Updated from Jan. 27

Electronic Arts

(ERTS)

reported earnings for its crucial fiscal third-quarter Tuesday that handily beat Wall Street estimates on a 20% surge in sales. But the company's guidance fell short of expectations.

Shares of Electronic Arts dropped sharply in after-hours trading Tuesday and were down $2.24, or 4.6%, to $46.29 early Wednesday.

Redwood City, Calif.-based Electronic Arts, the largest maker of video games, projected fourth-quarter revenue to range from $550 million and $570 million, up 19% to 23% year over year, and fourth-quarter earnings to range from 17 cents to 20 cents a share. That's short of analyst estimates calling for fourth-quarter revenue of $570.2 million and earnings of 25 cents a share.

For the full fiscal year ending March 31, Electronic Arts raised its earning target and the lower end of its revenue target. As a result, the higher end of its new guidance reached consensus estimates. The company expects to earn $1.74 to $1.77 a share a share on revenue ranging from $2.91 billion to $2.93 billion. Previously, the company projected it would earn $1.68 to $1.75 a share on a split-adjusted basis on $2.85 billion to $2.93 billion in sales. Analysts were predicting earnings would hit $1.77 a share on revenue of $2.93 billion for the full fiscal year.

Wedbush Morgan Securities analyst Michael Pachter believes the company's conservative fourth-quarter guidance reflects management's concern with setting the bar too high to register 15% earnings growth in the next fiscal year. "This is a slowing growth story," said Pachter, who has a hold rating on Electronic Arts. (Pachter's firm hasn't done any banking with the company.)

Gross margins, which climbed in the December quarter, will go down slightly in the fourth quarter, CFO Warren Jenson said in a postclose conference call. Jenson noted the company is moving the launches of a couple of high-margin games --

Sims

and

Medal of Honor

sequels -- into fiscal-year 2005.

The company expects research and development to trend up as a percentage of sales in fiscal year 2005 in part due to development for the next generation of game consoles. And second-tier games are expected to suffer a price decline to $39 in 2004, creating additional price pressure on the company's top line, Jenson said.

But with two to three years left before the next generation of game consoles comes out from

Sony

(SNE) - Get Report

and

Microsoft

(MSFT) - Get Report

, "the peak is still ahead" Jenson said. "The benefit of the mass market is coming our way."

Lower console prices will help attract the mass market, and Jenson predicted the console manufacturers will lower the price to $129 from $179 by May or Labor Day at the latest. "The opportunity for a $149 price point has come and gone," Jenson said, referring to the console price others have speculated manufacturers would favor this year.

Last year, Sony and Microsoft bucked conventional wisdom and refused to cut prices before the holidays.

Sony's launch of a new handheld, the PlayStation Portable (PSP), also will boost software sales, EA management said. EA CEO Larry Probst said his company believes Sony could ship 3 million PSPs by March 31, 2005, the end of Sony's fiscal year. But he made a point of noting that projection comes from EA and not Sony.

For the third quarter, Electronic Arts reported net income under generally accepted accounting principles of $392.3 million, or $1.26 a share, in the fiscal third quarter, which ended Dec. 31. That was up from net income of $250.2 million, or 85 cents a share, in the same period a year earlier.

Excluding charges, Electronic Arts said pro forma net income climbed to $393.2 million, or $1.26 a share, from $265.2 million, or 90 cents a share a year earlier. That beat the consensus estimate by six cents as well as the company's guidance, which ranged from $1.15 to $1.20 a share.

Revenue in the third quarter, when the company posts nearly half of its total sales, rose 20% to $1.475 billion from $1.234 billion a year earlier. Analysts were forecasting revenue of $1.48 billion. In October, EA disappointed investors with lower-than-expected third-quarter revenue targets ranging from $1.425 billion to $1.475 billion. At the time the consensus was at $1.47 billion.

As in past quarters, EA benefited from currency exchange rates. The company estimated that currency fluctuations added about $83 million, or 7%, to its top line in the quarter.

Roughly half of EA's revenue in the December quarter came from North America, where sales were up 8% year over year to $753 million from sales of such titles as

Lord of the Rings

,

Need for Speed

and

Medal of Honor

. Sales outside North America made up about 49% of sales. Europe posted the largest sales growth, up 40% year over year to $658 million. Sales in Japan fell by 29% to $21 million.

EA's gross margin climbed 11 points from a year ago to 65.2%. Yet the company's operating expenses grew 35.1% from a year ago to $404.6 million.

On EA's balance sheet, cash and short-term investments climbed $92 million from the September quarter to $1.8 billion and as reached $2.2 billion as of Tuesday.