Konami 20-F 2008
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the fiscal year ended March 31, 2008
Date of event requiring this shell company report . . . . . . . . . . . . . . . . . . .
For the transition period from to
Commission file number: 1-31452
Konami Kabushiki Kaisha
(Exact name of registrant as specified in its charter)
(Translation of registrants name into English)
Noriaki Yamaguchi, +81-3-5770-0573, email@example.com, +81-3-5412-3300,
7-2, Akasaka 9-chome, Minato-ku, Tokyo 107-8323, Japan
(Name, Telephone, E-mail and/or Facsimile number and Address of Company Contact Person)
Securities registered or to be registered pursuant to Section 12(b) of the Act:
Securities registered or to be registered pursuant to Section 12(g) of the Act:
(Title of Class)
Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act:
(Title of Class)
Indicate the number of outstanding shares of each of the issuers classes of capital or common stock as of the close of the period covered by the annual report.
As of March 31, 2008, 137,321,557 shares of common stock were outstanding, including 1,281,674 shares represented by 1,281,674 American Depositary Shares.
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No ¨
If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934. Yes ¨ No x
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨
Indicate by check mark which basis of accounting the registrant has used to prepare the financial statements included in this filing:
U.S. GAAP x International Financial Reporting Standards as issued by the International Accounting Standards Board ¨ Other ¨
If Other has been checked in response to the previous question, indicate by check mark which financial statement item the registrant has elected to follow.
Item 17 ¨ Item 18 ¨
If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
TABLE OF CONTENTS
As used in this annual report, references to Konami are to KONAMI CORPORATION and references to we, our and us are to KONAMI CORPORATION and its subsidiaries except as the context otherwise requires.
As used in this annual report, fiscal 2008 refers to our fiscal year ended March 31, 2008, and other fiscal years are referred to in a corresponding manner.
As used in this annual report, U.S. dollar or $ means the lawful currency of the United States of America, and yen or ¥ means the lawful currency of Japan.
As used in this annual report, U.S. GAAP means accounting principles generally accepted in the United States, and Japanese GAAP means accounting principles generally accepted in Japan.
As used in this annual report, ADS means an American Depositary Share, and ADR means an American Depositary Receipt.
A. Selected Financial Data.
The following tables include selected historical financial data as of and for the fiscal years ended March 31, 2004 through 2008, derived from our audited consolidated financial statements prepared in accordance with U.S. GAAP. You should read the selected financial data below in conjunction with Item 5 of this annual report and our audited consolidated financial statements and information prepared in accordance with U.S. GAAP which are included in this annual report.
Selected Financial Data Prepared in Accordance with U.S. GAAP
Exchange Rate Data
Fluctuations in exchange rates between the Japanese yen and U.S. dollar and other currencies will affect the U.S. dollar and other currency equivalent of the yen price of our shares and ADSs and the U.S. dollar amounts received on conversion of cash dividends. We have translated some Japanese yen amounts presented in this annual report into U.S. dollars solely for your convenience. Unless otherwise noted, the rate used for the translations was ¥100.19 per $1.00 which was the mid price for telegraphic transfer of U.S. dollars for yen quoted by The Bank of Tokyo-Mitsubishi UFJ, Ltd. as of March 31, 2008, the last business day on or prior to the date of our most recent annual consolidated financial statements. The translation should not be construed as a representation that the yen amounts have been, could have been, or could in the future be converted into U.S. dollars at the above or any other rate.
The following table presents the noon buying rates for Japanese yen per $1.00 in New York City for cable transfers in foreign currencies as certified for customs purposes by the Federal Reserve Bank of New York for and as of the end of each period indicated.
As of July 28, 2008, the noon buying rate was ¥107.49 per $1.00.
B. Capitalization and Indebtedness.
C. Reasons for the Offer and Use of Proceeds.
D. Risk Factors.
Special Note Regarding Forward-looking Statements.
This annual report contains forward-looking statements about our industry, our business, our plans and objectives, our financial condition and our results of operations that are based on our current expectations, assumptions, estimates and projections. These forward-looking statements are subject to various risks and uncertainties. Generally, these forward-looking statements can be identified by the use of forward-looking terminology such as may, will, expect, anticipate, estimate, plan or similar words. These statements discuss future expectations, identify strategies, discuss market trends, contain projections of results of operations or of financial condition, or state other forward-looking information. Known and unknown risks, uncertainties and other factors could cause our actual results to differ materially from and worse than those contained in or suggested by any forward-looking statement. We cannot promise that our expectations, projections, anticipated estimates or other information expressed in or underlying these forward-looking statements will turn out to be correct. We do not undertake any obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
Important risk factors that could cause our actual results to be materially different from as described in the forward-looking statements are set forth in this Item 3.D or elsewhere in this annual report and include, without limitation:
Risks Relating to Our Overall Business
Our future success is dependent on our ability to release hit products.
The market for video game software, amusement arcade games, token-operated games and card game products that belong to our Digital Entertainment segment, gaming machines that belong to our Gaming & System segment, and pachinko liquid crystal display and pachinko slot machines that belong to our Other Operations segment are hit driven. Hit products account for a substantial portion of our net revenues and of the revenues in each of these markets. For example, the fast growth of our card game products in recent years resulted from, and was heavily dependent on, the sales of our Yu-Gi-Oh! Trading Card Game. Similarly, hit video game software titles such as the Yu-Gi-Oh! series, the WORLD SOCCER Winning Eleven series and the
METAL GEAR SOLID series, as well as our e-AMUSEMENT products for our amusement facilities, have contributed significantly to our recent results. If we do not develop, publish and distribute hit products in the future, our financial condition, results of operations and profitability in these segments could be negatively affected. The most important factor in developing hit products is to respond quickly to public tastes and preferences that change rapidly and are hard to predict. Therefore, if we fail to accurately anticipate and promptly respond to changing tastes and preferences, our business, revenues and profits in these segments could be harmed.
Our revenues are dependent on timely introduction of popular new products.
Our success depends on generating revenue from the timely introduction and shipment of new products. The majority of sales of a new video game software generally occurs in the first thirty to one hundred and twenty days after release. The sales occurrence for amusement arcade games, token-operated games and card game products that belong to Digital Entertainment segment and gaming machines that belong to Gaming & System segment also tends to be limited. We are constantly required to introduce new products in order to generate revenues and/or to replace declining revenues from older products. Also, because revenues earned during the early life of a product generally constitute a relatively high percentage of the total revenues earned from a product, a significant delay in the introduction of one or more new products, or the inability to ship in sufficient quantities to meet demand, could negatively affect sales and have a negative impact on our financial condition and results of operations. Unanticipated delays could also cause us to miss an important selling season such as the year-end holiday buying season or summer vacation. Moreover, our products may not achieve and sustain market acceptance during the short life cycle sufficient to generate revenue to recover our investment in developing the products and to cover our other costs.
The timely shipment of a new product depends on various factors, including the development process, approval by third-party licensors, production capacity and other factors such as debugging and approval by hardware licensors, in the case of video game software. It is possible that some of our products will not be released or shipped in a timely fashion in accordance with our plans.
Competition for market acceptance and pricing competition affect our revenue and profitability.
The markets for video game software, arcade games, token-operated games, card game products, gaming machines and most of our other products are intensely competitive and new products and platforms are regularly introduced. Only a small percentage of products introduced in the market achieve any degree of sustained market acceptance. In the case of video game software for handheld systems and home game consoles, amusement arcade games, token-operated games and gaming machines, significant price competition and reduced profit margins may result as the hardware product cycle matures. In addition, competition from new technologies such as video game software for play over the Internet or mobile phones may reduce demand in markets in which we have traditionally competed. As a result of prolonged price competition and reduced demand due to competing technologies, our operations in the past have been, and in the future could continue to be, negatively impacted.
Our competitors vary in size from small companies to very large corporations, some of which have significantly greater financial, marketing and product development resources than we have. Due to these greater resources, certain of our competitors can undertake more extensive marketing campaigns, adopt more aggressive pricing policies, pay higher fees to licensors of desirable motion picture, television, music, sports and character properties and pay more to third party software developers than we can. It is also possible that some of our competitors will form alliances or enter into exclusive business arrangements with key creators, distributors or retailers overseas which could hinder our ability to expand into international markets.
A decline in consumer spending due to unfavorable economic conditions could hinder sales of our products.
Our product sales are affected by customers ability and desire to spend disposable income on the purchase of our products. Any significant downturn in general economic conditions which results in a reduction in
consumers discretionary spending could reduce demand especially for entertainment and health-oriented products and services like ours and may harm our business. Such industry downturns have been, and may continue to be, characterized by diminished product demand and subsequent erosion of average selling prices.
Our performance may be vulnerable to rapidly changing consumer preferences.
Sales of our products depend substantially on how consumers decide to spend their money. Many of our markets are characterized by rapidly changing trends and fads, and frequent innovations and improvements are necessary to maintain consumer interest. We compete with other forms of entertainment and leisure activities. For example, we believe that the overall growth in the use of the internet and online services by consumers may pose a competitive threat if customers and potential customers spend less of their available time using video game software, amusement arcade games, token-operated games, card game products, gaming machines and pachinko and pachinko slot machines, and more time using the Internet or otherwise choose to engage in other forms of entertainment and leisure activities. Our financial performance may be harmed if we are unable to successfully adapt our products and services to these changing trends and fads.
Fluctuations in our quarterly operating results make our quarterly revenues and income difficult to predict.
The timing of release of new products can cause material quarterly revenue and earnings fluctuations. A significant portion of revenues in any quarter is often derived from sales of new products introduced in that quarter or in the immediately preceding quarter. If we are unable to begin volume shipments of a significant new product during the scheduled quarter, our revenues and earnings will be negatively affected in that period. In addition, because a majority of the unit sales for many of our products typically occur in the first thirty to one hundred and twenty days following their introduction, revenues and earnings may increase significantly in a period in which a major product is introduced and may decline in the following period or in periods in which there are no major product introductions.
Our quarterly operating results also may be materially impacted by other factors, including the level of market acceptance or demand for video game software, the timing of hardware platform introductions, the level of development and/or promotion expenses for a video game title. Also, many of our products are in the greatest demand from November to January, particularly at the end and beginning of the year and, to a lesser extent, in August (summer vacation) and in March (spring vacation), in decreasing order. This trend is explained as these months correspond to the periods of childrens school holidays and it is customary in Japan to buy such products as Christmas and New Year presents in December and January. In addition, in the U.S. demand is highest from November, starting with Thanksgiving and through the Christmas season. Moreover, in a platform transition period, sales of video game software products can be significantly affected by the timeliness of introduction of video game systems by the manufacturers of those platforms, such as Sony Corporation (Sony), Nintendo Co., Ltd. (Nintendo) and Microsoft Corporation (Microsoft).
Inability to procure commercially valuable intellectual property licenses may prevent product releases or result in reduced product sales.
We focus our development and publishing activities principally on products that are, or have the potential to become, franchise brand properties. Many of our products are based on intellectual property and other character or story rights acquired or licensed from third parties. For example, our products often embody trademarks, trade names, logos, or copyrights licensed by third parties, such as Major League Baseball Properties, Inc., and Major League Baseball Players Association. We have also acquired content licenses from sports organizations such as FIFPro Commercial Enterprises BV, the Japan Professional Baseball League, the Japan Professional Soccer League, or J-League, and the Japan Football Association. In addition, we have obtained content licenses from various companies, including NIHON AD SYSTEMS Inc., Kodansha Ltd., and Shogakukan Production Inc.
These license and distribution agreements are limited in scope and time, and we may not be able to acquire new licenses, renew licenses when they expire or include new products in existing licenses. License agreements
relating to these rights generally extend for an initial term of two to three years. The agreements are terminable upon the occurrence of a number of factors, including our material breach of the agreement, failure to pay amounts due to the licensor in a timely manner, or a bankruptcy or insolvency. The loss of a significant number of our intellectual property licenses or of our relationships with licensors could have a material adverse effect on our ability to develop new products and therefore on our business and financial results.
Inadequate intellectual property protections could prevent us from enforcing or defending our proprietary technology.
We regard our products as proprietary and rely on a combination of patent, copyright, trademark and trade secret laws, employee and third party nondisclosure agreements and other methods to protect our proprietary rights. We own or license various patents, copyrights and trademarks. We are aware that some unauthorized copying occurs within the video game software, trading card game and arcade machine industries. For example, unauthorized copies of the Yu-Gi-Oh! Trading Card Game have been found in the United States, France, China, Taiwan and the Netherlands. If a significant volume of unauthorized copying of our trading card games and other products were to occur, it could cause material harm to our business and financial results.
Policing unauthorized use of our products is difficult and can be a persistent problem, especially in some international markets. Further, the laws of some countries where our products are or may be distributed either do not protect our products and intellectual property rights to the same extent as the laws of Japan and the United States, or are poorly enforced. Legal protection of our rights may be ineffective in such countries, and we may be unable to protect our intellectual property rights, particularly as we pursue new and emerging technologies. We cannot assure you that existing intellectual property laws will provide adequate protection for our products in connection with these emerging technologies.
Infringement of intellectual property rights could lead to costly litigation and/or the need to enter into license agreements, which may result in increased operating expenses.
Existing or future infringement claims against us may result in costly litigation or require us to obtain a license for the proprietary rights of third parties, which could have a negative impact on our results of operations. As the number of our products increases there is an increased possibility of the contents and features of these products overlapping with the products of other companies, and we become subject to an increasing possibility of infringement claims. Although we are making efforts to ensure that our products do not violate the intellectual property rights of others, it is possible that third parties still may claim infringement.
From time to time, third parties have asserted that some of our products infringed their proprietary rights. These infringement claims have sometimes resulted in litigation against us. For example, in video game software featuring sports such as baseball and soccer, we use individual names and images of professional players, team names, logos and uniforms. Although we have obtained licenses to use them from organizations and agents which manage the rights of the professional players and the teams, in the event agreements change or any disputes arise among the professional players, the teams and organizations or agents which manage their rights, it is possible that such professional players, teams, organizations or agents might bring a lawsuit against us to suspend manufacturing and sales of the relevant video game software. Such a lawsuit may be time consuming and expensive to defend.
Intellectual property litigation or claims could force us to do one or more of the following:
Any of these actions may cause material harm to our business and financial results.
If our products contain defects, our business could be harmed significantly.
Our video game software products, amusement arcade games, token-operated games, exercise equipments, gaming machines, pachinko liquid crystal displays (LCDs) and pachinko slot machines are complex and may contain undetected errors when first introduced or when new versions are released. We cannot assure you that, despite extensive testing prior to release, errors will not be found in new products or releases after shipment, resulting in loss of or delay in market acceptance. This loss or delay could significantly harm our business and financial results.
We may face limitations on our ability to find suitable acquisition opportunities and integrate acquired businesses.
In order to develop and market our products and services competitively, we are seeking opportunities in and outside Japan to make acquisitions of controlling or significant stakes in other businesses that will grow our current businesses. Some of these transactions could be material in size and scope. Our acquisitions strategy requires that we effectively coordinate and integrate our activities with those of the companies in which we invest or which we acquire. In the event we make such acquisitions or investments, we will face additional financial and operational risks, including:
While we will continually be searching for additional acquisition opportunities, we may not be successful in identifying suitable acquisitions. As the video game software, amusement arcade machine, fitness club, gaming machine and pachinko and pachinko slot industries continue to consolidate, we face significant competition in seeking and consummating acquisition opportunities. We may not be able to consummate potential acquisitions or investments on terms acceptable to us or such an acquisition or investment may not enhance our business or may decrease rather than increase our earnings. Our shareholders may not have the opportunity to review, vote on or evaluate future acquisitions.
Our business and financial results could be negatively impacted if we are unable to attract additional qualified employees or retain the services of key employees, the loss of whom could have a material adverse effect on our business.
Our continued growth and success depend to a significant extent on the continued service of our senior management and other key employees and the hiring of new qualified employees. The software industry in particular is characterized by a high level of employee mobility and aggressive recruiting among competitors for personnel with technical, marketing, sales, product development and management skills. We may not be able to attract and retain skilled personnel or may incur significant costs in order to do so that may not be offset through either improved productivity or higher prices.
Factors specific to international trade may result in reduced revenues and/or increased costs.
Approximately 74.1% of our net revenues during fiscal 2008 were derived from sales in Japan. Although we expect that domestic sales will continue to account for a significant portion of our revenues in future periods, we plan to expand our international operations, particularly with respect to video game software, gaming machines and card game products, including through alliances or investments. Sales in foreign countries may involve expenses incurred to customize products to comply with local laws, especially in the case of gaming machines. In addition, products that are successful in the domestic Japanese market may not be successful in foreign markets due to different consumer preferences. In addition, our costs will increase as a result of the need to conduct market research to discover local preferences and tastes and to develop foreign language versions or make product modifications in order to tailor our products to various local markets. In the case of video game software, we may have to grant price concessions to or accept returns from major retailers that control market access to consumers. International trade is also subject to general country risks, including suspension of currency exchange by governments, increases in tariffs, and forfeiture of property through expropriation by governments. International trade is also exposed to fluctuating exchange rates. We may become exposed to increased litigation risks or unexpected bankruptcy risks through product liabilities, facility liabilities, product defect or labor issues in the course of further expanding our business, enhancing our international network and increasing our vendors and customers. These and other factors specific to international trade may result in increased costs or reduced revenues.
