of sales—software royalties and amortiza- tion in both absolute dollars and as a percentage of publishing net revenues were mainly due to: • Impairment charges and recoverability write-offs of $12.6 million in fiscal 2006. We performed a detailed review of capitalized costs for released titles and determined that expected future revenues, given the change in market conditions, on certain titles would not support the remaining capitalized software balance on these titles. As a result, we incurred a $3.8 million recoverability charge on these titles in fiscal 2006. In addition, we reviewed future recoverability of capitalized amounts on titles in development and deter- mined that one of our titles, to be released in fiscal 2007, was unlikely to fully recover capitalized costs given the change in expectations as a result of weaker market conditions and uncertainty involved in the console transition and, as a result, took an impairment charge of $8.8 million on this title. • Overall continued increases in costs to develop titles for additional platforms, particularly those titles released for the more technologically advanced next-generation console platforms. Due to market uncertainty associated with the ongoing console transition to the next-generation hardware and our more focused fiscal 2007 title slate, we expect costs of sales—software royalties and amortization to decrease in fiscal 2007 in proportion to the expected decrease in net revenues. 27 Cost of Sales—Intellectual Property Licenses (in thousands) March 31, 2006 $57,666 % of Publishing Net Revenues 5% March 31, 2005 $62,197 % of Publishing Net Revenues 6% Increase/ (Decrease) $(4,531) Percent Change (7%) Cost of sales—intellectual property licenses for the year ended March 31, 2006 decreased in absolute dollars and as a percentage of publishing net revenues over the same period last year, from $62.2 million to $57.7 and from 6% to 5%, respectively. The decreases in both absolute dollars and as a percentage of publishing net revenues were due mainly to a one-time benefit related to the settlement of an intellectual property claim in the second quarter of fiscal 2006. The number of titles with associated intellectual property remained rela- tively flat year over year. In fiscal 2006, we released the following titles with associated intellectual property: Doom 3 for the Xbox, Madagascar, Fantastic Four, Ultimate Spider-Man, X-Men Legends II, THAW, Quake IV, and Shrek SuperSlam. In fiscal 2005 we released the following titles with associated intellectual property: Spider-Man 2, Shrek 2, Shark Tale, X-Men Legends, THUG 2, Lemony Snicket’s A Series of Unfortunate Events, and Doom 3. We expect cost of sales—intellectual property licenses for fiscal 2007 to remain relatively flat as a percentage of publishing net revenues but to decrease in absolute dollars in proportion to the expected decrease in net revenues in fiscal 2007. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Management’s Discussion and Analysis of Financial Condition and Results of Operations Product Development (in thousands) March 31, 2006 $131,782 % of Publishing Net Revenues 11% March 31, 2005 $86,543 % of Publishing Net Revenues 8% Increase/ (Decrease) $45,239 Percent Change 52% Product development expenses for the year ended March 31, 2006 increased as a percentage of publishing net revenues from the prior fiscal year, from 8% to 11%. In absolute dollars, product development expenses for the year ended March 31, 2006 also increased from the prior fiscal year, from $86.5 million to $131.8 million. The increase in product development expenses both in absolute dollars and as a percentage of publishing net revenues was due to: • Increased development, quality assurance, and outside developer costs as a result of the development of more technologically advanced titles across more platforms. • Product cancellation charges of $11.4 million, including termination fees, incurred during fiscal 2006. Given the market conditions, the lower than expected performance of some of our third quarter fiscal 2006 releases, and risks associated with console transition, we performed a thorough review of our upcom- ing product slate. To better align opportunities associated with the next-generation console platforms with income potential and risks associated with certain titles in development, we canceled development of certain titles and permanently removed them from our future title slate. • Increased costs in fiscal 2006 related to the full year operation of three recently acquired studios, Vicarious Visions, Inc., Toys for Bob, Inc., and Beenox, Inc., as well as costs incurred to fund more product development capacity at certain studios. 28 For fiscal 2007, we expect product development costs to increase as a percentage of net revenues due to the increased costs related to developing more technologically advanced titles for the next-generation console systems. Over time, we intend to offset increased development costs of the next-generation console systems by sharing technologies and tools across multiple platforms, increasing our development schedules to facilitate a longer pre-production phase and more predictable workflow times, and outsourcing certain areas of game development to lower cost service providers. Sales and Marketing (in thousands) March 31, 2006 $283,220 % of Consolidated Net Revenues 19% March 31, 2005 $230,058 % of Consolidated Net Revenues 16% Increase/ (Decrease) $53,162 Percent Change 23% Sales and marketing expenses of $283.2 million and $230.1 million represented 19% and 16% of consoli- dated net revenues for the years ended March 31, 2006 and 2005, respectively. The increases in both absolute dollars and as a percentage of net revenues was primarily generated by our publishing business as a result of significant marketing programs including television and in-theatre ad campaigns and in-store promotions to support our biggest product release slate in company history. The increase in sales and marketing investment as a percentage of net revenues was a result of additional sales and marketing investment during the key holi- day season which did not provide the revenue increase that was anticipated at the time that the marketing costs were incurred. We expect sales and marketing expense to decrease on both an absolute basis and as a percentage of consoli- dated net revenues in fiscal 2007 due to a more focused slate in fiscal 2007 and due to a more targeted sales and marketing plan. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T General and Administrative (in thousands) March 31, 2006 $94,679 % of Consolidated Net Revenues 7% March 31, 2005 $59,739 % of Consolidated Net Revenues 4% Increase/ (Decrease) $34,940 Percent Change 58% General and administrative expenses for the year ended March 31, 2006 increased $34.9 million over the same period last year, from $59.7 million to $94.7 million. As a percentage of consolidated net revenues, general and administrative expenses increased from 4% to 7%. The increases were primarily due to an increase in personnel costs including costs related to European territory expansion, separation and severance costs associated with a less than 7% reduction in workforce in the fourth quarter of fiscal 2006, increased bad debt write-offs, an increase in foreign currency transaction losses, and increased legal costs. We expect general and administrative expenses to decrease in absolute dollars in fiscal 2007 as we realize the benefits of a more efficient cost structure resulting from the recent workforce realignment partially offset by increases in compensation expense related to the implementation of the Financial Accounting Standards Board Statement No. 123 (revised 2004), Share-Based Payment. Operating Income (in thousands) Publishing Distribution Consolidated March 31, 2006 $ (3,984) 21,941 $ 17,957 % of Segment Net Revs —% 7% 1% March 31, 2005 $ 160,826 23,745 $ 184,571 % of Segment Net Revs 15% 7% 13% Increase/ (Decrease) $(164,810) (1,804) Percent Change (102%) (8%) $(166,614) (90%) 29 Publishing operating income for the year ended March 31, 2006 decreased $164.8 million from the same period last year, from $160.8 million to an operating loss of $4.0 million. Changes in exchange rates related to the year over year weakening of the EUR, GBP, and Australian dollar (“AUD”) in relation to the USD did not have a material impact on publishing operating income. The decrease is primarily due to: • Increased sales and marketing spending to support our large title release slate. • An increase in provision for returns and price protection throughout fiscal 2006 from 12% of net revenues in fiscal 2005 compared to 18% of net revenues in fiscal 2006, due to challenging market conditions and the ongoing console transition. • Cancellation, impairment, and earn-out recoverability charges totaling $24.0 million taken in fiscal 2006. See additional description of charges incurred in the cost of sales—software royalties and amortization and the product development discussions. • Write-downs of inventory costs of $14.5 million taken during fiscal 2006. See additional description in the cost of sales—product costs discussion. Distribution operating income for the year ended March 31, 2006 decreased over the same period last year, from $23.7 million to $21.9 million. The decrease was primarily due to the impact of changes in foreign currency rates on distribution operating income of approximately $1.4 million. Excluding the impact of changes in foreign currency rates, distribution operating income for the year ended March 31, 2006 decreased approxi- mately $0.4 million or 2% from the same period last year. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Management’s Discussion and Analysis of Financial Condition and Results of Operations Investment Income, Net (in thousands) March 31, 2006 $30,630 % of Consolidated Net Revenues 2% March 31, 2005 $13,092 % of Consolidated Net Revenues 1% Increase/ (Decrease) $17,538 Percent Change 134% Investment income, net for the year ended March 31, 2006 was $30.6 million as compared to $13.1 million for the year ended March 31, 2005. The increase was primarily due to higher invested balances combined with rising yields, a realized gain in the first quarter of fiscal 2006 of $1.3 million on the sale of an invest- ment in common stock, and a realized gain of $2.9 million on the sale of a cost basis investment during the year ended March 31, 2006 as compared to 2005. Provision for Income Taxes % of Pre-Tax Income (in thousands) March 31, 2006 $6,688 14% March 31, 2005 $59,328 % of Pre-Tax Income 30% Increase/ (Decrease) $(52,640) Percent Change (89%) The income tax provision of $6.7 million for the year ended March 31, 2006 reflects our effective income tax rate of 13.8%. The significant items that generated the variance between our effective rate and our statutory rate of 35% were research and development tax credits and the impact of foreign tax rate differentials, partially offset by an increase in our deferred tax asset valuation allowance and state taxes. The realization of deferred tax assets depends primarily on the generation of future taxable income. We believe that it is more likely than not that we will generate taxable income sufficient to realize the benefit of net deferred tax assets recognized. 30 Net Income Net income for the year ended March 31, 2006 was $41.9 million or $0.14 per diluted share, as compared to $138.3 million or $0.50 per diluted share for the year ended March 31, 2005. Results of Operations—Fiscal Years Ended March 31, 2005 and 2004 Net Revenues We primarily derive revenue from sales of packaged interactive software games designed for play on video game consoles (such as the PS2, Xbox, and GameCube), PCs, and hand-held game devices (such as the GBA, NDS, and PSP). We also derive revenue from our distribution business in Europe that provides logistical and sales services to third-party publishers of interactive entertainment software, our own publishing operations, and third-party manufacturers of interactive entertainment hardware. The following table details our consolidated net revenues by business segment and our publishing net revenues by territory for the years ended March 31, 2005 and 2004 (in thousands): For the years ended March 31, 2005 2004 Increase/ (Decrease) Percent Change Publishing net revenues North America Europe Other Total international Total publishing net revenues Distribution net revenues Consolidated net revenues $ 696,325 $ 446,812 $ 249,513 341,946 34,458 197,300 21,620 376,404 218,920 1,072,729 333,128 665,732 281,924 144,646 12,838 157,484 406,997 51,204 $ 1,405,857 $ 947,656 $ 458,201 56% 73% 59% 72% 61% 18% 48% A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Consolidated net revenues increased 48% from $947.7 million for the year ended March 31, 2004 to $1,405.9 million for the year ended March 31, 2005. This increase was principally generated by our publishing busi- ness. The increase in consolidated net revenues was driven by the following: • Strong performances from our publishing business on the releases of our largest ever lineup of titles including: Spider-Man 2, Call of Duty: Finest Hour, THUG 2, Shrek 2, X-Men Legends, Doom 3, Lemony Snicket’s A Series of Unfortunate Events, Shark Tale, Cabela’s Big Game Hunter 2005, and Rome: Total War. The strength of these titles combined with the significant sales and marketing investment led to over ten million-unit selling titles and achievement of our goal of having four multi-million-unit selling titles. We also had strong catalog sales from a number of our franchises including Tony Hawk, True Crime, Spider-Man, and Call of Duty. As a result of the strong performance of our key fiscal 2005 releases, we were able to maintain the original price points for those titles for an extended period of time. • Continued focus on international publishing expansion with the opening of offices in Spain and Italy and an increased focus on other territories contributing to an increase in International Publishing revenues of 72% over fiscal 2004. • An increase in our hand-held platform presence growing consolidated hand-held revenues by $118.7 million or 274% from $43.3 million for the year ended March 31, 2004 to $162.0 million for the year ended March 31, 2005. This was driven by a significant increase in the number of GBA titles released from four titles in fiscal 2004 to eleven titles in fiscal 2005, and by the introduction of the PSP and NDS platforms, for which we released a combined total of three titles. • International net revenues benefited from the year over year strengthening of the Euro (“EUR”) and Great British Pound (“GBP”) in relation to the U.S. dollar. We estimate that foreign exchange rates increased reported net revenues by approximately $55.3 million. Excluding the impact of changing foreign currency rates, our international net revenues increased 31% year over year. North America Publishing Net Revenues (in thousands) March 31, 2005 $696,325 % of Consolidated Net Revenues 50% March 31, 2004 $446,812 % of Consolidated Net Revenues 47% Increase/ (Decrease) $249,513 Percent Change 56% North America publishing net revenues increased 56% from $446.8 million for the year ended March 31, 2004, to $696.3 million for the year ended March 31, 2005. The increase reflects the strong performance of our fiscal 2005 slate of titles, strong catalog sales from a number of our franchises, and a significant increase in our hand-held platform presence. International Publishing Net Revenues (in thousands) March 31, 2005 $376,404 % of Consolidated Net Revenues 26% March 31, 2004 $218,920 % of Consolidated Net Revenues 23% Increase/ (Decrease) $157,484 Percent Change 72% International publishing net revenues increased by 72% from $218.9 million for the year ended March 31, 2004, to $376.4 million for the year ended March 31, 2005. International publishing also saw strong results from our 2005 titles, as well as strong fourth quarter performance in our LucasArts affiliate business. In addi- tion, we had strong catalog sales from a number of our franchises, including Spider-Man, Call of Duty, Tony Hawk, and True Crime. There also was a positive strengthening of the EUR and the GBP in relation to the U.S. dollar of approximately $29.0 million. Excluding the impact of changing foreign currency rates, our international publishing net revenues increased 59% year over year. 31 A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Management’s Discussion and Analysis of Financial Condition and Results of Operations Publishing Net Revenues by Platform Publishing net revenues increased 61% from $665.7 million for the year ended March 31, 2004 to $1,072.7 mil- lion for the year ended March 31, 2005. The following table details our publishing net revenues by platform and as a percentage of total publishing net revenues for the years ended March 31, 2005 and 2004 (in thousands): Publishing Net Revenues PC Console Sony PlayStation 2 Microsoft Xbox Nintendo GameCube Other Total console Hand-held Game Boy Advance PlayStation Portable Nintendo Dual Screen Other 32 Total hand-held Total publishing net revenues Year Ended March 31, 2005 % of Publishing Net Revs Year Ended March 31, 2004 % of Publishing Net Revs Increase/ (Decrease) Percent Change $ 220,087 21% $ 132,369 20% $ 87,718 66% 417,310 196,894 96,936 2,807 713,947 101,642 19,200 17,699 154 138,695 39% 18% 9% —% 66% 9% 2% 2% —% 13% 289,048 145,111 52,909 21,350 508,418 24,621 — — 324 24,945 43% 22% 8% 3% 76% 4% —% —% —% 4% 128,262 51,783 44,027 (18,543) 205,529 77,021 19,200 17,699 (170) 44% 36% 83% (87%) 40% 313% —% —% (52%) 113,750 456% $ 1,072,729 100% $ 665,732 100% $ 406,997 61% Personal Computer Net Revenues (in thousands) March 31, 2005 $220,087 % of Publishing Net Revenues 21% March 31, 2004 $132,369 % of Publishing Net Revenues 20% Increase/ (Decrease) $87,718 Percent Change 66% Net revenues from sales of titles for the PC increased 66% from $132.4 million for the year ended March 31, 2004 to $220.1 million for the year ended March 31, 2005. Driving the increase were the fiscal 2005 releases of Doom 3 and Rome: Total War combined with continued strong sell through of our catalog title, Call of Duty. According to NPD, we were the only publisher to have three top-ten PC titles for calendar year 2004: Doom 3, Call of Duty, and Rome: Total War. Also contributing to the increase in net revenues from sales of titles for the PC was an increase in the total number of titles shipped from eight in fiscal 2004 to fifteen in fiscal 2005. Sony PlayStation 2 Net Revenues (in thousands) March 31, 2005 $417,310 % of Publishing Net Revenues 39% March 31, 2004 $289,048 % of Publishing Net Revenues 43% Increase/ (Decrease) $128,262 Percent Change 44% Net revenues from sales of titles for the PS2 increased 44% from $289.0 million for the year ended March 31, 2004 to $417.3 million for the year ended March 31, 2005. The increase was primarily due to strong, world- wide sales of several of our fiscal 2005 releases including THUG 2, Call of Duty: Finest Hour, X-Men Legends, Spider-Man 2, Shrek 2, Shark Tale, Lemony Snicket’s A Series of Unfortunate Events, and Cabela’s Big Game Hunter 2005. In fiscal 2005, we released thirteen titles for PS2 compared to ten in fiscal 2004 which included: True Crime: Streets of L.A., Tony Hawk’s Underground, X2: Wolverine’s Revenge, Return to Castle Wolfenstein, Cabela’s Dangerous Hunts, and Cabela’s Deer Hunt 2004 Season. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Microsoft Xbox Net Revenues % of Publishing Net Revenues (in thousands) March 31, 2005 $196,894 18% March 31, 2004 $145,111 % of Publishing Net Revenues 22% Increase/ (Decrease) $51,783 Percent Change 36% Net revenues from sales of titles for the Xbox increased 36% from $145.1 million for the year ended March 31, 2004 to $196.9 million for the year ended March 31, 2005. Though the number of new Xbox titles remained relatively consistent from fiscal 2004 to fiscal 2005, we were able to increase our Xbox sales in both the North America and international markets. The increase was primarily due to strong worldwide sales of several of our Xbox titles including THUG 2, Call of Duty: Finest Hour, X-Men Legends, Spider-Man 2, Shrek 2, Shark Tale, Greg Hastings’ Tournament Paintball, and Cabela’s Big Game Hunter 2005. The increase was also affected by an increased installed base of the Xbox due mainly to the price cuts on the Xbox hardware in calendar 2004. Nintendo GameCube Net Revenues (in thousands) March 31, 2005 $96,936 % of Publishing Net Revenues 9% March 31, 2004 $52,909 % of Publishing Net Revenues 8% Increase/ (Decrease) $44,027 Percent Change 83% Net revenues from sales of titles for the Nintendo GameCube increased 83% from $52.9 million for the year ended March 31, 2004 to $96.9 million for the year ended March 31, 2005. The increase is primarily due to the increase in the number of GameCube new title releases from five in fiscal 2004 to eight in fiscal 2005. Also driving the increase in revenues was that the title slate in fiscal 2005 performed strongly as it was more targeted toward the demographic of the GameCube audience than the fiscal 2004 GameCube title slate. Our fiscal 2005 title slate was driven by new title releases of Shrek 2, Spider-Man 2, Shark Tale, Lemony Snicket’s A Series of Unfortunate Events, THUG 2, and Call of Duty: Finest Hour. Fiscal 2004 GameCube revenues were driven mainly by releases of Tony Hawk’s Underground and True Crime: Streets of L.A. 33 Hand-held (in thousands) March 31, 2005 $138,695 % of Publishing Net Revenues 13% March 31, 2004 $24,945 % of Publishing Net Revenues 4% Increase/ (Decrease) $113,750 Percent Change 456% Net revenues from sales of titles for the hand-held for the year ended March 31, 2005 increased 456% from the prior fiscal year, from $24.9 million to $138.7 million. This was driven mainly by a significant increase in the number of GBA titles released from four titles in fiscal 2004 to eleven titles in fiscal 2005 and the introduction of two new hand-held devices, NDS, which was released worldwide, and PSP, which was released in North America. We successfully executed our strategy of having a high-quality presence at the launch of both the NDS and PSP platforms with one title based on the Spider-Man franchise at the launch of the NDS and two titles based on the Spider-Man and Tony Hawk franchises for the launch of the PSP. In addition to the increase in the number of GBA titles released, we implemented a customized marketing plan for the GBA platform and demographic to support a strong slate of new releases including THUG 2, Shrek 2: Beg for Mercy!, Shark Tale, Lemony Snicket’s A Series of Unfortunate Events, Spider-Man 2, and Shrek 2 which were all targeted toward the demographic of the GBA audience. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Management’s Discussion and Analysis of Financial Condition and Results of Operations Overall A significant portion of our revenues and profits is derived from a relatively small number of popular titles and brands each year as revenues and profits are significantly affected by our ability to release highly successful or “hit” titles. For example, for the year ended March 31, 2005, 31% of our consolidated net revenues and 41% of worldwide publishing net revenues were derived from net revenues from our Spider-Man 2, THUG 2, and Call of Duty: Finest Hour titles. Though many titles have substantial production or acquisition costs and mar- keting budgets, once a title recoups these costs, incremental net revenues directly and positively impact operat- ing profits resulting in a disproportionate amount of operating income being derived from these select titles. Distribution Net Revenues % of Consolidated Net Revenues (in thousands) March 31, 2005 $333,128 24% March 31, 2004 $281,924 % of Consolidated Net Revenues 30% Increase/ (Decrease) $51,204 Percent Change 18% Distribution net revenues for the year ended March 31, 2005 increased 18% from the prior fiscal year, from $281.9 million to $333.1 million. Excluding the impact of the changing foreign currency rates, our distribu- tion net revenues increased 9% year over year. About half of this increase was due to the positive impact of the year over year strengthening of the EUR and the GBP in relation to the U.S. dollar. The increase was primarily due to the continued growth in the industry wide software market, an increase in sales to mass merchants, as well as a change in the product mix. The mix of distribution net revenues between hardware and software sales varied year over year with approximately 13% of distribution net revenues from hardware sales in the year ended March 31, 2005 as compared to 28% in the prior fiscal year. This was mainly attributed to an increase in business with large, mass-market customers that generate a higher percentage of sales from soft- ware. In both fiscal years, hardware sales were principally comprised of sales of console hardware. 