Electronic Arts Inc

Raiders Investment Associates

Software: Electronic Arts Inc. (NASDAQ, ERTS) November 05, 2004

Analysis Team Members: Norman Chow: [email protected] David Timmons: [email protected] Justin Key: [email protected] Kyle Lock: [email protected]

Table of Contents

Page 1. Executive Summary 4

1.1 Company, Industry Overview & Analysis 5

1.2 Accounting Analysis 5

1.3 Forecasting & Methodology 6

1.4 Derived Market Valuations 6

1.5 Recommendation 7

2. Business & Industry Analysis 8

2.1 Company Overview 8

2.2 Industry Overview 8 2.2.1 Trends 9

2.3 Five Forces 9 2.3.1 Current Competitors 9 2.3.2 New Entrants 10 2.3.3 Alternative Products 11 2.3.4 Customer Bargaining Power 11 2.3.5 Supplier Bargaining Power 12

2.4 Classification of Industry 12

2.5 Key Success Factors (KSF) 13 2.5.1 Competitive Advantage 13 2.5.2 Revenue 14

2.6 KSF: Degree of Attainment & Continuation 15 2.6.1 Customers 15 2.6.2 Distribution 16 2.6.3 Management 16 2.6.4 Facilities 17 2.6.5 Risks 17 2.6.6 Growth 18

2.7 Company & Industry Conclusions 19

3. Accounting Analysis 20

3.1 Key Accounting Polices 20

3.2 Accounting Flexibility 22

3.3 Accounting Strategy 23

3.4 Quality of Disclosure 26

3.5 Potential “Red Flags” 27 a. Appendix 3.1.1 53 b. Appendix 3.1.2 54

3.6 Quantitative Measures & Indicators: Explanation 28 3.6.1 Sales Manipulation Diagnostics 28 3.6.2 Core Expense Manipulation Diagnostics 29

3.7 Accounting Distortion 30

4. Ratio Analysis & Forecast 30

4.1 Analysis & Forecasting Overview 30

4.2 Financial Ratio Analysis 31 4.2.1 Time Series Analysis 32 a. Appendix 4.1 55 b. Appendix 4.2 56 c. Appendix 4.3 58 4.2.2 Cross-Sectional Analysis 33 a. Appendix 4.4 59 b. Appendix 4.5 60 c. Appendix 4.6 62 d. Appendix 4.7 64 e. Appendix 4.8 66

4.3 Financial Statement Forecasting: Methods & Assumptions 34 a. Appendix 4.2 56

4.4 Analysis & Forecasting Conclusions 36

5. Valuation Analysis 37

5.1 Valuation Segment Preface 37

5.2 Valuation of Electronic Arts, Inc. 38

5.2.1 Method of Comparables Valuation 38 a. Appendix 5.1 69

5.2.2 Intrinsic Valuation Method 40

5.2.2.1 Calculations of Beta (β), Cost of 40 Equity (Ke) and Debt (Kd), Sustainable Growth Rate (SGR), Effective Tax Rate Z-Score

5.2.2.2 Discounted Free Cash Flows 43 a. Appendix 5.2 70

5.2.2.3 Discounted Residual Income 45 a. Appendix 5.3 72

5.2.2.4 Discounted Abnormal Earnings Growth 46 a. Appendix 5.4 73

5.2.2.5 Long-Run Average Residual Income 47 Perpetuity Based on the P/B Ratio a. Appendix 5.5 74

5.3 Electronic Arts Valuation Synopsis 49

6. Financial Statements 75

6.1 Balance Sheet 75

6.2 Income Statement 76

6.3 Statement of Cash Flows 77

7. Sources 78

Analysis of Electronic Arts Inc.

Investment recommendation: Buy (November 05, 2004)

ERTS – NASDAQ (11/05/04) $ 47.88 EPS Forecast 52 Week Range $ 40.60 - 55.91 FYE 11/04 2004 2005 2006 2007 2008 Daily Range $ 50.01 – 53.17 EPS 1.92 2.13 2.36 2.62 2.91 Fiscal Year-End March

2004 Sales (mil) $2,957.1 Ratios EA Average of Competitor 1- Year Sales Growth 19.1% P/E 24.94 17.74 2004 Net Income (mil) $577.3 M/B 4.24 9.7 1- Year Net Income Growth 82.1% P/S 4.88 3.4 2004 Number of Employees 4,800 Valuation Prediction Dividend Yield 0 Actual Current Price $47.88 3-Month Avg Daily Trading 4,646,515 Long Run Avg. RI Valuation $42.08 Volume (Mil) P/E Valuation $34.06 Residual income Valuation $40.80 Book Value per Share 11.29 M/B Valuation $109.51 Return on Equity 21.6 % EBO (Abnormal Earnings Valuation) $38.86 Return on Asset 17% DCF Valuation $49.10 P/S Valuation $33.35

Key-Variables Beta (est.) .591 Cost-of-equity (est.) 9.04% Wacc (est.) 9.0% Cost-of-Debt .19%

Rating System: BUY: A strong purchase recommendation with above average long term potential OUTPERFORM: A purchase recommendation that is expected to marginally outperform the return of the market PERFORM: A purchase recommendation to maintain current position with returns to match the market SELL: A recommendation to sell the security as it is expected to decrease in price in the medium term

1.0 EXECUTIVE SUMMARY

1.1 Company, Industry Overview & Analysis Electronic Arts, Inc. (EA) is one of the largest companies in the North American home electronic entertainment industry who both publishes and develops interactive games for computers and consoles alike. It operates within an industry that has steadily grown since the early 1980’s with the advent of notable console systems such as various Atari models and the original Nintendo Entertainment System. As such, the average consumer age in this industry is in the early to late 20’s, although frequently updated console generations and the computer age continue to bring younger consumers into the market.

EA currently operates with weighty competitive advantages including a size large enough to deter new entrants to the industry, while the industry itself can be favorable toward companies due to factors such as extremely low supplier bargaining power. EA has and continues to exhibit steady growth throughout its domestic and global operations.

1.2 Accounting Analysis A major December sales season and resulting January returns causes EA to mark its fiscal year end at March 31. The company owes roughly half of its revenues to foreign activities, and it uses a combination of straight-line and double-declining balance methods to account for deprecation on its assets.

Due to the intangible nature of R&D and intellectual property development, EA has considerable flexibility in its accounting policies. Therefore, it has numerous opportunities to illegally hide business shortfalls with accounting tricks, yet the only obvious red flag is a $4 million loan to one of its executives that was not duly and obviously represented on EA’s financial statements. KPMG LLP, EA’s current auditing firm, did not report any problems during the last audit.

The retail nature of the industry necessitates large outlays for marketing activities and allowance for doubtful accounts. This may be partly why EA hosts a range of helpful SEC filings and investor information on the official EA website.

1.3 Forecasting & Methodology EA and three of its domestic competitors were broken apart for analysis into four sections: liquidity, profitability, capital structure, and additional ratios. Results indicate a growth industry that EA operates extremely well within, managing to establish steady expansion patterns in most areas of its business. Comparatively, other firms had extremely volatile or low earnings.

This steady growth carries into EA’s ten-year forecast. Assumptions for the forecasting include a continuance of this growth trend within a steadily recovering economy. Additionally, it is assumed that due to EA’s late fiscal year end that also falls before its primary sales season, fiscal 2005 can be treated the same as fiscal 2006 and so forth with very little distortion in resultant valuations.

1.4 Derived Market Valuations Of immediate interest is the fact that EA’s capital structure does not contain any debt, nor does the company pay out any dividends to investors. This places EA’s WACC very close to its cost of equity and SGR at its ROE value. SGR averages 11.7% for the previous five years, several points higher than the estimated WACC. Taking all assumptions and facts into consideration, EA was valued for November 5, 2004. Out of the four models utilized for this (Discounted Cash Flows, Discounted Residual Income, Abnormal Earnings Growth, and Long Run Average Residual Perpetuity), the range of estimated values fall between $42.13 and $62.18, although $49.16 is a price ceiling more consistent with the other valuations.

1.5 Recommendation EA’s November 5, 2004 market share price is $47.88, which falls much higher than valuations derived with the Value Line beta. If this beta is more accurate, EA’s stock price is severely overvalued. However, it is more likely that the much higher Value Line beta implies EA is more affected by movements in the market than what it actually is, most likely caused by computing it with a longer period of time before economically damaging events such as 9/11 and the tech crash.

Using the much lower derived beta, EA’s estimated stock price falls in the lower middle range of the valuations. In this case the company is most likely valued fairly or slightly undervalued, so that, combined with positive future growth prospects, leads to a recommendation of buy.

2.0 BUSINESS & INDUSTRY ANALYSIS

2.1 COMPANY OVERVIEW

Electronic Arts, Inc (ERTS) “develops, markets, publishes and distributes interactive games that are playable by consumers on home video game machines (such as Sony Playstation 2, Microsoft XBOX, and Nintendo Gamecube consoles), personal computers, handheld game machines (such as Game Boy Advance), and online.” Electronic Arts was founded in 1982 at Redwood, California and has since become one of the leading producers in home entertainment software, operating worldwide in over 100 countries; however, historically 50% of EA’s total revenue has come from within the North American market. Total company revenues for fiscal 2004, ending March 31, were roughly $3 billion, up 19.1% from fiscal 2003.

2.2 INDUSTRY OVERVIEW

The video game industry is very competitive because, in part, members must constantly fight for market share in a saturated, luxury market in order to amass enough revenue to continue developing or distributing games. If a company consistently experiences loss of market share, for whatever reason, it faces a high risk of being forced out of the industry; although, unique companies who operate solely on high quality or low price have a much healthier margin of safety.

Participants in the home electronic entertainment industry tend to be either small developers or massive corporations that develop and distribute games, due in part to the significant outlays of capital necessary to start up, operate, and remain in business. Smaller firms generally do not posses these

means and must rely on larger entities. Additionally, the video game industry is regulated by many license, copyright, and restriction laws.

2.21 Trends The ability to notice trends in the video game industry is very important as it allows companies to forecast future revenues and growth. Some important trends a company must take note of include the average age and income of its customers. The average age of gamers in the market has increased from 21.5 in 2002 to 25 in 2003. Studies have shown that as the average age of gamers increase, their income generally increases. This increase in available disposable income leads to more spending on entertainment software. Company’s must keep this in mind and constantly adjust the age that their software titles target

2.3 FIVE FORCES

It is necessary to fully understand the industry factors affecting a company’s performance if a reasonably accurate valuation is to be made. Five such factors that most affect any given company include that company’s current competitors, threat of new entrants, alternative products available, degree of customer bargaining power, and degree of supplier bargaining power.

2.3.1 Current Competitors For EA, there is currently little threat from competitors in the domestic software industry. The existing competition arises from companies battling for the top position EA currently possesses.

On the developer’s end, competition can be generalized as nonexistent or intense because each competing company normally specializes in a specific genre of video game. EA tends to dabble in most genres, but historically, they have concentrated on sports and action titles.

On the publisher’s end, companies in recent years have been striving to become less dependent on seasonal cyclical sales. Firms have traditionally been dependent on such cycles for revenue to the point that consumers expect games during peak seasons, leaving companies stuck with an overly aggressive widow to release their products. This window markedly affects the entire development cycle of a title as publishers often lean on developers to finish as quickly as possible. EA, as a leader in the industry, has already initialized many attempts to try and spread out their revenue over the entire year rather than just depend on holiday and summer sales. The company currently tries to counter cyclical seasonal sales by releasing games at different times during the year, such as the popular Madden NFL and Tiger Woods Golf series.

Domestically, the current competitors of EA include Microsoft and Midway, though there is also considerable threat from Japanese game developers like Nintendo and Capcom both domestically and abroad. While Electronic Arts does compete for software sales in numerous foreign markets, they favor distribution role in particularly competitive markets in order to avoid costly rivalries.

2.3.2 New Entrants The threat of new competitors or firms entering the existing video game market is relatively low because of the large amount of capital and marketing that is required in the home electronic entertainment industry. Another reason entry can be difficult concerns the high costs of licensing titles and the large development outlays required of producing one title for many different console systems. Many companies may choose to focus on only one system, but in that situation, unless the company has a high degree of name recognition, they forfeit potential sale from consumers who own other consoles. Therefore, a company without financial assets roughly equivalent to EA faces a difficult challenge in privately developing software titles.