Demographic trends may have an adverse effect on our target market and our ability to increase revenues.
The Japanese population of people in their teens and twenties, the traditional target market for our products and services including computer & video games products and arcade games, is expected to decline. Accordingly, we may not be able to increase or maintain revenues if we are unable to enter new markets such as fitness clubs and expand our customer base and product offerings to overseas markets. Life expectancy in Japan is among the highest of the developed countries. However, as a result of a decline in fertility rates, Japans population is expected to begin declining and its demographic makeup is already aging considerably. According to government estimates released in April 2008, as of calendar year 2006, 21.5% of Japans population was aged 65 or over and this percentage is expected to reach 25.2% by 2013 and 40.5% by 2055.
Risks Relating to Our Digital Entertainment Segment
Transitions in game consoles and technological change have a material impact on the market for video game software and may adversely affect our revenues and profitability.
The life cycle of existing game consoles and the market acceptance and popularity of new game consoles significantly affect the success of our products. The introduction of new technologies could render our current products or products in development obsolete or unmarketable. In addition, we cannot guarantee that we will be successful in developing and publishing video game software for new game consoles on a timely basis. Further, the release dates of new game platforms or the number of units that will be shipped upon such release are beyond the scope of our control.
Also, when new game consoles are announced or introduced into the market, consumers typically reduce their purchases of video game software products for current consoles in anticipation of new platforms becoming available. During these periods, sales of our video game software products can be expected to slow down or even decline until new platforms have been introduced and have achieved wide consumer acceptance. For example, sales of some of our products for the previous PlayStation and Nintendo 64 platforms were negatively affected by the platform transition to Sony PlayStation 2, Nintendo GameCube and Microsoft Xbox. Also, if fewer than expected units of a new game platform are manufactured or shipped, or the introduction of a new platform is significantly delayed, we may experience lower-than-expected sales.
We must make significant expenditures to develop products for new platforms which may not be successful or released when anticipated.
The cyclical nature of the industry requires us to anticipate and assess the emergence and market acceptance of new game consoles and develop new software well in advance of the time the platform is introduced to consumers. If the platforms for which we develop new software products do not attain significant market penetration or our new products fail to gain market acceptance, we may not be able to recover in revenues our development expenses, which could be significant, and our business and financial results could be significantly harmed. We anticipate that our profitability will continue to be impacted by the levels of research and development expenses relative to revenues, and by fluctuations relating to the timing of development in anticipation of future platforms.
If we are unable to obtain or renew licenses from hardware manufacturers, we will not be able to release video game software for popular video game systems and our revenue and profitability may be negatively impacted.
Substantially all of our revenues from Computer & Video Games business have historically been derived from sales of video game software for use on proprietary game platforms developed and manufactured by other companies. We may only publish our games for play on their game platforms if we receive a platform license from them, which is generally for an initial term of several years and may be extended for additional one-year terms. If we cannot obtain licenses to develop video game software from manufacturers of popular game consoles or if any of our existing license agreements are terminated, we will not be able to release video game software for those systems, which may have a negative impact on our results of operations and profitability. Although we cannot assure shareholders that we will be able to obtain extensions or that we will be successful in negotiating definitive license agreements with developers of new systems when the term of existing license agreements end, to date we have always obtained extensions or new agreements with the hardware companies. We also depend on hardware manufacturers for the following additional reasons:
In addition, we depend on Sony and Nintendo for the manufacture of products that we develop for their hardware platforms. Games for Microsofts hardware platforms must be manufactured by an authorized replicator. Our hardware platform licenses with these hardware manufacturers provide that the manufacturer may change licenses costs. These licenses include other provisions such as approval rights of all products and related promotional materials that could have an effect on our costs and the timing of release of new titles.
Since major manufacturers such as Sony and Nintendo are also publishers of games for their own hardware platforms and manufacture products for all of their other licensees, such manufacturers may give priority to their own products or those of our competitors in the event of insufficient manufacturing capacity. Our business and financial results could be materially harmed by unanticipated delays in the manufacturing and delivery of our products by Sony or Nintendo, which has occurred in the past. In addition, our business and financial results
could be materially harmed if Sony or Nintendo used their rights under these agreements to delay the manufacture or delivery of our products, limit the costs recoverable by us to manufacture video game software for their consoles, or elect to manufacture video game software themselves or use developers other than us.
Our video game software for both game consoles and amusement arcade games may be subject to governmental restrictions, rating systems or to legal claims regarding content.
Legislation is introduced at the local, state and federal levels in the United States and in other countries to establish a system for providing consumers with information about graphic violence and sexually explicit material contained in software products. In 2005, legislation was also introduced in Japan to establish a system for local authorities to restrict the provision of products containing graphic violence. In addition, many countries have laws that permit governmental entities to censor the content and advertising of software. Although there are no mandatory government-regulations in Japan, North America, Europe and Asian countries except China that are significant markets or potential markets for our products, governmental approval is required for software sales in China, and such governmental approval may be adopted elsewhere. We may be required to modify our products or alter our marketing strategies to comply with new regulations, which could delay the release of our products in those countries. Due to the uncertainties regarding these rating systems, confusion in the marketplace may occur, and we are unable to predict what effect, if any, such rating systems would have on our business.
Within the past several years, at least one lawsuit has been filed in the United States against video game companies, which did not name us as a defendant, by the families of victims who were shot and killed by teenage gunmen. This lawsuit alleged that the video game companies manufactured and/or supplied these teenagers with violent video games, teaching them how to use a gun and causing them to act out in a violent manner. While the plaintiffs claims were dismissed, similar lawsuits may be filed in the future which, if decided against us and our insurance carrier does not cover the amounts we are liable for, could have a material adverse effect on our business and financial results. Also payment of significant claims by insurance carriers may make such insurance coverage materially more expensive or unavailable in the future, thereby exposing our business to additional risk.
Although neither the terrorist attacks in the United States of America in September 2001, the late 2001 bio-terrorist attacks on various organizations nor war against Iraq commenced in March 2003 involving terrorist attacks have had a material adverse effect on our business, operations or financial condition, we cannot assure you that future terrorist attacks or the response of governments to any future terrorist actions, would not negatively affect our business by requiring us to modify the content of our video game software, which could result in expensive product recalls, reprogramming or delays in the release of future games.
Our results of operations may suffer if amusement arcade revenues and sales of arcade games and token-operated game machines continue to decline.
Amusement arcades are the primary venue for video game machines and token-operated game machines in Japan. Over the past several years, amusement arcade revenues and the sales of arcade games had bottomed out and recently have recovered. However, due to the development of full-scale home video game systems that can rival amusement arcade games in play quality and the introduction of advanced mobile telephones equipped with network and game functions, consumers now have increasing leisure alternatives outside of amusement arcades. As customer preferences diversify, fewer people may visit frequently the amusement arcades on which we depend for sales of our amusement arcade game software, amusement arcade games and token-operated game machines and this could have a negative impact on our results of operations if amusement arcade operators reduce purchases of our products as a result.
If our games are not accepted in the competitive domestic market for video game machines and token-operated game machines for amusement arcades, our results of operations will suffer.
Our success as a manufacturer of video game machines and token-operated game machines is dependent upon numerous factors, including our ability to design, manufacture, market and service video game machines
and token-operated game machines that achieve player acceptance while maintaining product quality and acceptable margins. In addition, we must compete against other large and well-established game manufacturers such as SEGA SAMMY HOLDINGS INC. (Sega Sammy) and NAMCO BANDAI Holdings Inc. (Namco Bandai). If any of these game manufacturers, or another competitor, develops popular video game machines or token-operated game machines for amusement arcades and installed these game machines in the same arcade floor space as our video games and token-operated game machines, our sales from the amusement arcade game and domestic token-operated game machine markets may decrease significantly.
Our business could be harmed if there is any substantial decline in the popularity of interactive Internet-based games or if our Internet-based games are not received favorably in the market.
In recent years, the rapid growth of the Internet has resulted in the development of interactive software games for play over networks and on mobile phones. Although we are marketing mobile phone-based games as well as games for Nintendo Wii, PlayStation 3, PlayStation 2 and Xbox, games downloadable using the Xbox 360 or personal computers and games for play over networks, games have diversified over recent years and consumers now have expanded choices. If there is any substantial decline in the popularity of our network-based games, our business, revenues and profits could be harmed.
In addition, the development and operation of Internet-based games require a long period for development and a substantial amount of initial investment, including for example numerous test operations of facilities such as servers. If our Internet-based games are not received favorably in the market, we may be unable to recoup our initial investment or operating expenses, and may have to recognize an impairment with respect to the servers and software assets associated with such games.
Information processing failures in the operation of our Internet-based games may adversely affect our revenues and income.
As our Internet-based games require servers that process a heavy volume of information, the computers we use as servers must be equipped with high processing capacity. Although we attempt to prevent troubles by performing maintenance for our servers, we may be unable to operate our Internet-based games if the information processing capacity of a server becomes suddenly overloaded or is unexpectedly attacked by external computer viruses. If the recovery of processing capacity requires a long period of time, thus driving customers away, or if such technical errors and interruptions occur repeatedly and cause our customers to lose confidence in our services, our net revenues and operating income may decrease.
Abuses of network-based credit card billing authorization may adversely affect our revenues and profits.
We collect charges for our network-based games based on consumers credit card information, through a credit card authorization agent. Although our credit card authorization agent takes all possible measures to ensure the privacy of customer information during billing transactions, if the credit card information of our customers is obtained by unauthorized third parties and used for unauthorized transactions, we may be required to make repayments of the unauthorized amounts out of the sales we made to such customers. In addition, if numerous abuses occur, a credit card authorization agent might cancel billing collection services with us, and our net revenues and operating income may be adversely affected.
Risks Relating to Our Health & Fitness Segment
Our health & fitness segment may not grow as we expect if we are not able to successfully develop and operate new club locations.
Our growth strategy depends in part on our ability to successfully develop and operate new club locations. The successful development of new clubs will depend on various factors, including our ability to:
If we are not able to achieve success with respect to the factors outlined above, the growth of our health & fitness segment may be limited. We cannot assure you that we will be able to implement our growth strategy, open new clubs in a timely and cost-efficient basis or operate our new clubs profitably. Upon opening a new fitness club, we often experience an initial period of operating losses with respect to that club for the first year. However, this period can vary depending on the individual club, and may be substantially longer than a year. If we are unable to enhance the performance of our new fitness clubs, our operating income may be adversely affected. In fiscal 2006, we recognized ¥19,713 million in impairment losses in our Health & Fitness segment partly as a result of the segments failure to meet previous growth expectations, and we may still incur future impairment charges against goodwill, other identifiable intangible assets, or property and equipment.
A decline in membership levels of our fitness clubs could have a negative effect on our business.
The performance of our fitness clubs is dependent on our ability to attract and retain members, and we cannot assure you that we will be successful in these efforts, or that the membership levels at one or more of our clubs will not decline. Our members can cancel their club membership at the end of any month provided that they give advance notice by the tenth day of that month. Because members periodically cancel their membership, our total number of members will decline unless we are able to attract new members each month. There are numerous factors that could lead to a decline in membership levels at established clubs or that could prevent us from increasing our membership at newer clubs, including our reputation, our ability to deliver quality service at a competitive cost, the presence of direct and indirect competition in the areas in which the clubs are located, general interest in sports and fitness clubs and general economic conditions. As a result of these factors, we cannot assure you that our membership levels will be adequate to maintain or permit the expansion of our operations. In addition, a decline in membership levels may have a material adverse effect on our performance, financial condition and results of operations.
Failure to compete effectively in the fitness club industry will have an adverse effect on our results of operations.
The fitness club industry is highly competitive. We compete with other fitness clubs, physical fitness and recreational facilities established by local governments, hospitals and businesses for their employees, amenity and condominium clubs and, to a certain extent, with racquet and tennis and other athletic clubs, country clubs, weight reducing salons and the home-use fitness equipment industry. We also compete with other entertainment and retail businesses for the discretionary income of our target markets. We cannot assure you that we will be able to compete effectively in the future in the markets in which we operate. In addition, we may face new competitors in the market that may be larger and have greater resources than us. These competitive conditions may limit our ability to increase dues without a material loss in membership, attract new members and attract and retain qualified personnel. Additionally, consolidation in the fitness club industry could result in increased competition among participants, particularly as large multi-facility operators are better able to compete for attractive acquisition candidates, thereby increasing costs associated with expansion through acquisitions, as well as negotiation of leases and the availability of real estate.
Future claimswe could be subject to claims related to health risks at our clubs.
Use of our fitness clubs and equipment poses some potential health risks to members or guests through exertion from use of our services and facilities including exercise equipment. As a result, we may be subject to
claims against us for death or injury suffered by members while exercising at our fitness clubs, and we may not be able to successfully defend any such claims. In addition, any such claims may harm our reputation. We currently maintain general liability insurance coverage but there can be no assurance that we will be able to maintain such liability insurance on acceptable terms in the future or that such insurance will provide adequate coverage against potential claims. Any liability claim in excess of our insurance coverage may adversely affect our results of operations.
We are subject to various governmental regulations, any con-compliance with which could result in temporary closings and negative publicity.
Our operations are subject to national, local and municipal government regulation in the various jurisdictions in which our clubs are located. These regulations include, but are not limited to, health, sanitation and safety regulations with respect to the sale of food and beverages and the operation of swimming pools and baths. Any failure to comply with these regulations could result in the temporary suspension or loss of licenses necessary for food service and other operations at of our clubs. In addition, any resulting negative publicity that could have an adverse effect on our reputation and ability to attract and retain club members.
We may be unable to get refunds of deposits and guarantee money relating to leases of land and buildings for the use of our fitness club facilities.
In many cases, we rent land and buildings when we open new fitness clubs. Under the lease agreements that we enter into with landowners, we are often required to make deposits and to provide guarantee money in case we default in payment of rent or neglect to restore the property to its original state upon termination of the lease agreement. Under such lease agreements, if we pay our rent and restore the property as stipulated, we are entitled to obtain refund of such deposits and guarantee money. However, if the owner of the property faces financial difficulty or is otherwise unable or unwilling to return these funds, we may not be able to obtain full refunds of such deposits and guarantee money. As of March 31, 2008, such deposits and guarantee money accounted for over 8% of our total assets.
Inability to procure licenses for fitness programs from third parties or changes in the conditions of such licenses may adversely affect our revenues.
Our company acts as a licensing agency in Japan, acquiring licenses for programs that have worldwide popularity, and supplies the programs to not only our own facilities but also to other fitness clubs. In the event that it becomes difficult to renew licenses or if any changes are made to the conditions of such licenses, there may be a material adverse effect on our ability to supply programs to each facility and our business results could be affected.
Risks Relating to Our Gaming & System Segment
If our gaming products are not accepted in the competitive market for gaming machines, we may be unable to compete in the gaming machine market.
Our success as a gaming machine manufacturer and supplier in overseas markets is dependent upon numerous factors, including our ability to design, manufacture, market and service gaming machines and casino management systems that achieve player and casino acceptance while maintaining product quality and acceptable margins and to obtain approvals for our products from gaming authorities. In addition, we must compete against gaming equipment and system companies such as International Game Technology, Bally Technologies, Inc., Aristocrat Leisure Limited and WMS Industries Inc., which are among the largest and most-established suppliers of gaming machines in the world. Some of our competitors have greater financial resources, name recognition, established service networks and customer relationships than we do, and are licensed in more jurisdictions than we are.
In order to diversify and expand sales, we have obtained licenses in every state in Australia, the main states in the United States, and some provinces in Canada, and are marketing and selling gaming products in those markets. If our games and our system products fail to be accepted by the market, and we are otherwise unable to develop products that offer technological advantages or unique entertainment features, we will be unable to generate the revenues necessary to compete effectively in the competitive gaming product market. Consequently, the results of our operations could suffer.
If our technologies for gaming products are subject to claims they infringe on competitors patents, trademark rights and design rights, we may be unable to market our products as planned, thus adversely affecting our profits.
As technological capabilities and an ability to develop effective business plans are constantly becoming more crucial for success in the gaming business, it has become a critical business strategy for companies, especially in the United States, to ensure an advantage over competitors by filing and acquiring their own intellectual property rights such as patents, trademark rights and design rights in advance of their competitors. In this competitive business environment, we strive to commercialize our products only after carefully examining the intellectual property rights status of the products. However, if the contents of our new products and services are deemed to infringe on the intellectual property rights of competitors, we may be unable to bring such products or services to market or be forced to cease selling such products or services.
An adverse change affecting the gaming and systems industries, including a change in gaming regulations or in the expansion and popularity of casino gaming, will negatively impact our profitability and our potential for growth.
Our ability to grow our business and operate profitably is substantially dependent upon the expansion of the gaming industry and factors that are beyond our control. These factors include, among others:
An adverse change in any of these political, legal and other factors may negatively impact our results of operations.