34 Costs and Expenses Cost of Sales—Product Costs % of Consolidated Net Revenues (in thousands) March 31, 2005 $658,949 47% March 31, 2004 $475,541 % of Consolidated Net Revenues 50% Increase/ (Decrease) $183,408 Percent Change 39% Cost of sales—product costs represented 47% and 50% of consolidated net revenues for the years ended March 31, 2005 and 2004, respectively. In absolute dollars, cost of sales—product costs increased 39% due to significantly higher sales in fiscal 2005 as compared to fiscal 2004. The primary factors affecting the reduction in the cost of sales—product costs as a percentage of consolidated net revenues were: • Increased ability to maintain premium pricing on “big proposition” titles for the year ended March 31, 2005. • An increase in publishing net revenues from sales of PC titles by 66% year over year. PC publishing revenues as a percent of publishing net revenues for the year also grew from 20% to 21%. PC titles typically have lower product costs associated with them. • A lower percentage of revenues generated from our distribution business, which is a lower margin busi- ness, in fiscal 2005 as compared to fiscal 2004. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Cost of Sales—Software Royalties and Amortization % of Publishing Net Revenues (in thousands) March 31, 2005 March 31, 2004 % of Publishing Net Revenues $123,800 12% $59,744 9% Increase/ (Decrease) $64,056 Percent Change 107% Cost of sales—software royalties and amortization for the year ended March 31, 2005 increased as a percent- age of publishing net revenues from the prior fiscal year, from 9% to 12%. In absolute dollars, cost of sales— software royalties and amortization for the year ended March 31, 2005 also increased from the prior fiscal year, from $59.7 million to $123.8 million. This increase was due to an increase in the number of titles released as well as an increase in the overall costs to develop games. This compares to fiscal 2004 in which a higher proportion of revenues were derived from internally developed titles with lower associated game development costs. Cost of Sales—Intellectual Property Licenses (in thousands) March 31, 2005 $62,197 % of Publishing Net Revenues 6% March 31, 2004 $31,862 % of Publishing Net Revenues 5% Increase/ (Decrease) $30,335 Percent Change 95% Cost of sales—intellectual property licenses for the year ended March 31, 2005 increased in absolute dollars and as a percentage of publishing net revenues over the same period last year, from 5% to 6%. The increases in both absolute dollars and as a percentage of publishing net revenues were due to the release of more titles with associated licensed intellectual property as well as continued strong catalog sales of titles with associated licensed intellectual property compared to the titles released in fiscal 2004 for which a higher proportion of revenues was derived from titles that were internally developed with no associated intellectual property. In fiscal 2005 we released the following titles with associated intellectual property: Spider-Man 2, Shrek 2, Shark Tale, X-Men Legends, THUG 2, Lemony Snicket’s A Series of Unfortunate Events, and Doom 3. In fiscal 2004, two of our top performing titles, True Crime: Streets of L.A. and Call of Duty, were based on our wholly- owned original intellectual property. 35 Product Development (in thousands) March 31, 2005 $86,543 % of Publishing Net Revenues 8% March 31, 2004 $97,859 % of Publishing Net Revenues 15% Increase/ (Decrease) $(11,316) Percent Change (12%) Product development expenses for the year ended March 31, 2005 decreased as a percentage of publishing net revenues from the prior fiscal year, from 15% to 8%. In absolute dollars, product development expenses for the year ended March 31, 2005 also decreased from the prior fiscal year, from $97.9 million to $86.5 million. The decrease in product development as a percentage of publishing net revenues and in absolute dollars pri- marily resulted from a pre-tax charge of approximately $21 million taken in the third quarter of fiscal 2004 related to the cancellation of products which were believed to be unlikely to produce an acceptable level of return on our investment. Excluding the impact of the pre-tax charge, product development expenses for the year ended March 31, 2005 increased by approximately $9.7 million. This increase was attributable to higher game development costs as development time and team sizes as well as quality assurance time increased due to enhanced production values and to support more complex and robust gaming experiences. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Management’s Discussion and Analysis of Financial Condition and Results of Operations Sales and Marketing (in thousands) March 31, 2005 $230,058 % of Consolidated Net Revenues 16% March 31, 2004 $128,221 % of Consolidated Net Revenues 14% Increase/ (Decrease) $101,837 Percent Change 79% Sales and marketing expenses of $230.1 million and $128.2 million represented 16% and 14% of consoli- dated net revenues for the years ended March 31, 2005 and 2004, respectively. The increases in both absolute dollars and as a percentage of net revenues was primarily generated by our publishing business as a result of significant marketing programs, including television and in-theatre ad campaigns and in-store promotions, run in support of our key fiscal 2005 “big proposition” title releases Spider-Man 2, Shrek 2, Doom 3, Shark Tale, X-Men Legends, THUG 2, Call of Duty: Finest Hour, and Lemony Snicket’s A Series of Unfortunate Events. Our experience has shown that this increased spending will lengthen the product sales life cycle and add to the long-term prospects of the respective product lines. General and Administrative (in thousands) March 31, 2005 $59,739 % of Consolidated Net Revenues 4% March 31, 2004 $44,612 % of Consolidated Net Revenues 5% Increase/ (Decrease) $15,127 Percent Change 34% 36 General and administrative expenses of $59.7 million and $44.6 million represented 4% and 5% of consoli- dated net revenues for the years ended March 31, 2005 and 2004, respectively. The increase in absolute dollars was primarily due to an increase in headcount and related costs to support business growth, as well as an increase in professional services fees to support Sarbanes-Oxley related compliance. The decrease as a percentage of consolidated net revenues was due mainly to the significant increase in sales volume. Operating Income (in thousands) Publishing Distribution Consolidated March 31, 2005 $ 160,826 23,745 $ 184,571 % of Segment Net Revs 15% 7% 13% March 31, 2004 $ 93,223 16,594 $ 109,817 % of Segment Net Revs Increase/ (Decrease) Percent Change 14% 6% 12% $ 67,603 7,151 $ 74,754 73% 43% 68% Publishing operating income for the year ended March 31, 2005 increased $67.6 million from the same period last year, from $93.2 million to $160.8 million. Excluding the impact of changes in foreign currency rates, publishing operating income for the year ended March 31, 2005 increased approximately $56.7 million from the same period last year. International publishing operating income for the year ended March 31, 2005 benefited from the positive impact of the year over year strengthening of the EUR and the GBP in relation to the U.S. dollar. The $56.7 million increase is primarily due to: • Strong performance in both the North America and international markets of our fiscal 2005 title releases. The strong performance of the fiscal 2005 releases was driven by our largest lineup ever of big proposi- tions, a record number of million-unit and multi-million unit titles, and an increased hand-held presence. Partially offset by: • Increased sales and marketing spending. • Increased cost of sales—product costs, cost of sales—software royalties and amortization, and cost of sales—intellectual property licenses. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Distribution operating income for the year ended March 31, 2005 increased over the same period last year, from $16.6 million to $23.7 million. Excluding the impact of changes in foreign currency rates, distribution operating income for the year ended March 31, 2005 increased approximately $5.4 million from the same period last year. Distribution operating income for the year ended March 31, 2005 benefited from the posi- tive impact of the year over year strengthening of the EUR and the GBP in relation to the U.S. dollar. The $5.4 million increase was primarily due to continued growth industry wide in the software market combined with a change in the product mix of hardware versus software sales as software tends to be a higher margin business. Investment Income, Net (in thousands) March 31, 2005 $13,092 % of Consolidated Net Revenues 1% March 31, 2004 $6,175 % of Consolidated Net Revenues —% Increase/ (Decrease) $6,917 Percent Change 112% Investment income, net for the year ended March 31, 2005 was $13.1 million as compared to $6.2 million for the year ended March 31, 2004. The increase was primarily due to higher invested balances combined with rising yields during the year ended March 31, 2005 as compared to 2004. Provision for Income Taxes % of Pre-Tax Income (in thousands) March 31, 2005 $59,328 30% March 31, 2004 $38,277 % of Pre-Tax Income 33% Increase/ (Decrease) $21,051 Percent Change 55% 37 The income tax provision of $59.3 million for the year ended March 31, 2005 reflects our effective income tax rate of 30%. The significant items that generated the variance between our effective rate and our statutory rate of 35% were research and development tax credits and the impact of foreign tax rate differentials, partially offset by an increase in our deferred tax asset valuation allowance and state taxes. The realization of deferred tax assets depends primarily on the generation of future taxable income. We believe that it is more likely than not that we will generate taxable income sufficient to realize the benefit of net deferred tax assets recognized. Net Income Net income for the year ended March 31, 2005 was $138.3 million or $0.50 per diluted share, as compared to $77.7 million or $0.30 per diluted share for the year ended March 31, 2004. Selected Quarterly Operating Results Our quarterly operating results have in the past varied significantly and will likely vary significantly in the future, depending on numerous factors, several of which are not under our control. Our business also has experienced and is expected to continue to experience significant seasonality, largely due to consumer buying patterns and our product release schedule focusing on those patterns. Net revenues typically are significantly higher during the fourth calendar quarter, primarily due to the increased demand for consumer software during the year-end holiday buying season. Accordingly, we believe that period to period comparisons of our operating results are not necessarily meaningful and should not be relied upon as indications of future performance. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Management’s Discussion and Analysis of Financial Condition and Results of Operations The following table is a comparative breakdown of our quarterly results for the immediately preceding eight quarters (amounts in thousands, except per share data): March 31, 2006 $188,125 128,309 Dec. 31, 2005 $816,242 498,325 Sept. 30, 2005 $222,540 141,458 June 30, 2005 $241,093 172,270 March 31, 2005 $203,861 141,544 Dec. 31, 2004 $680,094 397,292 Sept. 30, 2004 $310,626 187,091 June 30, 2004 $211,276 119,019 (26,115) (9,219) 84,067 67,945 (26,547) (13,242) (13,448) (3,585) (2,899) 3,573 137,079 97,262 34,658 25,543 15,733 11,957 (0.03) 0.25 (0.05) (0.01) 0.01 0.39 0.10 0.05 For the quarters ended Net revenues Cost of sales Operating income (loss) Net income (loss) Basic earnings (loss) per share(1) Diluted earnings (loss) per share(1) 0.04 (1) Consolidated financial information has been restated for the effect of our four-for-three stock split effected in the form of a 33 1⁄ 3% stock (0.03) (0.05) (0.01) 0.35 0.09 0.01 0.23 dividend to shareholders of record as of October 10, 2005, paid October 24, 2005. Liquidity and Capital Resources Sources of Liquidity (in thousands) As of and for the year ended March 31, 38 Cash and cash equivalents Short-term investments Percentage of total assets Cash flows provided by operating activities Cash flows used in investing activities Cash flows provided by financing activities 2006 $ 354,331 590,629 2005 $ 313,608 527,256 Increase/ (Decrease) $ 40,723 63,373 $ 944,960 $ 840,864 $ 104,096 67% 64% $ 86,007 (85,796) 45,088 $ 215,309 (143,896) 72,654 $ (129,302) 58,100 (27,566) As of March 31, 2006, our primary source of liquidity is comprised of $354.3 million of cash and cash equivalents and $590.6 million of short-term investments. Over the last two years, our primary sources of liquidity have included cash on hand at the beginning of the year and cash flows generated from continuing operations. We have also generated significant cash flows from the issuance of our common stock to employees through the exercise of options, which is described in more detail below in “Cash Flows from Financing Activities.” We have not utilized debt financing as a significant source of cash flows. However, we do have available at certain of our international locations, credit facilities, which are described below in “Credit Facilities,” that can be utilized if needed. In August 2003, we filed with the Securities and Exchange Commission two amended shelf registration state- ments, including the base prospectuses therein. The first shelf registration statement, on Form S-3, allows us, at any time, to offer any combination of securities described in the base prospectus in one or more offerings with an aggregate initial offering price of up to $500,000,000. Unless we state otherwise in the applicable prospectus supplement, we expect to use the net proceeds from the sale of the securities for general corporate purposes, including capital expenditures, working capital, repayment or reduction of long-term and short- term debt, and the financing of acquisitions and other business combinations. We may invest funds that we do not immediately require in marketable securities. The second shelf registration statement, on Form S-4, allows us, at any time, to offer any combination of securities described in the base prospectus in one or more offerings with an aggregate initial offering price of up to $250,000,000 in connection with our acquisition of the assets, business, or securities of other companies whether by purchase, merger, or any other form of business combination. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T We believe that we have sufficient working capital ($923.9 million at March 31, 2006), as well as proceeds available from our international credit facilities, to finance our operational requirements for at least the next twelve months, including purchases of inventory and equipment, the funding of the development, production, marketing and sale of new products, and the acquisition of intellectual property rights for future products from third parties. Cash Flows from Operating Activities The primary source of cash flows from operating activities typically have included the collection of customer receivables generated by the sale of our products, offset by payments to vendors for the manufacture, distribu- tion, and marketing of our products, third-party developers and intellectual property holders, and our own employees. A significant operating use of our cash relates to our continued investment in software development and intellectual property licenses. We spent approximately $193.9 million and $126.9 million in the years ended March 31, 2006 and 2005, respectively, in connection with the acquisition of publishing or distribution rights for products being developed by third parties, the execution of new license agreements granting us long- term rights to intellectual property of third parties, as well as the capitalization of product development costs relating to internally developed products. The increase period over period is primarily due to new agreements with DreamWorks Animation SKG, Marvel Enterprises, and Hasbro Properties Group, all of which were signed in fiscal 2006. We expect that we will continue to make significant expenditures relating to our invest- ment in software development and intellectual property licenses. Our future cash commitments relating to these investments are detailed below in “Commitments.” Cash flows from operations are affected by our ability to release highly successful or “hit” titles. Though many of these titles have substantial production or acquisi- tion costs and marketing expenditures, once a title recoups these costs, incremental net revenues typically will directly and positively impact cash flows. For the years ended March 31, 2006 and 2005, cash flows from operating activities were $86.0 million and $215.3 million, respectively. The principal components comprising cash flows from operating activities for the year ended March 31, 2006, included favorable operating results and collection of accounts receivable partially offset by investment in software development and intellectual property licenses. See an analysis of the change in key balance sheet accounts below in “Key Balance Sheet Accounts.” We expect that a primary source of future liquidity, both short-term and long-term, will be the result of cash flows from continuing operations. 39 Cash Flows from Investing Activities The primary source of cash used in investing activities typically have included capital expenditures, acquisi- tions of privately held interactive software development companies, and the net effect of purchases and sales/ maturities of short-term investment vehicles. The goal of our short-term investments is to maximize return while minimizing risk, maintaining liquidity, coordinating with anticipated working capital needs, and providing for prudent investment diversification. For the years ended March 31, 2006 and 2005, cash flows used in investing activities were $85.8 million and $143.9 million, respectively. For the year ended March 31, 2006, cash flows used in investing activities were primarily the result of capital expenditures, the increase in short-term investments, and business acquisitions. We have historically financed our acquisitions through the issuance of shares of common stock or a combination of common stock and cash. We will continue to evaluate potential acquisition candidates as to the benefit they bring to us. Cash Flows from Financing Activities The primary source of cash provided by financing activities have related to transactions involving our com- mon stock, including the issuance of shares of common stock to employees and the public, and the purchase of treasury shares. We have not utilized debt financing as a significant source of cash flows. However, we do have available at certain of our international locations, credit facilities, which are described below in “Credit Facilities,” that can be utilized if needed. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Management’s Discussion and Analysis of Financial Condition and Results of Operations For the years ended March 31, 2006 and 2005, cash flows from financing activities were $45.1 million and $72.7 million, respectively. The cash provided by financing activities for the year ended March 31, 2006 was the result of the issuance of common stock related to employee stock option and stock purchase plans. During fiscal 2003, our Board of Directors authorized a buyback program under which we can repurchase up to $350.0 million of our common stock. Under the program, shares may be purchased as determined by man- agement and within certain guidelines, from time to time, in the open market or in privately negotiated transactions, including privately negotiated structured stock repurchase transactions and through transac- tions in the options markets. Depending on market conditions and other factors, these purchases may be commenced or suspended at any time or from time to time without prior notice. In the past, we have entered into structured stock repurchase transactions that were settled in cash or stock based on the market price of our common stock on the date of the settlement. Upon settlement, we either had our capital investment returned with a premium or received shares of our common stock, depending, respectively, on whether the market price of our common stock was above or below a pre-determined price agreed in connection with each such transaction. As of March 31, 2006, we had approximately $226.2 million available for utilization under the buyback program and no outstanding structured stock repurchase transactions. We actively manage our capital structure as a component of our overall business strategy. Accordingly, in the future, when we deter- mine that market conditions are appropriate, we may seek to achieve long-term value for the shareholders through, among other things, new debt or equity financings or refinancings, share repurchases, and other transactions involving our equity or debt securities. Key Balance Sheet Accounts Accounts Receivable (amounts in thousands) 40 Gross accounts receivable Net accounts receivable March 31, March 31, 2006 2005 $127,035 28,782 $178,335 109,144 Increase/ (Decrease) $(51,300) (80,362) The decrease in gross accounts receivable was primarily the result of: • Late fourth quarter fiscal 2005 North American releases of THUG 2 Remix and Spider-Man 2 for the PSP. Both titles were released concurrently with the release of the PSP platform in late March 2005. There were no corresponding new releases in the fourth quarter of fiscal 2006. • The fourth quarter fiscal 2005 releases of three affiliate titles, Mercenaries, Star Wars: Knights of the Old Republic II, and Star Wars: Republic Commando, in our European territories. There was only one affiliate title released in our European territories in the fourth quarter of fiscal 2006, LucasArts’ Star Wars: Empire at War, which was only released on PC. Reserves for returns, price protection and bad debt increased from $69.2 million at March 31, 2005 to $98.3 million at March 31, 2006 while reserves as a percentage of gross receivables increased from 39% to 77%. This increase was largely due to increased reserves for returns and price protections related to weak market conditions and the uncertainty involved in the ongoing console transition. Reserves for returns and price protection are a function of the number of units and pricing of titles in retail inventory (see Notes to Consolidated Financial Statements, Note 1: Summary of Significant Accounting Policies: Allowances for Returns, Price Protection, Doubtful Accounts, and Inventory Obsolescence). Inventories (amounts in thousands) Inventories March 31, March 31, 2006 2005 Increase/ (Decrease) $61,483 $48,018 $13,465 Inventories have increased as a result of lower than expected performance on certain fiscal 2006 third quarter title releases. Uncertainties in the marketplace due to the current console transition cycle as well as changes in retailer buying patterns led to a buildup in inventories at the end of the third quarter of fiscal 2006, primarily in our Publishing business segment. As a result of the buildup in inventory levels, for the year ended March 31, 2006 we had write-downs of inventory costs for certain titles in the amount of $14.5 million, as we anticipate that certain titles in our current inventory will be sold below its original cost. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Software Development (amounts in thousands) Software development March 31, March 31, 2006 2005 Increase/ (Decrease) $60,619 $91,614 $(30,995) The decrease in software development was primarily the result of more titles in development at March 31, 2005 to support our fiscal 2006 title slate which was the largest in our history. As we plan a more focused title slate in fiscal 2007 due to the market uncertainty involved in the console transition, we have fewer titles in development than at the end of fiscal 2005. Intellectual Property Licenses (amounts in thousands) Intellectual property licenses March 31, March 31, 2006 2005 Increase/ (Decrease) $87,046 $35,726 $51,320 The increase in intellectual property licenses was primarily the result of continued investment in intellectual property licenses totaling $82.3 million year-to-date. In the third quarter of fiscal 2006, we further extended our exclusive licensing agreement with Marvel Enterprises by signing a multi-year extension to our current video game licensing agreement for the Spider-Man and X-Men franchises. This agreement grants us the exclusive rights to develop and publish video games based on Marvel’s comic book franchises Spider-Man and X-Men. We also signed an agreement with Spider-Man Merchandising LP in the third quarter of fiscal 2006, to extend our exclusive worldwide rights to publish entertainment software products based on movie sequels subsequent to Spider-Man 3 or new television series to be produced based upon certain Marvel characters through 2017. Additionally, in our third quarter of fiscal 2006 we signed a multi-year agreement with DreamWorks Animation SKG which extended our exclusive video game rights to future films in the “Shrek” franchise beyond “Shrek the Third,” as well as titles based on several other films currently planned or in development. In the fourth quarter of fiscal 2006, we signed an agreement with Hasbro Properties Group granting us the global rights, excluding Japan, to develop console, hand-held, and PC games based on Hasbro’s “Transformers” brand. 41 Accounts Payable (amounts in thousands) Accounts payable March 31, March 31, 2006 2005 Increase/ (Decrease) $88,994 $108,984 $(19,990) The decrease in accounts payable was primarily the result of a high level of payables at March 31, 2005 related to inventory purchases by our publishing business as a result of the release of Doom 3 for the Xbox in April 2005. There were no new releases early in the first quarter of fiscal 2007. Accrued Expenses (amounts in thousands) Accrued expenses March 31, March 31, 2006 2005 Increase/ (Decrease) $103,169 $98,067 $5,102 The increase in accrued expenses was primarily driven by increased payroll accruals and separation and sever- ance costs associated with a less than 7% reduction in workforce in the fourth quarter of fiscal 2006, increased accruals for legal costs, and increased co-op marketing support. The increase was partially offset by a reduced liability due to third parties on affiliate titles distributed during the fourth quarter of fiscal 2006 compared to the fourth quarter of fiscal 2005. Credit Facilities We have revolving credit facilities with our Centresoft subsidiary located in the UK (the “UK Facility”) and our NBG subsidiary located in Germany (the “German Facility”). The UK Facility provided Centresoft with the ability to borrow up to GBP 12.0 million ($21.0 million), including issuing letters of credit, on a revolving basis as of March 31, 2006. Furthermore, under the UK Facility, Centresoft provided a GBP 0.6 million ($1.0 million) guarantee for the benefit of our CD Contact subsidiary as of March 31, 2006. The UK Facility A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Management’s Discussion and Analysis of Financial Condition and Results of Operations bore interest at LIBOR plus 2.0% as of March 31, 2006, is collateralized by substantially all of the assets of the subsidiary and expires in January 2007. The UK Facility also contains various covenants that require the subsidiary to maintain specified financial ratios related to, among others, fixed charges. As of March 31, 2006, we were in compliance with these covenants. No borrowings were outstanding against the UK Facility as of March 31, 2006. The German Facility provided for revolving loans up to EUR 0.5 million ($0.6 million) as of March 31, 2006, bore interest at a Eurocurrency rate plus 2.5%, is collateralized by certain of the subsid- iary’s property and equipment and has no expiration date. No borrowings were outstanding against the German Facility as of March 31, 2006. As of March 31, 2006, we maintained a $7.5 million irrevocable standby letter of credit. The standby letter of credit is required by one of our inventory manufacturers to qualify for payment terms on our inventory purchases. Under the terms of this arrangement, we are required to maintain on deposit with the bank a compensating balance, restricted as to use, of not less than the sum of the available amount of the letter of credit plus the aggregate amount of any drawings under the letter of credit that have been honored thereunder but not reim- bursed. At March 31, 2006, the $7.5 million deposit is included in short-term investments as restricted cash. As of March 31, 2006, our publishing subsidiary located in the UK maintained a EUR 2.5 million ($3.0 mil- lion) irrevocable standby letter of credit. The standby letter of credit is required by one of our inventory manufacturers to qualify for payment terms on our inventory purchases. The standby letter of credit does not require a compensating balance and is collateralized by substantially all of the assets of the subsidiary and expires in July 2006. As of March 31, 2006, we had EUR 1.0 million ($1.2 million) of outstanding amounts against this letter of credit. 42 Commitments In the normal course of business, we enter into contractual arrangements with third parties for non-cancelable operating lease agreements for our offices, for the development of products, as well as for the rights to intel- lectual property. Under these agreements, we commit to provide specified payments to a lessor, developer, or intellectual property holder, based upon contractual arrangements. Typically, the payments to third-party developers are conditioned upon the achievement by the developers of contractually specified development milestones. These payments to third-party developers and intellectual property holders typically are deemed to be advances and are recoupable against future royalties earned by the developer or intellectual property holder based on the sale of the related game. Additionally, in connection with certain intellectual property right acquisitions and development agreements, we will commit to spend specified amounts for marketing support for the related game(s) which is to be developed or in which the intellectual property will be utilized. Additionally, we lease certain of our facitilites and equipment under non-cancelable operating lease agree- ments. Assuming all contractual provisions are met, the total future minimum commitments for these and other contractual arrangements in place as of March 31, 2006, are scheduled to be paid as follows (amounts in thousands): Contractual Obligations Fiscal year ending March 31, Facility & Equipment Leases Developer and IP 2007 2008 2009 2010 2011 Thereafter Total $12,980 13,443 12,652 11,709 9,415 21,651 $81,850 $ 39,905 11,022 16,300 23,300 19,300 35,600 Marketing Total $17,120 44,580 6,100 100 100 — $ 70,005 69,045 35,052 35,109 28,815 57,251 $ 145,427 $68,000 $ 295,277 A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T As of March 31, 2006 and 2005, we did not have any relationships with unconsolidated entities or financial parties, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As such, we are not exposed to any financing, liquidity, market, or credit risk that could arise if we had engaged in such relationships. Related Parties From August 2001 until September 2005, one of the members of our Board of Directors was an individual who is a partner in a law firm that has provided legal services to Activision for more than ten years. For the years ended March 31, 2005 and 2004, the years presented in this Annual Report for which that person was a member of the Board of Directors, the fees we paid to the law firm were an insignificant portion of the law firm’s total revenues. We believe that the fees charged to us by the law firm were competitive with the fees charged by other law firms. Financial Disclosure We maintain internal controls over financial reporting, which generally include those controls relating to the preparation of our financial statements in conformity with accounting principles generally accepted in the United States of America. We also are focused on our “disclosure controls and procedures,” which as defined by the Securities and Exchange Commission are generally those controls and procedures designed to ensure that financial and non-financial information required to be disclosed in our reports filed with the Securities and Exchange Commission is reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is communicated to management, including our Chief Executive Officers and our Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. 43 Our Disclosure Committee, which operates under the Board approved Disclosure Committee Charter and Disclosure Controls & Procedures Policy, includes senior management representatives and assists executive management in its oversight of the accuracy and timeliness of our disclosures, as well as in implementing and evaluating our overall disclosure process. As part of our disclosure process, senior finance and operational representatives from all of our corporate divisions and business units prepare quarterly reports regarding their current quarter operational performance, future trends, subsequent events, internal controls, changes in inter- nal controls, and other accounting and disclosure-relevant information. These quarterly reports are reviewed by certain key corporate finance representatives. These corporate finance representatives also conduct quarterly interviews on a rotating basis with the preparers of selected quarterly reports. The results of the quarterly reports and related interviews are reviewed by the Disclosure Committee. Finance representatives also conduct reviews with our senior management team, our internal and external counsel, and other appropriate personnel involved in the disclosure process, as appropriate. Additionally, senior finance and operational representatives provide internal certifications regarding the accuracy of information they provide that is utilized in the preparation of our periodic public reports filed with the Securities and Exchange Commission. Financial results and other financial information also are reviewed with the Audit Committee of the Board of Directors on a quarterly basis. As required by applicable regulatory requirements, the Chief Executive Officers and the Chief Financial Officer review and make various certifications regarding the accuracy of our periodic public reports filed with the Securities and Exchange Commission, our disclosure controls and procedures, and our internal con- trol over financial reporting. With the assistance of the Disclosure Committee, we will continue to assess and monitor our disclosure controls and procedures, and our internal controls over financial reporting, and will make refinements as necessary. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Management’s Discussion and Analysis of Financial Condition and Results of Operations Recently Issued Accounting Standards and Laws On December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued FASB Statement No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123R”), which is a revision of FASB Statement No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”). SFAS No. 123R supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and amends FASB Statement No. 95, “Statement of Cash Flows.” Generally, the approach in SFAS No. 123R is similar to the approach described in SFAS No. 123. However, SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. SFAS No. 123R permits public companies to adopt its requirements using one of two methods: • A “modified prospective” method in which compensation cost is recognized beginning with the effec- tive date (a) based on the requirements of SFAS No. 123R for all share-based payments granted after the effective date and (b) based on the requirements of SFAS No. 123 for all awards granted to employees prior to the effective date of SFAS No. 123R that remain unvested on the effective date. • A “modified retrospective” method which includes the requirements of the modified prospective method described above, but also permits entities to restate based on the amounts previously recognized under SFAS 123 for purposes of pro forma disclosures either (a) all prior periods presented or (b) prior interim periods of the year of adoption. As permitted by SFAS No. 123, prior to April 1, 2006, we accounted for share-based payments to employees using APB No. 25’s intrinsic value method and, as such, generally recognized no compensation cost for employee stock options. Accordingly, the adoption of the SFAS No. 123R fair value method will have a sig- nificant impact on our results of operations, although it will have no impact on our overall financial position. We adopted SFAS No. 123R on April 1, 2006 using the “modified prospective” approach. We currently believe that the expensing of stock-based compensation will have an impact on our Consolidated Statement of Operations similar to our pro forma disclosure under SFAS No. 123 and expect an impact in fiscal 2007 of approximately $0.05 per share. 44 On November 24, 2004, the FASB issued Statement No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4” (“SFAS No. 151”). The standard requires that abnormal amounts of idle capacity and spoilage costs within inventory should be excluded from the cost of inventory and expensed when incurred. The provi- sions of SFAS No. 151 are applicable to inventory costs incurred during fiscal years beginning after June 15, 2005. We expect the adoption of SFAS No. 151 will not have a material impact on our financial position or results of operations. On December 15, 2004, the FASB issued Statement No. 153 (“SFAS No. 153”), “Exchanges of Nonmonetary Assets—an amendment of Accounting Principles Board Opinion No. 29.” This standard requires exchanges of productive assets to be accounted for at fair value, rather than at carryover basis, unless (1) neither the asset received nor the asset surrendered has a fair value that is determinable within reasonable limits or (2) the trans- actions lack commercial substance. The new standard is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. The adoption of SFAS No. 153 did not have a material impact on our financial position or results of operations. In May 2005, the FASB issued Statement No. 154 (“SFAS No. 154”), “Accounting Changes and Error Corrections —a replacement of APB Opinion No. 20 and FASB Statement No. 3.” SFAS No. 154 changes the require- ments for the accounting and reporting of a change in accounting principle and correction of errors. Under previous guidance, changes in accounting principle were recognized as a cumulative effect in the net income of the period of the change. The new statement requires retrospective application of changes in accounting principle and correction of errors, limited to the direct effects of the change, to prior periods’ financial state- ments, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS No. 154 is effective for accounting changes and correction of errors made in fiscal years begin- ning after December 15, 2005. In the event that we have an accounting change or an error correction, SFAS No. 154 could have a material impact on our consolidated financial statements. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T On February 16, 2006, the FASB issued Statement No. 155 (“SFAS No. 155”), “Accounting for Certain Hybrid Financial Instruments—an amendment of FASB Statements No. 133 and 140.” SFAS No. 155 amends FASB Statements No. 133, “Accounting for Derivative Instruments and Hedging Activities,” and No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” to resolve issues addressed in Statement 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.” SFAS No. 155 permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation; clarifies which interest-only strips and principal-only strips are not subject to the requirements of Statement 133; establishes a requirement to evaluate interests in securitized financial assets to identify interests that are free- standing derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation; clarifies that concentrations of credit risk in the form of subordination are not embedded deriva- tives; and amends Statement 140 to eliminate the prohibition on a qualifying special purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS No. 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. We do not expect the adoption of SFAS No. 155 to have a material effect on our financial position or results of operations. On March 17, 2006, the FASB issued Statement No. 156 (“SFAS No. 156”), “Accounting for Servicing of Financial Assets—an amendment of FASB Statement No. 140.” SFAS No. 156 amends Statement No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” with respect to the accounting for separately recognized servicing assets and servicing liabilities. SFAS No. 156 requires an entity to recognize a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract in certain situations; requires all separately recognized servicing assets and servicing liabilities to be initially measured at fair value, if practicable; permits either the amortization method or the fair value measurement method, as subsequent measurement methods for each class of separately recognized servicing assets and servicing liabilities; permits a one-time reclassification of avail- able-for-sale securities to trading securities by entities with recognized servicing rights; and requires separate presentation of servicing assets and servicing liabilities subsequently measured at fair value in the statement of financial position and additional disclosures for all separately recognized servicing assets and servicing liabili- ties. SFAS No. 156 is effective in the first fiscal year that begins after September 15, 2006. We do not expect the adoption of SFAS No. 156 to have a material effect on our financial position or results of operations. 45 On October 22, 2004, the President of the United States signed the American Jobs Creation Act of 2004 (the “Act”) which contains a number of tax law modifications with accounting implications. For companies that pay U.S. income taxes on manufacturing activities in the U.S., the Act provides a deduction from taxable income equal to a stipulated percentage of qualified income from domestic production activities. The manu- facturing deduction provided by the Act replaces the extraterritorial income (“ETI”) deduction currently in place. We currently derive benefits from the ETI exclusion which was repealed by the Act. Our exclusion for fiscal 2006 and 2007 will be limited to 75% and 45% of the otherwise allowable exclusion and no exclusion will be available in fiscal 2008 and thereafter. The Act also creates a temporary incentive for U.S. multinationals to repatriate accumulated income earned abroad by providing an 85% dividends received deduction for cer- tain dividends from controlled foreign corporations (“Homeland Investment Act”). The deduction is subject to a number of limitations. The Act also provides for other changes in tax law that will affect a variety of taxpayers. On December 21, 2004, the Financial Accounting Standards Board (“FASB”) issued two FASB Staff Positions (“FSP”) regarding the accounting implications of the Act related to (1) the deduction for quali- fied domestic production activities and (2) the one-time tax benefit for the repatriation of foreign earnings. The FASB determined that the deduction for qualified domestic production activities should be accounted for as a special deduction under FASB Statement No. 109, Accounting for Income Taxes. The FASB also con- firmed, that upon deciding that some amount of earnings will be repatriated, a company must record in that period the associated tax liability. The guidance in the FSPs apply to financial statements for periods ending after the date the Act was enacted. We have evaluated the Act and have concluded that we will not repatriate foreign earnings under the Homeland Investment Act Provisions. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Management’s Discussion and Analysis of Financial Condition and Results of Operations Inflation Our management currently believes that inflation has not had a material impact on continuing operations. Quantitative and Qualitative Disclosures About Market Risk Market risk is the potential loss arising from fluctuations in market rates and prices. Our market risk expo- sures primarily include fluctuations in interest rates, foreign currency exchange rates, and market prices. Our market risk sensitive instruments are classified as instruments entered into for purposes “other than trading.” Our views on market risk are not necessarily indicative of actual results that may occur and do not represent the maximum possible gains and losses that may occur, since actual gains and losses will differ from those estimated, based upon actual fluctuations in interest rates, foreign currency exchange rates, market prices, and the timing of transactions. Interest Rate Risk Our exposure to market rate risk for changes in interest rates relates primarily to our investment portfolio. We do not use derivative financial instruments in our investment portfolio. We manage our interest rate risk by maintaining an investment portfolio consisting primarily of debt instruments with high credit quality and relatively short average maturities. We also manage our interest rate risk by maintaining sufficient cash and cash equivalent balances such that we are typically able to hold our investments to maturity. As of March 31, 2006, our cash equivalents and short-term investments included debt securities of $666.3 million. The following table presents the amounts and related weighted average interest rates of our investment portfolio as of March 31, 2006 (amounts in thousands): 46 Cash equivalents: Fixed rate Variable rate Short-term investments: Fixed rate Average Interest Rate Amortized Cost Fair Value 4.75% 4.59 $154,522 37,560 $154,368 37,560 3.87% $535,251 $529,881 Our short-term investments generally mature between three months and thirty months. Foreign Currency Exchange Rate Risk We transact business in many different foreign currencies and may be exposed to financial market risk resulting from fluctuations in foreign currency exchange rates, particularly EUR, GBP, and AUD. The volatility of EUR, GBP, and AUD (and all other applicable currencies) will be monitored frequently throughout the coming year. When appropriate, we enter into hedging transactions in order to mitigate our risk from foreign currency fluctuations. We will continue to use hedging programs in the future and may use currency forward con- tracts, currency options, and/or other derivative financial instruments commonly utilized to reduce financial market risks if it is determined that such hedging activities are appropriate to reduce risk. We do not hold or purchase any foreign currency contracts for trading purposes. As of March 31, 2006, we had no outstanding hedging contracts. Market Price Risk With regard to the structured stock repurchase transactions described in Note 15 in the Notes to the Consoli- dated Financial Statements, at those times when we have structured stock repurchase transactions outstanding, it is possible that at settlement we could take delivery of shares at an effective repurchase price higher than the then market price. As of March 31, 2006, we had no structured stock repurchase transactions outstanding. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Controls and Procedures Evaluation of Disclosure Controls and Procedures The Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) are designed to reasonably assure that (i) information required to be disclosed in the Company’s reports filed under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and (ii) information is accumulated and communicated to management, including the Chief Executive Officers and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that it will detect or uncover failures within the Company to disclose material information otherwise required to be set forth in our periodic reports. Inherent limitations to any system of disclosure controls and procedures include, but are not limited to, the possibility of human error and the circumvention or overriding of such controls by one or more persons. In addition, we have designed our system of controls based on certain assumptions, which we believe are reasonable, about the likelihood of future events, and our system of con- trols may therefore not achieve its desired purposes under all possible future events. The Company’s management, with the participation of the Chief Executive Officers and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures as of the end of the period covered by this report. Based on this controls evaluation, and subject to the limitations described above, the Chief Executive Officers and Chief Financial Officer concluded that, as of the end of the period covered by this report, our disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported on a timely basis. Changes in Internal Control Over Financial Reporting There was no change in our internal control over financial reporting (as such term is defined in Rules 13a-15(f ) and 15d-15(f ) under the Exchange Act) during our most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. 47 Management’s Report on Internal Control Over Financial Reporting The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Rules 13a-15(f ) and 15d-15(f ) under the Exchange Act. Under the supervision and with the participation of the Company’s management, including our Chief Executive Officers and Chief Financial Officer, the Company conducted an evaluation of the effectiveness of its inter- nal control over financial reporting based on criteria established in the framework in Internal Control— Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, the Company’s management concluded that its internal control over financial reporting was effective as of March 31, 2006. Because of its inherent limitations, internal control over financial reporting may not prevent or detect mis- statements. Also, projections of any evaluation of effectiveness to future periods are subject to the risks that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies and procedures may deteriorate. PricewaterhouseCoopers LLP, the Company’s independent registered public accounting firm has audited management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of March 31, 2006 as stated in their report. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Report of Independent Registered Public Accounting Firm To the Board of Directors and Shareholders of Activision, Inc.: We have completed integrated audits of Activision, Inc.’s 2006 and 2005 consolidated financial statements and of its internal control over financial reporting as of March 31, 2006 and an audit of its 2004 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below. Consolidated financial statements and financial statement schedule In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of Activision, Inc. and its subsidiaries (the “Company”) at March 31, 2006 and 2005 and the results of their operations and their cash flows for each of the three years in the period ended March 31, 2006 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the stand- ards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence support- ing the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. 48 Internal control over financial reporting Also, in our opinion, management’s assessment, included in Management’s Report on Internal Control Over Financial Reporting, that the Company maintained effective internal control over financial reporting as of March 31, 2006 based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all mate- rial respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of March 31, 2006, based on criteria established in Internal Control—Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assess- ment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external pur- poses in accordance with generally accepted accounting principles. A company’s internal control over finan- cial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the com- pany; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisi- tion, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstate- ments. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. PricewaterhouseCoopers LLP Los Angeles, California June 9, 2006 49 Consolidated Balance Sheets (in thousands, except share data) As of March 31, Assets Current assets: Cash and cash equivalents Short-term investments Accounts receivable, net of allowances of $98,253 and $69,191 at March 31, 2006 and 2005, respectively Inventories Software development Intellectual property licenses Deferred income taxes Other current assets Total current assets Software development Intellectual property licenses Property and equipment, net Deferred income taxes Other assets Goodwill Total assets 50 Liabilities and Shareholders’ Equity Current liabilities: Accounts payable Accrued expenses Total current liabilities Other liabilities Total liabilities Commitments and contingencies (Note 13) Shareholders’ equity: Preferred stock, $.000001 par value, 3,750,000 shares authorized, no shares issued at March 31, 2006 and 2005 Series A Junior Preferred stock, $.000001 par value, 1,250,000 shares authorized, no shares issued at March 31, 2006 and 2005 Common stock, $.000001 par value, 450,000,000 and 225,000,000 shares authorized, 277,020,898 and 268,040,831 shares issued and outstanding at March 31, 2006 and 2005, respectively Additional paid-in capital Retained earnings Accumulated other comprehensive income Unearned compensation Total shareholders’ equity Total liabilities and shareholders’ equity The accompanying notes are an integral part of these consolidated financial statements. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T 2006 2005 $ 354,331 590,629 $ 313,608 527,256 28,782 61,483 40,260 4,973 9,664 25,933 1,116,055 20,359 82,073 45,368 53,813 1,409 100,446 109,144 48,018 73,096 21,572 6,760 23,010 1,122,464 18,518 14,154 30,490 28,041 1,635 91,661 $ 1,419,523 $ 1,306,963 $ 88,994 103,169 192,163 1,776 193,939 $ 108,984 98,067 207,051 — 207,051 — — — 823,735 388,513 16,369 (3,033) — — — 741,680 346,614 11,618 — 1,225,584 1,099,912 $ 1,419,523 $ 1,306,963 A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Consolidated Statements of Operations (in thousands, except per share data) For the years ended March 31, Net revenues Costs and expenses: Cost of sales—product costs Cost of sales—software royalties and amortization Cost of sales—intellectual property licenses Product development Sales and marketing General and administrative Total costs and expenses Income from operations Investment income, net Income before income tax provision Income tax provision Net income Basic earnings per share Weighted average common shares outstanding Diluted earnings per share 2006 2005 2004 $ 1,468,000 $ 1,405,857 $ 947,656 734,874 147,822 57,666 131,782 283,220 94,679 658,949 123,800 62,197 86,543 230,058 59,739 1,450,043 1,221,286 17,957 30,630 48,587 6,688 184,571 13,092 197,663 59,328 475,541 59,744 31,862 97,859 128,221 44,612 837,839 109,817 6,175 115,992 38,277 $ $ $ 41,899 $ 138,335 $ 77,715 0.15 $ 0.55 $ 0.33 273,177 250,023 236,887 0.14 $ 0.50 $ 0.30 Weighted average common shares outstanding—assuming dilution 299,437 278,860 257,588 51 The accompanying notes are an integral part of these consolidated financial statements. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Consolidated Statements of Changes in Shareholders’ Equity Common Stock Shares Amount 286,329 $ — Additional Paid-In Capital Retained Earnings Treasury Stock Shares Amount Accumulated Other Comprehensive Income (Loss) Unearned Compensation Shareholders’ Equity $ 592,295 $ 130,564 (46,101) $ (121,685) $ (3,434) $ — $ 597,740 (in thousands) For the years ended March 31, 2006, 2005, and 2004 Balance, March 31, 2003 Components of comprehensive income: Net income for the year Unrealized depreciation on short-term investments Foreign currency translation adjustment Total comprehensive income Issuance of common stock to employees Issuance of common stock pursuant to warrants and common stock warrants Tax benefit attributable to employee stock options and common stock warrants Structured stock repurchase transactions Settlement of structured stock repurchase transactions Issuance of common stock to effect business combinations Purchase of treasury shares Balance, March 31, 2004 Components of comprehensive income: Net income for the year Unrealized depreciation on short-term investments Foreign currency translation adjustment 52 Total comprehensive income Issuance of common stock to employees Issuance of common stock pursuant to warrants and common stock warrants Tax benefit attributable to employee stock options and common stock warrants Issuance of common stock to effect business combinations Retirement of treasury shares Balance, March 31, 2005 Components of comprehensive income: Net income for the year Unrealized appreciation on short-term investments Foreign currency translation adjustment Total comprehensive income Issuance of common stock to employees Restricted stock grant Cash distribution for fractional shares Amortization of unearned compensation Tax benefit attributable to employee stock options and common stock warrants Issuance of common stock to effect business combinations — — — 9,137 744 — — — 459 — 296,669 — — — 22,255 1,497 — 145 (52,525) 268,041 — — — 8,782 — (7) — — 205 — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — 77,715 — — 25,730 1,038 12,417 (52,621) 176,521 3,246 — — — — — — — — — — — — — — — (3,051) — (3,373) — — — — (37) 13,432 — — — — (10,000) — (12,443) — — — — — — — 758,626 208,279 (52,525) (144,128) 9,961 — — — 138,335 — — — — — — — — 68,192 4,462 53,337 1,191 (144,128) — — — — — — — — — 52,525 — — — — 144,128 741,680 346,614 — — — 41,899 — — 45,188 3,500 (100) — 30,674 2,793 — — — — — — — — — — — — — — — — — — — — — — — — — — — — (3,317) 4,974 — — — — — 11,618 — 10,576 (5,825) — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — (3,500) — 467 — — 53 77,715 (37) 13,432 91,110 25,730 1,038 12,417 (52,621) 166,521 3,246 (12,443) 832,738 138,335 (3,317) 4,974 139,992 68,192 4,462 53,337 1,191 — 1,099,912 41,899 10,576 (5,825) 46,650 45,188 — (100) 467 30,674 2,793 Balance, March 31, 2006 277,021 $ — $ 823,735 $ 388,513 — $ The accompanying notes are an integral part of these consolidated financial statements. $ 16,369 $ (3,033) $ 1,225,584 A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Consolidated Statements of Cash Flows (in thousands) For the years ended March 31, Cash flows from operating activities: Net income Adjustments to reconcile net income to net cash provided by operating activities: Deferred income taxes Depreciation and amortization Realized gain on sale of short-term investments Amortization and write-offs of capitalized software development costs and intellectual property licenses Amortization of stock compensation expenses Tax benefit of stock options and warrants exercised Change in operating assets and liabilities (net of effects of acquisitions): Accounts receivable, net Inventories Software development and intellectual property licenses Other assets Accounts payable Accrued expenses and other liabilities 2006 2005 2004 $ 41,899 $ 138,335 $ 77,715 (28,677) 14,634 (4,297) 173,602 467 30,674 80,405 (13,465) (193,927) (2,038) (19,985) 6,715 878 10,702 (471) 134,799 — 53,337 (46,527) (21,591) (126,938) 1,543 35,413 35,829 15,147 10,795 (21) 87,922 — 12,417 (42,497) (6,850) (115,202) (5,232) 23,005 10,204 Net cash provided by operating activities 86,007 215,309 67,403 54 Cash flows from investing activities: Cash used in business acquisitions (net of cash acquired) Capital expenditures Increase in restricted cash Purchase of short-term investments Proceeds from sales and maturities of short-term investments Net cash used in investing activities Cash flows from financing activities: Proceeds from issuance of common stock to employees and common stock pursuant to warrants Notes payable, net Purchase of structured stock repurchase transactions Settlement of structured stock repurchase transactions Purchase of treasury stock Net cash provided by financing activities Effect of exchange rate changes on cash Net increase in cash and cash equivalents Cash and cash equivalents at beginning of period (6,890) (30,406) (7,500) (242,568) (21,382) (14,941) — (868,723) (3,480) (11,976) — (703,400) 201,568 761,150 548,701 (85,796) (143,896) (170,155) 45,088 — — — — 45,088 (4,576) 40,723 313,608 72,654 — — — — 72,654 4,421 148,488 165,120 26,483 (2,818) (52,621) 166,521 (19,996) 117,569 11,195 26,012 139,108 Cash and cash equivalents at end of period $ 354,331 $ 313,608 $ 165,120 The accompanying notes are an integral part of these consolidated financial statements. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Notes to Consolidated Financial Statements For the year ended March 31, 2006 1. Summary of Significant Accounting Policies Business Activision, Inc. (“Activision,” the “Company,” or “we”) is a leading international publisher of interactive enter- tainment software products. We have built a company with a diverse portfolio of products that spans a wide range of categories and target markets and that is used on a variety of game hardware platforms and operating systems. We have created, licensed, and acquired a group of highly recognizable brands, which we market to a variety of consumer demographics. Our products cover diverse game categories including action/adventure, action sports, racing, role-playing, simulation, first-person action, and strategy. Our target customer base ranges from casual players to game enthusiasts, children to adults, and mass-market consumers to “value” buyers. We currently offer our products primarily in versions that operate on the Sony PlayStation 2 (“PS2”), Nintendo GameCube (“GameCube”), Microsoft Xbox (“Xbox”), and Microsoft Xbox 360 (“Xbox360”) con- sole systems, Nintendo Game Boy Advance (“GBA”), Sony PlayStation Portable (“PSP”), and Nintendo Dual Screen (“NDS”) hand-held devices, and the personal computer (“PC”). In prior years, we have also offered our products on the Sony PlayStation (“PS1”) and Nintendo 64 (“N64”) console systems, and the Nintendo Game Boy Color (“GBC”) hand-held device. We are also in the process of developing titles for the next- generation console systems being developed by Sony and Nintendo, the PlayStation 3 (“PS3”) and the Wii, respectively. Our publishing business involves the development, marketing, and sale of products directly, by license, or through our affiliate label program with certain third-party publishers. Our distribution business consists of operations in Europe that provide logistical and sales services to third-party publishers of interactive entertain- ment software, our own publishing operations, and manufacturers of interactive entertainment hardware. We maintain operations in the United States, Canada, the United Kingdom (“UK”), Germany, France, Italy, Spain, Japan, Australia, Sweden, and the Netherlands. In fiscal year 2006, international operations contributed approximately 52% of consolidated net revenues. 55 Principles of Consolidation The consolidated financial statements include the accounts of Activision, Inc., a Delaware corporation, and its wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation. Cash, Cash Equivalents, and Short-term Investments Cash and cash equivalents include cash, money markets, and short-term investments with original maturities of not more than 90 days. Short-term investments generally mature between three and thirty months. Investments with maturities beyond one year may be classified as short-term based on their liquid nature and because such securities represent the investment of cash that is available for current operations. All of our short-term investments are classified as available-for-sale and are carried at fair market value with unrealized appreciation (depreciation) reported as a component of accumulated other comprehensive income (loss) in shareholders’ equity. The specific identifica- tion method is used to determine the cost of securities disposed with realized gains and losses reflected in investment income, net. Restricted Cash—Compensating Balances As of March 31, 2006, we maintained a $7.5 million irrevocable standby letter of credit. The standby letter of credit is required by one of our inventory manufacturers to qualify for payment terms on our inventory purchases. Under the terms of this arrangement, we are required to maintain on deposit with the bank a compensating balance, restricted as to use, of not less than the sum of the available amount of the letter of credit plus the aggregate amount of any drawings under the letter of credit that have been honored thereunder but not reimbursed. At March 31, 2006, the $7.5 million deposit is included in short-term investments as restricted cash. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Notes to Consolidated Financial Statements Concentration of Credit Risk Financial instruments which potentially subject us to concentration of credit risk consist principally of tem- porary cash investments and accounts receivable. We place our temporary cash investments with financial institutions. At various times during the fiscal years ended March 31, 2006 and 2005, we had deposits in excess of the Federal Deposit Insurance Corporation (“FDIC”) limit at these financial institutions. Our customer base includes retail outlets and distributors, including mass-market retailers, consumer elec- tronics stores, discount warehouses, and game specialty stores in the United States and countries worldwide. We perform ongoing credit evaluations of our customers and maintain allowances for potential credit losses. We generally do not require collateral or other security from our customers. We had two customers, Wal-Mart and GameStop, that accounted for 22% and 10% of consolidated net revenues for the year ended March 31, 2006 and 43% and 4% of consolidated gross accounts receivable at March 31, 2006. These customers were customers of both our publishing and distribution businesses. As of and for the years ended March 31, 2005 and 2004, our largest customer, Wal-Mart, accounted for 23% and 20%, respectively, of consolidated net revenues and 33% of consolidated gross accounts receivable in both periods. Financial Instruments The estimated fair values of financial instruments have been determined using available market information and valuation methodologies described below. However, considerable judgment is required in interpreting market data to develop the estimates of fair value. Accordingly, the estimates presented herein may not be indicative of the amounts that we could realize in a current market exchange. The use of different market assumptions or valuation methodologies may have a material effect on the estimated fair value amounts. 56 The carrying amounts of cash and cash equivalents, accounts receivable, accounts payable, and accrued expenses approximate fair value due to their short-term nature. Short-term investments are carried at fair value with fair values being estimated based on quoted market prices. We account for derivative instruments in accordance with Statement of Financial Accounting Standard (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities,” SFAS No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities, an amendment of SFAS No. 133” and SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 133, 138, and 149 require that all derivatives, including foreign exchange contracts, be recognized in the balance sheet in other current assets or accrued expenses at their fair value. We utilize forward contracts in order to reduce financial market risks. These instruments are used to hedge foreign currency exposures of underlying assets or liabilities. Our accounting policies for these instruments are based on whether they meet the criteria for designation as hedging transactions. Changes in fair value of derivatives that are designated as cash flow hedges, are highly effective, and qualify as hedging instruments, are recorded in other comprehensive income until the underlying hedged item is recognized in earnings within the financial statement line item consistent with the hedged item. Any ineffective portion of a deriva- tive change in fair value is immediately recognized in earnings. Changes in fair value of derivatives that do not qualify as hedging instruments are recorded in earnings. The fair value of foreign currency contracts is estimated based on the spot rate of the various hedged currencies as of the end of the period. As of March 31, 2006 and 2005, we had no outstanding foreign exchange forward contracts. Equity Investments From time to time, we may make a capital investment and hold a minority interest in a third-party developer in connection with entertainment software products to be developed by such developer for us. We account for those capital investments over which we have the ability to exercise significant influence using the equity method. For those investments over which we do not have the ability to exercise significant influence, we account for our investment using the cost method. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Software Development Costs Software development costs include payments made to independent software developers under development agreements, as well as direct costs incurred for internally developed products. We account for software development costs in accordance with SFAS No. 86, “Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed.” Software development costs are capitalized once technological feasibility of a product is established and such costs are determined to be recoverable. Technological feasibility of a product encompasses both technical design documentation and game design documentation. For products where proven technology exists, this may occur early in the development cycle. Technological feasibility is evaluated on a product-by-product basis. Prior to a product’s release, we expense, as part of cost of sales—software royalties and amortization, capitalized costs when we believe such amounts are not recoverable. Capitalized costs for those products that are cancelled or abandoned are charged to prod- uct development expense in the period of cancellation. Amounts related to software development which are not capitalized are charged immediately to product development expense. We evaluate the future recoverability of capitalized amounts on a quarterly basis. The recoverability of capitalized software development costs is evaluated based on the expected performance of the specific products for which the costs relate. Criteria used to evaluate expected product performance include: historical performance of comparable products using com- parable technology; orders for the product prior to its release; and estimated performance of a sequel product based on the performance of the product on which the sequel is based. Commencing upon product release, capitalized software development costs are amortized to cost of sales— software royalties and amortization based on the ratio of current revenues to total projected revenues, generally resulting in an amortization period of six months or less. For products that have been released in prior periods, we evaluate the future recoverability of capitalized amounts on a quarterly basis. The primary evaluation criterion is actual title performance. 57 Significant management judgments and estimates are utilized in the assessment of when technological feasibil- ity is established, as well as in the ongoing assessment of the recoverability of capitalized costs. In evaluating the recoverability of capitalized costs, the assessment of expected product performance utilizes forecasted sales amounts and estimates of additional costs to be incurred. If revised forecasted or actual product sales are less than and/or revised forecasted or actual costs are greater than the original forecasted amounts utilized in the initial recoverability analysis, the net realizable value may be lower than originally estimated in any given quarter, which could result in an impairment charge. Intellectual Property Licenses Intellectual property license costs represent license fees paid to intellectual property rights holders for use of their trademarks, copyrights, software, technology, or other intellectual property or proprietary rights in the development of our products. Depending upon the agreement with the rights holder, we may obtain the rights to use acquired intellectual property in multiple products over multiple years, or alternatively, for a single product. We evaluate the future recoverability of capitalized intellectual property licenses on a quarterly basis. The recoverability of capitalized intellectual property license costs is evaluated based on the expected performance of the specific products in which the licensed trademark or copyright is to be used. As many of our intellec- tual property licenses extend for multiple products over multiple years, we also assess the recoverability of capitalized intellectual property license costs based on certain qualitative factors such as the success of other products and/or entertainment vehicles utilizing the intellectual property, whether there are any future planned theatrical releases or television series based on the intellectual property, and the rights holder’s continued promotion and exploitation of the intellectual property. Prior to the related product’s release, we expense, as part of cost of sales—intellectual property licenses, capitalized intellectual property costs when we believe A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Notes to Consolidated Financial Statements such amounts are not recoverable. Capitalized intellectual property costs for those products that are cancelled or abandoned are charged to product development expense in the period of cancellation. Criteria used to evalu- ate expected product performance include: historical performance of comparable products using comparable technology; orders for the product prior to its release; and estimated performance of a sequel product based on the performance of the product on which the sequel is based. Commencing upon the related product’s release, capitalized intellectual property license costs are amortized to cost of sales—intellectual property licenses based on the ratio of current revenues for the specific product to total projected revenues for all products in which the licensed property will be utilized. As intellectual property license contracts may extend for multiple years, the amortization of capitalized intellectual property license costs relating to such contracts may extend beyond one year. For intellectual property included in products that have been released and unreleased products, we evaluate the future recoverability of capitalized amounts on a quarterly basis. The primary evaluation criterion is actual title performance. Significant management judgments and estimates are utilized in the assessment of the recoverability of capital- ized costs. In evaluating the recoverability of capitalized costs, the assessment of expected product performance utilizes forecasted sales amounts and estimates of additional costs to be incurred. If revised forecasted or actual product sales are less than, and/or revised forecasted or actual costs are greater than, the original forecasted amounts utilized in the initial recoverability analysis, the net realizable value may be lower than originally estimated in any given quarter, which could result in an impairment charge. Additionally, as noted above, as many of our intellectual property licenses extend for multiple products over multiple years, we also assess the recoverability of capitalized intellectual property license costs based on certain qualitative factors such as the success of other products and/or entertainment vehicles utilizing the intellectual property, whether there are any future planned theatrical releases or television series based on the intellectual property and the rights holder’s continued promotion and exploitation of the intellectual property. Material differences may result in the amount and timing of charges for any period if management makes different judgments or utilizes different estimates in evaluating these qualitative factors. 58 Inventories Inventories are valued at the lower of cost (first-in, first-out) or market. Property and Equipment Property and equipment are recorded at cost. Depreciation and amortization are provided using the straight-line method over the shorter of the estimated useful lives or the lease term: buildings, 25 to 33 years; computer equipment, office furniture and other equipment, 2 to 5 years; leasehold improvements, through the life of the lease. When assets are retired or disposed of, the cost and accumulated depreciation thereon are removed and any resulting gains or losses are recognized in current operations. Goodwill We account for goodwill using the provisions of SFAS No. 142, “Goodwill and Other Intangibles.” SFAS No. 142 addresses financial accounting and reporting requirements for acquired goodwill and other intangible assets. Under SFAS No. 142, goodwill is deemed to have an indefinite useful life and should not be amortized but rather tested at least annually for impairment. An impairment loss should be recognized if the carrying amount of goodwill is not recoverable and its carrying amount exceeds its fair value. Our impairment tests as of March 31, 2006, 2005, and 2004 did not indicate that goodwill was impaired. In accordance with SFAS No. 142, we have not amortized goodwill during the years ended March 31, 2006, 2005, and 2004. Revenue Recognition We recognize revenue from the sale of our products upon the transfer of title and risk of loss to our customers. Certain products are sold to customers with a street date (the date that products are made widely available for sale by retailers). For these products we recognize revenue no earlier than the street date. Revenue from product sales is recognized after deducting the estimated allowance for returns and price protection. With respect to A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T license agreements that provide customers the right to make multiple copies in exchange for guaranteed amounts, revenue is recognized upon delivery of such copies. Per copy royalties on sales that exceed the guarantee are recognized as earned. In addition, in order to recognize revenue for both product sales and licensing transac- tions, persuasive evidence of an arrangement must exist and collection of the related receivable must be prob- able. Revenue recognition also determines the timing of certain expenses, including cost of sales—intellectual property licenses and cost of sales—software royalties and amortization. Sales incentives or other consideration given by us to our customers is accounted for in accordance with the Financial Accounting Standards Board’s Emerging Issues Task Force (“EITF”) Issue 01-9, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products).” In accord- ance with EITF Issue 01-9, sales incentives and other consideration that are considered adjustments of the selling price of our products, such as rebates and product placement fees, are reflected as reductions of revenue. Sales incentives and other consideration that represent costs incurred by us for assets or services received, such as the appearance of our products in a customer’s national circular ad, are reflected as sales and marketing expenses. Allowances for Returns, Price Protection, Doubtful Accounts, and Inventory Obsolescence In determining the appropriate unit shipments to our customers, we benchmark our titles using historical and industry data. We closely monitor and analyze the historical performance of our various titles, the performance of products released by other publishers, and the anticipated timing of other releases in order to assess future demands of current and upcoming titles. Initial volumes shipped upon title launch and subsequent reorders are evaluated to ensure that quantities are sufficient to meet the demands from the retail markets but at the same time, are controlled to prevent excess inventory in the channel. We may permit product returns from, or grant price protection to, our customers under certain conditions. In general, price protection refers to the circumstances when we elect to decrease the wholesale price of a product by a certain amount and, when granted and applicable, allow customers a credit against amounts owed by such customers to Activision with respect to open and/or future invoices. The conditions our customers must meet to be granted the right to return products or price protection are, among other things, compliance with applicable payment terms, delivery to us of weekly inventory and sell-through reports, and consistent participa- tion in the launches of our premium title releases. We may also consider other factors, including the facilitation of slow-moving inventory and other market factors. Management must make estimates of potential future product returns and price protection related to current period product revenue. We estimate the amount of future returns and price protection for current period product revenue utilizing historical experience and information regarding inventory levels and the demand and acceptance of our products by the end consumer. The following factors are used to estimate the amount of future returns and price protection for a particular title: historical performance of titles in similar genres, historical performance of the hardware platform, historical performance of the brand, console hardware life cycle, Activision sales force and retail customer feedback, industry pricing, weeks of on-hand retail channel inventory, absolute quantity of on-hand retail channel inventory, our warehouse on-hand inventory levels, the title’s recent sell-through history (if available), marketing trade programs, and competing titles. The relative importance of these factors varies among titles depending upon, among other items, genre, platform, seasonality, and sales strategy. Significant management judgments and estimates must be made and used in connection with establishing the allowance for returns and price protection in any accounting period. Based upon historical experience we believe our estimates are reasonable. However, actual returns and price protection could vary materially from our allowance estimates due to a number of reasons including, among others, a lack of consumer acceptance of a title, the release in the same period of a similarly themed title by a competitor, or technological obsolescence due to the emergence of new hardware platforms. Material differences may result in the amount and timing of our revenue for any period if management makes different judgments or utilizes different estimates in determining the allowances for returns and price protection. For example, a 1% change in our March 31, 2006 allowance for returns and price protection would impact net revenues by $1.0 million. 59 A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Notes to Consolidated Financial Statements Similarly, management must make estimates of the uncollectibility of our accounts receivable. In estimating the allowance for doubtful accounts, we analyze the age of current outstanding account balances, historical bad debts, customer concentrations, customer creditworthiness, current economic trends, and changes in our customers’ payment terms and their economic condition, as well as whether we can obtain sufficient credit insurance. Any significant changes in any of these criteria would impact management’s estimates in establish- ing our allowance for doubtful accounts. We value inventory at the lower of cost or market. We regularly review inventory quantities on hand and in the retail channel and record a provision for excess or obsolete inventory based on the future expected demand for our products. Significant changes in demand for our products would impact management’s estimates in establishing our inventory provision. Shipping and Handling Shipping and handling costs, which consist primarily of packaging and transportation charges incurred to move finished goods to customers, are included in cost of sales—product costs. Advertising Expenses We expense advertising as incurred, except for production costs associated with media advertising which are deferred and charged to expense the first time the related ad is run. Advertising expenses for the years ended March 31, 2006, 2005, and 2004 were approximately $192.6 million, $150.7 million, and $76.6 million, respectively, and are included in sales and marketing expense in the consolidated statements of operations. Investment Income, Net Investment income, net is comprised of the following, (amounts in thousands): 60 For the years ended March 31, Interest income Interest expense Net realized gain on investments Investment income, net 2006 2005 2004 $ 26,595 (262) 4,297 $ 12,898 (277) 471 $ 6,502 (348) 21 $ 30,630 $ 13,092 $ 6,175 Income Taxes We account for income taxes using SFAS No. 109, “Accounting for Income Taxes.” Under SFAS No. 109, income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry- forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Foreign Currency Translation The functional currencies of our foreign subsidiaries are their local currencies. All assets and liabilities of our foreign subsidiaries are translated into U.S. dollars at the exchange rate in effect at the end of the period, and revenue and expenses are translated at weighted average exchange rates during the period. The resulting translation adjustments are reflected as a component of accumulated other comprehensive income (loss) in shareholders’ equity. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Comprehensive Income Comprehensive income includes net income, unrealized appreciation (depreciation) on short-term investments, foreign currency translation adjustments, and, if applicable, the effective portion of gains or losses on cash flow hedges that are presented as a component of accumulated other comprehensive income (loss) in share- holders’ equity. Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities or the disclosure of gain or loss contingencies at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Earnings Per Common Share Basic earnings per share is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding for all periods. Diluted earnings per share is computed by divid- ing income available to common shareholders by the weighted average number of common shares outstanding, increased by common stock equivalents. Common stock equivalents are calculated using the treasury stock method and represent incremental shares issuable upon exercise of our outstanding options and warrants and, if applicable in the period, conversion of our convertible debt. However, potential common shares are not included in the denominator of the diluted earnings per share calculation when inclusion of such shares would be anti-dilutive, such as in a period in which a net loss is recorded. Stock-Based Compensation and Pro Forma Information Under SFAS No. 123, “Accounting for Stock-Based Compensation,” compensation expense is recorded for the issuance of stock options and other stock-based compensation in accordance with either the fair value method specified in SFAS No. 123 or in accordance with the intrinsic value method specified in Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.” Under the intrinsic value method, compensation expense is recorded on the date of grant or measurement date only if the current market price of the underlying stock exceeds the stock option or other stock-based compensation exercise price. If the grant date stock price exceeds the strike price, then the intrinsic value is equal to the positive difference between these two values. At March 31, 2006, we awarded several stock-based employee compensation plans, which are described more fully in Note 14. We account for those plans under the recognition and measure- ment principles of APB Opinion No. 25 and related Interpretations. The following table illustrates the effect on net income and earnings per share if we had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation (in thousands, except per share data): 61 For the years ended March 31, Net income, as reported Add: Stock-based employee compensation expense included in reported net income, net of related tax effects Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects Pro forma net income Earnings per share Basic—as reported Basic—pro forma Diluted—as reported Diluted—pro forma 2006 2005 2004 $ 41,899 $ 138,335 $ 77,715 — 64 192 (17,939) (15,435) (18,303) $ 23,960 $ 122,964 $ 59,604 $ $ $ $ 0.15 0.09 0.14 0.08 $ $ $ $ 0.55 0.49 0.50 0.44 $ $ $ $ 0.33 0.25 0.30 0.23 A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Notes to Consolidated Financial Statements For disclosure purposes, prior to April 1, 2005, the fair value of options granted was estimated at the date of grant using the Modified Black-Scholes option pricing model as specified in SFAS 123. As of April 1, 2005, we switched to a binomial-lattice model to estimate the fair value of options granted from that date forward. The fair value of options granted in the years ended March 31, 2006, 2005, and 2004 has been estimated at the date of grant using the following weighted average assumptions: Employee and Director Options and Warrants Employee Stock Purchase Plan 2006 2005 2004 2006 2005 2004 Expected life (in years) Risk free interest rate Volatility Dividend yield 5 4 3 5.17% 3.25% 2.01% 49% 48% — — 48% — 0.5 0.5 0.5 3.05% 2.66% 1.75% 51% 46% — — 42% — 62 Both the binomial-lattice model and the Black-Scholes option-pricing model require the input of highly subjec- tive assumptions, including the expected stock price volatility. To estimate volatility for the binomial-lattice model, we use methods or capabilities that are discussed in SFAS 123R (“Statement No. 123(R), Share-Based Payment”). These methods included the implied volatility method based upon the volatilities for exchange- traded options on our stock to estimate short-term volatility, the historical method (annualized standard deviation of the instantaneous returns on Activision’s stock) to estimate long-term volatility and a statistical model to estimate the transition or “mean reversion” from short-term volatility to long-term volatility. Based on these methods, for options granted during the quarters in the year ended March 31, 2006, the expected stock price volatility ranged from 40% to 55%, with a weighted average volatility of 48% for options granted during the quarters in the year ended March 31, 2006. For the Black-Scholes option-pricing model used for options granted in each of the quarters in the year ended March 31, 2005, the historical stock price volatility used was based on weekly stock price observation, using an average of the high and low stock prices of our common stock, which resulted in an expected stock price volatility ranging from 45% to 48%. For purposes of the above pro forma disclosure, the fair value of options granted is amortized to stock-based employee compensation cost over the period(s) in which the related employee services are rendered. Accordingly, the pro forma stock-based compensation cost for any period will typically depend on options granted in both the current period and prior periods. For options granted during fiscal 2006, 2005, and 2004, the per share weighted average fair value of options with exercise prices equal to market value on the date of grant was $4.90, $3.08, and $1.56, respectively. The per share weighted average estimated fair value of Employee Stock Purchase Plan shares granted during the years ended March 31, 2006, 2005, and 2004 was $3.11, $1.59, and $0.85, respectively. The effects on pro forma disclosures of applying SFAS No. 123 may not be representative of the effects on actual compensation expense of applying SFAS No. 123R in future years. Common stock warrants are granted from time to time to non-employees in connection with the development of software and acquisition of licensing rights for intellectual property. In accordance with EITF No. 96-18, “Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring or in Connection With Selling Goods or Services,” the fair value of common stock warrants granted is determined as of the measurement date and is capitalized, expensed and amortized consistent with our policies relating to software development and intellectual property license costs. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Restricted Stock In June 2005, we issued the rights to 155,763 shares of restricted stock to an employee. Additionally, in October 2005, we issued the rights to 96,712 shares of restricted stock to an employee. These shares vest over a five-year period and remain subject to forfeiture if vesting conditions are not met. In accordance with APB No. 25, we recognize unearned compensation in connection with the grant of restricted shares equal to the fair value of our common stock on the date of grant. The fair value of these shares when issued was approxi- mately $12.84 and $15.51 per share, respectively, and resulted in a total increase in “Additional paid-in capital” and “Unearned compensation” on the accompanying balance sheet of $3.5 million. Over the vesting period, we reduce unearned compensation and recognize compensation expense. For the year ended March 31, 2006, we recorded expense related to these shares of approximately $467,000 in “General and administrative” on the accompanying statements of operations. 