2.3.3 Alternative Products Companies involved in this industry must compete with other forms of entertainment and resultant consumer spending habits, including purchases as simple as a trip to the movie theatre or music CD’s, home computing, television, and even time demands like busy jobs or intensive schooling. These all cut in to the available time a consumer has to spend playing video games, and when there is a perceived lack of time among target consumers, they tend to ignore games. Activities like purchasing a movie ticket or reading a book require a low outlay of disposable income for consumers, so many may choose the cheaper alternative to video games, especially in light of the typical video game’s suggested retail price of $50 when first available. Still, there are some devoted consumers who will find time to play video games, sometimes to the detriment of their social health; these devoted consumers comprise a very small part of the whole.

2.3.4 Customer Bargaining Power In the gaming industry, it is very commonplace for the typical consumer to posses little price bargaining power, having almost no effect on the price of a given product in the market. Producers and developers do take note of customer demand through the choice of games a customer decides to purchase, but this process is more reactive than proactive, causing prices to remain wholly steady until a game is on the clearance rack. Consequently, the overall percentage of available genre titles is in constant flux in direct proportion to the demand for that specific genre. This gives rise to a “copycat” effect in that titles that sell many copies direct the course of available material within the industry.

2.3.5 Supplier Bargaining Power Suppliers in the video game industry have relatively low bargaining power because material used in software development consists primarily of human resources and computer programs. The human resources necessary for game development include computer coders, artists, and designers; generally, so many professionals want to work in the gaming industry that a very competitive job market has arisen.

Companies have more flexibility in who they hire, what they choose to pay their talent, and how many hours they require an employee to work. In fact, many employees relate stories of long hours and nights spent sleeping in the office to get a game finished on schedule.

2.4 CLASSIFICATION OF INDUSTRY

EA operates within the home electronic entertainment industry. Their business relies heavily on distribution and technology for software development aimed at both consoles and computer so can be considered a part of the technology sector.

The technology industry is characterized by high risk and high reward with assets depreciating at a rate much higher than other industries. There are high risks of inventory becoming obsolete too quickly for a company to replace it with newer versions, and participating firms dealing with software must develop titles with multiple operating systems or consoles in mind, increasing production costs. Technology investors tend to rely on a company’s long-term, future value rather than immediate payoff and expect risks to be present due to the constant stream of technological innovations and dilapidation inherent to this industry.

2.5 KEY SUCCESS FACTORS (KSF)

While most companies can easily gain short-term success, only sustainable key success factors will carry it in the long run. Several factors particularly applicative to EA include certain competitive advantages and a reliance on sales garnered through successful titles.

2.5.1 Competitive Advantage Electronic Arts creates competitive advantage, in part, by participating in a differentiation strategy. EA currently publishes and develops numerous titles for over ten different hardware platforms including Sony’s Playstation 2, Microsoft’s XBOX, Nintendo’s Gamecube and Gameboy, Nokia’s N-Gage, PC, Macintosh, etc. An added advantage of producing products for so many disparate platforms lies with cost efficiencies in the areas of development and marketing, which constitute the bulk of the cost in the home electronic entertainment industry. Development costs can be reduced through assigning different subsidiaries the task of designing a title for each platform. Because EA is so large, this translates into a cost advantage by being able to produce these titles much quicker than one team working on a conversion for all platforms. Additionally, this large size allows EA to get speedier response from hardware developers like Sony or Nintendo than less notable companies by virtue of the large number of titles EA produces or distributes for these systems; if EA decided to stop supporting a company’s hardware, this would lead to lost sales for that company. EA’s ability to control cost in marketing and advertising activities enable them to produce consumer recognition of a wide variety of products for multiple hardware platforms without overly significant resource outlays. If a particular title is predominantly successful, EA’s staying power allows them to build upon prior marketing efforts to develop recurring franchise titles that help build brand equity and customer loyalty.

2.5.2 Revenue Solid revenue growth for Electronic Arts is tied to ‘platinum titles,’ which are software selling in excess of one million units. During fiscal 2004 (ending March 31), EA had 27 platinum titles, up from 22 in 2003, that included franchise titles such as Need for Speed, Madden NFL, Medal of Honor, FIFA Soccer, and Lord of the Rings.

Domestically during fiscal 2004, approximately 95% of net revenue came from direct sales through retailing entities and telephone sales representatives. Internationally, 60% of net revenue came directly through Sony distribution channels. Though Sony helped create the distribution channels EA utilizes abroad, EA’s brand equity is reaching a point where reliance on Sony’s distribution networks is becoming fundamentally unnecessary. Electronic Arts is the largest force in the home electronic entertainment industry, generating approximately 33% of overall revenue, 44% of which is derived from titles sold for Sony’s Playstation 2 as seen in the graphs below.

Source: Electronic Arts 2004 Interactive Annual Report

2.6 KSF: DEGREE OF ATTAINMENT & CONTINUATION

Key success factors for a company can only do some good if they are both attainable and sustainable. Electronic Arts is able to do just that through its customers, distributing activities, management team, and facilities, though matters related to its risk and growth must also be considered.

2.6.1 Customers According to a study by the Entertainment Software Association (ESA), “computers, video, and online games have become woven into the fabric of the everyday lifestyle of young Americans.” The demographics of Electronic Arts’ customer base are spread throughout a wide range of age groups. Consumers enter the market as early as six years old and commonly range up to 45 years of age, although ages chiefly range from 17 to 25 years. Even though Electronic Arts’ first generation video gamers have now grown up and entered the workforce, these consumers are still expected to spend the same percentage of their disposable income within the video game market according to research done by organizations like the ESA.

Highly profitable software is typically action-oriented, male-favored titles. One target market Electronic Arts hopes to gain a reasonable percentage of is the female gamer market, which has largely been ignored in the past by the industry in general. Games such as “The Sims” have been a recent attempt by EA to reach this largely untapped market.

2.6.2 Distribution In the gaming industry, total distribution costs hinge primarily on marketing expenditures and advertising activities. Facets of these expenses include logistics concerns, the direction and intent of product promotions, and handling consumers through front-end customer support while managing consumer perception (i.e. brand equity through EA owned subsidiaries like Origin Systems, Bullfrog Productions, and Maxis.)

Distribution costs are minimized through constant surveillance of marketing trends and according inventory adjustments, as needed, through use of cutting edge information technology. Electronic Arts owns 23% of the overall worldwide market share of the home electronic entertainment market as applies to gaming software, which enables them to have substantial price bargaining power with contracted logistics firms and retailers involved with the sale of entertainment software.

2.6.3 Management Efficient and effective management teams link to a company’s degree of success in an industry because it is the management team who determines the future direction and business strategy of a company; EA’s management team possesses a highly successful team focus.

After six years of filling in as acting president and CEO of EA, John Riccitiello resigned from the position in April 2003, replaced by Lawrence Probst III. Probst currently fills in as interim CEO while the current selection process for new president is ongoing. Warren Jenson is the current Chief Financial Officer and Executive Vice President. Don Mattrick is the Executive of Worldwide Studios. Russel Rueff, Jr. is the executive Vice President of Human Resources and Facilities.

Many of these executives have years of experience managing a firm, an important fact due to the instabilities created through the lack of a permanent CEO. This power void has temporarily been filled by Probst, but not having a stable figurehead for EA could potentially cause long-term morale problems if EA does not make an effort to stabilize Probst in his position or look for a permanent replacement.

2.6.4 Facilities Electronic Arts leases and owns both land and facilities in North America, Asia Pacific, and Europe. However, their principal administration, marketing, research, and development facilities originate out of their headquarters in Redwood City, California, which the company utilizes under two separate “build- to-suit” leases. Additionally, all but a few facilities in the areas EA conducts business are secured under leasing arrangement.

During fiscal year 2004, EA closed several U.S. facilities as part of a $9.2 million strategic decision to consolidate efforts at the Redwood City headquarters. Abundant facilities abroad minimize globalization costs by having a functional EA presence in the main commercial hubs of Europe and Asia.

2.6.5 Risks Electronic Arts faces several risks. Foremost, EA must determine which video game platforms will be successful in the marketplace and concentrate development efforts accordingly. A single misstep could prove a costly mistake, boldly underscored by the failure of Nokia’s N-Gage to amass a core consumer group. As development costs continue to escalate, precise decisions become increasingly vital.

Software piracy is a multinational risk that the entire industry must concern itself with. It affects viability in certain markets and can have a huge impact on sales. Government involvement can help stem the negative effects, but other times companies must suffer losses or avoid entire markets altogether. Electronic Arts is a large company that requires a constant inflow of revenues, so should the problem escalate or spill over into other countries, lost sales could hurt both global and domestic operations.

Secondly, EA faces the potentiality of having the content of their titles increasingly regulated by law due to the continual escalation of video game popularity and notoriety within present day society. The widespread penetration of the gaming market has brought attention to it by consumer groups who occasionally bring suit against publishers for perceived tasteless content, such as the recent lawsuit against Take-Two Interactive Software for certain racial references in its Grand Theft Auto series. Such notoriety can lead to a costly recall or setbacks in development which either delay product releases or force unfinished products into the market as a firm tries to recoup what development costs it can before suit can be brought against them. In recent years many lobbyist groups have also attempted to pass laws restricting the video game industry, a trend that looks to continue into the future.

The video game industry is both seasonal and cyclical, so EA must maintain strict schedules in order to get products on the market during key sales seasons, primarily the summer months and holiday season. Delays cost money which sometimes leads to the release of unfinished products, which in turn harms EA’s brand equity and future sales. All competitors in this industry must carefully plan out their development schedules so that a product can be given ample time to be finished yet mature during a season that it can easily be sold.

2.6.6 Growth The potential for growth in the video game industry looks solid. EA appears to be an industry front-runner in its ability to gain the most from increased revenue and expanding markets, taking the mantle of domestic market leader and continuing to reinvest its resources to sustain that title.

The company offers employee investment within its company that has been tremendously profitable with the rise of its stock prices. One notable detail is the lack of dividend payments. This will discourage some investors, but overall, EA’s past performance demonstrates strong incentive to retain earnings, providing greater company growth potential for shareholders.

EA’s growth is not limited to the United States as it is expanding worldwide with enough foreign facilities to allow them to deal in over 100 countries. International growth is strong but unpredictable because of foreign laws governing copyrights, trade restriction, and availability of necessary technology within certain foreign countries to produce EA’s products.

2.7 COMPANY & INDUSTRY CONCLUSIONS

Electronic Arts maintains its position as the top player in its industry segment simply by utilizing its competitive advantages, economies of scale, and the key factors that ensure success, such as the company’s widespread differentiation strategy. Because of its size, EA will encounter more risks than smaller companies, like representing a larger public target for detrimental consumer groups, but with greater opportunities for growth across the globe.

Competition in the gaming segment of the home electronic entertainment industry is highly competitive where companies often come and go in the blink of

an eye. Development costs only increase with newer technology and consumer demands, so it becomes ever more critical for viable companies to be well aware of market conditions and consumer tastes. However, low supplier and consumer bargaining power presents tangible benefits to industry participants, and as the core consumer base continues to age into higher salary brackets, the industry can only grow while attracting new generations of consumers.

3.0 ACCOUNTING ANALYSIS

3.1 KEY ACCOUNTING POLICIES

Electronic Arts has designated their fiscal year end at March 31st instead of the December 31st date usually chosen by other companies. Major video game selling seasons occur during the summer and late winter months, particularly May through July and November through December, as many younger consumers have the summer away from school and major gift-giving holidays occur at the end of the year.

Half of Electronic Arts’ total sales come from foreign operations. To successfully operate overseas, EA has developed an efficient process for accounting for the assets and liabilities generated from its foreign subsidies. The company utilizes the going foreign exchange rate for each respective country at fiscal year end to convert information into US dollars. This enables EA to accurately compare information across its many going concerns. Non-distributed foreign currency is not translated into US currency for income tax purposes as EA believes they are indefinite investments in non-US subsidiaries. In the 2004 fiscal year, EA earned $738.3 million from its foreign subsidiaries that it did not distribute.

Electronic Arts recognizes revenue by accounting for products when they are shipped or at the time of delivery of the master software copy to be used in the duplication process. If demand is particularly high for a given software title and EA produces more copies than allowed under the initial licensing agreement, Electronic Arts recognizes royalty revenue for each additional copy sold in excess of the maximum amount allowed under that particular license.

Electronic Art uses two methods in accounting for the depreciation of assets. The first is straight-line deprecation of management information systems, intangible assets, and buildings. The average useful life EA uses to account for buildings under this method is six to seven years. However, Electronic Arts also uses the declining balance method for the remainder of its property, plant, and equipment, which is understandable for companies such as EA who operate in the technology sector (assets quickly become outdated.)