Our failure to obtain or retain required licenses for our Gaming & System segment could prevent us from expanding our market and prohibit us from generating revenue in certain jurisdictions.
In North America, the manufacture and distribution of gaming products is subject to numerous federal, state, provincial, tribal, international and local regulations. In particular, we are subject to extensive regulation in Arizona, California, Idaho, Illinois, Indiana, Iowa, Kansas, Louisiana, Michigan, Minnesota, Mississippi, Nevada, New Jersey, New Mexico, New York, Oregon, West Virginia, Wisconsin, North Dakota, South Dakota, Oklahoma, Connecticut, Pennsylvania, Florida, Rhode Island, Puerto Rico and the Provinces of British Columbia, Ontario, Quebec, Alberta, Manitoba and Saskatchewan in Canada due to our gaming product business in those jurisdictions. In addition, we may also be subject to regulation as a gaming operator if we keep on developing lease participation agreements under which we share in the revenues generated by gaming machines. These regulations are constantly changing and evolving, and may curtail gaming in various jurisdictions in the future, which would decrease the number of jurisdictions from which we can generate revenues.
Together with our key personnel, we undergo extensive investigation before each jurisdictional license is issued. Our gaming products are subjected to independent testing and evaluation prior to approval from each
jurisdiction in which we do business. Generally, regulatory authorities have broad discretion when granting, renewing or revoking these game approvals and licenses. Our failure to obtain or retain a required license or approval in one jurisdiction could negatively impact our ability to obtain or retain required licenses and approvals in other jurisdictions. The failure to obtain or retain a required license or approval in any jurisdiction would decrease the geographic areas where we may operate and generate revenues, decrease our share in the gaming marketplace and put us at a disadvantage compared with our competitors. Consequently, the market price of our common stock may suffer.
Regulatory authorities may require shareholders to submit to background investigations and respond to questions from regulatory authorities, and may deny a license or revoke our licenses based upon their findings. These licensing procedures and background investigations may inhibit potential investors from becoming significant shareholders.
The future revenue growth of our Gaming & System segment depends on our ability to strengthen our research and development departments and improve the effectiveness of our sales organizations and service departments.
In order to increase market awareness and sales of our gaming products, it is important for us to develop hit products that are received favorably in our markets and for us to maintain technology that allows for future innovation and adaptations to changes in customer preferences. If we fail to assess market needs or be technologically innovative, our net revenues and operating income may be adversely affected.
In addition, it is important for us to improve the effectiveness of our sales operations and service departments internationally. Our gaming business is expanding from sales of slot machines to sales of casino management systems, which connect gaming machines under a single accounting, marketing and customer management system and reinforcement of security. Casino management systems provide for relatively stable revenues, as proceeds from the initial sale are supplemented by subsequent connection fees. However, gaming products require sophisticated sales efforts targeted at selected people within the gaming industry and quality post-sale servicing. Competition for qualified sales personnel is intense, and we might not be able to hire the kind and number of sales personnel we are targeting. In addition, we will need to effectively train and educate our sales force and strengthen our service departments to ensure trust in our products if we are to be successful in selling into the gaming machine market.
If our manufacturing plant in the United States has operational difficulties, and we have problems with manufacturing capacity and quality control, our business growth may be adversely affected.
In June 2005, we started operation of a manufacturing plant in Nevada to strengthen production capacity and customer service and expand development and sales in the U.S. market. We depend on our manufacturing capacity for substantially all of our sales in the U.S. market. If operational troubles occur in this plant, we may be unable to maintain sufficient manufacturing capacity to meet increases in orders, and our financial performance may be adversely affected.
Natural disasters such as hurricanes Katrina in August 2005 and Rita in September 2005, which caused a tremendous amount of damage to the southern part of the United States, could have a material adverse effect on our Gaming & System segment.
In summer 2005, hurricanes caused a tremendous amount of damage to the gaming business in the southern part of the United States, where we ship some of our products. The hurricanes resulted in loss of gaming equipment and a decrease in and cancellation of purchase orders. We also faced losses of gaming devices inventory, although to a lesser degree. Our results of operations may be adversely affected if similar natural disasters occur in the future.
Risks Relating to Our Other OperationsLCDs for Pachinko machines and Pachinko slot machines
As we do not manufacture LCDs for Pachinko machines, any delay or disruption in shipments from outside sources or incorporation of our software into the LCDs by subcontractors may adversely affect our profits.
Our revenues and profits from sales of our pachinko LCDs business come from sales of software that is integrated into LCDs. The manufacturing of LCDs is a complicated process which we entrust to third parties through agreements with certain suppliers who specialize in LCD commercial production. While we believe that we currently enjoy good relations with these suppliers, we cannot ensure that they will be able to provide us with the quality and quantity of LCDs which we may require in the future. We also rely on subcontractors to incorporate our software into the LCDs, which makes it possible that we will suffer profitability losses in the event of complications or delay. In addition, if any of the manufacturers or subcontractors discontinue their operations and we cannot find suitable replacements in a timely manner, we may face delays in introducing new products into the market and a decreased capacity for supplying software that is integrated into LCDs, adversely affecting our results of operations.
If the makers of LCDs for pachinko machines experience production delays, there may be unforeseen rises in inventory and delays in the posting of sales.
If the product release dates of makers of LCDs for pachinko machines are delayed for reasons such as revisions of the product release dates (due to changes in the market environment, efforts to differentiate themselves from competitors, or efforts to create balance between other products in their product line), or failure to pass the testing of the Security Electronics and Communications Technology Association (the Security Association), etc., there may be unforeseen rises in inventory and delays in the posting sales.
Our companys pachinko slot machines may not pass the testing of the Security Association due to circumstances beyond our control, and as a result, there may be delays in the date of release. Further, due to the tightening of regulations on the pachinko business by the National Police Agency, pachinko slot machines which had passed the Security Association testing and were scheduled for release may not be able to be sold.
Upon receipt of commission by a prefectural public safety commission, the Security Association conducts a regulations test as to whether pachinko and pachinko slot machines fulfill prescribed conditions on the basis of documents submitted by the pachinko and pachinko slot makers, as well as the practical exam, as described below:
The date of release for a product may be delayed if reapplication becomes necessary in the process of the above procedures due to failure to gain an application lot, changes to the test standards or are tightening of regulations on the industry by the National Police Agency or other similar considerations.
Our companys pachinko slot machines may be adversely affected because of groups attempting to make money through illicit methods (commonly referred to as goto-shi) in the pachinko and pachinko slot industry.
Our companys pachinko slot machines may be adversely affected because of groups attempting to make money through illicit methods (commonly referred to as goto-shi) in the pachinko and pachinko slot industries.
In the event of such manipulation by goto-shi, there may be a decline in sales volume due to the tarnishing of our brand image, and delays in the dates of release due to measures to prevent goto-shi manipulation of our other products.
Risks Relating to the Shares and the ADSs
Our share price is volatile and shareholders may not be able to recoup their investment.
Disclosures of our operating results (particularly if below the estimates of securities industry analysts), announcements of various events by us or by our competitors or other industry participants or the development and marketing of new products, as well as other factors, may cause the market price of our common stock to change significantly over short periods of time. The price of our common stock has been and is likely to continue to be highly volatile, and shareholders may not be able to recoup their investment. For example, the closing highs and lows of price per share of our common stock ranged from ¥2,580 to ¥4,120 during fiscal 2008.
A substantial number of our shares of common stock are eligible for future sale, and the sale of these shares may cause the price of our common stock to decline even if our business is performing well.
As of March 31, 2008, there were 137,321,557 shares of our common stock outstanding including 35,016,353 shares, representing 25.50% of our outstanding shares, beneficially owned by Kagemasa Kozuki, our founder, Representative Director, Chairman of the Board, President and Chief Executive Officer, and his affiliate holders Yoko Kozuki, Kozuki Holding B.V., Kozuki Foundation for Sports and Higher Education, and Kozuki Capital Corporation. These shares and, generally, the shares owned by other shareholders, can be disposed of on the Tokyo Stock Exchange or otherwise in Japan without any legal restriction. Additionally, under our Articles of Incorporation, our board of directors is authorized to issue 306,500,000 additional shares of common stock generally without any shareholder approval. In addition, as of March 31, 2008, we held 6,178,443 shares of treasury stock which our board of directors may sell without any shareholder approval, and as of March 31, 2008, we retired 55,786 issued shares.
Additional sales of a substantial amount of our common stock in the public market, or the perception that such sales may occur, could cause the market price of our common stock to decline. This could also impair our ability to raise additional capital through the sale of our securities. Also, in the future, we may issue common stock to raise cash for additional capital expenditures, working capital, research and development or acquisitions, and we may also pay for additional interests in subsidiaries or affiliated companies by using cash, common stock or both. We may also issue securities convertible into our common stock. Any of these events may dilute your ownership interest in us and have an adverse impact on the price of our common stock.
Investors holding less than a unit of shares will have limited rights as shareholders.
Pursuant to the Corporate Law of Japan relating to joint stock corporations and other related legislation, our Articles of Incorporation provide that 100 shares of common stock constitute one unit. The Corporate Law imposes significant restrictions and limitations on holdings of shares that do not constitute whole units. In general, holders of shares constituting less than one unit do not have the right to vote or to examine our books and records. The transferability of our shares of common stock constituting less than one unit is significantly limited. For a more complete description of the unit share system and its effect on the rights of holders of our shares, see Item 10.B Unit Share System below.
There are restrictions on your ability to withdraw shares from the depositary receipt facility.
Each ADS represents the right to receive one share of common stock. Each ADR will bear a legend to that effect. Holders of ADSs will be unable to withdraw fractions of shares from the depositary or receive any cash settlement in lieu of withdrawal of fractions of shares. Therefore, pursuant to the terms of the deposit agreement with our depositary, JPMorgan Chase Bank in order to withdraw any shares, a holder of ADSs must surrender for
cancellation and withdrawal of shares, ADRs evidencing 100 ADSs or any integral multiple thereof. In addition, although the ADSs themselves may be transferred in any lots pursuant to the deposit agreement, the ability to trade the underlying shares may be limited.
Holders of ADRs have fewer rights than shareholders and must act through the depositary to exercise those rights.
Holders of ADRs do not have the same rights as shareholders and accordingly cannot exercise rights of shareholders against us. JPMorgan Chase Bank, as depositary, through its custodian agent, is the registered shareholder of the deposited shares underlying the ADSs, and therefore only it can exercise the rights of shareholders in connection with the deposited shares. In certain cases, we may not ask JPMorgan Chase Bank to ask holders of ADSs for instructions as to how they wish their shares voted. Even if we ask JPMorgan Chase Bank to ask holders of ADSs for such instructions, it may not be possible for JPMorgan Chase Bank to obtain these instructions from ADS holders in time for JPMorgan Chase Bank to vote in accordance with such instructions. JPMorgan Chase Bank is only obliged to try, as far as practical, and subject to Japanese law and our Articles of Incorporation, to vote or have its agents vote the deposited shares as holders of ADSs instruct. In your capacity as an ADS holder, you will not be able to bring a derivative action, examine the accounting books and records of the company, or exercise appraisal rights.
Rights of shareholders under Japanese law may be more limited than under the laws of other jurisdictions.
Our Articles of Incorporation, our board of directors Regulations and the Corporate Law of Japan govern our corporate affairs. Legal principles relating to such matters as the validity of corporate procedures, directors fiduciary duties and liabilities, and shareholders rights may be different from those that would apply to a non-Japanese company. Shareholders rights under Japanese law may not be as extensive as shareholders rights under the laws of other countries or jurisdictions within the United States. You may have more difficulty in asserting your rights as a shareholder than you would as a shareholder of a corporation organized in another jurisdiction.
Because of daily price range limitations under Japanese stock exchange rules, you may not be able to sell your shares of our common stock at a particular price on any particular trading day, or at all.
Stock prices on Japanese stock exchanges are determined on a real-time basis by the equilibrium between bids and offers. These exchanges are order-driven markets without specialists or market makers to guide price formation. To prevent excessive volatility, these exchanges set daily upward and downward price fluctuation limits for each stock, based on the previous days closing price. Although transactions may continue at the upward or downward limit price if the limit price is reached on a particular trading day, no transactions may take place outside these limits. Consequently, an investor wishing to sell at a price above or below the relevant daily limit may not be able to sell his or her shares at such price on a particular trading day, or at all.
U.S. investors may have difficulty in serving process or enforcing a judgment against us or our directors, executive officers or corporate auditors.
We are a limited liability, joint-stock corporation incorporated under the laws of Japan. Most of our directors, executive officers and corporate auditors reside in Japan. All or substantially all of our assets and the assets of these persons are located in Japan and elsewhere outside the United States. It may not be possible, therefore, for U.S. investors to effect service of process within the United States upon us or these persons or to enforce against us or these persons judgments obtained in U.S. courts predicated upon the civil liability provisions of the federal securities laws of the United States. There is doubt as to the enforceability in Japan, in original actions or in actions for enforcement of judgment of U.S. courts, of liabilities predicated solely upon the federal securities laws of the United States.
The dollar amount of the dividends to be paid to ADS and ADS holders might be affected by fluctuations in the foreign currency market.
The market price of our companys ADS might drop in the event of a decline in the yen-U.S. dollar exchange rate. Further, the U.S. dollar amount of the cash dividend and other cash payments to be paid to holders of our companys ADS will decrease in the event that the yen-U.S. dollar exchange rate declines.
Foreign exchange fluctuations may affect the dollar value of our ADSs and dividends payable to holders of our ADSs.
Market prices for our ADSs may fall if the value of the yen declines against the U.S. dollar. In addition, the U.S. dollar amount of cash dividends and other cash payments made to holders of our ADSs would be reduced if the value of the yen declines against the U.S. dollar.
A. History and Development of the Company.
Our business was founded by our current Representative Director, Chairman of the Board and Chief Executive Officer, Kagemasa Kozuki, in Osaka on March 21, 1969. Konami was incorporated as a joint stock corporation under the laws of Japan on March 19, 1973 under the name Konami Industries Co., Ltd.
We originally were established to produce amusement arcade games and since that time have expanded the range of our products. We began to produce and market microcomputer-equipped video game machines in 1978, video game software for personal computers in 1982, game software for a home video game system in 1985 and software for LCDs for pachinko machines in 1992. We began our Toy & Hobby business in 1996. We obtained a license to manufacture and sell gaming machines in Nevada, and entered the gaming business in the United States in 2000. We entered the fitness club and equipment business through our acquisition of PEOPLE CO., LTD., which was renamed Konami Sports Corporation, in February 2001.
We initiated overseas operations by exporting amusement arcade games in 1979. We established our U.S. sales and manufacturing subsidiary, Konami of America, Inc. (the predecessor of Konami Digital Entertainment, Inc.) in 1982. Later, we established sales and manufacturing subsidiaries in a number of foreign countries.
We listed our shares on the Osaka Securities Exchange in 1984 (subsequently delisted in December 2002), on the Tokyo Stock Exchange in 1988, on the Singapore Exchange in 1997, on the London Stock Exchange in 1999 and on the New York Stock Exchange in September 2002.
In 1991, we changed our name to Konami Co., Ltd. and subsequently changed our name to KONAMI CORPORATION in 2000.
In 2006, we made Konami Sports Corporation (the predecessor of Konami Sports & Life Co., Ltd.) a wholly-owned subsidiary by issuing Konami shares to the minority shareholders of Konami Sports after Konami Sports Corporation merged with Konami Sports Life Corporation. In addition, we newly established Konami Digital Entertainment Co., Ltd. through a company separation to succeed to our digital entertainment business and we changed our group structure so that we act as a holding company.
In April 2007, we moved our principal head office to 7-2, Akasaka 9-chome, Minato-ku, Tokyo 107-8323, Japan. Our telephone number is 81-3-5770-0573.
For a discussion of recent and current capital expenditures, please see Capital Expenditures at the end of Item 5.A. We have had no recent significant divestitures nor are any significant divestitures currently being made.
B. Business Overview.
We develop, publish, market and distribute video game software products globally for stationary consoles such as Sony PlayStation, PlayStation 2, PlayStation 3, Nintendo Wii, Nintendo GameCube, Microsoft Xbox and Microsoft Xbox 360, and for portable consoles such as Sony PlayStation Portable, Nintendo Game Boy Advance and Nintendo DS, as well as for use on personal computers. In addition, we plan, produce, operate and distribute entertainment content for mobile phone online games.
We also produce card games, character goods, toys & hobbies, publications, CDs and DVDs and other merchandize products, many of which use popular characters seen in movies, television, comic books, video games, advertising or other media. We also publish, produce and provide post-sale service for software and hardware for amusement arcade games. In addition, we produce software for pachinko slot machines and LCDs used in pachinko machines, and produce video games and token-operated games installed in amusement arcades and other entertainment venues in Japan as well as gaming machines for casinos in the United States, Australia and other overseas jurisdictions.