2. Stock Splits In April 2003, the Board of Directors approved a three-for-two split of our outstanding common shares effected in the form of a 50% stock dividend. The split was paid on June 6, 2003 to shareholders of record as of May 16, 2003. In February 2004, the Board of Directors approved a second three-for-two split of our out- standing common shares effected in the form of a 50% stock dividend. The split was paid on March 15, 2004 to shareholders of record as of February 23, 2004. In February 2005, the Board of Directors approved a four- for-three split of our outstanding common shares effected in the form of a 331⁄3% stock dividend. The split was paid March 22, 2005 to shareholders of record as of March 7, 2005. In September 2005, the Board of Directors approved a four-for-three split of our outstanding common shares effected in the form of a 331⁄3% stock dividend. The split was paid October 24, 2005 to shareholders of record as of October 10, 2005. The par value of our common stock was maintained at the pre-split amount of $.000001. The Consolidated Financial Statements and Notes thereto, including all share and per share data, have been restated as if the stock splits had occurred as of the earliest period presented. 63 On March 7, 2005, in connection with our March 22, 2005 stock split, all shares of common stock held as treasury stock were formally cancelled and restored to the status of authorized but unissued shares of common stock. 3. Acquisitions During the three years ended March 31, 2006, we separately completed the acquisition of four privately held interactive software development companies. We accounted for these acquisitions in accordance with SFAS No. 141, “Business Combinations.” SFAS No. 141 addresses financial accounting and reporting for business combinations, requiring that the purchase method be used to account and report for all business combinations. These acquisitions have further enabled us to implement our multi-platform development strategy by bolstering our internal product development capabilities for console systems and personal computers and strengthening our position in the first-person action, action/adventure, and action sports game categories. A significant por- tion of the purchase price for all of these acquisitions was assigned to goodwill as the primary asset we acquired in each of the transactions was an assembled workforce with proven technical and design talent with a history of high quality product creation. Pro forma consolidated statements of operations for these acquisitions are not shown, as they would not differ materially from reported results. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Notes to Consolidated Financial Statements 4. Cash, Cash Equivalents, and Short-Term Investments The following table summarizes our cash, cash equivalents and short-term investments as of March 31, 2006 (amounts in thousands): Cash and cash equivalents: Cash and time deposits Commercial paper Money market instruments U.S. agency issues Cash and cash equivalents Short-term investments: U.S. agency issues Corporate bonds Mortgage-backed securities Common stock Asset-backed securities Commercial paper Certificate of deposit Restricted cash 64 Short-term investments Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Fair Value $162,403 141,086 37,560 13,436 354,485 259,055 171,207 55,139 47,868 16,866 15,016 10,468 7,500 583,119 $ — 4 — — $ — $ 162,403 140,935 37,560 13,433 (155) — (3) 4 (158) 354,331 — 1 — 12,880 — — — — 12,881 (3,444) (1,376) (459) — (47) (26) (19) — (5,371) 255,611 169,832 54,680 60,748 16,819 14,990 10,449 7,500 590,629 Cash, cash equivalents and short-term investments $937,604 $12,885 $ (5,529) $ 944,960 The following table summarizes our cash, cash equivalents and short-term investments as of March 31, 2005 (amounts in thousands): Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Fair Value Cash and cash equivalents: Cash and time deposits Money market funds Commercial paper Corporate bonds Cash and cash equivalents Short-term investments: Auction rate notes Corporate bonds U.S. agency issues Asset-backed securities Municipal bonds Common stock Short-term investments $180,871 107,519 21,589 3,638 313,617 15,020 160,907 266,837 83,517 4,019 167 530,467 Cash, cash equivalents and short-term investments $844,084 $ $ — — — — — — 6 — 23 — 895 924 924 $ — $ 180,871 107,519 21,582 3,636 — (7) (2) (9) 313,608 — (1,602) (2,037) (496) — — (4,135) 15,020 159,311 264,800 83,044 4,019 1,062 527,256 $ (4,144) $ 840,864 A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Auction rate securities are securities that are structured with short-term reset dates of generally less than 90 days but with maturities in excess of 90 days. At the end of the reset period, investors can sell or continue to hold the securities at par. These securities are classified in the table below based on their legal stated maturity dates. The following table summarizes the final maturities of our investments in debt securities as of March 31, 2006 (amounts in thousands): Due in one year or less Due after one year through two years Due after two years through three years Due in three years or more Asset-backed securities Total investments in debt securities Amortized Cost Fair Value $412,677 169,967 — 17,156 599,800 72,005 $410,504 167,740 — 16,557 594,801 71,499 $671,805 $666,300 For the year ended March 31, 2006, net realized gains on investments consisted of $4.3 million of gross realized gains and no gross realized losses. For the year ended March 31, 2005, net realized gains on investments con- sisted of $471,000 of gross realized gains and no gross realized losses. For the year ended March 31, 2004, net realized gains on investments consisted of $25,000 of gross realized gains and $4,000 of gross realized losses. In accordance with EITF 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” the fair value of investments in an unrealized loss position for which an other-than- temporary impairment has not been recognized was $672.4 million and $508.2 million at March 31, 2006 and 2005, respectively, with related gross unrealized losses of $5.5 million and $4.1 million, respectively. At March 31, 2006, the gross unrealized losses were comprised mostly of unrealized losses on U.S. agency issues, corporate bonds, and mortgage-backed securities with $3.9 million of unrealized loss being in a continuous unrealized loss position for twelve months or greater. At March 31, 2005, the gross unrealized losses were comprised mostly of unrealized losses on corporate bonds, U.S. agency issues, and asset-backed securities with $464,000 of unrealized loss being in a continuous unrealized loss position for twelve months or greater. 65 The Company’s investment portfolio usually consists of government and corporate securities with effective maturities less than 30 months. The longer the term of the securities, the more susceptible they are to changes in market rates of interest and yields on bonds. Investments are reviewed periodically to identify possible impairment. When evaluating the investments, the Company reviews factors such as the length of time and extent to which fair value has been below cost basis, the financial condition of the issuer, and the Company’s ability and intent to hold the investment for a period of time which may be sufficient for anticipated recovery in market value. The Company has the intent and ability to hold these securities for a reasonable period of time sufficient for a forecasted recovery of fair value up to (or beyond) the initial cost of the investment. The Company expects to realize the full value of all of these investments upon maturity or sale. 5. Software Development Costs and Intellectual Property Licenses As of March 31, 2006, capitalized software development costs included $45.0 million of internally developed software costs and $15.6 million of payments made to third-party software developers. As of March 31, 2005, capitalized software development costs included $61.3 million of internally developed software costs and $30.3 million of payments made to third-party software developers. Capitalized intellectual property licenses were $87.0 million and $35.7 million as of March 31, 2006 and 2005, respectively. Amortization and write-offs of capitalized software development costs and intellectual property licenses, combined, was $173.6 million, $134.8 million, and $87.9 million for the years ended March 31, 2006, 2005, and 2004, respectively. Amorti- zation and write-offs of capitalized software development costs and intellectual property licenses for the year ended March 31, 2006 included product cancellation charges, exclusive of termination fees, of $10.3 million, impairment charges of $8.8 million, and recoverability write-offs of $3.8 million. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Notes to Consolidated Financial Statements 6. Inventories Our inventories consist of the following (amounts in thousands): As of March 31, Finished goods Purchased parts and components 2006 2005 $ 58,876 2,607 $ 45,926 2,092 $ 61,483 $ 48,018 For the year ended March 31, 2006, we had write-downs of inventory costs for certain titles in the amount of $14.5 million. For the year ended March 31, 2005, we had write-downs of inventory costs for certain titles in the amount of $3.6 million. 7. Property and Equipment, Net Property and equipment, net was comprised of the following (amounts in thousands): As of March 31, Land Buildings Leasehold improvements Computer equipment Office furniture and other equipment Total cost of property and equipment 66 Less accumulated depreciation Property and equipment, net $ 2006 557 4,463 18,904 50,795 18,480 $ 2005 592 4,684 9,391 39,696 14,560 93,199 (47,831) 68,923 (38,433) $ 45,368 $ 30,490 Depreciation expense for the years ended March 31, 2006, 2005, and 2004 was $14.2 million, $10.6 million, and $10.0 million, respectively. 8. Goodwill The changes in the carrying amount of goodwill were as follows (amounts in thousands): Balance as of March 31, 2004 Goodwill acquired during the year Issuance of contingent consideration Adjustment—prior period purchase allocation Effect of foreign currency exchange rates Balance as of March 31, 2005 Goodwill acquired during the year Issuance of contingent consideration Adjustment—prior period purchase allocation Effect of foreign currency exchange rates Publishing Distribution Total $ 70,898 16,194 1,191 (2,384) — 85,899 6,459 2,793 (260) 203 $5,595 — — — 167 5,762 — — — (410) $ 76,493 16,194 1,191 (2,384) 167 91,661 6,459 2,793 (260) (207) Balance as of March 31, 2006 $ 95,094 $5,352 $100,446 A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T 9. Accrued Expenses Accrued expenses were comprised of the following (amounts in thousands): As of March 31, Accrued royalties payable Accrued selling and marketing costs Affiliate label program payable Income tax payable Accrued payroll related costs Accrued customer payments Accrued professional and legal costs Other Total accrued expenses 2006 2005 $ 8,961 24,637 1,121 2,253 31,741 5,077 11,568 17,811 $ 11,851 17,521 20,605 3,977 22,452 — 3,950 17,711 $ 103,169 $ 98,067 10. Operations by Reportable Segments and Geographic Area We operate two business segments: (i) publishing of interactive entertainment software and (ii) distribution of interactive entertainment software and hardware products. Publishing refers to the development, marketing, and sale of products directly, by license or through our affiliate label program with certain third-party publishers. In the United States, we primarily sell our products on a direct basis to mass-market retailers, consumer electronics stores, discount warehouses, and game specialty stores. We conduct our international publishing activities through offices in the UK, Germany, France, Italy, Spain, the Netherlands, Australia, Sweden, Canada, and Japan. Our products are sold internationally on a direct-to-retail basis and through third-party distribution and licensing arrangements and through our wholly- owned distribution subsidiaries located in the UK, the Netherlands, and Germany. 67 Distribution refers to our operations in the UK, the Netherlands, and Germany that provide logistical and sales services to third-party publishers of interactive entertainment software, our own publishing operations, and manufacturers of interactive entertainment hardware. Resources are allocated to each of these segments using information on their respective net revenues and oper- ating profits before interest and taxes. The accounting policies of these segments are the same as those described in the Summary of Significant Accounting Policies. Transactions between segments are eliminated in consolidation. Information on the reportable segments for the three years ended March 31, 2006 is as follows (amounts in thousands): For the year ended March 31, 2006 Total segment revenues Revenue from sales between segments Revenues from external customers Operating income (loss) Total assets Publishing Distribution Total $ 1,154,663 (131,631) $ 313,337 131,631 $ 1,468,000 — $ 1,023,032 $ 444,968 $ 1,468,000 $ (3,984) $ 21,941 $ 17,957 $ 1,294,282 $125,241 $ 1,419,523 A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Notes to Consolidated Financial Statements For the year ended March 31, 2005 Total segment revenues Revenue from sales between segments Revenues from external customers Operating income Total assets For the year ended March 31, 2004 Total segment revenues Revenue from sales between segments Revenues from external customers Operating income Total assets Publishing Distribution Total $ 1,072,729 (111,676) $ 333,128 111,676 $ 1,405,857 — $ 961,053 $ 444,804 $ 1,405,857 $ 160,826 $ 23,745 $ 184,571 $ 1,174,910 $ 132,053 $ 1,306,963 $ 665,732 (67,859) $ 281,924 67,859 $ 947,656 — $ 597,873 $ 349,783 $ 947,656 $ 93,223 $ 16,594 $ 109,817 $ 859,874 $ 108,943 $ 968,817 Geographic information is based on the location of the selling entity. Revenues from external customers by geographic region were as follows (amounts in thousands): For the years ended March 31, North America Europe Other 68 Total Revenues by platform were as follows (amounts in thousands): For the years ended March 31, Console Hand-held PC Total 2006 2005 2004 $ 710,040 717,494 40,466 $ 696,325 675,074 34,458 $ 446,812 479,224 21,620 $ 1,468,000 $ 1,405,857 $ 947,656 2006 2005 2004 $ 1,008,758 235,834 223,408 $ 970,399 161,977 273,481 $ 732,220 43,306 172,130 $ 1,468,000 $ 1,405,857 $ 947,656 A significant portion of our revenues is derived from products based on a relatively small number of popular brands each year. In fiscal 2006, 30% of our consolidated net revenues (38% of worldwide publishing net revenues) was derived from three brands, which accounted for 14%, 8%, and 8% of consolidated net revenues (18%, 10%, and 10% of worldwide publishing net revenues). In fiscal 2005, 37% of our consolidated net revenues (48% of worldwide publishing net revenues) was derived from three brands, which accounted for 16%, 11%, and 10% of consolidated net revenues (21%, 14%, and 13% of worldwide publishing net reve- nues). In fiscal 2004, 35% of our consolidated net revenues (49% of worldwide publishing net revenues) was derived from three brands, which accounted for 17%, 14%, and 4% of consolidated net revenues (24%, 20%, and 5% of worldwide publishing net revenues). A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T 11. Computation of Earnings Per Share The following table sets forth the computations of basic and diluted earnings per share (amounts in thousands, except per share data): For the years ended March 31, Numerator: 2006 2005 2004 Numerator for basic and diluted earnings per share—income available to common shareholders $ 41,899 $ 138,335 $ 77,715 Denominator: Denominator for basic earnings per share—weighted average common shares outstanding Effect of dilutive securities: Employee stock options and stock purchase plan Warrants to purchase common stock Potential dilutive common shares 273,177 250,023 236,887 25,667 593 26,260 27,546 1,291 28,837 19,631 1,070 20,701 Denominator for diluted earnings per share—weighted average common shares outstanding plus assumed conversions 299,437 278,860 257,588 Basic earnings per share Diluted earnings per share $ $ 0.15 0.14 $ $ 0.55 0.50 $ $ 0.33 0.30 Options to purchase approximately 993,000, 243,000, and 16,837,000 shares of common stock for the years ended March 31, 2006, 2005, and 2004, respectively, were not included in the calculation of diluted earnings per share because their effect would be antidilutive. 69 12. Income Taxes Domestic and foreign income before income taxes and details of the income tax provision are as follows (amounts in thousands): For the years ended March 31, Income (loss) before income taxes: Domestic Foreign Income tax expense (benefit): Current: Federal State Foreign Total current Deferred: Federal State Foreign Total deferred 2006 2005 2004 $ 55,052 (6,465) $ 174,535 23,128 $ 84,339 31,653 $ 48,587 $ 197,663 $ 115,992 $ — $ 308 4,383 4,691 (11,296) (7,289) (10,092) (28,677) (355) 342 5,126 5,113 $ 502 311 9,899 10,712 5,744 (2,707) (2,159) 878 14,113 (871) 1,906 15,148 Add back benefit credited to additional paid-in capital: Tax benefit related to stock option and warrant exercises 30,674 53,337 12,417 Income tax provision $ 6,688 $ 59,328 $ 38,277 A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Notes to Consolidated Financial Statements The items accounting for the difference between income taxes computed at the U.S. federal statutory income tax rate and the income tax provision for each of the years are as follows: For the years ended March 31, Federal income tax provision at statutory rate State taxes, net of federal benefit Research and development credits Decremental effect of foreign tax rates Increase of valuation allowance Other 2006 2005 2004 35.0% 35.0% 35.0% 2.8 4.3 (6.4) (34.2) (2.3) (9.9) 2.3 15.0 (1.4) 3.6 2.3 (8.0) (2.3) 5.8 0.2 13.8% 30.0% 33.0% Deferred income taxes reflect the net tax effects of temporary differences between the amounts of assets and liabilities for accounting purposes and the amounts used for income tax purposes. The components of the net deferred tax asset and liability are as follows (amounts in thousands): As of March 31, Deferred asset: Allowance for doubtful accounts Allowance for sales returns Inventory reserve Vacation and bonus reserve Amortization and depreciation Tax credit carryforwards Net operating loss carryforwards Other 70 Deferred asset Valuation allowance Net deferred asset Deferred liability: Capitalized research expenses State taxes Deferred liability Net deferred asset 2006 2005 $ 739 16,200 2,474 4,993 3,970 74,488 18,729 6,209 $ 205 8,580 391 2,961 4,306 53,130 31,885 3,899 127,802 (35,555) 105,357 (25,666) 92,247 79,691 22,537 6,233 28,770 41,208 3,682 44,890 $ 63,477 $ 34,801 The tax benefits associated with certain net operating loss carryovers relate to employee stock options. Pursuant to SFAS No. 109, net operating losses do not include $30.9 million relating to these items which will be credited to additional paid-in capital when realized. As of March 31, 2006, our available federal net operating loss carryforward of approximately $87.7 million is subject to certain limitations as defined under Section 382 of the Internal Revenue Code. The net operating loss carryforwards expire between 2020 and 2024. We have various state net operating loss carryforwards totaling $51.0 million which are not subject to limitations under Section 382 of the Internal Revenue Code. We have tax credit carryforwards of $43.7 million and $31.4 million for federal and state purposes, respec- tively, which begin to expire in 2008. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T At March 31, 2006, our deferred income tax asset for tax credit carryforwards and net operating loss carry- forwards was reduced by a valuation allowance of $35.6 million as compared to $25.7 million in the prior fiscal year. Realization of the deferred tax assets is dependent upon the continued generation of sufficient taxable income prior to expiration of tax credits and loss carryforwards. Although realization is not assured, manage- ment believes it is more likely than not that the net carrying value of the deferred tax asset will be realized. Cumulative undistributed earnings of foreign subsidiaries for which no deferred taxes have been provided approximated $68.4 million at March 31, 2006. Deferred income taxes on these earnings have not been pro- vided as these amounts are considered to be permanent in duration. On October 22, 2004, the President of the United States signed the American Jobs Creation Act of 2004 (the “Act”) which contains a number of tax law modifications with accounting implications. For companies that pay U.S. income taxes on manufacturing activities in the U.S., the Act provides a deduction from taxable income equal to a stipulated percentage of qualified income from domestic production activities. The manu- facturing deduction provided by the Act replaces the extraterritorial income (“ETI”) deduction currently in place. We currently derive benefits from the ETI exclusion which was repealed by the Act. Our exclusion for fiscal 2006 and 2007 will be limited to 75% and 45% of the otherwise allowable exclusion and no exclusion will be available in fiscal 2008 and thereafter. The Act also creates a temporary incentive for U.S. multinationals to repatriate accumulated income earned abroad by providing an 85% dividends received deduction for cer- tain dividends from controlled foreign corporations (“Homeland Investment Act”). The deduction is subject to a number of limitations. The Act also provides for other changes in tax law that will affect a variety of taxpayers. On December 21, 2004, the Financial Accounting Standards Board (“FASB”) issued two FASB Staff Positions (“FSP”) regarding the accounting implications of the Act related to (1) the deduction for quali- fied domestic production activities and (2) the one-time tax benefit for the repatriation of foreign earnings. The FASB determined that the deduction for qualified domestic production activities should be accounted for as a special deduction under FASB Statement No. 109, “Accounting for Income Taxes.” The FASB also confirmed, that upon deciding that some amount of earnings will be repatriated, a company must record in that period the associated tax liability. The guidance in the FSPs apply to financial statements for periods ending after the date the Act was enacted. We have evaluated the Act and have concluded that we will not repatriate foreign earnings under the Homeland Investment Act Provisions. 71 13. Commitments and Contingencies Credit Facilities We have revolving credit facilities with our Centresoft subsidiary located in the UK (the “UK Facility”) and our NBG subsidiary located in Germany (the “German Facility”). The UK Facility provided Centresoft with the ability to borrow up to Great British Pounds (“GBP”) 12.0 million ($21.0 million) and GBP 8.0 million ($15.0 million), including issuing letters of credit, on a revolving basis as of March 31, 2006 and 2005, respectively. Furthermore, under the UK Facility, Centresoft provided a GBP 0.6 million ($1.0 million) and a GBP 0.6 million ($1.1 million) guarantee for the benefit of our CD Contact subsidiary as of March 31, 2006 and 2005, respectively. The UK Facility bore interest at LIBOR plus 2.0% as of March 31, 2006 and 2005, is collateralized by substantially all of the assets of the subsidiary and expires in January 2007. The UK Facility also contains various covenants that require the subsidiary to maintain specified financial ratios related to, among others, fixed charges. As of March 31, 2006 and 2005, we were in compliance with these covenants. No borrowings were outstanding against the UK Facility as of March 31, 2006 or 2005. The German Facility provided for revolving loans up to EUR 0.5 million ($0.6 million) as of both March 31, 2006 and 2005, bore interest at a Eurocurrency rate plus 2.5%, is collateralized by certain of the subsidiary’s property and equip- ment and has no expiration date. No borrowings were outstanding against the German Facility as of March 31, 2006 or 2005. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Notes to Consolidated Financial Statements As of March 31, 2006, we maintained a $7.5 million irrevocable standby letter of credit. As of March 31, 2005, we did not maintain this standby letter of credit. The standby letter of credit is required by one of our inventory manufacturers to qualify for payment terms on our inventory purchases. Under the terms of this arrangement, we are required to maintain on deposit with the bank a compensating balance, restricted as to use, of not less than the sum of the available amount of the letter of credit plus the aggregate amount of any drawings under the letter of credit that have been honored thereunder but not reimbursed. At March 31, 2006, the $7.5 mil- lion deposit is included in short-term investments as restricted cash. As of March 31, 2006, our publishing subsidiary located in the UK maintained a EUR 2.5 million ($3.0 mil- lion) irrevocable standby letter of credit. As of March 31, 2005, we did not maintain this standby letter of credit. The standby letter of credit is required by one of our inventory manufacturers to qualify for payment terms on our inventory purchases. The standby letter of credit does not require a compensating balance and is collateralized by substantially all of the assets of the subsidiary and expires in July 2006. As of March 31, 2006, we had EUR 1.0 million ($1.2 million) of outstanding amount against this letter of credit. Commitments In the normal course of business, we enter into contractual arrangements with third parties for non-cancelable operating lease agreements for our offices, for the development of products, as well as for the rights to intel- lectual property. Under these agreements, we commit to provide specified payments to a lessor, developer, or intellectual property holder, based upon contractual arrangements. Typically, the payments to third-party developers are conditioned upon the achievement by the developers of contractually specified development milestones. These payments to third-party developers and intellectual property holders typically are deemed to be advances and are recoupable against future royalties earned by the developer or intellectual property holder based on the sale of the related game. Additionally, in connection with certain intellectual property right acquisitions and development agreements, we will commit to spend specified amounts for marketing support for the related game(s) which is to be developed or in which the intellectual property will be utilized. Additionally, we lease certain of our facilities and equipment under non-cancelable operating lease agree- ments. Assuming all contractual provisions are met, the total future minimum commitments for these and other contractual arrangements in place as of March 31, 2006, are scheduled to be paid as follows (amounts in thousands): 72 Fiscal year ending March 31, 2007 2008 2009 2010 2011 Thereafter Total Contractual Obligations Facility & Equipment Leases $12,980 13,443 12,652 11,709 9,415 21,651 $81,850 Developer and IP $ 39,905 11,022 16,300 23,300 19,300 35,600 $145,427 Marketing Total $17,120 44,580 6,100 100 100 — $68,000 $ 70,005 69,045 35,052 35,109 28,815 57,251 $ 295,277 Facilities rent expense for the years ended March 31, 2006, 2005, and 2004 was approximately $14.2 million, $10.6 million, and $8.7 million, respectively. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Compensation Guarantee In June 2005, we entered into an employment agreement with the President and Chief Executive Officer of Activision Publishing, Inc. containing a guarantee related to total compensation. The agreement guarantees that in the event that on May 15, 2010 total compensation has not exceeded $20.0 million, we will make a payment for the amount of the shortfall. The $20.0 million guarantee will be recognized as compensation expense evenly over the term of the employment agreement comprising of salary payments, bonus payments, restricted stock expense, stock option expense, and an accrual for any anticipated remaining portion of the guarantee. The remaining portion of the guarantee is accrued over the term of the agreement in “Other liabilities” and will remain accrued until the end of the employment agreement at which point it will be used to make a payment for any shortfall or reclassified into shareholders’ equity. Legal Proceedings On March 5, 2004, a class action lawsuit was filed against us and certain of our current and former officers and directors. The complaint, which asserts claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 based on allegations that our revenues and assets were overstated during the period between February 1, 2001 and December 17, 2002, was filed in the United States District Court, Central District of California by the Construction Industry, and Carpenters Joint Pension Trust for Southern Nevada purporting to represent a class of purchasers of Activision stock. Five additional purported class actions were subsequently filed by Gianni Angeloni, Christopher Hinton, Stephen Anish, the Alaska Electrical Pension Fund, and Joseph A. Romans asserting the same claims. Consistent with the Private Securities Litigation Reform Act (“PSLRA”), the court appointed lead plaintiffs consolidating the six putative securities class actions into a single case. In an Order dated May 16, 2005, the court dismissed the consolidated complaint because the plaintiffs failed to satisfy the heightened pleading standards of the PSLRA. The court did, however, give the lead plaintiffs leave to file an amended consolidated complaint within 30 days of the order. Rather than file a new complaint, the Plaintiff agreed to dismiss the entire case with prejudice. The Order dismissing the action with prejudice was entered on June 17, 2005. 73 In addition, on March 12, 2004, a shareholder derivative lawsuit captioned Frank Capovilla, Derivatively on Behalf of Activision, Inc. v. Robert Kotick, et al. was filed, purportedly on behalf of Activision, which in large measure asserts the identical claims set forth in the federal class action lawsuit. That complaint was filed in California Superior Court for the County of Los Angeles. On August 11, 2005, in light of the ruling dismissing with prejudice the complaint in the earlier filed federal securities class action, plaintiffs in the shareholder derivative action filed an amended complaint, dropping most of the causes of action, and focusing only on the allegations of insider trading and breaches of fiduciary duty that were based on the same claimed misrepresen- tations set forth in the dismissed federal securities class action. On September 15, 2005, Activision and the individual defendants filed separate demurrers to the Derivative Action and a motion to strike plaintiff’s jury demand. Prior to the hearing on the demurrers, the parties came to a resolution of the action and agreed to a stipulation of settlement to be submitted to the court for preliminary approval. No cash recovery is to be paid to the plaintiff pursuant to the stipulation of settlement, which also stated that the Company vigorously denied any assertion of wrongdoing or liability. In furtherance of the settlement, the Company agreed to pay $200,000 in plaintiffs’ fees, to be funded by the Company’s D&O insurance carrier. The settlement acknowledged that, after the time the derivative action was filed, the Company implemented certain enhancements to its corporate governance policies. Notice of Settlement was mailed and emailed to shareholders as well as posted on the Company’s website. No objections to settlement were received. At a hearing held on May 22, 2006, the Court approved the settlement and released and dismissed the alleged claims. In addition, we are party to other routine claims and suits brought by us and against us in the ordinary course of business, including disputes arising over the ownership of intellectual property rights, contractual claims, employment relationships, and collection matters. In the opinion of management, after consultation with legal counsel, the outcome of such routine claims will not have a material adverse effect on our business, financial condition, results of operations, or liquidity. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Notes to Consolidated Financial Statements 14. Stock Compensation and Employee Benefit Plans Stock Option Plans We sponsor several stock option plans for the benefit of officers, employees, consultants, and others. On February 28, 1992, the shareholders of Activision approved the Activision 1991 Stock Option and Stock Award Plan, as amended, (the “1991 Plan”) which permits the granting of “Awards” in the form of non-qualified stock options, incentive stock options (“ISOs”), stock appreciation rights (“SARs”), restricted stock awards, deferred stock awards, and other common stock-based awards to directors, officers, employees, consultants, and others. The total number of shares of common stock available for distribution under the 1991 Plan is 45,400,000. The 1991 Plan requires available shares to consist in whole or in part of authorized and unissued shares or treasury shares. There were no shares remaining available for grant under the 1991 Plan as of March 31, 2006. On September 23, 1998, the shareholders of Activision approved the Activision 1998 Incentive Plan, as amended (the “1998 Plan”). The 1998 Plan permits the granting of “Awards” in the form of non-qualified stock options, ISOs, SARs, restricted stock awards, deferred stock awards, and other common stock-based awards to directors, officers, employees, consultants, and others. The total number of shares of common stock available for distribution under the 1998 Plan is 18,000,000. The 1998 Plan requires available shares to con- sist in whole or in part of authorized and unissued shares or treasury shares. There were approximately 9,500 shares remaining available for grant under the 1998 Plan as of March 31, 2006. 74 On April 26, 1999, the Board of Directors approved the Activision 1999 Incentive Plan, as amended (the “1999 Plan”). The 1999 Plan permits the granting of “Awards” in the form of non-qualified stock options, ISOs, SARs, restricted stock awards, deferred share awards, and other common stock-based awards to direc- tors, officers, employees, consultants, and others. The total number of shares of common stock available for distribution under the 1999 Plan is 30,000,000. The 1999 Plan requires available shares to consist in whole or in part of authorized and unissued shares or treasury shares. There were approximately 103,800 shares remaining available for grant under the 1999 Plan as of March 31, 2006. On August 23, 2001, the shareholders of Activision approved the Activision 2001 Incentive Plan, as amended (the “2001 Plan”). The 2001 Plan permits the granting of “Awards” in the form of non-qualified stock options, ISOs, SARs, restricted stock awards, deferred stock awards, and other common stock-based awards to directors, officers, employees, consultants, and others. The total number of shares of common stock avail- able for distribution under the 2001 Plan is 9,000,000. The 2001 Plan requires available shares to consist in whole or in part of authorized and unissued shares or treasury shares. There were approximately 421,700 shares remaining available for grant under the 2001 Plan as of March 31, 2006. On April 4, 2002, the Board of Directors approved the Activision 2002 Incentive Plan (the “2002 Plan”). The 2002 Plan permits the granting of “Awards” in the form of non-qualified stock options, ISOs, SARs, restricted stock awards, deferred share awards, and other common stock-based awards to officers (other than executive officers), employees, consultants, advisors, and others. The 2002 Plan requires available shares to consist in whole or in part of authorized and unissued shares or treasury shares. The total number of shares of common stock available for distribution under the 2002 Plan is 17,400,000. There were approximately 625,700 shares remaining available for grant under the 2002 Plan as of March 31, 2006. On September 19, 2002, the shareholders of Activision approved the Activision 2002 Executive Incentive Plan (the “2002 Executive Plan”). The 2002 Executive Plan permits the granting of “Awards” in the form of non-qualified stock options, ISOs, SARs, restricted stock awards, deferred share awards, and other common stock-based awards to officers, employees, directors, consultants, and advisors. The total number of shares of common stock available for distribution under the 2002 Executive Plan is 10,000,000. The 2002 Executive A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Plan requires available shares to consist in whole or in part of authorized and unissued shares or treasury shares. There were approximately 8,700 shares remaining available for grant under the 2002 Executive Plan as of March 31, 2006. On December 16, 2002, the Board of Directors approved the Activision 2002 Studio Employee Retention Incentive Plan, as amended (the “2002 Studio Plan”). The 2002 Studio Plan permits the granting of “Awards” in the form of non-qualified stock options and restricted stock awards to key studio employees (other than executive officers) of Activision, our subsidiaries and affiliates, and to contractors and others. The 2002 Studio Plan requires available shares to consist in whole or in part of authorized and unissued shares or trea- sury shares. The total number of shares of common stock available for distribution under the 2002 Studio Plan is 6,000,000. There were approximately 4,200 shares remaining available for grant under the 2002 Studio Plan as of March 31, 2006. On April 29, 2003, our Board of Directors approved the Activision 2003 Incentive Plan (the “2003 Plan”). On September 15, 2005, the shareholders of Activision approved the 2003 Plan. The 2003 Plan permits the granting of “Awards” in the form of non-qualified stock options, SARs, restricted stock awards, deferred stock awards, and other common stock-based awards to directors, officers, employees, consultants, and others. The 2003 Plan requires available shares to consist in whole or in part of authorized and unissued shares or treasury shares. The total number of shares of common stock available for distribution under the 2003 Plan is 24,000,000. There were approximately 13,232,900 shares remaining available for grant under the 2003 Plan as of March 31, 2006. The exercise price for Awards issued under the 1991 Plan, 1998 Plan, 1999 Plan, 2001 Plan, 2002 Plan, 2002 Executive Plan, 2002 Studio Plan, and 2003 Plan (collectively, the “Plans”) is determined at the discretion of the Board of Directors (or the Compensation Committee of the Board of Directors, which administers the Plans), and for ISOs, is not to be less than the fair market value of our common stock at the date of grant, or in the case of non-qualified options, must exceed or be equal to 85% of the fair market value of our common stock at the date of grant. Options typically become exercisable in installments over a period not to exceed seven years and must be exercised within 10 years of the date of grant. Historically, stock options have been granted with exercise prices equal to or greater than the fair market value at the date of grant. 75 Other Employee Stock Options In connection with prior employment agreements between Activision and Robert A. Kotick, Activision’s Chairman and Chief Executive Officer, and Brian G. Kelly, Activision’s Co-Chairman, Mr. Kotick and Mr. Kelly were granted options to purchase common stock. The Board of Directors approved the granting of these options. Relating to such grants, as of March 31, 2006, approximately 8,304,800 shares were outstanding with a weighted average exercise price of $1.74. We additionally have approximately 35,400 options outstanding to employees as of March 31, 2006, with a weighted average exercise price of $3.48. The Board of Directors approved the granting of these options. Such options have terms similar to those options granted under the Plans. Employee Stock Purchase Plans On April 1, 2005, the Board of Directors approved the Second Amended and Restated 2002 Employee Stock Purchase Plan (the “Amended 2002 Purchase Plan”) for eligible Employees. Under the Amended 2002 Purchase Plan, up to 500,000 shares of our common stock may be purchased by eligible employees during two six-month offering periods that commence each April 1 and October 1 (the “Offering Period”). The first day of each Offering Period is referred to as the “Offering Date.” Common stock is purchased by the Amended 2002 Purchase Plans participants at 85% of the lesser of fair market value on the Offering Date for the Offering Period that includes the common stock purchase date or the fair market value on the common stock A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Notes to Consolidated Financial Statements purchase date. Employees may purchase shares having a value not exceeding 15% of their gross compensation during an Offering Period, limited to a maximum of $10,000 in value for any two purchases within the same calendar year. During the year ended March 31, 2006, employees purchased approximately 101,800 and 282,900 shares at a price of $9.83 and $11.72 per share, respectively, within the Amended 2002 Purchase Plans’ Offering Periods. Prior to the Amended 2002 Purchase Plan, on January 22, 2002, the Board of Directors approved the 2002 Employee Stock Purchase Plan for eligible domestic employees. The shareholders of Activision subsequently approved the 2002 Employee Stock Purchase Plan on September 19, 2002. Then, on February 11, 2003, the Board of Directors approved the 2002 Employee Stock Purchase Plan For International Employees. The pri- mary terms of the 2002 Employee Stock Purchase Plan and the 2002 Employee Stock Purchase Plan For International Employees (collectively the “2002 Purchase Plans”) are the same. Under the 2002 Purchase Plans, up to 1,125,000 shares of our common stock may be purchased by eligible employees during two over- lapping, twelve-month offering periods that commence each April 1 and October 1 (the “Offering Period”). At any point in time, employees may participate in only one Offering Period. The first day of each Offering Period is referred to as the “Offering Date.” Common stock is purchased by 2002 Purchase Plans participants at 85% of the lesser of fair market value on the Offering Date for the Offering Period that includes the com- mon stock purchase date or the fair market value on the common stock purchase date. Employees may pur- chase shares having a value not exceeding 15% of their gross compensation during an Offering Period, limited to a maximum of 15,000 common shares per common stock purchase date. During the year ended March 31, 2006, employees purchased approximately 289,200 shares at a price of $6.45 within the 2002 Purchase Plans’ Offering Period. During the year ended March 31, 2005, employees purchased approximately 197,100, 67,300 and 349,700 shares at a price of $8.84, $5.29 and $8.61 per share, respectively, within the 2002 Purchase Plans’ Offering Periods. Activity of Employee and Director Options and Warrants Activity of all employee and director options and warrants during the last three fiscal years was as follows (amounts in thousands, except weighted average exercise price amounts): 76 Outstanding at beginning of year Granted Exercised Forfeited Outstanding at end of year Exercisable at end of year 2006 2005 2004 Shares 48,772 8,728 (8,108) (1,055) 48,337 27,126 Wtd. Avg. Ex. Price $ 4.84 12.66 4.81 7.35 $ 6.20 $ 4.17 Shares 65,135 7,501 (22,167) (1,697) 48,772 25,180 Wtd. Avg. Ex. Price $3.71 8.82 2.90 4.47 $4.84 $3.92 Shares 65,263 12,080 (8,151) (4,057) 65,135 34,844 Wtd. Avg. Ex. Price $3.57 4.07 2.74 4.54 $3.71 $2.96 For the years ended March 31, 2006, 2005, and 2004, all options were granted at an exercise price equal to the fair market value on the date of grant. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T The following tables summarize information about all employee and director stock options and warrants outstanding as of March 31, 2006 (share amounts in thousands): Outstanding Options Exercisable Options Range of exercise prices: $1.00 to $1.08 $1.38 to $1.75 $1.76 to $3.48 $3.52 to $4.17 $4.17 to $5.74 $5.79 to $7.38 $7.39 to $8.58 $8.58 to $11.98 $12.02 to $15.86 $15.88 to $17.21 Remaining Wtd. Avg. Contractual Life (in years) Wtd. Avg. Exercise Price 4.11 2.98 5.86 6.66 6.63 6.30 8.02 9.07 9.35 9.52 6.56 $ 1.05 1.75 3.23 3.65 5.38 6.77 8.09 11.08 13.63 16.67 $ 6.20 Shares 721 8,217 4,907 5,899 7,962 5,225 5,197 5,114 4,864 231 48,337 Wtd. Avg. Exercise Price $ 1.05 1.75 3.18 3.70 5.41 6.75 7.89 10.96 12.62 16.45 $ 4.17 Shares 721 8,217 3,149 3,913 4,394 4,054 2,325 232 100 21 27,126 Non-Employee Warrants In prior years, we have granted stock warrants to third parties in connection with the development of soft- ware and the acquisition of licensing rights for intellectual property. The warrants generally vest upon grant and are exercisable over the term of the warrant. The exercise price of third-party warrants is generally greater than or equal to their fair market value of our common stock at the date of grant. No third-party warrants were granted during the year ended March 31, 2006. As of March 31, 2006, 936,000 third-party warrants to purchase common stock were outstanding with a weighted average exercise price of $4.54 per share. No third- party warrants were granted during the year ended March 31, 2005. As of March 31, 2005, 936,000 third-party warrants to purchase common stock were outstanding with a weighted average exercise price of $4.54 per share. No third-party warrants were granted during the year ended March 31, 2004. As of March 31, 2004, 2,736,000 third-party warrants to purchase common stock were outstanding with a weighted average exercise price of $5.35 per share. 77 In accordance with EITF 96-18, we measure the fair value of the securities on the measurement date. The fair value of each warrant is capitalized and amortized to expense when the related product is released and the related revenue is recognized. Additionally, as more fully described in Note 1, the recoverability of capitalized software development costs and intellectual property licenses is evaluated on a quarterly basis with amounts determined as not recoverable being charged to expense. In connection with the evaluation of capitalized software development costs and intellectual property licenses, any capitalized amounts for related third-party warrants are additionally reviewed for recoverability with amounts determined as not recoverable being amor- tized to expense. For the years ended March 31, 2006, 2005, and 2004, $0.5 million, $1.6 million, and $0.2 million, respectively, was amortized and included in cost of sales—software royalties and amortization and/or cost of sales—intellectual property licenses. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Notes to Consolidated Financial Statements Employee Retirement Plan We have a retirement plan covering substantially all of our eligible employees. The retirement plan is quali- fied in accordance with Section 401(k) of the Internal Revenue Code. Under the plan, employees may defer up to 92% of their pre-tax salary, but not more than statutory limits. We contribute 20% of each dollar con- tributed by a participant. Our matching contributions to the plan were approximately $1.3 million, $905,000, and $700,000 during the years ended March 31, 2006, 2005, and 2004, respectively. 