Costs associated with software systems used within Electronic Arts and customized for their use are capitalized upon reaching the development stage. These include external direct costs dealing with employee payroll for those involved with the application of capitalization cost that begins with a project and ends when materially complete.

EA subcontracts much of its development to independent software developers and so pays out a fair amount of its funds to such entities. The standard contract agreements usually pay for such developers in advance, recording the transaction as non-current and current prepaid royalties. These prepaid royalties are expensed based upon the actual net product sales and are adjusted on a quarterly basis.

3.2 ACCOUNTING FLEXIBILITY

As a software development company, Electronic Arts has a considerable degree of flexibility in choosing different accounting policies and estimates, even though the company is required to prepare financial statements within the US in accordance to GAAP. For example, EA generally has a large amount of accounts receivable recorded for each fiscal year on the balance sheet because much of its retail customer base (large entities such as Wal-Mart, Target, or Electronic Boutique) pay on credit. This could lead to the practice of EA allowing credit sales to companies with a low likelihood to pay in order to boost EA’s quarterly or annual net income.

Electronic Arts must make certain to allow suitable leeway for its doubtful account estimates without being overly aggressive or conservative as too much in either direction will mask its financial realities. Because they have the option of using different methods for evaluating total customer creditworthiness, EA can switch methods in order to get different estimates, though they currently use the balance sheet method. This has the potential to materially affect EA’s net income. The company can also evaluate customers through different quantitative and qualitative factors liable to change. Such significant factors include the overall economic climate, the financial position of EA’s downstream customers, and the amount and period that EA expenses bad debt. Also, because EA cannot predict with complete accuracy the ability of a customer to meet their financial obligations, its estimates are allowed and are expected to differ materially from the actual results.

The depreciation of assets method EA chooses to utilize greatly affects the valuation of such assets and thus net income. The straight-line method used for building, MIS, and intangible depreciation causes EA’s assets to have a higher valuation than its other assets due to the equal amounts of depreciation assigned

per year. Assets such as property, plant, and equipment are depreciated in accordance with the declining balance method, which devaluates these assets much faster. One possible explanation for the use of these particular methods is that EA desires to boost the value of its buildings since they are primarily leased, without significantly affecting earnings, and then quickly declining the assets it specifically owns. In this way only assets that EA has complete control over have a large impact on earnings.

When determining where the development cycles will fall for its various software titles, EA has considerable flexibility in choosing the timing and fiscal release date. This can materially affect net income depending on when these outlays are capitalized. Such a large degree of timing flexibility can also lower net income if EA deliberately releases a title in an off season, or alternately, timing can raise net income if EA releases that same title during the key summer or winter months.

Financing for EA comes primarily from equity and reserve accounts. This allows EA to raise more money on demand by issuing stocks or decreasing cash levels through repurchase of stock, resulting in an easily manipulated cash flow. A lack of long-term liabilities reduces interest expense greatly and allows for easier changes to the capital structure.

3.3 ACCOUNTING STRATEGY

Electronic Arts Inc.’s accounting strategy is very similar to others in the home electronic entertainment industry. They have large outlays in marketing and advertising to drive sales (the industry is focused on “hits”), large research and development costs to bring these games to market (both in-house and associated with independent development firms that EA contracts with), policies

to write off products at an accelerated depreciation rate around the time of a console generation switch, and managers who keep track of historical returns and current market conditions to monitor the number of products in the distribution channel.

Overall, EA tries to comply with GAAP, the FCPA, and various international accounting standards board in the interest of accurate stockholder information. There are several non-GAAP financial measures that EA does utilize to make decisions concerning operations – specifically amortization of intangibles, restructuring and asset impairment charges, other-than-temporary impairment of investments in affiliates, and charges of acquired in-process technology – but they show comparisons where relevant between the GAAP measures and non- GAAP measures. Several key flexibility issues follow.

Of EA’s 4,800 employees, EA covers those working in the US with a 401(k) plan that allows the company to contribute discretionary amounts to these accounts, depending on performance. In both 2003 and 2004 thus far, they have contributed $5.1 million.

The company has been publicly traded since 1989. There have been four, 2-for-1 stock splits since then with the last occurring November 2003. Currently, the company deals with class A and class B common stock, but a vote to consolidate these into one class will come up at the next annual stockholders’ meeting. EA has adopted a stock options incentive plan where management can be compensated with EA stock, which can include restricted stock, at a minimum of 85% market value. These options can be exercised with up to 24% of the shares after 12 months with the remaining to be available in equal increments over 38 months. Management does have incentive to adjust earnings to affect stock options, but this is downside to the whole system of stock compensation not necessarily specific to Electronic Arts. However, several proposed bills in

Congress, as well as upcoming FASB regulations, could materially increase the expenses associated with EA’s reporting of stock options.

EA has entered into multiple, non-cancelable operating lease agreements for its facilities, including several for its Redwood City headquarters. Though there are no capitalized leases at present, the total amount of operating leases EA has on record is $27.3 million. Most have a built-in option to buy the property, sell the lease, or extend the lease. EA is able to account for its leases as operating because they do not meet the qualifications under GAAP to account for them as capital leases. These qualifications include a lease life exceeding 75% of the asset life, transfer of ownership at the end of the lease, an option to purchase the asset for a ‘low’ price at the end of the lease, or a present value of the lease payments that exceeds 90% of the fair market value of the asset – only one of these requirements must be met to capitalize a lease and Electronic Arts does not currently qualify. EA has taken advantage of the option to extend lease terms in the past, and has entered into additional lease agreements to help remodel their various buildings to their liking. They have the option of purchasing the Redwood City headquarters property for $130 million.

The company has entered into many agreements that require the payment of royalties. To entities such as sports leagues and universities, celebrities, or distributors, EA generally prepays these royalties and capitalizes it as such. To entities such as independent software developers, EA considers such payment to be a risk so expenses it to research and development as costs are incurred. This could potentially lead to hiding costs associated with non- profitable games or companies under research and development.

Electronic Arts has been in the process of implementing various restructuring plans since fiscal 2002, including eliminating around 270 positions and the discontinuation of certain product offerings. During fiscal 2004, pre-tax,

EA spent $8.7 million on cash charges and wrote off $0.5 million in non-current assets. The amount of write-offs are fairly insignificant when compared to EA’s ongoing operations, and the cash charges deal with employee layoffs, transfer of assets, and fees related to alteration of computer systems and properties.

In dealing with the amortization of goodwill and other intangibles, EA uncovered an impairment of $12.4 million after checking themselves with SFAS No. 144 Business Combinations test. This amount arose primarily from the repurchase of EA stocks, acquisition of several companies, and purchase of equitable brand names.

3.4 QUALITY OF DISCLOSURE

The official EA website has been set up to be very investor friendly. It features sections that include SEC filings, an overview of the current management team and code of conduct, a graph showing stock performance over a user specified period, EA press releases, e-mail alerts for site updates, and a list of contact information should an investor need further clarification concerning any of the available information.

EA’s current auditing firm, KPMG LLP, states it is their opinion that the financial statements for Electronic Arts Inc.’s 2004 fiscal year are free from material error and conform to GAAP standards.

Management’s discussion section in the SEC reports do an excellent job of explaining changes in performance, EA’s operations across different regions, current market conditions with associated risks, and even feature a console-by- console breakdown of financial performance. This section seems to be focused on accuracy and information quality, more than puffing up the company, with

detailed descriptions of such topics as the fiscal 2004 increase in general and administrative expenses associated with employing an increased number of people to help grow the business and an increase in professional and contract services.

During March 2003 EA consolidated its online operations (EA.com) with its core operations (EA) to form a single entity. It is their belief that this will make it easier to accurately record company operations and that it makes strategic sense as the marketplace is quickly moving to an online atmosphere. Consequently, EA continues to become divided into segments mostly geographically based; the 10K and 10Q reports adequately summarize all of EA’s international transactions.

3.5 POTENTIAL “RED FLAGS”

Electronic Arts Inc. does not seem to have any substantial red flags. Though it does have a few write-offs (such as the $0.5 million related to company restructuring), they are not significant or frequent enough to warrant concern. There are no fourth quarter adjustments out of the ordinary. EA does, however, have many leases that it accounts for as operating leases, yet because they do not meet qualifications under GAAP, it would not be wrong to avoid classifying these as capital leases.

The only major red flag that stands out is a related party transaction dealing with a 24 June 2002 non-interest bearing loan of $4 million to Warren Jenson (Executive Vice President and Chief Financial and Administration Officer.) The loan was to be forgiven over a period of four years, $2 million being forgiven after two (along with the funds necessary to pay any resulting taxes) based on Jenson’s continued employment. As of 31 March 2004, the loan had yet to be

repaid. Changes to the financial statements have been made to reflect this (Appendix 3.1.1 and Appendix 3.1.2)

3.6 Quantitative Measures & Indicators: Explanation To determine if Electronic Arts has manipulated sales or expenses, it is necessary to run several diagnostics on the company’s financials. At that point it should become more obvious if they have engaged in any suspicious accounting. Please see below for diagnostic results.

3.6.1 Sales Manipulation Diagnostics Sales Manipulation Diagnostics 2004 2003 2002 2001 2000 1999 Net Sales/Cash 1.0772 1.034 1.124 1.152 1.1974 1.1394 from sales Net Sales/Net Accounts 13.95 30.24 9.054 7.58 6.0662 8.1747 Receivable Net Sales/Unearned Revenues 129.13 234.42 129.8 77.8 768.82 148.9

Net Sales/Inventory 53.63 62.56 72.53 84.29 61.777 54.606

Note: There is insignificant information available on EA’s financial statements to determine a value for warranty liabilities.

The measures show steady numbers for all fiscal years between 2001 and 2004 with the exception of 2003 (which saw major company restructuring.) During that year EA had lower than expected unearned revenue and accounts receivable. Sales for that year went up slightly from fiscal 2002, which could indicate that EA changed its method of reporting these numbers, market conditions facilitated quicker payments of debt, or more likely, the lower unearned revenue and accounts receivable were managed differently with alternate credit policies that worked itself out by fiscal 2004.

Net sales over inventory show a diminishing trend that indicates sales are not growing as fast as inventory. This could signify a more competitive marketplace than years past that requires foregone sales through aggressive pricing or the inability of EA to sell steady levels of its merchandise, which can become a problem if this trend continues and obsolete inventory begins to build.

3.6.2 Core Expense Manipulation Diagnostics Core Expense Manipulation Diagnostics 2004 2003 2002 2001 2000 1999 Declining Asset Turnover 0.87 1.05 1.015 0.959 1.191 1.355 (sales/assets) Changes in 0.863 1.57 2.13 (6.4) 0.2948 1.432 CFFO/OI Total Accruals/Change in 1.28 0.613 0.906 (2.73) 0.8458 0.551 Sales

Note: There is insignificant information available on EA’s financial statements to determine a value for net operating assets, pension expenses, or other employment expenses

Declining Asset Turnover reveals a largely steady ratio that hovers around 1.0. This can be dangerous as it indicates EA has a large amount of money tied up in assets. Higher numbers are generally much more favorable up to a point.

Changes in cash flow from operating activities over operating income fluctuate wildly. Of particular interest is the negative value in 2001 where EA had about an $11 million loss and the small 2004 value that demonstrates the effects of $76.9 million in impairments and restructuring fees from fiscal 2003. Higher values almost always indicate the profitability of the company, and in light of EA’s past successes, fiscal 2003 and 2002 should be taken as more indicative of expected future values.

Total accruals over changes in sales is another value that widely varies. This ratio aids comparison between the number of sales made without the exchange of inventory and the change in total sales. EA varies on this measurement but generally remains below 1.00, indicating speedy recognition of sales and related expenses. Fiscal 2004 saw this value increase to 1.28, indicating the possibility of padding the bottom line. However, this should not be taken as indicative of company policy as it is the only year of the previous six years that saw a value over 1.00.

3.7 ACCOUNTING DISTORTION

The accounting distortion can be undone by increasing general and administrative expenses by $1 million for each year starting fiscal 2003 on the statement of income. On the balance sheet, cash should decrease by $4 million for fiscal year 2003 and notes receivable should increase by $4 million. These values should be adjusted each year until the loan is paid off. Please see Appendix 3.1.1 and 3.1.2 for the adjusted income and balance sheets.