In addition, we believe that we are the leading operator of health and fitness clubs in Japan, in terms of revenues, members and the total number of facilities. As of March 31,2008, our nationwide network of 209 directly operated health and fitness club facilities and 110 sports facilities whose operations are outsourced to us, cater to all age groups, from children through senior citizens. Moreover, Konami Sports Corporation merged with Konami Sports Life Corporation to establish Konami Sports & Life Co., Ltd. as of February 28, 2006, and COMBI WELLNESS Corporation became its wholly-owned subsidiary as of May 31, 2006 following our acquisition of all of its outstanding shares. Furthermore, Sportsplex Japan, which has 13 facilities in the Tokyo metropolitan area, became our subsidiary on March 6, 2008, after we acquired its shares from Tokyo Electric Power Company. We aim to create new markets and provide various health-related services through the operation of fitness club facilities and the development and manufacturing of heath-related equipment and supplements.
Because our sales are affected by changes in how consumers, particularly children and young adults, spend their leisure time, we seek to meet consumers needs and preferences by developing products that can be used in a number of environments, including home video games, games for amusement arcades and card games, casinos and pachinko parlors. We also recognize that borders that separate product categories such as games, movies, music, toys, books and television programs are blurring. We seek to capitalize on this trend by projecting successful concepts across different types of leisure environments and product categories.
Many of our successful products have resulted from diversified use of strong contents. For example:
We have built a company with a portfolio of products and services that spans a range of categories and target markets. We have created, licensed and acquired a group of recognizable brands that we market to a growing variety of consumer demographics.
For the fiscal year ended March 31, 2008, we had consolidated net revenues and net income of ¥297,402 million and ¥18,345 million, respectively, compared with net revenues and net income of ¥280,279 million and ¥16,211 million, respectively, for the fiscal year ended March 31, 2007.
Products and Services
During the fiscal year ended March 31, 2006, we classified our businesses into three segments: Digital Entertainment, Health & Fitness and Gaming & System, each of which is operated on a separate basis. The net revenue figures for each business segment described below are before elimination of intersegment revenues.
Digital Entertainment Segment
Operating in a business environment with lowering barriers to entry in the digital entertainment industry, we decided to reposition our existing major business segmentsvideo game software, amusement, card game and onlineinto one Digital Entertainment Segment from April 2005 to create a business structure where we can achieve maximum synergies. During fiscal 2008, this segment had net revenues of ¥178,939 million, which accounted for 60.2% of our consolidated net revenues, before elimination of intersegment revenues. Our Digital Entertainment Segment consists of the five businesses as follows:
Health & Fitness Segment
We are the leading health and fitness club operator and health-related business enterprise in Japan. We believe that we had approximately 29% of the market as measured by revenues based on the Nikkei Marketing Journals article on November 7, 2007. During fiscal 2008, this segment had net revenues of ¥86,544 million, which accounted for 29.1% of our consolidated net revenues, before elimination of intersegment revenues.
Gaming & System Segment
This segment is involved in developing content and hardware for gaming machines for casinos outside of Japan. During fiscal 2008, our net revenues from this segment were ¥18,471 million, which accounted for 6.2% of our consolidated net revenues, before elimination of intersegment revenues.
In addition, as part of our shift to a holding company structure, we transferred our research and development center for gaming machines to Konami Gaming, Inc., our U.S. subsidiary in March 2006, to become Konami Gamings Japanese branch and research and development hub. We also changed the segment name from Gaming to Gaming & System during fiscal 2006.
The following table presents net revenues in each of our historical business segments, before elimination of intersegment revenues, for each of the three years ended March 31, 2008.
Other consists of businesses which do not meet the quantitative criteria for separate presentation under SFAS No. 131 Disclosures about Segments of an Enterprise and Related Information.
Eliminations primarily consists of eliminations of intercompany sales and of intercompany profits on inventories.
Digital Entertainment Segment
Consolidated net revenues generated by our Digital Entertainment Segment, before elimination of intersegment revenues, amounted to ¥165,044 million in fiscal 2007 and to ¥178,939 million in fiscal 2008, an increase of ¥13,895 million.
Computer & Video Games business
The video game industry is comprised of video game hardware manufacturers and video game software publishers. Game hardware systems, frequently referred to as platforms, include home game consoles, handheld platforms and personal computers. In Japan, mobile phones are yet another platform for which there is an emerging demand for video game software applications.
A new generation of more technologically advanced game consoles has been introduced every several years. The first platform was Nintendo Entertainment System introduced by Nintendo in 1983 with its central processing unit, or CPU, using 8-bit 1.78 MHz technology. The CPU is a chip on which the software operates, with a bite indicating capacity to process data and clock frequency (MHz) indicating the processing speed. Subsequent advances in technology have resulted in continuous increases in the processing power of the chips that power both the consoles and PCs. With the advancement of hardware technology, software has also advanced, with faster and more complex images, more lifelike animation and sound effects and more intricate scenarios.
Each new generation, or cycle, of hardware has resulted in larger numbers of consoles being purchased. At the beginning of each cycle, during the period of rapid growth in the installed base of the new generation of consoles, the video game software industry has experienced rapid periods of expansion, as buyers purchase video
games for their new consoles. Shortly before and after the release of a new generation of game consoles, sales of the current generation of platforms and games generally diminish, as consumers defer purchases in anticipation of the new platforms and games.
Platform manufacturers license publishers to publish games for their platforms and retain a degree of control over the quality and manufacturing of these games. The publishers, subject to the approval of the platform manufacturers, determine the types of games they will create. Software publishers either create their games in-house, through their own development teams, or outsource this function to independent developers.
The following table illustrates the evolution of the principal platforms of both video game system and handheld system.
Handheld systems such as Nintendo DS and Sony PlayStation Portable have widely been accepted in markets, and in Japan in particular, strong sales of Nintendo DS tapped a market of new users who were not yet familiar with such games, further expanding new markets for these devices.
As for stationary systems, starting with Microsoft Xbox 360 released in December 2005 in Japan and November 2005 in North America, Sony PLAYSTATION 3 was launched in November 2006 in Japan and March 2007 in Europe, as well as Nintendo Wii in December 2006 in Japan and November 2006 in North America. These next-generation game consoles have become more highly sophisticated in their ability to show expressiveness when playing games. As a result, demand for home game consoles compatible with online usage are on the rise, exhibiting developments in service and products using online networks. This further led to the diversification of consumers preferences, attracting a wide range of users across different age and gender groups and stimulating markets for home game machines.
World Video Game Software Markets
According to data by the Computer Entertainment Suppliers Association, or CESA, in 2007, although the value of shipments of video game software decreased to ¥288 billion in Japan from ¥311 billion in 2006, and the value of exports to North America and Europe greatly increased to ¥286 billion and ¥246 billion from ¥190 billion and ¥158 billion in 2006, respectively. The increase was due to significant expansion of North American and European markets in 2007.
Our Computer & Video Games Software Business
Our Computer & Video Games business develops, publishes, distributes and markets software for video game systems and, to a lesser extent, personal computers. Most of our software consists of video games designed for use with video game platforms, including PlayStation 2, PLAYSTATION 3, PlayStation Portable, Nintendo Nintendo DS, Game Boy Advance, Nintendo Wii, Microsoft Xbox and Xbox 360, and PCs.
By developing video game software for each of the leading home and handheld video game platforms, we are able to limit our dependence on individual platforms, capitalize on the popularity of successful platforms from time to time, and sell to a more diverse group of consumers since the target age group for each major platform differs. Along with the diversification of consumers preferences, Nintendo DS attracts a wide range of users across different age and gender groups.
The market for video game software is substantially affected by sales of the various video game platforms. Our sales of video game software are inevitably affected to a substantial degree by the cyclical nature of the industry generally as platforms change, but through diversification we seek to limit this effect.
We publish more than 100 new titles of video game software each year, almost all of which are designed for use with leading platforms. We publish software titles in a variety of genres, including sports, action, role playing and music simulation.
The following two tables indicate the major software titles that we have either published, or anticipate publishing, during fiscal years 2008 and 2009 in each geographic market indicating for each title (i) the category of the game, (ii) the platform on which the game can be played, (iii) the date of release or anticipated release, and (iv) the market in which the product is sold. We cannot assure you that each of the titles anticipated for release in fiscal 2009 will be released when scheduled, if ever.
Titles Released In Fiscal 2008 (1)
The primary home video game software products on which we rely as revenue sources have been our hit titles, which include the following:
The following table illustrates the number of units that we have sold by platform for the periods indicated on a consolidated basis. This table indicates where we have concentrated our development efforts as well as changes in the relative significance of individual platforms.
We seek to develop video game software that is fun and exciting, and which provide sufficient challenges at various levels of proficiency to encourage repeated play. We also develop and release titles with comic, cartoon and movie contents and achieve synergy with media. We develop most of our own video game software.
Because the popularity of successful titles fades quickly, we are constantly working to develop new titles and sequels to existing titles. The life span for video game software titles depends on the type of title. Sports titles, which are updated frequently, may last indefinitely. Other titles usually have short life spans, generally six months to one year.
Most of our video game software development, including titles designed for overseas markets, is conducted by our group companies in Japan and the U.S. We subcontract part of the development to a subsidiary in China, Konami Software Shanghai, Inc. We expect that this subsidiary will be able to create and develop sophisticated video game software for both the Japanese market and the international market as it gradually acquires additional expertise and know-how.
On March 31, 2006, we founded Konami Digital Entertainment Co., Ltd. through a transfer of our digital entertainment operations including our video game software business, in the form of corporate separation and, as a result, we shifted to a holding company structure. We presently provide substantial discretion to our subsidiaries to achieve timely decision-making processes while the parent company develops group strategies and distributes management resources among group companies.
Hiring and retaining talented creative staff is key to developing successful content. To do this, we have introduced equity-based incentives and remuneration packages for creative staffs and developers that reflect the financial results of their work. We believe that this compensation structure that rewards creators for the success of their games and our policy of providing creators substantial independence and flexibility, enables us to attract and retain game creators that are among the best in the industry.
Through our long experience in developing software, we have developed significant in-house expertise and many proprietary development tools that streamline the development process, allowing members of our development teams to focus their efforts on the play and simulation aspects of the product under development. We believe our accumulated know-how and proprietary development tools enable our software designers to develop compelling, graphically sophisticated games quickly and efficiently, which may give us an advantage over competitors.
Our video game software is manufactured upon acceptance by Sony, Nintendo and Microsoft as required by the applicable platform license. We believe that this is the most desirable arrangement for both parties because we avoid the costs associated with the construction and maintenance of manufacturing facilities while the hardware manufacturers collect per unit royalties for each game they manufacture. The manufacturing process begins with our placing a purchase order with a manufacturer. Hardware manufacturers or their authorized vendors typically ship the first order to us within two to six weeks and additional orders for the same title within three days to four weeks.
We maintain both the proprietary rights and risks associated with each game title. In addition, at the time our product unit orders are filled by the manufacturer, we become responsible for the costs of manufacturing and/or the applicable per unit royalty on such units, even if the units do not ultimately sell. We provide a standard defective product warranty on all of the products sold. We are responsible in most cases for resolving, at our expense, any applicable warranty or repair claim. To date, we have not experienced any material costs from warranty or repair claims.
Our video game software business is dependent on our license agreements with the manufacturers of hardware platforms. All of these licenses are non-exclusive with fixed terms although these contracts are usually extended for additional terms. Each license grants us the right to develop, publish and distribute titles for use on the manufacturers platforms. Manufacturers typically have the right to approve the titles to be released and embodied in products that are manufactured solely by the manufacturer or its authorized vendor.
The following table sets forth information with respect to our platform licenses. In some instances, we have more than one platform license for a particular platform.
Nintendo charges us an amount for each Game Boy Advance, Game Boy Color and Nintendo DS cartridge manufactured. This amount varies based, in part, on the memory capacity of the cartridges. Nintendo GameCube, Nintendo Wii, Sony and Microsoft contracts include a charge for every disc manufactured. The amounts charged by the manufacturers include a royalty for the use of the manufacturers name, proprietary information and technology, and are subject to adjustment by the manufacturers at their discretion. The manufacturers have the right to review, evaluate and approve a demo-disc of each title and the titles packaging.
Marketing, Sales and Distribution
We believe that we benefit from a strong positive perception in Japan of the Konami brand name. We are focusing on further enhancing the Konami brand name by aggressively advertising and promoting ourselves and our products and services. To continue to increase our brand name recognition, we advertise on television, the radio and through various magazines and newspapers.
In October 2005, we merged with Konami Marketing Japan, Inc., a wholly-owned subsidiary for our marketing, sales and distribution businesses. As a result, we believe we are able to operate our digital entertainment business in a more consistent manner, from planning and production to advertisement and sales, and operate more efficiently. In addition, we newly established Konami Digital Entertainment Co., Ltd. through a company separation to succeed to our digital entertainment business in March 2006.
Our video game software products are sold in Japan primarily through our sales distribution network, which we coordinate, and offices throughout Japan. Each of these sales offices focuses its efforts on a specific area within Japan. We bear inventory risk until the product is sold to the retailer. However, once products are sold to a
retailer, they cannot be returned unless they are defective. We believe that our distribution network is a major asset of our business. In addition, we also conduct online sales through a directly operated website, and online sales have accounted for a greater percentage of our sales each year since 2007 due to the strengthening of our website through sales of limited editions of our video game software products on our website.
As for overseas marketing, we sell our products through sales representatives at our subsidiaries, principally those in the United States, Germany and Hong Kong. Due to different commercial environments, there are some risks for price protection or returned goods. In the European markets, soccer game software have made solid sales, whereas in the North American market, music game software are popular.
Card Games Business
Toy Industry Overview
Consumption TrendsDeclining Child Population and Enlarging the Age Brackets of Consumers
The Japanese toy industry is being forced to restructure as a result of a declining child population, the growing number of alternative options for play, changes in distribution systems and the bankruptcy of major toy wholesalers. Furthermore, companies must develop toys with original ideas so children will play with toys to a more advanced age than at present.
Since the population of children (those aged 0-14 years old) has been steadily declining and since the number of live births has also tended to decline, the child population is expected to continue to decline slightly in the future. According to the National Institute of Population and Social Security Research, the number of births in Japan has declined from 2.09 million in 1973 to 1.10 million in 2007. Consequently, the population of this age group has decreased from 27 million in the beginning of the 1980s to 17.2 million in the population census of 2007. The population of children is expected to fall below 10 million in 2039.
The phenomenon of children abandoning toys at a younger age is due to the changing pattern of childrens lives. A large number of children go to music classes (piano classes, etc.), fitness clubs (swimming schools, etc.) and cram schools (educational institutions to help enter kindergartens, primary schools and junior and senior high schools) from infancy and thus they spend less of their leisure time playing with toys than previous generations did. Moreover, electronic toys such as Nintendo DS now occupy an important position in the toy market. These toys are also used by younger people. The popularity of electronic games contributes much to the decreasing demand for general toys.
Trends and Characteristics of Toy Demand
According to market research conducted by the Japan Toy Association, total revenue of toys sold domestically for fiscal 2007, based on market price, was ¥670.9 billion, or 3% more than the amount from the previous year and surpassed the previous year for the first time in four years. The toy and hobby business is recently facing difficult conditions not only due to the decline in birthrates but also by the changes in and the variety of customer tastes. However, there has been progress in terms of logistics, expanding new service organizations and diversification of products.
The toy and hobby related market is starting to grow through the consolidation of such specialized markets as the character goods, figures, adult-targeted hobby and kids card game machines markets. The toy and hobby market is moving in a direction of widening products as it seeks to move past traditional lines of business by producing robots, digital cameras, movie cameras, apparels, home interior goods, bicycles and other products. Also, the target ages are widening from new born babies to seniors. Under these circumstances, according to the market research conducted by the Japan Toy Association, sales of stuffed toys, card game products, trading card products, toys for girls, toys for boys and character goods for toys are increasing toy and hobby sales on a year on year base.
Popular goods reflect contemporary social conditions. We believe that the changing market environment has led to certain goods being introduced and produced, as mentioned below.
The distribution of toys has greatly changed owing to the entry of the large U.S. chain toy store ToysRUs into the Japanese market in 1991 and to the increased sales made by suburban toy chain stores. The sales share of specialty toy shops has decreased and wholesalers, which act as intermediaries for manufacturers and retailers, have been affected by the change of distribution routes and the shortened distribution channels, which have caused them difficulties. The system of fixed retail price sales, which is the traditional business practices in the toy market, has begun to collapse, and even department stores have sold toys at discount prices.
According to the research conducted by the NPD Group, the toy market in North America has a size of $22.1 billion in annual sales for 2007, a decline of two percent compared to $22.6 billion for 2006, despite difficult economic conditions that plagued the industry in 2007. The strong performance of two categories, Action Figures & Accessories and Vehicles helped to offset losses. However, the most significant losses were experienced in Infant/Preschool, Outdoor & Sports Toys, and Dolls.
Costs for product development and marketing in European markets are generally higher than other markets due primarily to costs for translation in several languages and different distribution system in each country.
