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Profit Sinks at Activision

Joining its game peers, the company warns of tough times ahead.

Updated from 4:35 p.m. EST

The cyclical nature of the video-game market is finally catching up with

Activision

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.

In its earnings report Monday, executives at the video-game software publisher predicted essentially flat sales this fiscal year and an outright sales decline in the coming one. Should those forecasts come to pass, they would mark a big change for a company that has prided itself on consistently growing its top line year to year for some 13 years.

That time period encompassed two different console transitions -- the periodic replacement of video-game hardware and software with updated versions. Industrywide, such transitions have typically led to slumping sales and increased costs.

Although Activision was able to weather those past cyclical changes without taking a hit to its top line, it won't be able to escape unharmed the current one that began with the launch last fall of

Microsoft's

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Xbox 360 console, company officials said.

But the problem for Activision could be bigger than failing to hit a numeric target -- the forecast has called into question the company's basic strategy of frequently updating an ever-increasing number of franchise games.

The first signs of the transition's impact on Activision came to light in the company's just-completed holiday quarter. Although sales actually came in better than expected in the period, it's a misleading picture. The company's costs in the quarter soared as it upped advertising expenses and raised its reserves to protect against price cuts to move games. As a result, profit plunged much lower than analysts expected.

In the just-completed quarter, "The market environment was tougher than we expected," said Michael Griffith, CEO of Activision's publishing division, on a conference call. "The console transition came on sooner and harder than we expected."

Investors appeared surprised and disappointed by the company's report. In recent after-hours trading the company's stock was off more than 7% to $13.30.

In the company's third quarter, which ended Dec. 31, it earned $67.9 million, or 23 cents a share. That was down 30% from the $97.3 million, or 39 cents a share, in the year-prior quarter.

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In contrast to the earnings decline, sales jumped 20% year over year to $816.2 million.

While sales topped Wall Street's revised expectations, earnings fell far shy. On average, analysts polled by Thomson First Call were expecting the company to earn 36 cents a share in the just-completed quarter on $707.1 million in sales. Activision warned in December that its results for the holiday period would be "significantly lower" than its previous guidance of 52 cents a share on $790 million in sales but did not give a specific new forecast.

Looking forward, Activision predicted "weaker than expected market conditions." In its current, fourth quarter, the company now expects to lose 7 cents to 9 cents a share on sales ranging from $125 million to $135 million.

Wall Street had predicted that Activision would earn 2 cents a share in the current period on sales of $198.3 million. In the same quarter last year, the company earned $3.6 million, or about 2 cents a share, on sales of $203.9 million.

The company also sketched out its expectations for its next two fiscal years. In fiscal 2007, the company forecast revenues "slightly" above $1 billion and a "modest" increase in earnings per share over the 9 cents to 11 cents it expects to earn this fiscal year. For fiscal 2008, Griffith predicted $1.6 billion in sales; Griffith and other Activision executives declined to give a prediction of the company's earnings for that year.

Analysts had predicted far better results, forecasting 46 cents a share in earnings in fiscal 2007 on $1.48 billion in sales and 67 cents a share on sales of $1.81 billion in fiscal 2008.

Company officials attributed the muted outlook for the coming quarter and next fiscal year to their efforts to scale back the number of games the company will release. Activision won't release any new games this quarter, for instance, and pushed an unspecified number of games out of fiscal 2007 and into fiscal 2008, they said.

The company plans "to launch a more focused slate" of games this year, Griffith said. "We're focused on driving the breadth and quality of our slate and the efficiency in our business model."

Activision officials attributed the company's sales gain in the just-completed quarter to its large lineup of titles. The company ended the year as the No. 2 publisher in North America in terms of market share and had the top-selling title during the holiday on the Xbox 360 with its

Call of Duty 2

game.

But the company had a number of disappointments. Sales of

Gun

, a new western-themed game, fell shy of the company's expectations, as did

True Crime: New York City

, the latest version of the company's gangster-themed game. Additionally the company's

The Movies

title, another holiday-quarter release, performed so poorly as a game for the PC that the company cancelled plans to port it over to the PlayStation 2 and other game consoles.

The problem Activision had with

True Crime

, at least, had to do with quality, Griffith said, saying that the game "fell short" of the company's expectations.

As a result of the problems with

True Crime

and

Gun

, the company hasn't yet committed to doing a sequel of either game, Griffith said.

"We're examining the franchises for their future potential," he said.

In order to prop up those and other titles, the company spent heavily on advertising. Marketing costs jumped 48% year over year to $156 million.

But other costs soared as well. Software royalties jumped 79% to $104.2 million. Product development costs more than doubled to $53.1 million as the company upped spending on creating games for the new consoles.

The soft sales showed up elsewhere in the company's report. Inventories rose 77% to $84.8 million as the company saw weaker-than-expected reorders of particular titles. Compared to fourth-quarter sales, days sales outstanding jumped to 46 days from 14 days last year.