4.0 RATIO ANALYSIS AND FORECAST

4.1 ANALYSIS & FORECASTING OVERVIEW

The purpose of analyzing and forecasting ratios associated with Electronic Arts and the gaming industry in general serves as a method of determining individual success for a given company, especially in light of industry performance. In order to resolve this, aspects of EA and its primary domestic competitors have been broken apart into four different sections of analysis to

include liquidity, profitability, capital structure, and additional ratios that will help paint a complete picture of the company’s overall wellness. The end result should communicate to potential investors several key factors that will help determine whether or not to invest in Electronic Arts.

Analysis begins with calculating a uniform set of ratios for EA and four different, domestic competitors. These numbers are compiled within appendices (Appendix 4.4 through 4.7) and graphs (Appendix 4.8) below. With this information it should be clear how well each company currently performs as a factor of both current and past performance. Such information also makes possible a forecast of expected performance for Electronic Arts out to an arbitrary time horizon, in this case a horizon of 10 years. Finally, after considering both the ratio analyses and forecasting results, many questions concerning Electronic Arts’ prospects will be answered.

4.2 FINANCIAL RATIO ANALYSIS

Outlined below are various liquidity, profitability, and capital structure ratios used in analyzing Electronic Arts both by itself and against several of its direct competitors in the home electronic gaming industry. Of EA’s competitors Activision Inc., Take-Two Interactive Software Inc., and Midway Games Inc. have been chosen as representative of EA’s domestic market. These three companies share traits that EA also possesses including a domestic base of operations, distribution of each company’s respective games both within the United States and within other countries, and having been publicly traded for at least five years. Companies such as Nintendo or Capcom were not chosen for comparison in this section (please see the Valuation Section for information on these companies) due to their incorporation within Japan, a fact which would skew any derived results by reason of different operating conditions and accounting standards within the two countries.

In addition to the standard 14 ratios used in business analysis, the dividend payout ratio, sustainable growth rate, net long-term asset turnover ratio, and NOPAT margin figures have been included. The dividend payout ratio and sustainable growth rate should give a summary indication concerning the firm’s profitability and future growth prospects. Inclusion of the net long-term asset turnover ratio will provide some insight into how efficiently industry firms utilize assets not specifically involved with short-term development processes; this can be an important indicator of good organization. Lastly, a NOPAT margin will give an idea as to operating efficiency apart from capital structuring related issues.

The quantitative information obtained through these figures can then be compared across the board in order to better understand average performance in this particular industry and how Electronic Arts stacks up against its competition. EA will be examined first followed by the industry as a whole.

4.2.1 Time Series Analysis Ratio analysis shows several key points concerning Electronic Arts that must be kept in mind. Overall, total sales have steadily increased over the past five years with cost of goods sold as a percentage of total sales having increased at a less than proportional rate, signaling strong managerial decisions, especially in light of marketing and administrative expenses floating at about the same level during this period.

Of particular note is the large increase in accounts receivable turnover EA experienced during their 2003 fiscal year. Due to a companywide implemented restructuring plan and consolidation of its online interests, EA was able to dramatically decrease the number of accounts receivable on its books. This, taken with the steady increase in net income, implies tighter collection policies that have improved on EA’s ability to convert its revenues into cash.

All profitability ratios, except for the operating expense ratio, show a general increasing trend that denotes good company and smart business decisions. Ratios like the operating expense ratio show a favorable decreasing trend. The debt-to-equity ratio stays approximately level, which indicates that EA is not puffing up its ratios through issuing more stock than necessary or loading up on debt.

Working capital turnover has decreased at a steady pace explained by the increase of working capital at a rate faster than sales due to significant increases in current assets. This indicates EA is pulling in more cash as it liquidates the accounts it owes. While this is good, EA must be careful to invest its money wisely rather than simply hold on to it since the rapid buildup in current assets could turn into many missed business opportunities that would affect further continued future earnings growth.

4.2.2 Cross-Sectional Analysis (Appendix 5.1) Excluding outliers, industry comparisons for key variables show a general upward trend in the home electronic entertainment industry. As a side note, Electronic Arts’ fiscal 2004 year was not used in these comparisons as their fiscal year ends March 31st while its competitors end at December 31st.

Current ratio comparisons show the upward trend at relatively the same levels for all companies except Midway. The same is true for the quick asset ratio, as well as gross profit margin and return on equity. The debt service margin shows the same increase, but it is much more erratic; this could simply be a reflection of turbulent sales in the market due to a combination of an unsteady economy, the position of video games as a luxury item, and the intense cyclical sales cycles inherent to the industry, which could, depending on the

severity, affect either operating cash flow or notes payable positively or negatively. With net long-term asset turnover, the numbers become slightly more erratic. The only two companies who show an increase in turnover are Take-Two Interactive and Electronic Arts, though Take-Two is beginning to level off. EA’s strength in managing its development and equipment resources shines through here with the beginnings of a significant advantage over its competition, particularly over Activision who has been in a downward spiral with regards to this measure since fiscal 2000. Appendix 4.8 contains corresponding industry comparison charts. In general, the home electronic gaming industry seems to show positive growth. EA is in particularly good straights with increasing profitability and efficiency that are increasing slowly enough to be sustainable. While companies like Activision may be growing much faster than the industry norm, it cannot sustain this rate forever, particularly in light of its poor long-term asset turnover rate which indicates that the company is not particularly skilled in handling its resources. Electronic Arts appears to be in a period of solid growth that should persist with the continuance of forward-thinking managers and effective new policies.

4.3 Financial Statement Forecasting: Methods & Assumptions (Appendix 4.1 through Appendix 4.3)

Because Electronic Arts’ fiscal year ends annually on March 31st, only two quarters of information from fiscal 2005 are available for analysis. The forecast assumes that fiscal 2005 is largely devoid of relevant financial information as Q1 through Q2 did not see any massive financial fluctuations away from normal operations, and Q3 through Q4, containing the crucial holiday shopping season, have yet to arrive. As such, the forecasts for EA treat fiscal 2005 no different from fiscal 2006 and so forth. This assumption presumes that fiscal 2005 will be another normal operating cycle for Electronic Arts.

In order to obtain the forecasted financial information for EA, the percentage change from one year to the next for each line item (i.e. gross sales or net income), starting with fiscal 1999 and ending with fiscal 2004, was computed. From this series of six values for each relevant line item, the highest and lowest percentage changes were taken out and the three remaining numbers averaged to get an expected future percentage change. This number was then multiplied by actual fiscal 2004 financial statement information, as found on EA’s 10-K report, to arrive at a forecasted assessment for fiscal 2005. That forecast was then multiplied by the same percentage change, again for each relevant line item, to arrive at expected values for each fiscal cycle until 2014. This conservative straight-line method of forecasting will curb any extraneous aggressiveness from adversely affecting future values, an assumption necessary to continue the observed pattern of steady growth.

A limited time horizon has been utilized because, as economic practice dictates, the longer the horizon, the less accurate the forecast. Ten years was chosen as a reasonable timeframe to evaluate EA as new decades bring new realities that must be incorporated into an accurate assessment; the chosen time horizon ends 2014, one year before that decade’s halfway point and potential divergence from past trends.

This straight-line percentage change forecast and ten year time horizon operates under two assumptions: the economy will continue to recover and sales for the home electronic entertainment industry will continue to expand. Additionally, to support the assumption of a continual expansion in this particular industry, the next generation of console gaming systems will begin to arrive at market within several years time, which should install a new or altered user base that continues the growth trend that has been observed over the past several years.

While these assumptions will most likely hold true in light of EA’s steady performance, especially when compared with the industry as a whole, the forecasting methods chosen simply produce numbers that continue EA’s pattern of steady growth. However, it is possible that the economy, still in stages of recovery, could take another hit and industry sales could start to decline. It is also possible that EA’s management team could leave or that EA will have an abnormally low number of platinum titles, which would affect sales negatively as competitors in this industry rely heavily on these titles for the bulk of their revenue in the home markets. Furthermore, it is possible that the next generation of consoles could increase the market abnormally due to factors like the increasingly older, and therefore more affluent, primary market, many expensive marketing campaigns by participating companies, or various other unforeseeable factors. This would cause the forecast to fluctuate and could create exceedingly conservative values when compared to actual figures.

Finally, fiscal 2003 financials have been used to compare Electronic Arts with industry competitors as many of these companies do not have more recent 10-K reports available for analysis. This will cause EA to appear slightly more sluggish in performance terms as their fiscal 2004 cycle saw roughly a 7% increase in net income, among other variations.

4.4 ANALYSIS & FORECASTING CONCLUSIONS

After analyzing industry norms in terms of ratio analysis and analyzing Electronic Arts with these same ratios and various other measures, it becomes obvious that the gaming industry is in a time of expanding markets and profitability, a fact that EA definitely shares in and uses to its advantage. Electronic Arts has been able to increase its growth factors across the board with competent managers and progressive corporate strategies that those of its

competitors cannot seem to match. In fact, though this period is certainly a positive one for this industry, the demanding nature of consumers and reliance on best selling, quality titles to obtain needed revenues serves as a sieve for companies who have not been able to adequately mange their resources or attract the creative talent necessary to produce these titles; companies like Midway Games Inc. are very representative of this fact.

The future looks bright for this industry, especially for Electronic Arts who has been able to take advantage of the positive prospects it offers. There are many factors that can affect this positive growth, but if trends persist, the market should continue to expand, and EA, with its forward-looking company policies, should continue to grow and be a dominant industry player.

5.0 VALUATION ANALYSIS

5.1 VALUATION SEGMENT PREFACE

In this section five different valuation techniques are used to help uncover a reasonably accurate, estimated value of Electronic Arts, Inc. per share as compared to the actual price per share at November 5. One irregularity immediately noticed is EA’s capital structure, which is almost entirely financed through equity, save for a smattering of short-term liability accounts with rapid turnover. Additionally, though EA appears to be a profitable company, they have not issued any preferred stock and do not pay out dividends to common shareholders. These two facts have a material effect on several valuation methods presented below.

Initially, a reference point of comparable industry values for direct and non-direct competitors in the home electronic gaming industry, including EA, should give some idea of industry performance. Still, there is such a broad spread in data that the numbers should not be taken as much more than a simple industry snapshot. With that in mind, four different intrinsic valuation methods have also been applied to EA.

These methods include an analysis of Free Cash Flows (FCF), Residual Income (RI), Abnormal Earnings Growth (AEG), and a long run average perpetuity based on the price-to-book ratio, all discounted to fiscal 2004 values where appropriate. By utilizing these varied intrinsic valuation models, estimation confidence should correlate to the degree of convergence upon a single value.

Overall, this section will provide several different means of valuing Electronic Arts. Our goal is to decide if Electronic Art’s share price is fairly valued, overvalued, or undervalued. Ideally, that value should be a slightly higher, close approximation of current share price, yet this may not be the case. Dependant on how skewed the two are in relation to one another, the economic strength of EA, as reflected in share price, should be considered grossly overstated or grossly undervalued based upon the assumptions used to arrive at these assessments.

5.2 VALUATION OF ELECTRONIC ARTS, INC.

Five specific methods, including four intrinsic valuation models, are presented below in order to arrive at a reasonably accurate estimation concerning the value of Electronic Arts. Each process arrives at its given estimation through various means, all of which tell a slightly different story. By

comparing the valuations provided by each technique, a truer estimate of EA’s value should become clear, at which point it can then be easily compared to the actual valuation assigned by the marketplace.

5.2.1 Method of Comparables Valuation (Appendix 5.1) Every commonly used ratio or per share value for companies in Electronic Arts’ industry form a fairly wide range of values. There are the companies with extremely low or negative values, such as Midway Games, Inc., and healthy companies with solid, positive values, like Take-Two Interactive Software, Inc. The picture formed is one of an industry with erratic tendencies, which makes it difficult to deduce a summary value for EA simply by comparing ratios across the board.

Industry Comparables Valuation of EA Fiscal Year End 2004

P/E P/B D/P P/S

Sum 88.71 58.21 0.12 20.41

Average 17.74 9.70 0.04 3.40

Electronic Arts, Inc. (Price) 34.06 109.51 - 33.35

In fact, two other difficulties lie with general anomalism found in the likes of Atari, Inc. and the inclusion of Japanese firms into the mix. Figures for Atari give rise to inconsistencies with other firms through the issuance of a very modest sum of common shares that, when matched with massive comparative sales (eaten away by equally massive expenses as seen on the company’s statement of income), make for drastic outliers in computations that must be

accounted for. As far as the Japanese firms Nintendo Co. Ltd. and Capcom Co. Ltd. go, such firms form a major component of the domestic video game market yet present a problem when compared to American firms due to Japan’s slightly different accepted accounting principles.