Our Card Games Business
We produce, develop, design and sell a range of card products and card-related products. These products are based on well-known characters, brands and images, or content, that we either produce on our own or license from third parties. Because of our strong reputation in the industry, we are able to acquire licenses to use popular characters and images such as those contained in Yu-Gi-Oh!. Although each product is different, in most cases, we produce, develop and design the product around popular content and subcontract the manufacturing to a third party.
More than 90% of our revenues from our Card Games business has been derived from worldwide sales of our Yu-Gi-Oh! Trading Card Game, and changes in the revenues and income of our Card Games business have depended primarily on changes in worldwide sales of our Yu-Gi-Oh! Trading Card Game. We believe we have the largest share of the worldwide card game market according to data available from the Japan Toy Association and the Toy Industry Association, Inc. In February 1999, we launched our Yu-Gi-Oh! Trading Card Game in Japan. The Yu-Gi-Oh! Trading Card Game is based on a comic that was originally serialized in one of Japans most popular weekly comic magazines. We continue to sell our Yu-Gi-Oh! Trading Card Game globally in the United States and European countries, as well as in Japan.
Our Card Games products are produced both overseas and in Japan by various third-party manufacturers. We are not dependent on any single manufacturer for the production of our Card Games products.
Marketing, Sales and Distribution
Marketing and sales in Japan are mostly conducted through direct sales to retailers, but depending on our target users and market conditions, we may choose more suitable methods. In July 2001, we opened the Konami
Card Game Center in Tokyo as a customer service base for our card game business. Our retail partner, The Upper Deck Company, LLC, acts as our distributor in the U.S. In Europe, we conducted sales of Yu-Gi-Oh! Trading Card Game either directly or through our retail partners, including The Upper Deck Company, LLC until March 2004. We currently distribute our products through The Upper Deck Company, LLCs European entity employing the scheme used in the U.S.
Our Amusement business produces and sells video game machines and token-operated game machines for amusement arcades.
Amusement Arcade GamesIndustry Overview
According to the most recent industry statistics, the domestic amusement industry had total revenues of ¥926.2 billion during fiscal year 2007. The breakdown by category is shown in the following table.
Amusement IndustryRevenues in Japan
*Salesamounts related to the Kids card games Industry was added from 2007.
Due to the development of powerful home game consoles that can rival amusement arcade games in play quality and the introduction of advanced mobile telephones equipped with online and game functions, consumers now have competitive leisure alternatives. However, revenues from the operation of amusement arcades increased for five consecutive years, from ¥605.5 billion in 2003, ¥637.7 billion in 2004, ¥649.2 billion in 2005, ¥682.5 billion in 2006, and to ¥702.9 billion in 2007, due primarily to progress in the restructuring of the amusement industry, including the closing of unprofitable small sized amusement arcades and the efficient development of large-scale amusement arcades that attract customers, and increased sales at shopping centers that target families.
Our Amusement BusinessVideo Game Machines
Our Amusement business develops, produces and sells video game machines for amusement arcades, many of which use sophisticated computer graphics technology. In fiscal year 2008, we introduced approximately 13 new titles for video game machines for amusement arcades, more than half of which were sequel titles. Such
titles typically have life spans of six to 18 months, although popular titles may have a longer life and are sometimes developed into a series of titles, which together constitute a recognized brand such as Dance Dance Revolution and MAH-JONG FIGHT CLUB.
The main purchasers of our video game machines are amusement arcades. We have sought to respond to market trends by introducing low price products and products that involve the type of play that cannot be replicated easily by home video game systems. In this regard, our music simulation games have been successful. These games evolved from beatmania, a disc jockey simulation game developed in our Amusement business. Hit music simulation games have included Dance Dance Revolution, beatmania, popn music, GuitarFreaks & DrumMania. These music-simulation game machines are relatively expensive, but can accommodate relatively inexpensive software updates for sequel games. Because the price of new software generally is substantially less expensive as compared to the price of a new amusement arcade machine, software upgrades tend to be more attractive to our customers.
In March 2002, our Amusement business introduced the e-AMUSEMENT service that connects amusement arcades all over Japan through a computer network run by Konami, creating a new amusement arcade market. This service allows multiple players to participate in the same game simultaneously from different locations nationwide and to continue playing after saving the game. Our MAH-JONG FIGHT CLUB, which is our first title compatible with e-AMUSEMENT, is retaining its popularity in part due to events such as national conventions where players can try their skills in a tournament.
Our e-AMUSEMENT titles include:
Video Game MachinesProduction
Our video game machines for amusement arcades designed for both the Japanese and the overseas markets are developed in Kobe and Tokyo. As for production, Konami Manufacturing and Service, Inc., a wholly owned subsidiary, produces our amusement arcade games designed for the Japanese market.
Video Game MachinesMarketing, Sales and Distribution
Konami Digital Entertainment Co., Ltd. markets and sells our video game machines for amusement arcades, and Konami Manufacturing & Service, Inc. handles our distribution business. As a result, we believe we have become able to provide more efficient services in our distribution activities. In overseas markets, our foreign sales subsidiaries are responsible for marketing, sales and distribution of our video game machines for amusement arcades.
Amusement BusinessOverview of Token-Operated Game Machines Business
Token-operated game machines in Japan
As indicated in the following table, as of fiscal 2007, sales of token-operated game machines amounted to ¥48.5 billion, comprising approximately 23% of the ¥210.2 billion Japanese amusement arcade game market. Also, as indicated in the following table, revenues from amusement arcade operations and revenues from the
operation of token-operated game machines increased every year from 2002 through 2007. We believe that the sale of medium- and large-sized token-operated game machines, which provide the type of entertainment that cannot be replicated on home video game systems, is largely responsible for this trend.
Token-Operated Game MachinesJapanese Industry Revenues
Our Amusement BusinessOverview of Token-Operated Game Machines Business
We develop, produce and sell token-operated game machines that are primarily targeted to amusement arcade operators in Japan. All token-operated game machines that we sell in Japan are played by purchasing tokens that are inserted into the machine, the object being for the player to win more tokens to extend the playing time. Our popular token-operated game machines, SPINFEVER and GRANDCROSS, accounted for a substantial majority of our net revenues of token-operated game machines in fiscal 2008. SPINFEVER is a medium-size pusher machine which is equipped with a new lottery mechanism incorporating pinball elements in which players can play thrilling high-speed bonus games, and can be used in conjunction with e-AMUSEMENT to see nationwide rankings of monthly token acquisition and choose desired background music during play. GRANDCROSS is a large-scale token-operated pusher-machine game, enabling 32 users to play together simultaneously, and provides an innovative fusion of token-pushing games and BINGO, presenting the orchestration of lights, sounds, and pictures.
Medium- and large-sized game machines, which attract older children and adults, are supplied mainly to amusement arcades. In addition to SPINFEVER and GRANDCROSS, our principal machines include ETERNAL NIGHTS, a new sensory experience adventure game simulation RPG, and the GI-HORSEPARK series, large-scale horse race games in which users can bet tokens and play racing games or training games. We also sell small-sized token-operated game machines, including games such as TwinkleDrop and PanicPirates. In this way, we are advancing a full lineup of various types of token games.
Token Operated Game MachinesProduction
Our domestic token-operated game machines are developed in our production facilities in Kanagawa, Japan. As for production, Konami Manufacturing and Service, Inc. produces the domestic token-operated game machines.
Token Operated Game MachinesMarketing, Sales and Distribution
While Konami Digital Entertainment Co., Ltd. market and sell our token-operated game machines, Konami Manufacturing & Service, Inc. is in charge of distribution.
Online Business Overview
Growth of broadband, online games and mobile phones as a platform
Internet technology for high speed broadband enables customers to have a more enhanced and interactive online experience. Going forward, we expect the spread of broadband services and continued competition among broadband providers to lead to further growth in the market for online games. With the rapid spread of broadband infrastructure, many game console manufacturers and video game software publishers are entering the online game business. For example, Sony Computer Entertainment started a broadband online service for PlayStation 2 in the spring of 2002 through which users can play games online and download software as well as enjoy broadband contents such as movies and music at home. In August 2002, Sony Computer Entertainment America Inc. started selling online adaptors and software for PlayStation 2 in the U.S., and in the fall of 2006, started a download service through its network in conjunction with the release of PlayStation 3. In the fall of 2002, Nintendo started an online service for GameCube in Japan and the U.S., and in conjunction with the release of Wii at the end of 2006, started a virtual console service in which users can download and play previously released game software for old models, and in March 2008, launched the WiiWare service, in which users can download new game software not available in stores. Microsoft started an online service for Xbox called Xbox Live in November 2002 in the U.S. and in January 2003 in Japan, and the service has been continued for Xbox 360, which was released in 2005. Now all portable game consoles and stationary game consoles have built-in network functions. Consequently, we are expanding further our range of online services. Some of our competitors have already started operating web sites where players can download a game and play it on the Internet. We expect that with the spread of broadband and faster services, investment into and interest in online games will expand significantly.
We also expect mobile phones to become a new platform for home video game software. In Japan, mobile phones are not just phones, but wireless Internet handsets loaded with digital cameras and multi-media processors. As of February 2008, the number of mobile phone subscriptions exceeded 1.01 million, and due to the prevalence of flat-rate plans offered by communication carriers, as well as advancements in mobile phone handset functions, the shift to content-rich media has expanded. Although usage rates for personal computers and the Internet is higher in the U.S. than in Japan, comparatively more people access the Internet via mobile phones in Japan and mobile phones are increasingly becoming a popular way to access the Internet.
Companies such as NTT DoCoMo, Inc. (DoCoMo) have developed a cutting-edge third-generation mobile phone technology enabling 24-hour access to the Internet at low cost from mobile phones for Japanese subscribers. One of the most popular services, i-mode, has been developed by DoCoMo and enables subscribers to view specified websites and to receive e-mails from mobile phones. In addition to accessing the Internet and e-mails, i-mode provides access to financial information (including share prices and net banking), travel information, news and entertainment information. Additional contents such as games are usually provided for an additional subscription of ¥100 to ¥300 per month. Other online mobile phone services, such as Softbank Mobiles Yahoo! Keitai and Ezweb by KDDI (au), provide similar functions. These third-generation services not only enable efficient access to e-mails, faster viewing for websites and e-commerce application, but also provide necessary speed and volume to support innovative multimedia applications such as more enhanced online games, downloading of music and video images.
Our Online Business
We develop, publish, distribute and sell software for home video game systems, personal computers, mobile phones and online networks. We plan to actively enter the mobile phone and online game software business in light of the recent growth of the online and mobile phone game markets, and we believe there may be new opportunities for profits with our software titles.
In October 2001, we established Konami Mobile Online, Inc. as our principal subsidiary developing games for mobile phones. In September 2003, we renamed it Konami Online, Inc. and added online game business to its
existing businesses to manage online game infrastructures. Konami Online, Inc. later merged into Konami Corporation in April 2005. In the same month, Konami Corporation accepted new third-party shares issued by HUDSON SOFT CO., Ltd. and made it a consolidated subsidiary. Konami Digital Entertainment Co., Ltd. was established to take over our digital entertainment business and, starting from March 31, 2006, develop our online business for the purpose of synergetic effects between the Computer and Video Games Software and Card Games businesses. We develop and distribute various contents for all domestic mobile network services, including i-mode, Yahoo! Keitai and Ezweb. In 2003, we started distribution of various game contents in North America, Europe and Asia. In Japan, we provide a download service for ringer melodies and wallpapers for mobile phones. Most of our games for mobile phones are mobile phone versions of our popular home video game software. Depending on the type of service, the subscription fee for users is ¥70 to ¥300 per month.
Prior to fiscal 2007, we hosted online functionalities for our console games with online capability on our internal servers mainly for PlayStation 2. As the online capability of PlayStation 2 was rather limited, our video game software with online functionality was designed so that playing games on the console was the major premise, and the online usage rate was relatively low at that time. However, since PlayStation 3, which provides easier Internet access to users, led to significant improvements in the quality of the online component, from fiscal 2008 we have produced and sold video game software for PlayStation 3 which emphasizes the online services. Accordingly, the rate of online usage in fiscal 2008 increased substantially compared to fiscal 2007.
Health & Fitness Segment
Our Health & Fitness segment is comprised of the operation of fitness clubs and the design, manufacture and sales of fitness machines and fitness-related products.
Consolidated net revenues generated by our Health & Fitness segment, before elimination of intersegment revenues, amounted to ¥88,459 million in fiscal 2007 and ¥86,544 million in fiscal 2008, a decrease of ¥1,915 million.
Fitness club business
According to Club Business Trends in Japan, 2007 a report available at Fitness Online, private fitness club revenues in Japan have increased from ¥367.5 billion in 2003 to ¥422 billion in 2007, a trend that shows the industry has been growing. Over the same period, the number of private fitness clubs has grown from 1,901 in 2003 to 3,040 in 2007, and especially in 2007, with 512 newly opened clubs, the growth rate for private fitness clubs reached 20%. This has led to diversification of the industry, as evidenced by an increase in small-scale circuit-training gyms. In addition, fitness club memberships have increased from 3.67 million in 2003 to 4.1 million in 2007. Also, the year 2007 marked the highest average consumer spending per person among fitness club members, as a result of a growing trend that has been continuing since 2001, after a period between 1996 and 2000 with a downward trend. With increasing demands of middle-aged and senior users based on higher health-consciousness, we believe private fitness club revenues in Japan from membership fees and other means are on the rise, and prospects for short- and long-term profits are hopeful.
Growing health consciousness among an aging society has led to an expanding market in the fitness club business. From a demand perspective, while the participation of our former target clientele of 20 to mid-30-year-old men and women is declining, the participation of 50-year-old and over men and women in the middle-aged and senior categories are increasing. Broken down in terms of participation by men vs. women, participation by women is high as always, but in recent years, there has been a marked increase in participation by 50-year-old and over men.
On the other hand, from the supply-side point of view, each company has continued a certain pace of new store openings while maintaining its current locations in anticipation of growth in demand. We have also diversified our fitness club facilities to suit the tastes of customers, and our facility types range from large-scale
comprehensive facilities to convenience-type small-scale facilities. As a result, while the market has grown, on the whole the supply of facilities has outstripped demand, and the number of members per facility has been on a declining trend since the latter half of 2006 as reported in Club Business Trends in Japan, 2007.
We believe that attracting customers to fitness clubs will be attributed to population aging; an increase in leisure time, disease rates, personal share of medical expenses, and health-consciousness; implementation of health-promoting policies at the national and local levels; and an increasing number of fitness clubs and improvements in quality. Other factors that are taken into account when selecting fitness clubs include the distance from home, programs, quality of facilities and price. We believe that interest in fitness clubs has heightened due to the efforts of club owners to renew facilities, reduce membership fees, offer more diverse membership options, extend club hours, increase group exercise programs such as aerobics and jazzercise, and enhance marketing and sales activities. We also believe that fitness clubs provide a more convenient venue for exercise than outdoor activities, particularly in densely populated metropolitan areas.
According to published industry sources, the major trends that are driving changes in the health and fitness industry include:
We believe that we had approximately 29% of the Japanese fitness club market, as measured by revenues, for fiscal 2007 based on the Nikkei Marketing Journals article published on November 7, 2007. We have several other competitors in an otherwise fragmented market but, as noted above, the industry is undergoing consolidation which may result in the creation of additional significant competitors.
Our Fitness club Business
Through our acquisition of a majority of the outstanding common stock of PEOPLE CO., LTD. in February 2001, which we renamed Konami Sports Corporation, we have become the leading operator of health and fitness clubs in Japan in terms of revenues, members and total number of facilities. Since our acquisition of PEOPLE CO., LTD., we have grown our fitness club business primarily through acquisitions of other fitness clubs. We increased our presence in this market even further through the acquisition in February 2002 of a majority of the shares of the Daiei Olympic Sports Club, Inc., one of the major fitness club operators in Japan in terms of revenues, which was subsequently taken over by Konami Sports Corporation in October 2002. These acquisitions were part of our strategy to diversify our revenue base. Fitness club revenues tend to be more stable than revenues in other segments, which can fluctuate widely depending on the release of hit products. Fitness clubs also tend to have a more diverse consumer base across both gender and age. Finally, we expect that our fitness clubs will provide demand for our fitness machine business.
The environment surrounding the fitness club business has changed significantly due to the rapid aging of Japanese population. This change has included a shift in fitness needs toward senior members of the society. In fiscal year 2005, in response to this change in the operating environment, we restructured the management team of our fitness club business in an attempt to fundamentally change our fitness club business model and business
plan. Under our current management policy, we have shifted our strategic focus from simply expanding the number of fitness clubs to critically assessing and managing profits of individual clubs. As a result, we now believe it is possible to close unprofitable clubs in a much shorter time frame than before.
As of March 31, 2008, we directly owned and operated a nationwide network of 209 fitness clubs and operated an additional 110 sports facilities outsourced to us. The directly owned clubs collectively served approximately 990,000 members as of March 31, 2008. We offer a wide variety of health and fitness related services, including traditional membership-based clubs with swimming, gymnastics and tennis school programs, aerobics programs, combat-type exercise programs and health and advisory services to people of all ages. In addition to our facility-based operations, we also provide health and fitness advisory services to corporations and to public sector entities. Our non-facility business includes franchising of fitness clubs and the licensing of specific products and programs, such as diet programs. We also act as a nationwide agent of health and fitness programs for the Japan area, acquiring licenses for programs having worldwide popularity, and supply these programs to other fitness clubs as well. We are also engaged in other activities incidental to our core Health & Fitness segment, including travel agency operations and publishing a magazine for club members.