15. Capital Transactions Buyback Program During fiscal 2003, our Board of Directors authorized a buyback program under which we can repurchase up to $350.0 million of our common stock. Under the program, shares may be purchased as determined by management, from time to time and within certain guidelines, in the open market or in privately negotiated transactions, including privately negotiated structured stock repurchase transactions and through transactions in the options markets. Depending on market conditions and other factors, these purchases may be commenced or suspended at any time or from time to time without prior notice. Under the buyback program, we did not repurchase any shares of our common stock in the years ended March 31, 2006 and March 31, 2005. We repurchased approximately 3.4 million shares of our common stock for $12.4 million in the year ended March 31, 2004. In addition, approximately 3.1 million shares of common stock were acquired in the year ended March 31, 2004 as a result of the settlement of $10.0 million of struc- tured stock repurchase transactions entered into in fiscal 2003. As of March 31, 2006, we had no outstanding structured stock repurchase transactions. Structured stock repurchase transactions are settled in cash or stock based on the market price of our common stock on the date of the settlement. Upon settlement, we either have our capital investment returned with a premium or receive shares of our common stock, depending, respectively, on whether the market price of our common stock is above or below a pre-determined price agreed in connection with each such transaction. These transactions are recorded in shareholders’ equity in the accompanying consolidated balance sheets. As of March 31, 2006, we had approximately $226.2 million available for utilization under the buyback program and no outstanding stock repurchase transactions. 78 Shelf Registrations In August 2003, we filed with the Securities and Exchange Commission two amended shelf registration state- ments, including the base prospectuses therein. The first shelf registration statement, on Form S-3, allows us, at any time, to offer any combination of securities described in the base prospectus in one or more offerings with an aggregate initial offering price of up to $500,000,000. Unless we state otherwise in the applicable prospectus supplement, we expect to use the net proceeds from the sale of the securities for general corporate purposes, including capital expenditures, working capital, repayment or reduction of long-term and short- term debt, and the financing of acquisitions and other business combinations. We may invest funds that we do not immediately require in marketable securities. The second shelf registration statement, on Form S-4, allows us, at any time, to offer any combination of securities described in the base prospectus in one or more offerings with an aggregate initial offering price of up to $250,000,000 in connection with our acquisition of the assets, business or securities of other companies whether by purchase, merger, or any other form of business combination. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Shareholders’ Rights Plan On April 18, 2000, our Board of Directors approved a shareholders’ rights plan (the “Rights Plan”). Under the Rights Plan, each common shareholder at the close of business on April 19, 2000, received a dividend of one right for each share of common stock held. Each right represents the right to purchase one six-hundredths (1/600) of a share, as adjusted on account of stock dividends made since the plan’s adoption, of our Series A Junior Preferred Stock at an exercise price of $6.67 per share, as adjusted on account of stock dividends made since the plan’s adoption. Initially, the rights are represented by our common stock certificates and are neither exercisable nor traded separately from our common stock. The rights will only become exercisable if a person or group acquires 15% or more of the common stock of Activision, or announces or commences a tender or exchange offer which would result in the bidder’s beneficial ownership of 15% or more of our common stock. In the event that any person or group acquires 15% or more of our outstanding common stock each holder of a right (other than such person or members of such group) will thereafter have the right to receive upon exer- cise of such right, in lieu of shares of Series A Junior Preferred Stock, the number of shares of common stock of Activision having a value equal to two times the then current exercise price of the right. If we are acquired in a merger or other business combination transaction after a person has acquired 15% or more of our common stock, each holder of a right will thereafter have the right to receive upon exercise of such right a number of the acquiring company’s common shares having a market value equal to two times the then current exercise price of the right. For persons who, as of the close of business on April 18, 2000, beneficially own 15% or more of the common stock of Activision, the Rights Plan “grandfathers” their current level of ownership, so long as they do not purchase additional shares in excess of certain limitations. We may redeem the rights for $.01 per right at any time until the first public announcement of the acquisition of beneficial ownership of 15% of our common stock. At any time after a person has acquired 15% or more (but before any person has acquired more than 50%) of our common stock, we may exchange all or part of the rights for shares of common stock at an exchange ratio of one share of common stock per right. The rights expire on April 18, 2010. 79 16. Comprehensive Income (Loss) and Accumulated Other Comprehensive Income (Loss) The components of comprehensive income (loss) were as follows (amounts in thousands): For the years ended March 31, Net income Other comprehensive income (loss): Unrealized appreciation (depreciation) on investments Foreign currency translation adjustment Other comprehensive income Comprehensive income 2006 2005 2004 $41,899 $138,335 $77,715 10,576 (5,825) 4,751 (3,317) 4,974 (37) 13,432 1,657 13,395 $46,650 $139,992 $91,110 A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Notes to Consolidated Financial Statements The components of accumulated other comprehensive income (loss) for the years ended March 31, 2006 and 2005 were as follows (amounts in thousands): Balance, March 31, 2005 Other comprehensive income (loss) Balance, March 31, 2006 Foreign Currency $14,838 (5,825) $ 9,013 Unrealized Appreciation (Depreciation) on Investments Accumulated Other Comprehensive Income (Loss) $ (3,220) 10,576 $ 7,356 $11,618 4,751 $16,369 Income taxes were not provided for foreign currency translation items as these are considered indefinite investments in non-U.S. subsidiaries. 17. Supplemental Cash Flow Information Non-cash investing and financing activities and supplemental cash flow information are as follows (amounts in thousands): For the years ended March 31, 2006 2005 2004 Non-cash investing and financing activities: Subsidiaries acquired with common stock Adjustment—prior period purchase allocation Change in unrealized appreciation (depreciation) on investments 80 Supplemental cash flow information: Cash paid for income taxes Cash received for interest, net 18. Quarterly Financial and Market Information (Unaudited) $ 2,793 (260) 10,576 $ 1,191 (2,384) (3,317) $ 3,246 — (37) $ 4,698 25,912 $ 12,178 10,543 $ 10,463 6,213 (amounts in thousands, except per share data) June 30 Sept. 30 Dec. 31 Mar. 31 For the quarters ended For the year ended Fiscal 2006: Net revenues Cost of sales Operating income (loss) Net income (loss) Basic earnings (loss) per share Diluted earnings (loss) per share Common stock price per share: High Low Fiscal 2005: Net revenues Cost of sales Operating income (loss) Net income Basic earnings per share Diluted earnings per share Common stock price per share: High Low $ 241,093 172,270 (13,448) (3,585) (0.01) (0.01) $ 222,540 141,458 (26,547) (13,242) (0.05) (0.05) $ 816,242 498,325 84,067 67,945 0.25 0.23 $ 188,125 128,309 (26,115) (9,219) (0.03) (0.03) $1,468,000 940,362 17,957 41,899 0.15 0.14 13.88 10.64 17.30 12.07 18.03 12.94 15.93 11.81 18.03 10.64 $ 211,276 119,019 15,733 11,957 0.05 0.04 $ 310,626 187,091 34,658 25,543 0.10 0.09 $ 680,094 397,292 137,079 97,262 0.39 0.35 $ 203,861 141,544 (2,899) 3,573 0.01 0.01 $1,405,857 844,946 184,571 138,335 0.55 0.50 9.61 7.74 9.23 6.84 11.53 7.02 14.04 10.19 14.04 6.84 A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T 19. Recently Issued Accounting Standards and Laws On December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued FASB Statement No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123R”), which is a revision of FASB Statement No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”). SFAS No. 123R supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and amends FASB Statement No. 95, “Statement of Cash Flows.” Generally, the approach in SFAS No. 123R is similar to the approach described in SFAS No. 123. However, SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. SFAS No. 123R permits public companies to adopt its requirements using one of two methods: • A “modified prospective” method in which compensation cost is recognized beginning with the effec- tive date (a) based on the requirements of SFAS No. 123R for all share-based payments granted after the effective date and (b) based on the requirements of SFAS No. 123 for all awards granted to employees prior to the effective date of SFAS No. 123R that remain unvested on the effective date. • A “modified retrospective” method which includes the requirements of the modified prospective method described above, but also permits entities to restate based on the amounts previously recognized under SFAS 123 for purposes of pro forma disclosures either (a) all prior periods presented or (b) prior interim periods of the year of adoption. As permitted by SFAS No. 123, prior to April 1, 2006 we accounted for share-based payments to employees using APB No. 25’s intrinsic value method and, as such, generally recognized no compensation cost for employee stock options. Accordingly, the adoption of the SFAS No. 123R fair value method will have a significant impact on our results of operations, although it will have no impact on our overall financial position. We adopted SFAS No. 123R on April 1, 2006 using the “modified prospective” approach. We currently believe that the expensing of stock-based compensation will have an impact on our Consolidated Statement of Operations similar to our pro forma disclosure under SFAS No. 123 and expect an impact in fiscal 2007 of approxi- mately $0.05 per share. 81 On November 24, 2004, the FASB issued Statement No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4” (“SFAS No. 151”). The standard requires that abnormal amounts of idle capacity and spoilage costs within inventory should be excluded from the cost of inventory and expensed when incurred. The provisions of SFAS No. 151 are applicable to inventory costs incurred during fiscal years beginning after June 15, 2005. We expect the adoption of SFAS No. 151 will not have a material impact on our financial posi- tion or results of operations. On December 15, 2004 the FASB issued Statement No. 153 (“SFAS No. 153”), “Exchanges of Nonmonetary Assets—an amendment of Accounting Principles Board Opinion No. 29.” This standard requires exchanges of productive assets to be accounted for at fair value, rather than at carryover basis, unless (1) neither the asset received nor the asset surrendered has a fair value that is determinable within reasonable limits or (2) the trans- actions lack commercial substance. The new standard is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. The adoption of SFAS No. 153 did not have a material impact on our financial position or results of operations. In May 2005, the FASB issued Statement No. 154 (“SFAS No. 154”), “Accounting Changes and Error Corrections —a replacement of APB Opinion No. 20 and FASB Statement No. 3.” SFAS No. 154 changes the require- ments for the accounting and reporting of a change in accounting principle and correction of errors. Under previous guidance, changes in accounting principle were recognized as a cumulative effect in the net income of the period of the change. The new statement requires retrospective application of changes in accounting A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Notes to Consolidated Financial Statements principle and correction of errors, limited to the direct effects of the change, to prior periods’ financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS No. 154 is effective for accounting changes and correction of errors made in fiscal years beginning after December 15, 2005. In the event that we have an accounting change or an error correction, SFAS No. 154 could have a material impact on our consolidated financial statements. On February 16, 2006, the FASB issued Statement No. 155 (“SFAS No. 155”), “Accounting for Certain Hybrid Financial Instruments—an amendment of FASB Statements No. 133 and 140.” SFAS No. 155 amends FASB Statements No. 133, “Accounting for Derivative Instruments and Hedging Activities,” and No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” to resolve issues addressed in Statement 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.” SFAS No. 155 permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation; clarifies which interest-only strips and principal-only strips are not subject to the requirements of Statement 133; establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation; clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and amends Statement 140 to eliminate the prohibition on a qualifying special purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS No. 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. We do not expect the adoption of SFAS No. 155 to have a material effect on our financial position or results of operations. 82 On March 17, 2006, the FASB issued Statement No. 156 (“SFAS No. 156”), “Accounting for Servicing of Financial Assets—an amendment of FASB Statement No. 140.” SFAS No. 156 amends Statement No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” with respect to the accounting for separately recognized servicing assets and servicing liabilities. SFAS No. 156 requires an entity to recognize a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract in certain situations; requires all separately recognized servicing assets and servicing liabilities to be initially measured at fair value, if practicable; permits either the amortization method or the fair value measurement method, as subsequent measurement methods for each class of separately recognized servicing assets and servicing liabilities; permits a one-time reclassification of avail- able-for-sale securities to trading securities by entities with recognized servicing rights; and requires separate presentation of servicing assets and servicing liabilities subsequently measured at fair value in the statement of financial position and additional disclosures for all separately recognized servicing assets and servicing liabili- ties. SFAS No. 156 is effective in the first fiscal year that begins after September 15, 2006. We do not expect the adoption of SFAS No. 156 to have a material effect on our financial position or results of operations. On October 22, 2004, the President of the United States signed the American Jobs Creation Act of 2004 (the “Act”) which contains a number of tax law modifications with accounting implications. For companies that pay U.S. income taxes on manufacturing activities in the U.S., the Act provides a deduction from taxable income equal to a stipulated percentage of qualified income from domestic production activities. The manu- facturing deduction provided by the Act replaces the extraterritorial income (“ETI”) deduction currently in place. We currently derive benefits from the ETI exclusion which was repealed by the Act. Our exclusion for fiscal 2006 and 2007 will be limited to 75% and 45% of the otherwise allowable exclusion and no exclusion will be available in fiscal 2008 and thereafter. The Act also creates a temporary incentive for U.S. multina- tionals to repatriate accumulated income earned abroad by providing an 85% dividends received deduction for certain dividends from controlled foreign corporations (“Homeland Investment Act”). The deduction is subject to a number of limitations. The Act also provides for other changes in tax law that will affect a variety of taxpayers. On December 21, 2004, the Financial Accounting Standards Board (“FASB”) issued two FASB Staff Positions (“FSP”) regarding the accounting implications of the Act related to (1) the deduction for A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T qualified domestic production activities and (2) the one-time tax benefit for the repatriation of foreign earn- ings. The FASB determined that the deduction for qualified domestic production activities should be accounted for as a special deduction under FASB Statement No. 109, “Accounting for Income Taxes.” The FASB also confirmed, that upon deciding that some amount of earnings will be repatriated, a company must record in that period the associated tax liability. The guidance in the FSPs apply to financial statements for periods ending after the date the Act was enacted. We have evaluated the Act and have concluded that we will not repatriate foreign earnings under the Homeland Investment Act Provisions. 20. Subsequent Events On May 3, 2006, we announced that MGM Interactive and EON Productions, Ltd. have awarded us the rights to develop and publish interactive entertainment games based on the James Bond license through 2014. The agreement, signed on April 11, 2006, did not have an impact on our March 31, 2006 statement of finan- cial condition or results of operations. On May 9, 2006, we announced that we have entered into an agreement, signed on May 6, 2006, to acquire video game publisher RedOctane, Inc. (“RedOctane”), the publisher of the Guitar Hero franchise. Under the terms of the agreement, RedOctane became a wholly owned subsidiary of Activision and RedOctane’s man- agement team and key employees signed long-term employment contracts with Activision. RedOctane will continue to be based in Sunnyvale, CA. The agreement, did not have an impact on our March 31, 2006 state- ment of financial condition or results of operations. 83 A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Market for Registrant’s Common Equity and Related Shareholder Matters Our common stock is quoted on the Nasdaq National Market under the symbol “ATVI.” The following table sets forth for the periods indicated the high and low reported sale prices for our common stock. As of May 31, 2006, there were approximately 2,650 holders of record of our common stock. Fiscal 2005 First Quarter ended June 30, 2004 Second Quarter ended September 30, 2004 Third Quarter ended December 31, 2004 Fourth Quarter ended March 31, 2005 Fiscal 2006 First Quarter ended June 30, 2005 Second Quarter ended September 30, 2005 Third Quarter ended December 31, 2005 Fourth Quarter ended March 31, 2006 High Low $ 9.61 9.23 11.53 14.04 $ 13.88 17.30 18.03 15.93 $ 7.74 6.84 7.02 10.19 $ 10.64 12.07 12.94 11.81 On May 31, 2006, the last reported sales price of our common stock was $13.08. Cash Dividends We paid no cash dividends in our fiscal years 2006 or 2005 nor do we anticipate paying any cash dividends at any time in the foreseeable future. We expect that earnings will be retained for the continued growth and development of the business. Future dividends, if any, will depend upon our earnings, financial condition, cash requirements, future prospects, and other factors deemed relevant by our Board of Directors. 84 Stock Splits In April 2003, the Board of Directors approved a three-for-two split of our outstanding common shares effected in the form of a 50% stock dividend. The split was paid on June 6, 2003 to shareholders of record as of May 16, 2003. In February 2004, the Board of Directors approved a second three-for-two split of our out- standing common shares effected in the form of a 50% stock dividend. The split was paid on March 15, 2004 to shareholders of record as of February 23, 2004. In February 2005, the Board of Directors approved a four- for-three split of our outstanding common shares effected in the form of a 331⁄3% stock dividend. The split was paid on March 22, 2005 to shareholders of record as of March 7, 2005. In September 2005, the Board of Directors approved a four-for-three split of our outstanding common shares effected in the form of a 331⁄3% stock dividend. The split was paid October 24, 2005 to shareholders of record as of October 10, 2005. The par value of our common stock was maintained at the pre-split amount of $.000001. All share and per share data have been restated as if the stock splits had occurred as of the earliest period presented. On March 7, 2005, in connection with our March 22, 2005 stock split, all shares of common stock held as treasury stock were formally cancelled and restored to the status of authorized but unissued shares of common stock. A C T I V I S I O N , I N C . • • 2 0 0 6 A N N U A L R E P O R T Officers Robert A. Kotick Chairman and Chief Executive Officer Brian G. Kelly Co-Chairman Michael Griffith President and Chief Executive Officer, Activision Publishing, Inc. Thomas Tippl Chief Financial Officer, Activision Publishing, Inc. Robin Kaminsky Executive Vice President, Publishing George L. Rose General Counsel and Secretary Michael J. Rowe Executive Vice President, Human Resources Board of Directors Robert A. Kotick Chairman and Chief Executive Officer Brian G. Kelly Co-Chairman Robert J. Corti Chairman of the Board, Avon Products Foundation Ronald Doornink Director and Senior Advisor, Activision, Inc. Barbara S. Isgur Former Senior Vice President, Stratagem Robert J. Morgado Chairman, Maroley Media Group Peter J. Nolan Managing Partner, Leonard Green & Partners L.P. Richard Sarnoff Executive Vice President, Random House, Inc. m o c . s r o n n o c - n a r r u c . w w w / . c n i , s r o n n o c & n a r r u c y b d e n g i s e d Corporate Information Transfer Agent Continental Stock Transfer & Trust Company 17 Battery Place New York, New York 10004 (212) 509-4000 Auditor PricewaterhouseCoopers LLP Los Angeles, California Bank US Bank Los Angeles, California Corporate Counsel Bryan Cave LLP New York, New York Corporate Headquarters Activision, Inc. 3100 Ocean Park Boulevard Santa Monica, California 90405 (310) 255-2000 Domestic Offices Albany, New York Dallas, Texas Eagan, Minnesota Eden Prairie, Minnesota Encino, California Fayetteville, Arkansas Foster City, California Los Angeles, California Madison, Wisconsin Mountain View, California New York, New York Novato, California San Francisco, California Santa Monica, California Sunnyvale, California Woodland Hills, California International Offices Bezons, France Birmingham, United Kingdom Breda, The Netherlands Burglengenfeld, Germany Legnano, Italy Madrid, Spain Ontario, Canada Quebec City, Canada Seoul, Korea Shanghai, China Stockholm, Sweden Sydney, Australia Tokyo, Japan Uxbridge, United Kingdom Venlo, The Netherlands Forward-Looking Statement The statements contained in this report that are not historical facts are “ forward-looking statements.” The company cautions readers of this report that a number of important factors could cause Activision’s actual future results to differ materially from those expressed in any such forward- looking statements. These important factors, and other factors that could affect Activision, are described in Activision’s Annual Report on Form 10-K for the fiscal year ended March 31, 2006, which was filed with the United States Securities and Exchange Commission. Readers of this Annual Report are referred to this filing. World Wide Web Site www.activision.com E-Mail IR@activision.com Annual Meeting September 14, 2006 The Beverly Hills Hotel 9641 Sunset Boulevard Beverly Hills, California 90210 Annual Report on Form 10-K Activision’s Annual Report on Form 10-K for the year ended March 31, 2006 is available to shareholders without charge upon request from our corporate offices. 3100 Ocean Park Boulevard Santa Monica, California 90405 telephone: (310) 255-2000 fax: (310) 255-2100 www.activision.com 

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