Taking all of this into consideration, calculations for an expected EA price cannot be anything but inaccurate, even with the removal of outliers like Atari’s misleading $195 price-to-book ratio and $3,868.19 sales-per-share figure. As such, these comparable figures are more useful as an insight into industry turmoil consistent with technology-related firms and the relative health of companies compared against such business mainstays as Microsoft Corp. If any truth is to be gleaned from this table, it would be that the most relevant measure of company value within this particular industry segment includes a given company’s earnings or sales figures as the $34.06 price-to-earnings and $33.35 price-to-sales ratio for EA gleaned from the industry average comes closest to approximating the November 5, 2004 actual price per share of $47.88. These consistent figures indicate relative correlation between the two, but the price-to- book value of $109.51 for EA is abnormally high due to extreme variance in related values.

This may imply that the intrinsic valuation of EA’s discounted FCF (please see Appendix 5.2) comes closest to a true measure of firm value. However, to get the best measure, it is, again, necessary to compare the values provided by all four intrinsic methods as presented below.

5.2.2 Intrinsic Valuation Methods In this section EA will be valued through the use of FCF, RI, AEG, and a long run average perpetuity based on the price-to-book ratio. To begin, an explanation of how key EA figures to include beta, cost of equity, cost of debt,

and the effective tax rate used in these valuations follows. In order to have a standard against which to compare the estimated beta and derived variables, the published Value Line beta was chosen due to its respectability within the business community.

Model Result Summary (Electronic Arts) Estimated Value Line Estimated Intrinsic Valuation Models Results Results Discounted Cash Flows 49.16 32.88 Discounted Residual Income 48.06 27.92 Abnormal Earnings Growth Model 33.90 14.27 Long Run Average Residual Perpetuity 42.13 26.79 Actual Share Price 47.88

5.2.2.1 Calculations of Beta (β), Cost of Equity (Ke ) and Debt (Kd ), Sustainable Growth Rate (SGR), Effective Tax Rate, Z-Score

Calculated key variables for Electronic Arts, Inc. can be seen in the table below. Both a derived beta and Value Line beta have been compared in order to arrive at a closer approximation of EA’s share price.

Key Variables for Electronic Arts Beta (estimated) 0.591 Beta (Value Line) 1.05 Cost of Equity (estimated) 9.04% Cost of Equity (Value Line) 12.25% WACC (estimated) 9.00% WACC (Value Line) 12.20% Cost of Debt 0.19% SGR 3.76% Effective Tax Rate 30.30%

The method used to calculate beta consists of a regression analysis (seen below) between EA’s monthly return for a 72 month period, from November 1998 to October 2004, and the market risk premium for those same months. A

six year period is the best fit for the regression because not only does it encompass the average amount of time the typical investor will hold onto a stock, it adequately covers the console generation switch from the Playstation era to the Playstation 2 era and all the financial rough areas innate to such a fundamental change in development efforts.

Correlation of EA Values and Risk Premium

0.4 0.3 0.2 0.1 0 -0.150 -0.100 -0.050-0.10.0000 0.0500 0.1000 0.1500

Inc.'s Return Inc.'s 0 0 0 -0.2 Electronic Arts, Arts, Electronic -0.3 -0.4 Market Risk Premium

Though there are many valid approaches to be considered in selecting the proper risk free rate to compare against S&P returns for a given month, the monthly interest rate for five-year US Treasury constant maturity bonds is the choice that most closely matches the six year investment horizon assumed in the selection of a company return timeframe.

The capital asset pricing model (CAPM) was used to determine Electronic Arts’ cost of equity. A beta of 0.59, the number calculated with preceding assumptions, was used in the calculation, while a market risk premium of 7%

was substituted in favor of the long-run average. A long-run average, as had been the preferred method in years past, was not used for this risk premium value as poor market returns in recent years has actually caused the risk-free return to be more than market returns for many months. Seven percent is substituted based upon the assumption that the interest rate on intermediate- term US Treasury bonds reflect non-short term discounted cash flows, values that better reflect the average of the period from 1926 to 2004 more than simply relying on rates afforded by short-maturity bonds. The resulting cost of equity is 9.04%.

For the cost of debt, the monthly rate on an average of one-month financial commercial papers was computed. Annual rates from 2000 to 2003 were averaged and then re-averaged with the weighted average of monthly rates from January 2004 through October 2004 to arrive at a debt cost of 0.185%. Because EA in financed almost entirely with equity, they did not have any long-term debt listed on their financial statements, causing 0.185% to be the cost of debt used in the following valuations.

EA does not pay out dividends, so SGR can be calculated as simply the return on equity. To determine EA’s SGR, used in these models primarily for estimations of continuing value, the ROE for forecasted fiscal year 2014 was calculated to be 3.76%.

Finally, to arrive at a value for EA’s effective tax rate, the average of the previous five years’ effective tax rate was taken to arrive at a value of 30.3%. Such an average is a better reflection of running company policy than either the statutory 35% rate or the most recent effective rate of 27.5%.

Altman's Z-Score (Bad Credit: Less than 1.8; Good Credit: More than 2.7) Electronic Arts Take-Two Interactive Activision Midway 14.6259 8.7318 13.0749 1.8106

When calculating the Z-score for EA and its domestic competitors, it becomes apparent that there is as wide a range in Z-scores as there are in the comparables valuations. EA shows a very high Z-score that is in line with their choice not to utilize long-term debt, resulting in a glowing credit score should they decide to take on some debt. The values seem somewhat reasonable, if a little optimistic, considering Midway’s long history of net losses.

5.2.2.2 Discounted Free Cash Flows (Appendix 5.2) The actual price per share for Electronic Arts at the close of business November 5th 2004 was $47.88. The value of EA per share, as derived through the discounted cash flow analysis, is $49.16. With the published Value Line beta of 1.05, the estimated price per share is $32.88.

FCF Sensitivity Analysis Growth

0 0.02 0.025 0.03 0.0376

0.06 56.12 70.9 77.24 85.68 105.75

0.08 42.88 49.01 51.24 53.92 59.19

0.0904 38.31 42.52 43.97 45.66 49.16

Cost of Equity 0.1 34.94 38 39.02 40.19 42.32

0.12 26.65 31.35 31.89 32.49 33.54

Sensitivity analysis shows that with the calculated 0.691 β, an estimated 9.00% WACC and 3.485% growth would value EA at $47.88 per share. For Value Line’s 1.05 β and corresponding estimated 12.20% WACC with 8.465% growth, EA is valued at $47.88 per share. If SGR remains at the estimated 3.76% value, a 9.16% WACC would be required to reach the market price of $47.88 per share.

Using only the estimated WACC (rather than factoring in the Value Line estimations) and the lower, corresponding growth rate necessary to reach the market price, it seems likely that the market price is a fair assessment of the company. The only difference is a smaller growth rate, which is certainly reasonable as EA is one of the most mature companies in the industry, or a slightly higher WACC, which is also reasonable given EA’s reliance on equity financing.

This model seems a fair representation of EA given the results of the industry comparables. Although, one of the few limitations of this model lies with the fact that it does not show timely expenses and revenues. The nature of the cash flows from operations and financing is to report these items when the cash moves around rather than when expenses actually occur or revenues are actually earned. This could cause problems in valuation assumptions if EA begins to have trouble collecting its accounts receivable or becomes consistently delinquent in payments.

5.2.2.3 Discounted Residual Income (Appendix 5.3) By using the residual income model, the value per share for Electronic Arts was estimated at $48.06, a difference of only 0.375% from the actual price per share. The cost of equity and the SGR used in the estimated residual income valuation are 9.04% and 3.76% respectively.

RI Sensititvity Analysis Growth

0 0.02 0.025 0.03 0.0376

0.06 59.25 75.81 82.9 92.36 114.83

0.08 42.28 49.15 51.64 54.64 60.55

0.0904 36.26 40.97 42.59 44.49 48.06

Cost of Equity 0.1 31.76 35.19 36.33 37.64 40.03

0.12 24.61 26.52 27.12 27.79 28.97

With sensitivity analysis the estimated Ke requires a growth rate of 3.73%,

or the same SGR with a Ke of 9.1%. The Value Line derived variables require an increase in the SGR to a rate of 8.87%. These changes in value to arrive at the market are very reasonable for the estimated values. However, the drastic

increase in SGR necessary to sustain the Value Line Ke is unreasonably due to its sizeable hike.

The present value of the continuing value makes up about 59% of the total estimated share price. This implies that the book value is not worth as much as the expected future value, a conclusion that is consistent with most technology related firms. It also implies that investors in EA stock rely heavily on future earnings in order to sustain their investment.

This model presents a helpful method of valuation in order to arrive at an estimated value per share. It takes into account both earnings per share and the effects of dividends, or the lack thereof, to arrive an estimate that is not heavily

weighted in any one factor yet that encompasses every value that goes into a determination of retained earnings and income over what is expected.

5.2.2.4 Discounted Abnormal Earnings Growth (Appendix 5.4)

According to this model, EA should be valued at $33.90 per share with the calculated beta, while the Value Line beta produces a share value of $14.26.

The estimated Ke with a 7.25% growth produces a value close to the market-

assigned value, while the estimated growth rate and a Ke of 8% will also come close.

AEG Sensitivity Analysis

Growth

0 0.02 0.025 0.03 0.0376

0.06 81.13 94.86 100.75 108.6 127.23

0.08 41.84 44.45 45.4 46.54 48.78

0.0904 31.28 32.33 32.69 33.11 33.9

Cost of Equity 0.1 24.48 24.83 24.95 25.08 25.33

0.12 15.5 15.34 15.28 15.22 15.12

The roughly 7% growth rate, when using the estimated Ke, necessary to bring the share price up to the market value is not wholly unreasonable; it might even be considered low. EA is positioned to continue its pattern of growth into the future, especially if it reacts wisely to the upcoming console generation switch. Though EA is becoming a mature company, the industry as a whole remains relatively young enough to facilitate continued growth of its larger

companies. For the Value Line variables, a Ke of zero is not reasonable in light of EA’s vast equity financing and current policy of not paying dividends. This enables the company to have a large sustainable growth rate that casts some doubt as to the Value Line estimation’s accuracy.

This model is fairly limited in its useful application toward EA due to its reliance on paid dividends to determine value. As such, its constant upward trend reflects the assumptions used in forecasting Electronic Arts’ future values and also explains the large difference between the share values. Nevertheless, at least two useful observations can be culled from this model. One is that EA will most likely earn more than their Ke and keep shareholders happy. Another is that the market-assigned share value falls in-between the two calculated values indicating that the assumptions used to reach these conclusions can be considered fairly accurate.

5.2.2.5 Long-Run Average Residual Income Perpetuity Based on the P/B Ratio (Appendix 5.5)

Periods of ten years rearward looking and ten years forward looking were used in order to get a better feel for how EA’s return on equity has acted over time. With this balancing effect offsetting future predicted values, the model produces an estimated price per share of $42.13 with the estimated Ke. The

Value Line derived Ke produces a value of $26.79.

Long-Run Average Residual Income Perpetuity

Sensitivity Analysis Growth

0 0.02 0.025 0.03 0.0376

0.06 55.62 68.63 74.21 81.64 99.3

0.08 41.72 45.75 47.22 48.98 52.46

0.0904 38.99 38.99 39.71 40.55 42.13

Cost of Equity 0.1 33.37 34.32 34.63 34.99 35.65

0.12 27.81 27.45 27.34 27.21 26.99

With sensitivity analysis, the model requires about a 5.4% growth rate to

accompany the estimated Ke or an 8.45% Ke to accompany the estimated SGR; Value Line figures do not come close with sensitivity analysis as an SGR of 0% only produces a share price $27.24.

It would be reasonable for the SGR to slightly increase over the base estimated value in light of the onset of purchases new console generations commonly herald. Additionally, because the Ke decreases less than a percentage point to arrive at the market value, this can be construed as an accurate value as well.

Overall, this long-run average residual income perpetuity model based on the price-to-book ratio gives an estimate fairly close to the other models. One of the strengths of this model’s possible applications include its grounding in past company financials to help balance out potentially aggressive future forecasts. This should have an averaging effect that brings the estimated share price moderately close to the market-assigned value.

5.3 ELECTRONIC ARTS VALUATION SYNOPSIS

For the most part, the intrinsic valuation models perform quite well for estimating the true value of Electronic Arts, Inc., although that is not to say that some are not better than others. The models such as Abnormal Earnings Growth that rely heavily on payment of dividends to arrive at the valuation seem to work less accurately in EA’s case than models such as the free cash flows valuation technique because EA does not payout dividends to its common shareholders and does not issue preferred stock.