We principally sell month-to-month membership payment plans that are generally cancelable by members at the end of any month provided that they give advance notice by the tenth day of that month. We believe that members generally prefer this non-commit membership plan over long term commitments. The non-commit membership plan also provides us with an incentive to deliver high quality programs and services in order to retain members.
We have experienced significant growth through a combination of (i) acquiring existing single and multi-club businesses, and (ii) developing and opening new club locations. We believe that there are further opportunities to grow our business profitably. While Japans population is growing very slowly, is aging rapidly, and is projected to begin contracting in the future, the percentage of the population that are members of fitness clubs is significantly lower in Japan than it is in the United States. First, we plan to carefully continue opening of new fitness club facilities focusing on their profitability in a short to medium term, while critically assessing the profitability of existing facilities. Second, we believe that we can increase our market penetration by adding services and facilities that will attract new members from all age groups. We plan to differentiate us from our competitors by introducing fitness machines that include differentiated features and by expanding our business into value-added services that can meet the evolving needs of consumers such as cafeterias. In September 2007, we set up a booth at the 34th International Home Care & Rehabilitation Exhibition H.C.R 2007 to introduce our original equipment, programs and services developed in response to an ageing society.
We believe we are the only company in Japan which operates fitness clubs and conducts a product development business. We expect to continue to increase revenues through club and membership growth not only by increasing the number of facilities and members, but also by providing products and services in relation to overall health service. We currently serve many, but not all, of the major cities in Japan. We plan to extend our reach into new geographic markets until we cover all of Japan.
We have taken actions to create a more powerful brand. To cement our position as the No. 1 brand in the fitness club industry in Japan, we unified our collection of brands, including Egzas and PEOPLE, into a single brand: Konami Sports club, thereby strengthening our brand recognition and providing more sophisticated facility services, as part of our continuous efforts to improve the retention rate of current customers. Improving the retention rate of customers of existing clubs is one of our major objectives as revenue growth of existing clubs is lower than newly opened clubs. In a move to improve customer convenience, we introduced new services and products such as a personal trainer system where an instructor with specialized knowledge provides individualized lessons for each customer. Furthermore, we launched the first official i-mode (internet enabled cellular phone) site in the fitness industry, which provides various club facility information and health related information. Going forward, we plan to offer an IT health management system that will enable comprehensive management of a persons health, connecting the three aspects of daily health and lifestylethe fitness club, the home and outside the home.
Also, we focus more on improving the quality of our services than on reducing our prices in order to compete efficiently. For example, we offer value-added services such as spa and massage in our fitness clubs for extra charges. Also, we offer events and tours such as Honolulu Marathon tours and ski tours in which our members can participate.
Our Health & Fitness segment develops fitness machines for home use by our consumers and fitness equipment for serious exercise for use principally in our Konami Sports fitness clubs. In fiscal 2006, we completed a full lineup of our fitness machines, such as the EZ series, and these machines are now in our Konami Sports fitness clubs. We also have several new machines in various stages of development. In addition, since COMBI WELLNESS Corporation became a wholly-owned subsidiary in May 2006, our product portfolio has been expanded, including Aerobike, our principal product in this business.
Further, in fiscal 2005, we introduced Refreshment bike, the home-used fitness machine which incorporates the emission features of highly-concentrated oxygen and negative ions, Kenshin Keikaku 2, the software which displays and manages the exercise data saved in e-walkeylife 2, the multifunctional pedometer, Flavangenol Up 50 and Flvangenol MSM Plus, our original supplements.
In fiscal 2006, we introduced Forced Rep Upper Body, the business-use fitness machine which can automatically control the burden on a body and enables training tailored to each user through six modes and Body Scan, the highly accurate body scale connectable to the network. Also, EXERDIET and Konami Sports Club BLACKCURRANT, our original supplements were released.
In fiscal 2007, in addition to the releases of Massugu Sesuji and Anshin Hokou, the nursing care machines, Kenshin Keikaku 2, the latest software which jointly manages the data of e-walkey life 2, the multifunctional pedometer as well as AROMA@FITNESS, our original supplement, we launched 6WEEKS, the program to prevent lifestyle related diseases promoting improvement of lifestyle and Hatsuratsu Kenko Juku, to provide exercise instructions to the elderly.
In fiscal 2008, we announced our business and academic collaborations with Kagawa Education Institute of Nutrition and Osaka Electro-Communication University, and became involved in the training of instructors who are able to provide guidance in exercise and nutrition, the joint development of an effective health program to maintain both exercise and a nutritious diet, the training of staff who can act to maintain and control health, and the development of effective and practical health apparatuses. In addition, we have also begun sales of an original supplement for health and beauty called Cristal Ottimo and it is available at pharmacies, drugstores and Konami fitness clubs nationwide.
Club Formats and Location
Our clubs generally have relatively high retail visibility, and close proximity to subway, train and bus stations in urban areas and commuter suburbs in accordance with our operating strategy of offering our target members the convenience of multiple locations close to where they live and work, reciprocal use privileges and standardized facilities and services.
In addition, we are making efforts to provide safe, clean and comfortable facilities from the viewpoint of our customers. We plan to further improve the safeness of our facilities and provide quality services to our customers, through introducing Automated External Defibrillators or AEDs in all of Konami Sports Club facilities as well as renovating older buildings. We aim to respond to various customer needs by providing a broad range of services that meet all age groups and to operate fitness club facilities that can contribute to the enhancement of the health of our community members.
We operate the following three types of service businesses at various locations in Japan.
Our marketing campaigns are directed by our in-house Publicity Unit of Facility Operation Department. This team conveys each of our nationally branded fitness clubs as the premier network of fitness clubs in that region. Advertisements are designed to highlight the consistent quality and high value-to-price ratio that we believe we provide through a combination of our membership programs, club facilities and personnel. Our goal is to achieve broad awareness of our brand names primarily through television, newspaper, and magazine and our web site.
We also engage in public relations and special events to promote our image in surrounding local communities. We believe that these public relations efforts enhance our image and the image of our brand names in the communities in which we operate.
Sales of new memberships are generally handled at the club level. In making a sales presentation, we emphasize: (i) the proximity of our clubs to concentrated commercial and residential areas convenient to where target members live and work; (ii) the advantages of a membership with a club that has an extensive nationwide network; (iii) the lack of a long-term obligation on the part of the enrollee; (iv) the price value relationship of a membership; and (v) access to value-added services.
We generally offer five principal types of memberships: (i) GRANCISE Regular Membership, which entitles members to use all facilities of GRANCISE and Egzas for no charge; (ii) GRANCISE Branch Membership, which enables members to use one GRANCISE facility and all Egzas facilities for no charge; (iii) Egzas Special Membership, which allows members to use all Egzas facilities nationwide for no charge; (iv) Egzas Regular Membership, which entitles members to use one Egzas facility for no charge and all other Egzas facilities nationwide on a per-use charge; and (v) Egzas Branch Membership, which enables members to use one Egzas facility during certain hours on weekdays or any time during the operation hours of Saturdays, Sundays and holidays.
In joining a club, a new member signs a membership agreement which obligates the member to pay monthly dues on an ongoing basis. We collect approximately 70% of monthly membership dues through automatic payments based on credit card contained in the membership agreement. Most membership dues are paid one month in advance. Members can generally cancel their membership at the end of any month provided that they give advance notice by the tenth day of that month. We believe that this program of monthly dues collection provides a predictable and stable cash flow for us and eliminates the traditional accounts receivable function while providing a significant competitive advantage in terms of the sales process, dues collection, working capital management and membership retention. During the first week of each month, we receive the dues for that month initiated by third party processors such as JACCS or OMC, two Japanese credit card companies.
We also respond to the needs of various companies by establishing differentiated prices for corporate membership plans. We have also developed corporate fitness programs, fitness evaluations and health clinics allowing corporations to use our fitness club facilities as part of their employee benefits plans.
The Fitness Product business
Industry OverviewConsumer Trends
We believe that the domestic market for fitness equipment has potential for growth due to a number of demographic and market trends that we expect will continue, including:
Our Fitness Product Business
Our fitness equipment business is primarily comprised of procurement and sales, manufacturing and marketing of fitness equipment and related products. We believe that we can create fitness machines which meet
customer needs and provide convenience to provide healthy and enjoyable training as well as enabling the management of ones exercise history by using the e-XAX IT healthy management system, leveraging our know-how gained through development of entertainment software and hardware as well as operation and management systems networked with such software and hardware. Such machines will further stimulate the desires of consumers thinking about joining fitness clubs, and through the exercise history and being able to see the results of their exercise, will maintain the motivation of current members. This will result in benefits for our fitness club business.
We also expanded into the home fitness equipment market, by leveraging the product development know-how of COMBI WELLNESS Corporation, which became a wholly-owned subsidiary in May 2006. In particular, we plan to grow our operations by developing high quality, branded fitness equipment that better meets the needs of our customers and retailers.
Production, Marketing, Sales and Distribution
We have developed and introduced the EZ Series as Exertainment equipment which adds entertainment aspects to traditional fitness machines and combines exercising and entertainment. In addition to home fitness products that allow users to enjoy exercising at home, such as Refreshment Bike, a home fitness machine with a built-in generator of high amounts of concentrated oxygen and negative ions, as well as Kenshin Keikaku, a software which displays and manages physical activity data stored in e-walkeylife, a multi-functioned pedometer.
Further, with respect to full-scale exercise-oriented equipment, we have released products such as FORCED REP, a next generation strength machine which can automatically control the load and Massugu Sesuji and Anshin Hokou, nursing care equipment for the elderly. Additionally, we have released e-walkeylife2 and Kenshin Keikaku 2, updated versions of pedometer and management software, as well as Kenshin Keikaku TV, which can be connected to a TV, and we provide a system by which users can enhance their exercise habits and lifestyle by using their own data at home.
We have developed original supplements such as FLAVANGENOL, which is high in polyphenol and helps improve blood flow and burn off body fat, Konami Sports Club BLACKCURRANT, which is high in anthocyanin and controls active enzymes, and EXERDIET, which helps to burn off body fat efficiently during workouts. We also introduced a service called Supplement Member, a delivery service of popular supplements for our club members to their home addresses. In addition, since January 2007, we have commenced the nationwide sales at Konami Sports Club and Seven Eleven of AROMA@FITNESS, a healthcare product from which customers can easily enjoy aromatic effects by sticking the product inside their clothing. In February 2008, we began sales of a supplement drink for beauty and health called Cristal Ottimo.
Our fitness equipment and health related products are designed, produced, developed, manufactured, marketed, sold and distributed by Konami Sports Life Corporation, our wholly owned subsidiary. Konami Sports Life Corporation merged with Konami Sports Corporation and became Konami Sports & Life Co., Ltd. as of February 28, 2006. In addition, we made COMBI WELLNESS Corporation a wholly-owned subsidiary in May 2006, and we will promote creation of new markets and provision of various health services, through for example engaging in comprehensive operation of fitness club facilities, development and manufacturing of health-related equipment and supplement products.
Gaming & System Segment
Our Gaming & System segment develops, produces and sells gaming machines such as video and mechanical slot machines and management systems to gaming operators in North America, Oceania and other overseas markets. Net revenues generated by our Gaming business, before elimination of intersegment revenues,
amounted to approximately ¥16,744 million in fiscal 2007 and approximately ¥18,471 million in fiscal 2008, an increase of approximately ¥1,727 million, or 10.3%. We develop, produce and sell gaming machines for international markets, primarily in North America and Australia, and sell casino management systems in North America.
Gaming Industry Overview
Global Gaming Industry
The North American market is the worlds largest gaming market, followed by the Oceanian markets. Other major gaming markets include South America, Africa, Europe and Asia. The North American gaming market has been growing every year, with the number of major players in this market growing significantly.
Gaming in the United States
The gaming industry in the United States has generally experienced substantial growth in the last decade. Prior to 1979, gaming was limited to Nevada. In 1979, gaming was legalized in New Jersey. Between 1979 and 1988, gaming activities by various Native American tribes developed, leading to the enactment of the federal Indian Gaming Regulatory Act. The growth of Native American gaming served as a catalyst for certain jurisdictions to consider non-Native American gaming because of its potential as a source of government revenue. Since 1989, various forms of gaming have been legalized in numerous states including but not limited to Colorado, Illinois, Indiana, Iowa, Louisiana, Michigan, Mississippi, Missouri and Pennsylvania. In addition, gaming facilities operate at casino hotels, river boat casinos and on cruise ships sailing out of numerous ports in and around the United States. Several other states have approved or are considering approval of some form of gaming.
Gaming in Australia
In Australia, the gaming industry is characterized by intense competition between manufacturers over a limited total market share due to an increase in the gaming tax rate and restrictions on the numbers of gaming machines permitted to be installed in larger states, as part of the Gambling Harm Minimization Policies implemented by the Australian government. Australia is the largest and most established market for gaming products outside of North America and is primarily oriented towards the video slot machine market.
Our Gaming Business
We have expanded our gaming machines business in international markets. This expansion, initiated in March 1998 by exporting components of video slot machines to Australia, was followed by the launch of video slot machine sales in the United States in late 2000. In August 2001, we acquired Paradigm Gaming Systems, Inc., through our American subsidiary, Konami Gaming, Inc., and integrated it into the Systems Division of Konami Gaming, Inc. Paradigm Gaming Systems, Inc. is a developer of casino management systems. Our casino management system product enables simultaneous accounting, marketing management, customer management and security enhancement by connecting all of the gaming machines to a casino in a unified management system. Due to the acquisition of Paradigm Gaming Systems, Inc., we are further expanding our opportunities in the gaming machine market in North America and are steadily expanding our client list. We have received licenses to manufacture and/or sell gaming machines in almost all of the major states and provinces in North America and Canada that permit gaming. For example, we acquired licenses from New Jersey in 2004, Oklahoma and Alberta, Canada in 2005, and Pennsylvania and Florida in 2006, and Rhode Island in 2007. In October 2005, we entered into an agreement for a large-scale installation of the Casino Management System in Quebec, Canada which commenced implementation in 2006 and was completed in 2007. In November 2007, we participated in the Global Gaming Expo to introduce casino management systems and our first five-reel mechanical slot machines, Advantage 5, to demonstrate the expanded scope of our products.
We originally started our Gaming & System segment with sales of video slot machines in Australia and later introduced our video slot machine products into the North American market. We are currently focused on the development of new models, including mechanical slot machines, to secure revenues generated in the North American market, where the market share of mechanical slot machines accounted for 56% of the entire market, according to the latest data from the State Gaming Commissions, and a substantial portion of the demand for gaming machines is attributed to mechanical slot machines.
In North America, the largest gaming machine market in the world, we currently hold licenses to manufacture and sell gaming machines in major states and sell gaming machines to major Native American casinos. We participated in the Global Gaming Expo in November 2006, and advertised the expansion of our product line by exhibiting our products, including the K2V series with a variety of game contents and our casino management systems.
Konami Australia Pty Ltd, which has licenses for sales and manufacturing of gaming machines in all Australian states, markets gaming machines with a focus on our main K2V series product a new platform which was released in 2006, as well as our ES series product. Although the dominance of the largest player in the Australian gaming markets has made it difficult for us to become a market leader quickly, we have gained a stable position in the Australian market as one of the other main gaming machine sellers and manufacturers. We believe the Australian gaming market is mature and has been leveling off, due in part to the tax system revision, smoking bans, and regulations limiting the maximum number of gaming machines allowed in each state, and we do not expect our sales of gaming machines in Australia to expand substantially in the future unless there is a major change in the nature or regulation of the market. We intend to continue to try to expand our business to overseas markets.
In contrast to Australia, we believe demand for gaming machines in North America has been increasing. Also, following acquisition of a license in New Jersey, one of the largest gaming markets in North America, in August 2004, we have acquired additional licenses, mainly in Oklahoma, New Mexico, Pennsylvania and Alberta in Canada. We have built a new gaming machine facility in Las Vegas which commenced operations in June 2005, and which has significantly increased our production capacity to meet increasing demand in each market.
Our gaming machines and casino management system, sold in North America are assembled at our production facility in Las Vegas, Nevada. Gaming machines sold in Australia are assembled at our production facility in Sydney, Australia. Our products are assembled utilizing various parts and components from a large base of local vendors. A Japanese branch of our North American subsidiary supplies certain software and electronic components to our overseas production facilities. We have also identified alternate sources of supply for significant parts and components in the event any of our current vendors fail to meet order requirements.
We completed the construction of a new building in Las Vegas in June 2005. More than a half of our worldwide sales are derived from the U.S. market, and products sold in the U.S. market are built solely in the facility in Las Vegas. We believe we have thus achieved more efficient operations through increased production capacity compared to our previous building and an enhanced training facility for customers of our casino management system.