According to the valuation methods presented, the market-assigned value per share for EA seems to be roughly correct. Though each model presents a slightly different valuation, the estimated variables used to arrive at these valuations seem to cause a convergence around the given $47.88 market price per share. The Value Line beta assumes that EA is much more affected by the movements of the market, an assumption that seemingly does not take into consideration the size of EA and their position as a major, stable, global competitor in the home electronic gaming market. This can further be seen in the steady long-term growth trends of EA’s net income during the prior six years despite a few periods of less than stellar performance. The more conservative beta used in the intrinsic valuation estimates is more befitting of EA’s market position and financial strengths, which are bolstered by a rapid accounts receivable turnover and an unusual absence of long-term liabilities.

As such, the derived WACC of 9.00% and Ke of 9.04% are reasonable. Because they form a range of values ($33.90 to $49.16 per share) around the actual share price of $47.88 when used in these valuation models, the proximity to what the market assigned a long existing company such as EA denotes

accuracy. The Value Line WACC and Ke, 12.20% and 12.25% respectively,

obtained from the same assumptions hold EA’s share price in a range far too conservative in light of EA’s prior performance and future growth prospects.

A strength of the valuation work performed for EA includes the wide variety of techniques used to arrive at the different estimates. Because all the valuations point to the same, narrow range of values, it legitimizes many of the assumptions used to arrive at these values through virtue of consistency. Another strength of the valuation methods employed for EA deals with the ease of changing variables to determine which factors play against each other to derive company value. In other words these models make facilitate knowledge of how accurate estimates are with the ease of variable interchangeability – simply cycle through values for the isolated variable until the price matches the market value. In this way a range of possibilities present themselves concerning how EA can maintain a certain level of performance.

There are also inherent weaknesses to these valuations that rest with poor market performance in recent years. This causes several additional assumptions that must be made in order for key company variables to be usable, assumptions that would not be present in a completely healthy economy. An example would be the use of a 7% market risk premium when calculating CAPM for EA rather than simply taking the premium average over a selected time period. The more assumptions built into a valuation, the more room for error there is in the valuation.

Forecasting efforts could be facilitated by having access to insider management discussions both for Value Line and for Electronic Arts. Special knowledge of Value Line would make clear the assumptions included in their beta of 1.05 and could possibly bring to light factors that were overlooked in the calculated beta of 0.65. For EA, such an insider’s perspective for upcoming release strategies and reasoning behind current management decisions would

definitely prove useful as well; access to information of this nature can have a direct influence on forecasting results to positive or negative ends. Other quantitative and qualitative information is readily available, yet behind-the- scenes insight could have provided better accuracy.

Forecasts, in general, are the basis for valuation models. If the forecasts are too conservative or too aggressive, estimated values for a company will inevitably be skewed. The forecasts used in EA’s valuations are reasonable, but there could potentially be a bit of aggressiveness in the obtained prognostications. This would likely have the effect of boosting the estimated share value past where is should be to a certain degree, but with that in mind, the true value of Electronic Arts would rest very close to where the market originally assigned it.

Electronic Arts, Inc. is a newly mature company in an industry that is still expanding its market. With positive upward trends in earnings and outwardly solid management decisions, EA has positioned themselves at or very near to the top in the domestic video game market. It has already expanded into global markets and should continue to gain market share in other parts of the world, especially if the issue of Chinese piracy can be skirted to make possible entry into that fertile market. While there is no indication that EA will achieve a radical future SGR, there is every indication that it will continue to expand its operations while keeping its base stable enough to build upon. Ergo, Electronic Arts will not make instant millionaires of its shareholders, but it is a very solid investment that should be considered as part of any balanced investment portfolio looking for persistent steady returns in a segment of the technology industry barely out of its infancy.

With all of these factors in mind, EA is slightly undervalued. The market share price falls closer to the upper range of prices taken from the valuation

models than the lower range, only 18 cents away from the first value in the upper range while $5.75 away from the first value in the lower range. Though the market value of $47.88 does fall in the middle of the valuation range, it is much closer to the upper values, lending credence to the idea that these are more accurate assessments. The Value Line valuation estimates do not appear to be accurate at all when used with the assumptions presented elsewhere. Therefore, it seems likely that EA is undervalued anywhere from 18 cents to $1.28, roughly.

Raiders Investment Associates rates Electronic Arts, Inc. shares “buy” as of November 5, 2004.

Appendix 3.1.1

ELECTRONIC ARTS INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS

(ADJUSTED FOR RELATED PARTY TRANSACTION)

(In thousands, except share data) March 31, March 31, 2004 2003

ASSETS Current assets: Cash and cash equivalents (adjusted) $ 2,146,885 $ 945,995 Short-term investments 264,461 637,623 Marketable equity securities 1,225 1,111 Receivables, net of allowances of $154,682 and $164,634, respectively 211,916 82,083 Inventories 55,143 39,679 Deferred income taxes 84,312 117,180 Other current assets 143,865 83,466

Total current assets (adjusted) 2,907,807 1,907,137

Property and equipment, net 298,073 262,252 Investments in affiliates 14,332 20,277 Goodwill 91,977 86,031 Other intangibles, net 18,468 21,301 Long-term deferred income taxes 40,755 13,523 Other assets (adjusted) 29,199 49,012

TOTAL ASSETS $ 3,400,611 $ 2,359,533

LIABILITIES, MINORITY INTEREST AND STOCKHOLDERS’ EQUITY Current liabilities: Accounts payable $ 114,087 $ 106,329 Accrued and other liabilities 608,166 464,547

Total current liabilities 722,253 570,876

Commitments and contingencies — — Minority interest in consolidated joint venture — 3,918

Stockholders’ equity: Preferred stock, $0.01 par value. 10,000,000 shares authorized — — Common stock Class A common stock, $0.01 par value. 400,000,000 shares authorized;

301,332,458 and 288,266,610 shares issued and outstanding, respectively 3,013 2,883 Class B common stock, $0.01 par value. 100,000,000 shares authorized; 200,130 and 225,130 shares issued and outstanding, respectively 2 2 Paid-in capital 1,153,680 856,428 Retained earnings 1,501,184 923,892 Accumulated other comprehensive income 20,479 1,534

Total stockholders’ equity 2,678,358 1,784,739

TOTAL LIABILITIES, MINORITY INTEREST AND

STOCKHOLDERS’ EQUITY $ 3,400,611 $ 2,359,533

Appendix 3.1.2

ELECTRONIC ARTS INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS

(ADJUSTED FOR RELATED PARTY TRANSACTION)

(In thousands, except per share data)

Year Ended March 31,

2004 2003 2002

Net revenue $ 2,957,141 $ 2,482,244 $ 1,724,675 Cost of goods sold 1,102,950 1,072,802 814,783

Gross profit 1,854,191 1,409,442 909,892

Operating expenses: Marketing and sales 370,468 332,453 241,109 General and administrative (adjusted) 185,825 131,859 107,059 Research and development 510,858 400,990 380,564 Amortization of intangibles 2,735 7,482 25,418 Restructuring charges 9,708 15,102 7,485 Asset impairment charges — 66,329 12,818

Total operating expenses (adjusted) 1,079,594 954,215 774,453

Operating income (adjusted) 774,597 455,227 135,439 Interest and other income, net 20,963 5,222 12,848

Income before provision for income taxes and… (adjusted) 795,560 460,449 148,287 Provision for income taxes (adjusted) 219,018 142,739 45,969

Income before minority interest (adjusted) 576,542 317,710 102,318

Minority interest in consolidated joint venture — (1,303) (809)

Net income (adjusted) $ 576,542 $ 316,410 $ 101,509

Appendix 4.1 Electronic Arts, Inc. Past Financial Values (In Thousands of Dollars)

Income Statement Year 1999 2000 2001 2002 2003 2004

Total Sales 1,221,863 1,420,011 1,322,273 1,724,675 2,482,244 2,957,141

Cost of Goods Sold 627,589 705,808 652,242 807,611 1,072,802 1,102,950

Gross Profit 594,274 714,203 670,031 917,064 1,409,442 1,854,191

Operating Expense 488,762 560,417 700,347 781,625 953,215 1,078,594

NIBIT 105,278 153,786 (30,316) 135,439 456,227 775,597 Interest Gain 13,180 16,028 16,886 12,848 5,222 20,963

Net Income 72,872 116,751 (11,082) 101,509 317,097 577,292 Dividends Paid ------Balance Sheet

Accounts Receivable 149,468 234,087 174,449 190,495 82,083 211,916 Inventory 22,376 22,986 15,686 23,780 25,170 55,143

Current Assets 569,465 705,323 818,727 1,152,543 1,911,130 2,910,807

Quick Assets 467,174 809,891 650,963 994,300 1,588,729 2,415,571

Accounts Payable 97,703 97,703 73,061 88,563 106,329 114,087 Current liabilities 265,302 265,302 340,026 452,982 570,876 722,253

Working Capital 304,163 440,021 478,701 699,561 1,340,254 2,188,554

Total Assets 3,400,611 901,873 1,378,918 1,699,374 2,359,533 3,400,611 Total Liabilities 722,253 236,209 340,026 452,982 570,876 722,253 Total Stockholders 662,931 Equity 2,678,358 1,034,347 1,243,924 1,784,739 2,678,358 Statement of Cash Flows Operating Cash Flow 50,768 45,336 196,646 288,070 714,451 669,285 Investing Cash Flow (151,631) (179,555) (112,694) (238,072) (463,015) (287,692)

Appendix 4.2 Electronic Arts, Inc. Forecasted Financial Values (In Thousands of Dollars)

Income Statement Year 2005 2006 2007 2008 2009

Total Sales 3,605,642 4,362,827 5,279,020 6,387,615 7,729,014 Cost of Goods Sold 1,246,334 1,408,357 1,591,443 1,798,331 2,032,114

Gross Profit 2,359,308 2,954,470 3,387,577 4,589,284 5,696,900 Operating Expense 1,257,641 1,466,408 1,709,833 1,993,665 2,324,613 NIBIT 767,841 760,163 752,561 745,035 737,585 Interest Gain 21,117 21,384 21,598 21,814 22,032

Net Income 640,794 711,281 789,522 876,370 972,771 Balance Sheet

Accounts Receivable 240,313 272,515 309,032 350,442 397,401 Inventory 66,172 79,406 95,287 114,344 137,213 Current Assets 4,046,022 562,397 7,817,319 10,866,073 15,103,841 Quick Assets 3,719,979 5,728,768 8,822,303 13,586,347 20,922,974

Accounts Payable 124,355 135,547 147,746 161,043 175,537 Current liabilities 928,817 1,194,459 1,536,074 1,975,392 2,540,354 Working Capital 3,304,717 4,990,122 7,535,084 11,377,977 17,180,745

Total Assets 4,454,800 5,835,788 7,644,883 10,014,797 13,119,384 Total Liabilities 902,816 1,128,520 1,410,650 1,763,313 2,204,141 Total Stockholders 3,562,216 4,737,748 6,301,204 8,380,601 11,146,200 Equity Statement of Cash Flows Operating Cash Flow 1,084,242 1,756,472 2,845,484 4,609,684 7,467,688

Investing Cash Flow (202,808) (142,835) (100,597) (70,849) (49,898)

Income Statement Year 2010 2011 2012 2013 2014

Total Sales 9,352,107 11,316,050 13,692,420 16,567,828 20,201,153

Cost of Goods Sold 2,296,289 2,594,806 2,932,131 3,313,308 3,744,038

Gross Profit 7,055,818 8,721,244 10,760,289 13,254,520 16,457,115

Operating Expense 2,710,499 3,160,442 3,685,076 4,296,798 5,010,067

NIBIT 730,209 722,907 715,678 708,521 701,436

Interest Gain 22,253 22,475 22,700 22,927 23,156

Net Income 1,079,775 1,198,551 1,330,391 1,476,734 1,639,175 Balance Sheet

Accounts Receivable 450,653 511,040 579,520 657,175 745,237

Inventory 164,656 197,587 237,105 284,526 341,431

Current Assets 20,994,340 29,182,132 40,563,164 56,382,797 78,372,088

Quick Assets 32,221,380 49,620,924 76,416,223 117,680,983 181,228,714

Accounts Payable 191,335 208,555 227,326 247,785 270,085

Current liabilities 3,266,895 4,201,227 5,402,778 6,947,972 8,935,092

Working Capital 25,942,926 39,173,818 59,152,465 89,320,222 134,873,535

Total Assets 17,186,393 22,514,174 29,493,568 38,636,575 50,613,913

Total Liabilities 2,755,177 3,443,971 4,304,963 5,381,204 6,726,505 Total Stockholders Equity 13,932,750 18,530,558 24,645,641 32,778,703 43,595,675 Statement of Cash Flows

Operating Cash Flow 12,097,655 19,598,200 31,749,084 51,433,517 83,322,298 Investing Cash Flow (35,143) (24,751) (17,432) (12,277) (8,646)

Appendix 4.3 Electronic Arts, Inc. Common-Sized Income Statements Year 2004 2003 2002 Net Revenue 100% 100% 100% Cost of Goods Sold 37.30 43.20 47.24 Gross Profit 62.70 56.80 52.76 Marketing and Sales 12.53 13.40 13.98 General and Administrative 6.25 5.27 6.21 Research and Development 17.28 16.16 22.06 Amortization of Intangibles 0.09 0.30 1.47 Restructuring Charges 0.33 0.61 0.43 Asset Impairment Charge ---- 2.68 0.74 Interest and Other Income (0.71) (0.21) (0.74) Provision for Income Taxes 7.41 5.77 2.67 Minority Interest in Consolidated ---- 0.05 0.05 Joint Venture Net Income 19.52 12.77 5.89

Year 2001 2000 1999 Net Revenue 100% 100% 100% Cost of Goods Sold 66.85 71.77 68.04 Gross Profit 33.15 28.23 31.96 Marketing and Sales 13.77 15.26 15.22 General and Administrative 6.05 6.41 5.03 Research and Development 6.67 4.59 5.24 Amortization of Intangibles 0.24 7.27 0.36 Interest and Other Income 1.17 1.47 0.69 Provision for Income Taxes 1.94 (0.81) 2.00 Net Income 3.31 (5.96) 3.41

Appendix 4.4 Electronic Arts, Inc. Financial Statement Ratio Analysis

Year 2004 2003 2002 2001 2000 1999

Liquidity Analysis

Current Ratio 4.03 3.35 2.54 2.41 2.66 2.15 Quick Asset Ratio 3.34 2.78 2.20 1.91 3.05 1.76 Accounts Receivable Turnover 13.95 30.24 9.05 7.58 6.07 8.17 Days Supply of Receivables 26.16 12.07 40.32 48.15 60.17 44.65 (Days Sales Outstanding) Inventory Turnover 20.00 42.62 33.96 41.58 30.71 28.05 Days Supply of Inventory 18.25 8.56 10.75 8.78 11.89 13.01 Working Capital Turnover 1.35 1.85 2.47 2.76 3.23 4.02

Profitability Analysis

Gross Profit Margin 62.7% 56.8% 53.2% 50.7% 50.3% 48.6% Operating Expense Ratio 36.5% 38.4% 45.3% 53.0% 39.5% 40.0% Net Profit Margin 19.5% 12.8% 5.9% (0.8%) 8.2% 6.0% Asset Turnover 0.87 1.05 1.01 0.96 1.19 1.35 Return on Assets 17.0% 13.4% 6.0% (0.8%) 9.8% 8.1% Return on Equity 21.6% 17.8% 8.2% (1.1%) 12.6% 11.0%

Capital Structure Analysis

Debt to Equity Ratio 0.27 0.32 0.36 0.33 0.29 0.36 Times Interest Earned ------Debt Service Margin 5.87 6.72 3.25 2.69 0.46 1.54

Additional Analysis

Dividend Payout Ratio ------Sustainable Growth Rate (SGR) 21.6% 17.8% 8.2% (1.1%) 12.6% 11.0% Net Long-term Asset Turnover 6.04 5.54 3.15 2.36 2.92 3.68 Net Operating Profit After Taxes 0.19 0.13 0.05 (0.02) 0.07 0.05 (NOPAT) Margin Note: Electronic Arts Inc. did not report any interest expense or dividends paid for fiscal years 2004 through 1999

Appendix 4.5 Activision, Inc. Financial Statement Ratio Analysis (In Thousands of Dollars)

Year 2003 2002 2001 2000 1999 Income Statement

Total Sales 864,116 786,434 620,183 572,205 436,485 Cost of Goods Sold 565,173 531,731 414,609 410,660 297,866

Gross Profit 298,943 254,703 205,574 161,545 138,619 Operating Expense 769,269 705,860 580,376 602,530 409,859 NIBIT 94,847 80,574 39,807 (30,325) 27,245 Interest Expense 8,560 2,546 7,263 8,411 3,031

Net Income 66,180 52,238 20,507 (34,088) 15,254 Dividends Paid - - - - - Balance Sheet

Accounts Receivable 15,822 76,733 73,802 108,108 117,541 Inventory 19,577 20,736 43,888 40,453 30,931 Current Assets 526,905 456,873 298,230 264,097 231,360 Quick Assets 422,776 355,740 199,352 158,093 150,578

Accounts Payable 45,602 64,410 60,980 38,284 43,853 Current Liabilities 104,405 123,674 115,250 103,948 95,005 Working Capital 422,500 333,199 182,980 160,149 136,355

Total Assets 704,816 556,887 359,957 309,737 283,345 Total Liabilities 107,076 126,796 178,651 177,728 156,155 Total Stockholders' Equity 597,740 430,091 181,306 132,009 127,190 Statement of Cash Flows Operating Cash Flow 90,975 11,792 81,565 2,883 18,190 Investing Cash Flow (155101) (15169) (3800) (25041) (8631)

Year 2003 2002 2001 2000 1999

Liquidity Analysis

Current Ratio 5.05 3.69 2.59 2.54 2.44 Quick Asset Ratio 4.05 2.88 1.73 1.52 1.58 Accounts Receivable Turnover 54.61 10.25 8.40 5.29 3.71 Days Supply of Receivables 6.68 35.61 43.45 69.00 98.38 (Days Sales Outstanding) Inventory Turnover 28.87 25.64 9.45 10.15 9.63 Days Supply of Inventory 12.64 14.24 38.62 35.96 37.90 Working Capital Turnover 2.05 2.36 3.39 3.57 3.20

Profitability Analysis

Gross Profit Margin 34.6% 32.4% 33.1% 28.2% 31.8% Operating Expense Ratio 89.0% 89.8% 93.6% 105.3% 93.9% Net Profit Margin 7.7% 6.6% 3.3% (6.0%) 3.5% Asset Turnover 1.23 1.41 1.72 1.85 1.54 Return on Assets 9.4% 9.4% 5.7% (11.0%) 5.4% Return on Equity 11.1% 12.1% 11.3% (25.8%) 12.0%

Capital Structure Analysis

Debt to Equity Ratio 0.18 0.29 0.99 1.35 1.23 Times Interest Earned 11.08 31.65 5.48 - 8.99 Debt Service Margin 1.99 0.18 1.34 0.08 0.41

Additional Analysis

Dividend Payout Ratio - - - - - Sustainable Growth Rate (SGR) 11.1% 12.1% 11.3% (25.8%) 12.0% Net Long-term Asset Turnover 4.86 7.86 10.05 12.54 8.40 Net Operating Profit After 0.08 0.07 0.04 (0.05) 0.04 Taxes (NOPAT) Margin

Appendix 4.6 Take-Two Interactive Software, Inc. Financial Statement Ratio Analysis (In Thousands of Dollars)

Year 2003 2002 2001 2000 1999 Income Statement

Total Sales 1,033,693 794,676 451,396 387,006 305,932 Cost of Goods Sold 637,554 500,084 306,323 247,796 215,122

Gross Profit 396,139 294,592 145,073 139,210 90,810 Operating Expense 233,128 171,887 116,696 94,149 63,429 NIBIT 163,011 122,705 28,377 45,061 27,381

Interest Expense (Gain) 2,265 480 8,510 6,069 2,910

Net Income 98,118 71,563 6,918 24,963 16,332 - - - - - Dividends Paid Balance Sheet

Accounts Receivable 166,536 105,576 94,950 134,877 107,799 Inventory 101,748 74,391 61,937 44,922 41,300 Current Assets 513,402 328,365 222,874 214,908 187,970 Quick Assets 350,013 213,945 101,006 140,122 118,173

Accounts Payable 106,172 79,660 60,223 47,972 71,230 Current Liabilities 165,247 131,810 134,645 153,023 146,531 Working Capital 348,155 196,555 88,229 61,885 41,439

Total Assets 707,298 491,440 354,997 351,641 231,712 Total Liabilities 173,806 135,896 134,936 164,639 146,609

Total Stockholders' Equity 533,492 355,544 220,061 187,002 85,103 Statement of Cash Flows Operating Cash Flow 80,628 144,998 27,319 55,259 16,748 Investing Cash Flow (45881) (18084) (13479) (12906) (21540)

Note: Take-Two Interactive Software, Inc. did not report any dividends paid for fiscal years 2003 through 1999; the interest gain in fiscal 2003 reflects the company’s repayment of borrowed debt

Year 2003 2002 2001 2000 1999

Liquidity Analysis

Current Ratio 3.11 2.49 1.66 1.40 1.28 Quick Asset Ratio 2.12 1.62 0.75 0.92 0.81 Accounts Receivable Turnover 6.21 7.53 4.75 2.87 2.84 Days Supply of Receivables 58.80 48.49 76.78 127.21 128.61 (Days Sales Outstanding) Inventory Turnover 6.27 6.72 4.95 5.52 5.21 Days Supply of Inventory 58.25 54.30 73.80 66.17 70.07 Working Capital Turnover 2.97 4.04 5.12 6.25 7.38

Profitability Analysis

Gross Profit Margin 38.3% 37.1% 32.1% 36.0% 29.7% Operating Expense Ratio 22.6% 21.6% 25.9% 24.3% 20.7% Net Profit Margin 9.5% 9.0% 1.5% 6.5% 5.3% Asset Turnover 1.46 1.62 1.27 1.10 1.32 Return on Assets 13.9% 14.6% 1.9% 7.1% 7.0% Return on Equity 18.4% 20.1% 3.1% 13.3% 19.2%

Capital Structure Analysis

Debt to Equity Ratio 0.33 0.38 0.61 0.88 1.72 Times Interest Earned - 255.64 3.33 7.42 9.41 Debt Service Margin 0.76 1.82 0.45 1.15 0.24

Additional Analysis

Dividend Payout Ratio - - - - - Sustainable Growth Rate (SGR) 18.4% 20.1% 3.1% 13.3% 19.2% Net Long-term Asset Turnover 5.33 4.87 3.42 2.83 6.99 Net Operating Profit After Taxes 0.10 0.09 0.03 0.07 0.06 (NOPAT) Margin

Appendix 4.7

Midway Games Inc. Financial Statement Ratio Analysis (In Thousands of Dollars)

Year 2003 2002 2001 2000 1999 Income Statement

Total Sales 92,524 191,857 115,993 333,865 351,795 Cost of Goods Sold 113,305 142,699 75,278 207,326 215,568

Gross Profit (20,781) 49,158 40,715 126,539 136,227 Operating Expense 62,732 64,492 52,613 78,729 61,705 NIBIT (115,975) (52,265) (63,486) (20,881) 8,328 Interest Gain 2,012 3,919 2,122 1,301 1,586

Net Income (115,227) (53,823) (61,364) (12,041) 6,147 Preferred Stock Dividends 2,707 19,795 5,414 - - Balance Sheet

Accounts Receivable 15,814 54,265 23,572 25,398 46,244 Inventory 3,566 9,313 2,203 27,528 32,278 Current Assets 76,988 141,420 175,003 123,493 157,229 Quick Assets 57,496 103,248 151,454 59,491 97,790

Accounts Payable 5,413 10,410 5,462 8,959 13,457 Current Liabilities 26,319 40,783 28,118 24,500 37,190 Working Capital 50,669 100,637 146,885 98,993 120,039

Total Assets 125,449 201,400 246,405 186,575 219,259 Total Liabilities 77,556 61,433 65,822 26,220 41,683

Total Stockholders' Equity 47,893 139,967 180,583 160,355 177,576 Statement of Cash Flows Operating Cash Flow (48,368) (59,942) (20,932) (657) 23,842 Investing Cash Flow (32558) (22782) (31444) (5595) (5220)

Note: Midway Games, Inc. shows an interest gain for fiscal year 2003 through 1999 due to a lack of borrowed debt in the company’s capital structure; fiscal years 2003 through 2001 end December 31 while fiscal years 2000 through 1999 end June 30