Marketing, Sales and Distribution
Our gaming machines are marketed, sold and distributed overseas through our local subsidiaries directly to casino operators. Currently, in Las Vegas, which is representative of the North American market, there is substantial management integration of gaming facilities.
Pachinko and Pachinko Slot
PachinkoOverview of Merchandise
The pinball-like game of pachinko is a national pastime in Japan. Players purchase a supply of tiny metal pinball that they then propel with a motorized trigger at a maximum permitted rate of 100 times a minute through a vertically mounted pinball-like maze in a pachinko machine. As the balls bounce through a maze of pins, they either hit jackpots to produce more balls or fall into the gutter at the bottom of the machine. The board face, which has moving images on a LCD panels and flashing lights is designed to attract potential players and is the most important component. Our LCDs are installed in the board face of machines.
Our Pachinko LCD Operations
We develop software that is incorporated into and sold together with LCDs for pachinko machines. The life cycle of such software for LCDs is approximately several months to one year.
Currently, we typically introduce between five and ten new pachinko software installed in LCDs each year. Pachinko machines must be inspected by The Security Electronics and Communications Technology Association, an extra-governmental organization associated with the Metropolitan Police Department, before being marketed in Japan. This process exposes us to possible delays in our introduction of new software installed in LCDs because we may be required to change software content.
To attract a wider customer base, we have expanded the type of pachinko game machine titles we develop to focus software development to a great extent on entertainment and game value. We believe that the pachinko game machine manufacturing market in Japan is mature and is unlikely to grow significantly, if at all. However, we plan to expand our market share by increasing the volume of software we sell.
Development, Production and Components Supply
We develop software for LCDs used in pachinko machines and, in a few limited cases, we have begun to outsource a portion of the software production to various third parties who produce our software to our circuit design specifications. We also work with third-party contractors who integrate the software with LCDs, semi-conductors and printed circuit boards that we order from major electrical manufacturers in Japan. We have encountered difficulties in the past in procuring LCDs in sufficient quantities, although less so currently due to the increasing production capabilities of LCD makers. However, there is also increasing demand for semiconductors due to advanced LCD technologies and, in order to avoid future procurement problems, we place orders in advance to meet the requirements. We have not encountered, and do not expect to encounter, any difficulty in procuring printed circuit boards for our use. After our contractors have integrated the software and hardware, we then supply the bundled unit to the pachinko hardware manufacturer for the relevant pachinko machines.
Marketing and Sales
We sell our LCDs directly to pachinko machine manufacturers. Some of the larger manufacturers publish their own software for pachinko machines, but most manufacturers purchase software from third parties, including us. We commenced sales in 1992 and currently have basic product and sales agreements with over six companies with which we try to strengthen business relations.
The number of pachinko and pachinko slot outlets in Japan has decreased in the last few years. According to statistics released by the National Policy Agency on April 2008, the number of nationwide pachinko outlets has decreased by 1,089, or 7.4%, to 13,585 at the end of 2007 compared to the previous year. The number of pachinko machines per outlet was 337.9, an increase of 0.4% from the previous year.
Pachinko SlotOverview of Merchandise
The pachinko slot machine is a slot machine found mainly in pachinko outlets, and its official name is Kaidoushiki Yugiki. It is an entertainment machine which is as popular among the Japanese people as traditional pachinko. Players purchase tokens which they put into pachinko slot machines and then must press buttons to stop each spinning reel, and acquire tokens by matching patterns. In recent years, there has been widespread growth in pachinko slot machines with LCD panels, as the display of effects on the screen while playing pachinko slot has made the experience more enjoyable.
Our Pachinko Slot Operations
We conduct a wide range of operations, ranging from planning and production to the manufacture and sales of pachinko slot machines. The life cycle of a pachinko slot machine can span from a few months to over a year.
Like pachinko machines, pachinko slot machines must be inspected by the Security Electronics and Communications Technology Association. Since changes may need to be made to the software or hardware following the inspection procedure, the release of new pachinko slot machines may at times be delayed.
Last fiscal year, we released four different pachinko slot titles. In the future, we plan to expand our market share by utilizing our experience in game development and the various rights to content held by our company to create new types of pachinko slot machines with high entertainment value.
Marketing and Sales
We sell our pachinko slot machines through two different methods. The first is to sell our pachinko slot machines to pachinko halls and pachinko slot halls directly, and the other is to sell through well-connected third parties (agencies). At present, we have contracts with over 25 agencies, and we will continue to maintain a strong alliance system to expand sales.
Please see the information provided under PachinkoMarket Environment above.
A significant portion of our products include content (brands) such as characters, images, trademarks and logos, to which we have been granted licenses from a broad range of licensors. The success of our business depends to a significant extent on our ability to create or license content with strong consumer appeal and a high level of recognition or acceptance. To do so, we must identify and respond rapidly to new and emerging consumer trends.
Content is one of our most valuable assets. Accordingly, we actively seek to obtain licenses of prominent brands for our video game software, amusement arcade games, gaming machines, card games, toys, music CDs and other consumer merchandise. Our most important source for licensed brands has been sports organizations. Use of the names of actual players in our games is a relatively new phenomenon in response to the demand for greater reality in game software content and as such, securing necessary licenses is critical to success of our sports titles. Increasingly, we also seek to license brands from film makers, comics publishers, and animation and TV program producers.
Our significant brand licensing activities include the following:
The following tables show net revenues, operating expenses and operating income (loss) by geographic area for the fiscal years ended March 31, 2006, 2007 and 2008:
One of our principal strategies is to significantly increase our overseas revenues in absolute terms and as a percentage of our overall revenues.
Our present overseas activities consist principally of sales of video game software, amusement arcade games, card game products and gaming machines and revenues from charges on mobile games.
In fiscal 2007, our net revenues increased ¥1,409 million in the United States and ¥3,656 million in Europe, respectively, resulting mainly from an increase in sales of gaming machines and casino management system in the United States. In Europe, the increase was due mainly to an increase in strong sales of the Winning Eleven (Pro Evolution Soccer) series of video game software.
In fiscal 2008, our net revenues increased ¥2,188 million in the United States and ¥3,688 million in Europe, respectively, resulting mainly from the strong sales of gaming machines and the Dance Dance Revolution series of video game software in North America and Pro Evolution Soccer series of video game software in Europe.
We initiated overseas operations by exporting amusement arcade games in 1979, and in 1982 we established a sales subsidiary in the United States. In subsequent years, we established additional sales subsidiaries in Germany, the United Kingdom, Korea, Singapore and Hong Kong, and a software game development subsidiary in Shanghai. In February 1997 we established Konami Gaming, Inc. to manufacture and distribute gaming machines in Nevada. Having received all licenses required by the state and county officials in Nevada, we began distributing gaming machines in Nevada beginning in fiscal 2001. Since then, we have received similar licenses and/or permission to operate in major states in North America. In addition, we have been licensed by Native American tribes in California, Arizona, New Mexico, Minnesota and Michigan. We have obtained licenses in a number of other gaming jurisdictions in North America. Konami Australia Pty Ltd., which became our consolidated subsidiary in October 2001, have obtained licenses to manufacture and sell gaming machines in all states in Australia, and exports gaming machines to overseas markets.
During the fiscal year ended March 31, 2001, the gaming machines we sold in the United States and two video slot machine components we exported to Australia were produced in Japan. Later, our production facility in Las Vegas, Nevada, which houses the headquarters and principal manufacturing facility of our U.S. gaming machine business, began operations in September 2001 and we completed construction of a new building in June 2005 which is currently operating under full production.
In October 2003, Konami of America, Inc., our sales subsidiary in the United States, added a new function of overseas business administration to its existing sales business and changed its name to Konami Digital Entertainment, Inc. It established a new administrative office in Los Angeles in order to conduct various activities responding to local market needs for expanding shares of our Computer & Video Games business overseas. Subsequent to the introduction of this regional autonomy system, all overseas offices in our Digital Entertainment business changed their names to Konami Digital Entertainment.
We are committed to build our market share in China by localizing our popular products for the Chinese market. Additionally, in Korea, we released the PC online-game version of the WORLD SOCCER Winning Eleven series in March 2006, following the release of the online-game version of Yu-Gi-Oh. We plan to start full operation in other Internet-developed countries in Asia.
In line with our strategy to expand our international business, we are investigating acquisition and investment opportunities outside Japan for businesses that will grow or complement our current businesses.
Research and Development
An important requirement for success in the highly competitive markets in which we operate is the ability to create quality products that attract public attention. We are also working to expand into new markets such as fitness equipment and nursing care equipment. The following three tables show our primary research and development activities, during each of the last three fiscal years.
The markets for video game software and most of our other products are intensely competitive and are characterized by the frequent introduction of new hardware systems, software products and other innovations.
In addition, the domestic Japanese market is gradually shrinking due partly to the declining birthrate. Japanese game producers are competing to bolster their product lineups and expand their overseas operations. Moreover, the spread of online games due to the expansion of broadband networks and the market growth of cellular phone contents owing to the improvement of cellular phone capabilities have intensified competitions over limited users leisure times and made it extremely important for game software producers to develop software for a wide variety of media and outlets in order to maintain growth.
Rapid changes in the business environment as mentioned above are also driving reorganization in the game software industry. For example, Enix Co., Ltd. and Square Co., Ltd. merged on April 1, 2003 and the new company, Square Enix Co., Ltd., is expected to focus on strengthening software development and expanding the lineup of online games. Also, in October 2004, Sammy Corporation founded Sega Sammy Holdings Inc., a holding company through which it acquired SEGA Corporation. In addition, Bandai Co., Ltd. and Namco Limited consolidated their operations to establish Namco Bandai Holdings Inc. in September 2005, and later established Namco Bandai Games Inc. through the consolidation of their domestic game businesses in March 2006.
We believe that the most significant competitive factors in all of our major business lines are the ability to develop compelling content and bring it to market at the appropriate time to capitalize on ever-changing consumer preferences. We believe our ability to develop content internally, as well as our strong internal distribution network, give us an advantage over many of our competitors. However, our competitors vary in size from small companies to very large corporations which have significantly greater financial, marketing and product development resources than we have. Due to these greater resources, some of our competitors are better able to undertake more extensive marketing campaigns, adopt more aggressive pricing policies and pay higher fees to licensors of desirable properties.
Our competitors and potential competitors in the video game software industry include the following:
There are barriers to entry in the video game software market, consisting mainly of the difficulty of developing the technical and creative resources as well as the distribution networks of established competitors. However, the development of the Internet as a medium for the distribution of video game software, the use of the Internet to facilitate the formation of collaborative technical and creative networks, and the proliferation of programming tools and other resources may have the effect of reducing these barriers.
Our most significant competitors in the market for card game products and toy & hobby products are mainly toy makers, such as Namco Bandai. We believe that the most significant competitive factor in the market for card game products and toy & hobby products is the ability to timely develop popular products based on appealing
characters and themes. In addition, there have been business reorganizations such as consolidation of the operations of Takara Co., Ltd. and Tomy Co., Ltd. in March 2006 and their establishment of Takara Tomy Co., Ltd.
The market for video game machines and token-operated game machines for amusement arcades in Japan is dominated by a few large manufacturers, including ourselves as well as Sega Sammy and Namco Bandai, and competition in these markets is intense. The principal method of competition in the market for video game machines and token-operated game machines for amusement arcades is new product development.
The market for software for LCDs for pachinko machines in Japan is relatively stable, with manufacturers of pachinko machines having close relationships with particular producers of such software. We believe that we have benefited from our ability to provide software with strong entertainment value rather than speculation-oriented software. Competitors that produce entertainment-oriented software may pose a threat to us. We believe that our strong relationships with pachinko machine manufacturers and our reputation for making reliable, appealing products give us a competitive advantage in the market for software for LCDs for pachinko machines. The market for pachinko slot machines is intensely competitive among several major makers, such as Sega Sammy Holdings Inc., Aruze Corp. and Sankyo Co., Ltd. The principal method of competition in the market for software for LCDs for pachinko machines and pachinko slot machines is new product development.
In the fitness club market, we compete with other commercial health and fitness clubs, such as Central Sports Co., Ltd., physical fitness and recreational facilities established by local governments, hospitals, nursing homes, businesses for their employees and similar organizations, and, to a certain extent, with racquet, tennis and other athletic clubs, country clubs, weight-reducing salons and the home-use fitness equipment industry. We also compete, to some extent, with entertainment and retail businesses for the discretionary income of our target markets. However, we believe our brand identity, operating experience, ability to allocate advertising and administration costs over all of our fitness clubs, nationwide operations, purchasing power and account processing and collection infrastructure, provide us with distinct competitive advantages. As the fitness market in Japan still has room for further growth, we expect more companies to enter the market both regionally and nationally and we may not be able to continue to compete effectively in each of our markets in the future.
Our principal competitors in overseas gaming machine markets include International Game Technology, Bally Technologies, Inc., Aristocrat Leisure Limited and WMS Industries Inc. A library of strong performing games, the possession of valuable patents and the development of unique products differentiable from those of others can be a significant competitive advantage. Other methods of competition include quality and breadth of sales and service organizations, financial stability of the manufacturer, and pricing.
As of March 31, 2008, we had approximately 3,866 trademarks, 1,395 patents, four registrations of utility models and 155 registered designs (excluding applications pending) in Japan and we also had approximately 4,961 trademarks, 1,593 patents and 343 registered designs (excluding applications pending) overseas. The trademarks and patents relate to our hardware and software for video game software products, input equipment for home video games, amusement arcade and token-operated games and gaming machines, fitness machines, nursing care machines, nursing prevention care machines, LCDs for pachinko machines and pachinko slot machines. The utility models relate to input equipment for home video games, amusement and gaming machines and creative products. The registered designs relate to input equipment for home video game machines, amusement and gaming machines, designs for icons, creative products, pachinko equipment and pachinko slot machines.
Intellectual property for video game software is registered to us, our subsidiaries or to us and our subsidiaries as joint owners.
We believe that our trademarks (which, once registered, are perpetual, subject to use and payment of registration fees) and other intellectual property rights referred to above are important assets. Accordingly, we established divisions to necessary steps to secure and protect such rights, including registration with appropriate authorities and, if necessary, legal proceedings. The non-registration or expiration of registration of some of our intellectual property rights could have a material adverse effect on our business.
Although we use copy-protection devices, an unauthorized person may be able to copy our software or otherwise obtain and use our proprietary information. If a significant amount of illegal copying of software published by us occurs, our product revenues could be adversely affected. Policing illegal use of software is extremely difficult and software piracy is expected to persist. In addition, the laws of some foreign countries in which our software is distributed do not protect us and our intellectual property rights to the same extent as the laws of Japan and the United States. Although illegal copying of our software has not been a major problem for us to date, it could have an adverse effect on our software business if we expand that business into China and Southeast Asia, where protection of intellectual property rights is weak.
Each of Nintendo, Sony and Microsoft incorporates security devices in the software and their respective hardware systems in order to prevent unlicensed software from infringing their respective proprietary rights by manufacturing software compatible with their hardware. Under our various license agreements with Nintendo, Sony and Microsoft, we are responsible for protecting our own and our licensors intellectual property rights that are used or incorporated in our software.
We do not own the trademarks, copyrights or patents covering the proprietary information and technology utilized in the game consoles marketed by Nintendo, Sony, Microsoft or, to the extent licensed from third parties, the brands, concepts and game programs featured in and comprising our software. See Item 4.B Business OverviewBrand Sourcing. Accordingly, we must rely on the trademarks, copyrights and patents of these third-party licensors for protection of such intellectual property from infringement. Under our license agreements with certain licensors, we may bear the risk of claims of infringement brought by third parties and arising from the sale of software.
The manufacture, sale and distribution of gaming devices, equipment and related software is subject to federal, state, tribal and local regulations in the United States and foreign jurisdictions. While the regulatory requirements vary from jurisdiction to jurisdiction, the majority of these jurisdictions require licenses, registrations, permits, findings of suitability, documentation of qualification including evidence of financial stability and/or other required approvals for companies who manufacture and distribute gaming equipment, as well as the individual suitability or licensing of officers, directors, major shareholders and key employees. Laws of the various gaming regulatory agencies generally serve to protect the public and ensure that gaming related activity is conducted honestly, competitively, and free of corruption.
Various gaming regulatory agencies have issued licenses allowing us to manufacture and/or distribute our products and operate wide area progressive systems, also known as WAP systems. We and our key personnel have obtained or applied for all government licenses, permits, registrations, findings of suitability and approvals necessary allowing for the manufacture, distribution, and where permitted, operation of gaming machines in the jurisdictions where we do business. We have never been denied a gaming related license, nor have our licenses been suspended or revoked.