Year 2003 2002 2001 2000 1999

Liquidity Analysis

Current Ratio 2.93 3.47 6.22 5.04 4.23 Quick Asset Ratio 2.18 2.53 5.39 2.43 2.63 Accounts Receivable Turnover 5.85 3.54 4.92 13.15 7.61 Days Supply of Receivables (Days Sales Outstanding) 62.39 103.11 74.19 27.76 47.96 Inventory Turnover 31.77 15.32 34.17 7.53 6.68 Days Supply of Inventory 11.49 23.83 10.68 48.47 54.64 Working Capital Turnover 1.83 1.91 0.79 3.37 2.93

Profitability Analysis

Gross Profit Margin (22.5%) 25.6% 35.1% 37.9% 38.7% Operating Expense Ratio 67.8% 33.6% 45.4% 23.6% 17.5% Net Profit Margin (124.5%) (28.1%) (52.9%) (3.9%) 1.7% Asset Turnover 0.74 0.95 0.47 1.79 1.60 Return on Assets (91.9%) (26.7%) (24.9%) (6.5%) 2.8% Return on Equity (240.6%) (38.5%) (34.0%) (7.5%) 3.5%

Capital Structure Analysis

Debt to Equity Ratio 1.62 0.44 0.36 0.16 0.23 Times Interest Earned - - - - - Debt Service Margin (8.94) (5.76) (3.83) (0.07) 1.77

Additional Analysis

Dividend Payout Ratio - - - - - Sustainable Growth Rate (SGR) (246.2%) (52.6%) (37.0%) (7.5%) 3.5% Net Long-term Asset Turnover 1.91 3.20 1.62 5.29 5.67 Net Operating Profit After Taxes (1.23) (0.27) (0.52) (0.03) 0.02 (NOPAT) Margin Note: Midway Games, Inc. shows no Notes Payable for fiscal years 2003 through 1999, so Accounts Payable has been substituted where necessary

Appendix 4.8 Key Industry Ratios

Appendix 5.1 Industry Comparables Selected Data Fiscal Year End 2003 and 2004 Company EPS BPS DPS SPS PPS

Electronic Arts, Inc. 1.92 11.29 - 9.81 47.88 Take-Two Interactive Software, Inc. 2.22 15.99 - 23.37 34.76

Activision, Inc. 0.57 0.71 - 6.90 15.38

Midway Games, Inc. (1.96) 2.13 - 1.57 10.35

Microsoft Corp. 0.75 5.19 0.16 3.39 29.31

Atari, Inc. 6.32 0.01 - 3,868.19 1.95

Nintendo Co. Ltd. 2.23 0.68 1.33 34.58 14.90

Capcom Co. Ltd. (1.49) 4.50 0.19 8.58 8.81 Company P/E P/B D/P P/S Electronic Arts, Inc. 24.94 4.24 - 4.88 Take-Two Interactive Software, Inc. 15.66 2.17 - 1.49 Activision, Inc. 26.98 21.66 - 2.23

Midway Games, Inc. (5.28) 4.86 - 6.59

Microsoft Corp. 39.08 5.65 0.01 8.65 Atari, Inc. 0.31 195.00 - 0.00

Nintendo Co. Ltd. 6.68 21.91 0.09 0.43

Capcom Co. Ltd. (5.91) 1.96 0.02 1.03

Industry Comparables Valuation of EA Fiscal Year End 2004

P/E P/B D/P P/S

Sum 88.71 58.21 0.12 20.41

Average 17.74 9.70 0.04 3.40

Electronic Arts, Inc. (Price) 34.06 109.51 - 33.35

Key: P/E (price/earnings), P/B (price/book), D/P (dividends/price), P/S (price/sales) Conversion Rate: ¥105 to $1

Appendix 5.2

(Discounted Free Cash Flows Model)

Discounted Cash Flow Analysis (Electronic Arts)

2005 - 2014 Forecast: 2004 Forecast Year: 0 Discount Factor: 1.0000

Net cash provided by operating activities: 669,285,000 Net cash provided by (used in) investing activities: 287,962,000 Free cash flow to Electronic Arts: 957,247,000 Present value of free cash flows: 957,247,000

Total present value of annual cash flows: 7,100,152,034 Continuing value (assuming 3.76% SGR): 18,263,193,040 Present value of continuing cash flows: 7,713,579,316

Value of Electronic Arts (end of 2004): 14,813,731,350 Book value of debt (no preferred stock): 722,253 Value of equity (end of 2004): 14,813,009,097

Estimated value per share: (with 0.591 ß) 49.16 Estimated value per share: (with published Value Line 1.05 ß) 32.88 Adjusted for Nov. 5 49.10 Actual value per share (5 November 2004): 47.88

2005 - 2014 Forecast: 2005 2006 2007 2008 2009 Forecast Year: 123 45 Discount Factor: 0.9174 0.8417 0.7722 0.7084 0.6499

Net cash provided by operating activities: 669,285,000 669,285,000 669,285,000 669,285,000 669,285,000

Net cash provided by investing activities: 287,962,000 287,962,000 287,962,000 287,962,000 287,962,000

Free cash flow to Electronic Arts: 957,247,000 957,247,000 957,247,000 957,247,000 957,247,000

Present value of free cash flows: 878,196,977 805,674,952 739,141,839 678,103,069 622,104,917

2005 - 2014 Forecast: 2010 2011 2012 2013 2014 Forecast Year: 678910 Discount Factor: 0.5962 0.5470 0.5018 0.4604 0.4224

Net cash provided by operating activities: 669,285,000 669,285,000 669,285,000 669,285,000 669,285,000 Net cash provided by investing activities: 287,962,000 287,962,000 287,962,000 287,962,000 287,962,000 Free cash flow to Electronic Arts: 957,247,000 957,247,000 957,247,000 957,247,000 957,247,000 Present value of free cash flows: 570,731,125 523,599,812 480,360,630 440,692,166 404,299,546

Sensitivity Analysis Rate Needed to Equate Actual Share Price (with SGR or WACC held constant) ß = 0.691 Est. Rate Req. Rate Value PS

WACC: 9.00% 3.49% 47.90

SGR: 3.76% 9.16% 47.88 WACC: 0.16% Difference: SGR: -0.28% ß = 1.05 Est. Rate Req. Rate Value PS

WACC: 12.20% 8.47% 47.92

SGR: 3.76% 9.16% 47.88 WACC: -3.04% Difference: SGR: 4.71%

Appendix 5.3 (Residual Income Model)

Discounted Residual Income Analysis (Electronic Arts) 2004 2005 2006 2007 2008 2009 Beginning BE (per share) 11.29 13.42 15.78 18.4 21.31 EPS 2.13 2.36 2.62 2.91 3.23 DPS 0 0 0 0 0 Ending BE (per share) 11.29 13.42 15.78 18.4 21.31 24.54 "Normal" Income 1.020616 1.213168 1.426512 1.66336 1.926424 Residual Income (RI) 1.109384 1.146832 1.193488 1.24664 1.303576 PV Factor 0.917095 0.841063 0.771334 0.707386 0.64874 Present Value of RI 1.01741 0.964557 0.920578 0.881856 0.845682

BV Equity (per share) 11.29 Total PV of RI 8.41 Sensitivity Analysis

Continuation (Terminal) Value 67.38 Ke 0.0904 Ke 0.091 PV of Terminal Value 28.36 SGR 0.0373 SGR 0.0376 Estimated Value Per Share (end of 2004) 48.06 PPS 47.9 PPS 47.47 Adj. for Nov. 5 48.00

Discounted Residual Income Analysis (Continued…) 2010 2011 2012 2013 2014 Beginning BE (per share) 24.6 28.18 32.15 36.56 41.46 EPS 3.58 3.97 4.41 4.9 5.44 DPS 0 0000 Ending BE (per share) 28.18 32.15 36.56 41.46 46.9 Normal Income 2.22384 2.547472 2.90636 3.305024 3.747984 Residual Income (RI) 1.35616 1.422528 1.50364 1.594976 1.692016 3.557716 PV Factor 0.594956 0.545631 0.500395 0.45891 0.420864 Present Value of RI 0.806856 0.776175 0.752414 0.73195 0.712108

Value Line Sensitivity Analysis Cost of Equity 12.25% Cost of Equity 9.10% SGR 8.80% SGR 3.76% Price 47.2 Price 47.48

Appendix 5.4 (Abnormal Earnings Growth Model)

Abnormal Earnings Growth Analysis (Electronic Arts) 2004 2005 2006 2007 2008 2009 EPS 1.92 2.13 2.36 2.62 2.91 3.23 DPS 0 0 0 0 0

DPS invested at Ke 0000 0 Cum-Dividend Earnings 2.36 2.62 2.91 3.23 Normal Earnings 2.3226 2.5733 2.8568 3.1731 Abnormal Earning Growth 0.0374 0.0467 0.0532 0.0569 PV Factor 0.9171 0.8411 0.7713 0.7074 PV of AEG 0.0343 0.0392 0.0410 0.0403

EPS at 2005 2.13 Total PV of AEG 0.37 Continuing (Terminal) Value 1.24 Sensitivity Analysis

PV of Terminal Value 0.57 Ke 0.08 Ke 0.904 Total PV of AEG 3.06 SGR 0.0376 SGR 0.0725 Capitalization Rate 9.04% PPS 48.73 PPS 47.32 (perpetuity) Value Per Share 33.90 Adj. for Nov. 5 33.86

Abnormal Earnings Growth (Continued…) 2010 2011 2012 2013 2014 EPS 3.58 3.97 4.41 4.90 5.44 DPS 0 0 0 0 0

DPS invested at Ke 0 000 0 Cum-Dividend Earnings 3.58 3.97 4.41 4.9 5.44 Normal Earnings 3.5220 3.9036 4.3289 4.8087 5.3430 Abnormal Earning Growth 0.0580 0.0664 0.0811 0.0913 0.0970 PV Factor 0.6487 0.5950 0.5456 0.5004 0.4589 PV of AEG 0.0376 0.0395 0.0443 0.0457 0.0445

Value Line Beta Value Line Sensitivity Analysis

Ke 0.122515 Cost of Equity 12.25% Cost of Equity 8.05% SGR 0.0376 SGR 0.00% SGR 3.76% PPS 14.26 Price 14.71 Price 47.87

Appendix 5.5 (Long-Run Average Residual Income Perpetuity)

Long-Run Average Residual Income Perpetuity (EA) growth Year Net Income Shareholder Equity ROE Ke rate B V E Price 1995 55,718,000 237,073,000 0.235 0.0904 0.0376 29.600 42.13 1996 46,677,000 322,317,000 0.145 Nov. 5 42.08 1997 51,327,000 447,776,000 0.115 1998 72,562,000 563,968,000 0.129 1999 72,872,000 662,931,000 0.110 2000 116,751,000 923,393,000 0.126 - 2001 (11,082,000) 2,034,347,000 0.005 Sensitivity Analysis

2002 101,509,000 1,243,294,000 0.082 Ke 0.0904 Ke 0.0845 2003 317,097,000 1,784,739,000 0.178 SGR 0.054 SGR 0.0376 2004 577,292,000 2,678,358,000 0.216 PPS 47.77 PPS 47.43 2005 640,794,000 3,562,216,000 0.180 2006 711,281,000 4,737,748,000 0.150 Value Line

2007 789,522,000 6,301,204,000 0.125 Ke 0.122515 2008 876,369,900 8,380,601,000 0.105 SGR 0.0376 2009 972,770,600 11,146,200,000 0.087 PPS 26.79 2010 1,079,775,000 13,932,750,000 0.077 2011 1,198,550,650 18,530,557,500 0.065 2012 1,330,391,000 24,645,641,000 0.054 2013 1,476,734,000 32,778,703,000 0.045 2014 1,639,175,000 43,595,675,000 0.038 Average 605,804,308 8,925,474,575 0.113

Value Line Sensitivity Analysis Cost of Equity 12.25% Cost of Equity 8.45% SGR 0.00% SGR 3.76% Price 27.24 Price 47.43

7.0 Sources

1. Activision Official homepage – http://www.activison.com 2. EA Official homepage- http://www.ea.com 3. ESA Study: Games and Socialization, Jones, S., July 6, 2003, Let the Games Begin: Games and Entertainment Among College Students. 4. Federal Reserve website – http://www.federalreserve.gov 5. Midway Official homepage – http://www.midway.com 6. MSN Business – http://www.msnbc.com 7. Lubomir Pechala, “Pechala’s Reports: Electronic Arts Inc. 2 – week forecast”, Sep 20-04, page 1-2 8. Take Two Interactive Official homepage – http://www.take2games.com 9. Yahoo Finance – http://finance.yahoo.com