The manufacture, sale and distribution of gaming devices in Nevada or for use outside Nevada are subject to the Nevada Gaming Control Act and the regulations of the Nevada Gaming Commission (Commission), and the
State Gaming Control Board (GCB), and the local laws, regulations and ordinances of various county and municipal regulatory authorities (collectively referred to as the Nevada gaming authorities). These laws, regulations and ordinances primarily concern the responsibility, financial stability and character of gaming device manufacturers, distributors and operators, as well as persons financially interested or involved in gaming operations. The manufacture, distribution and operation of gaming devices require separate licenses. The laws, regulations and supervisory procedures of the Nevada gaming authorities seek to (i) prevent unsavory or unsuitable persons from having a direct or indirect involvement with gaming at any time or in any capacity, (ii) establish and maintain responsible accounting practices and procedures, (iii) maintain effective control over the financial practices of licensees, including establishing minimum procedures for internal fiscal affairs and the safeguarding of assets and revenues, providing reliable record keeping and requiring the filing of periodic reports with the Nevada gaming authorities, (iv) prevent cheating and fraudulent practices, and (v) provide a source of state and local revenues through taxation and licensing fees. Changes in these laws, regulations, procedures, and judicial or regulatory interpretations could have an adverse effect on our gaming operations.
Our subsidiary that conducts the manufacturer, sale, and distribution of gaming devices in Nevada or for use outside Nevada, as well as the operation of slot machine routes and other gaming activities in Nevada, is required to be licensed by the Nevada gaming authorities. Our licenses require the periodic payment of fees and taxes and are not transferable. Each type of machine we sell in Nevada must first be approved by the Commission and may require subsequent machine modification. Our gaming subsidiary licensed in Nevada must also report substantially all loans, leases, sales of securities and similar financing transactions to the GCB and the Commission, and/or have them approved by the Commission. We believe we have obtained all required licenses and/or approvals necessary to carry on our business in Nevada.
We are registered with the Commission as a publicly traded corporation and are required periodically to submit detailed financial and operating reports to the Commission and to furnish any other information that the Commission may require. No person may become a stockholder of or receive any percentage of profits from our licensed gaming subsidiaries, without first obtaining licenses and approvals from the Nevada gaming authorities.
Our officers, directors and key employees who are actively engaged in the administration or supervision of gaming and/or directly involved in gaming activities of our licensed gaming subsidiaries may be required to file applications with the Nevada gaming authorities and may be required to be licensed or found suitable by them. Officers, directors and certain key employees of our licensed gaming subsidiaries must file applications with the Nevada gaming authorities and may be required by them to be licensed or found suitable. Our bylaws provide for us to pay all costs of the GCB investigations that are related to our officers, directors or employees.
The Nevada gaming authorities may investigate any individual who has a material relationship or involvement with us, or any of our licensed gaming subsidiaries in order to determine whether such individual is suitable or should be licensed as a business associate of a gaming licensee. The Nevada gaming authorities may deny an application for licensure or finding of suitability for any cause deemed reasonable. A finding of suitability is comparable to licensing and both require submission of detailed personal and financial information followed by a thorough background investigation. The applicant for licensing or a finding of suitability must pay all costs of the investigation. We must report changes in licensed positions to the Nevada gaming authorities. The Nevada gaming authorities may disapprove any change in position by one of our officers, directors or key employees, or require us to suspend or dismiss officers, directors or other key employees and sever all relationships with such persons, including those who refuse to file appropriate applications or whom the Nevada gaming authorities find unsuitable to act in such capacities. Determinations of suitability or of questions pertaining to licensing are not subject to judicial review in Nevada.
We are required to submit detailed financial and operating reports to the Commission. If it were determined that any Nevada gaming laws were violated by us or any of our licensed gaming subsidiaries, our gaming licenses could be limited, conditioned, suspended or revoked, subject to compliance with certain statutory and regulatory procedures. In addition, we, our licensed gaming subsidiaries and any persons involved may be
subject to substantial fines for each separate violation of the Nevada gaming laws at the discretion of the Commission. The Commission also has the power to appoint a supervisor to operate our gaming properties and, under certain circumstances, earnings generated during the supervisors appointment could be forfeited to the State of Nevada. The limitation, conditioning or suspension of our gaming licenses or the appointment of a supervisor could (and revocation of our gaming licenses would) materially and adversely affect our gaming operations.
The Commission may require any beneficial holder of our voting securities, regardless of the number of shares owned, to file an application, be investigated, and be found suitable, in which case the applicant would be required to pay all of the costs and fees of the GCB investigation. If the beneficial holder of voting securities who must be found suitable is a corporation, partnership, or trust, it must submit detailed business and financial information including a list of beneficial owners. Any person who acquires more than 5% of our voting securities must report this to the Commission. Any person who becomes a beneficial owner of more than 10% of our voting securities must apply for a finding of suitability within 30 days after the chairman of the GCB mails the written notice requiring this filing.
Under certain circumstances, an Institutional Investor, as this term is defined in the Commission regulations, which acquires more than 10%, but not more than 15%, of our voting securities may apply to the Commission for a waiver of these finding of suitability requirements, provided the institutional investor holds the voting securities for investment purposes only. An institutional investor will not be deemed to hold voting securities for investment purposes unless the voting securities were acquired and are held in the ordinary course of its business and not for the purpose of causing, directly or indirectly (i) the election of a majority of our board of directors, (ii) any change in our corporate charter, bylaws, management, policies or operations, or (iii) any other action which the Commission finds to be inconsistent with holding our voting securities for investment purposes only. The Commission considers voting on all matters voted on by shareholders and the making of financial and other informational inquiries of the type normally made by securities analysts, and such other activities as the Commission may determine, to be consistent with holding voting securities for investment purposes only. If the beneficial holder of voting securities who must be found suitable is a corporation, partnership, limited partnership, limited liability company or trust, it must submit detailed business and financial information including a list of beneficial owners. The applicant is required to pay all costs of the GCB investigation.
Any person who fails or refuses to apply for a finding of suitability or a license within 30 days after being ordered to do so by the Commission or the chairman of the GCB may be found unsuitable. The same restrictions apply to a record owner who fails to identify the beneficial owner, if requested to do so. Any stockholder found unsuitable and who holds, directly or indirectly, any beneficial ownership of our voting securities beyond that period of time as may be prescribed by the Commission may be guilty of a criminal offense. We are subject to disciplinary action, and possible loss of our approvals, if, after we receive notice that a person is unsuitable to be a stockholder or to have any other relationship with us or any of our licensed gaming subsidiaries, we (i) pay that person any dividend or interest upon our voting securities, (ii) allow that person to exercise, directly or indirectly, any voting right conferred through securities held by that person, (iii) give remuneration in any form to that person, for services rendered or otherwise, or (iv) fail to pursue all lawful efforts to require the unsuitable person to relinquish his voting securities for cash at fair market value. Additionally, the Clark County authorities have taken the position that they have the authority to approve all persons owning or controlling the stock of any corporation controlling a gaming licensee.
The Commission may, in its discretion, require the holder of any of our debt securities to file an application, be investigated and be found suitable to own any of our debt securities. If the Commission determines that a person is unsuitable to own any of these securities, then pursuant to the Nevada gaming laws, we can be sanctioned, including the loss of our approvals, if without prior Commission approval, we: (i) pay to the unsuitable person any dividend, interest, or any distribution whatsoever; (ii) recognize any voting right by the unsuitable person in connection with these securities; (iii) pay the unsuitable person remuneration in any form; or (iv) make any payment to the unsuitable person by way of principal, redemption, conversion, exchange, liquidation, or similar transaction.
We are required to maintain a current stock ledger in Nevada which may be examined by the Nevada gaming authorities at any time. If any of our securities are held in trust by an agent or by a nominee, the record holder may be required to disclose the identity of the beneficial owner to the Nevada gaming authorities. A failure to make this disclosure may be grounds for finding the record holder unsuitable. We are also required to render maximum assistance in determining the identity of the beneficial owner. The Commission has the power at any time to require our stock certificates to bear a legend indicating that the securities are subject to the Nevada gaming laws and the regulations of the Commission. To date, the Commission has not imposed this requirement on us.
We may not make a public offering of our securities without the prior approval of the Commission if the securities or their proceeds are intended to be used to construct, acquire or finance gaming facilities in Nevada, or retire or extend obligations incurred for such purposes. Such approval, if given, does not constitute a finding, recommendation, or approval by the Commission or the GCB as to the accuracy or adequacy of the prospectus or the investment merits of the securities. Any representation to the contrary is unlawful.
Changes in control of Konami through merger, consolidation, acquisition of assets or stock, management or consulting agreements or any act or conduct by a person whereby he obtains control, may not occur without the prior investigation of the GCB and approval of the Commission. Entities seeking to acquire control of us must satisfy the GCB and the Commission in a variety of stringent standards prior to assuming control. The Commission may also require controlling shareholders, officers, directors and other persons having a material relationship or involvement with the entity proposing to acquire control, to be investigated and licensed as part of the approval process relating to the transaction.
The Nevada legislature has declared that some corporate acquisitions opposed by management, repurchases of voting securities and other corporate defense tactics that affect Nevada gaming licensees, and publicly-traded corporations that are affiliated with those operations, may be injurious to stable and productive corporate gaming. The Commission has established a regulatory scheme to ameliorate the potentially adverse effects of these business practices upon Nevadas gaming industry and to further Nevadas policy to (i) assure the financial stability of corporate gaming operators and their affiliates; (ii) preserve the beneficial aspects of conducting business in the corporate form; and (iii) promote a neutral environment for the orderly governance of corporate affairs. Approvals are, in certain circumstances, required from the Commission before we can make exceptional repurchases of voting securities above their current market price and before a corporate acquisition opposed by management can be consummated. Nevadas gaming laws and regulations also require prior approval by the Commission if we were to adopt a plan of recapitalization proposed by our board of directors in opposition to a tender offer made directly to our shareholders for the purpose of acquiring control of us.
License fees and taxes, computed in various ways depending on the type of gaming or activity involved, are payable to the State of Nevada and to the cities and counties where our subsidiaries conduct operations. Depending on the particular fee or tax involved, these fees and taxes are payable either monthly, quarterly or annually. Annual fees are payable to the State of Nevada to renew our licenses as a manufacturer, distributor, and operator of a slot machine route. Nevada gaming law also requires persons providing gaming devices in Nevada to casino customers on a revenue participation basis to pay their proportionate share of the taxes imposed on gaming revenues generated by the participation gaming devices.
Any person who is licensed, required to be licensed, registered, required to be registered, or is under common control with such persons (collectively referred to as licensees), and who proposes to participate in the conduct of gaming operations outside of Nevada is required to deposit with the GCB, and thereafter maintain, a revolving fund in the amount of $10,000 to pay the expenses of investigation by the GCB of the licensees participation in foreign gaming. This revolving fund is subject to increase or decrease at the discretion of the Commission. As a licensee, we are required to comply with certain reporting requirements imposed by the Nevada gaming laws. We are also subject to disciplinary action by the Commission if we knowingly violate any laws of the foreign jurisdiction pertaining to our foreign gaming operation, fail to conduct our foreign gaming
operations in accordance with the standards of honesty and integrity required of Nevada gaming operations engage in any activity or enter into any association that is unsuitable because it poses an unreasonable threat to the control of gaming in Nevada, reflects or tends to reflect discredit or disrepute upon the State of Nevada or gaming in Nevada, or is contrary to the gaming policies of Nevada, engage in any activity or enter into any association that interferes with the ability of the State of Nevada to collect gaming taxes and fees, or employ, contract with or associate with any person in the foreign gaming operation who has been denied a license or a finding of suitability in Nevada on the ground of personal unsuitability, or who has been found guilty of cheating at gambling.
The manufacture, sale and distribution of gaming machines for use or play in Mississippi or for distribution outside of Mississippi and the operation of wide area progressive gaming devices are subject to the Mississippi Act. Konami Gaming, Inc.s (KGI) license as a wide area progressive operator permits placement of slot machines and gaming devices on the premises of other licensees on a participation basis. All manufacturing, distribution and wide area progressive operation are subject to licensing and regulatory control of the Mississippi Gaming Commission (the Mississippi Commission).
The laws, regulations and supervisory procedures of the Mississippi Commission are based upon declarations of public policy which are concerned with, among other things: (i) the prevention of unsavory or unsuitable persons from having a direct or indirect involvement with gaming at any time or in any capacity; (ii) the establishment and maintenance of responsible accounting practices and procedures; (iii) the maintenance of effective controls over the financial practices of licensees, including the establishment of minimum procedures for internal fiscal affairs and the safeguarding of assets and revenues, providing reliable record keeping and requiring the filing of periodic reports with the Mississippi Commission; (iv) the prevention of cheating and fraudulent practices; (v) providing a source of state and local revenues through taxation and licensing fees; and (vi) the strict regulation of all persons, locations, practices, associations and activities related to the operation of licensed gaming establishments and the manufacture and distribution of gaming devices and associated equipment. Changes in these laws, regulations and procedures could have an adverse effect on our future Mississippi operations.
Certain of our subsidiaries that manufacture and distribute gaming devices or operate a slot machine route, or operate wide area progressive gaming, or which hold stock of a subsidiary which does so (a Gaming Subsidiary), are required to be licensed or registered by the Mississippi Gaming Commission. The Licenses require the periodic payment of fees and taxes and are not transferable. We are registered by the Mississippi Commission as a publicly-traded corporation (Registered Corporation) and so we are required periodically to submit detailed financial operation reports to the Mississippi Commission and to furnish any other information which the Mississippi Commission may require. We have obtained from the Mississippi Commission the various registrations, finding of suitability, approvals, permits and licenses (collectively, referred to as Licenses) required to engage in manufacturing of gaming devices and for KGI to engage in wide area progressive operations, the manufacture, sale distribution of gaming devices for use or play in Mississippi or for distribution outside of Mississippi. We cannot assure you that these Licenses will not be revoked, suspended, limited or conditioned by the Mississippi Commission.
All gaming devices that are manufactured, sold or distributed for use or play in Mississippi, or for distribution outside of Mississippi, must be manufactured by licensed manufacturers and distributed or sold by licensed distributors. All gaming devices manufactured for use or play in Mississippi must be approved by the Mississippi Commission before sales distribution or exposure for play. The approval process for gaming devices includes rigorous testing by the Mississippi Commission, a field trial and a determination as to whether the gaming machine meets strict technical standards that are set forth in the regulations of the Mississippi Commission. Associated equipment (as defined in the Mississippi Act) must be administratively approved by the Chairman of the Mississippi Commission before it is distributed for use in Mississippi.
The Mississippi Commission may investigate any individual who has a material relationship or involvement with us in order to determine whether that individual is suitable or should be licensed as a business associate of a licensee. Officers, directors and certain key employees of our Gaming Subsidiary must file license applications with the Mississippi Commission. Our officers, directors and key employees who are actively and directly involved in activities of our Gaming Subsidiary may be required to be licensed or found suitable by the Mississippi Commission. The Mississippi Commission may deny an application for licensing for any cause which they deem reasonable. A finding of suitability is comparable to licensing, and both require submission of detailed personal financial information followed by a thorough investigation. The applicant for licensing or a finding of suitability must pay all the costs of the investigation. Changes in licensed positions must be reported to the Mississippi Commission and, in addition to their authority to deny an application for a finding of suitability or license, the Mississippi Commission have jurisdiction to disapprove a change in a corporate position.
If the Mississippi Commission were to find an officer, director or key employee unsuitable for licensing or unsuitable to continue having a relationship with us, we would have to sever all relationships with that person. In addition, the Mississippi Commission may require us to terminate the employment of any person who refuses to file appropriate applications. Determinations of suitability or of questions pertaining to licensing are not subject to judicial review in Mississippi.
We are required to submit detailed financial and operating reports to the Mississippi Commission. Substantially all material loans, leases, sales of securities and similar financing transactions by our Gaming Subsidiary must be reported to, and approved by, the Mississippi Commission.
If the Mississippi Commission determines that we violated the Mississippi Act, our Licenses could be limited, conditioned, suspended or revoked subject to compliance with certain statutory and regulatory procedures. In addition, we and the persons involved could be subject to substantial fines for each separate violation of the Mississippi Act at the discretion of the Mississippi Commission. The limitation, conditioning or suspension of any License or the appointment of a supervisor could, and the revocation of any license would, materially adversely affect our future operation in Mississippi.
Any beneficial holder of our voting securities, regardless of the number of shares owned, may be required to file applications, be investigated and have his, her or its suitability as a beneficial holder of our voting securities determined if the Mississippi Commission has reason to believe that ownership would otherwise be inconsistent with the declared policies of the State of Mississippi. The applicant must pay all costs of investigation incurred by the Mississippi Commission in conducting any such investigation.
The Mississippi Act requires any person who acquires beneficial ownership of more than 5% of our voting securities to report the acquisition to the Mississippi Commission. The Mississippi Act requires that beneficial owners of more than 5% of our voting securities apply to the Mississippi Commission for a finding of suitability within 30 days after the mailing of the written notice by the Executive Director of the Mississippi Commission requiring that filing. Under certain circumstances, an institutional investor, as defined in the Mississippi Act, which acquires more than 10%, but not more than 15% or our voting securities may apply to the Mississippi Commission for a waiver of that finding for suitability if the institution investor holds the voting securities for investment purposes only. An institutional investor shall not be deemed to hold voting securities for investment purposes unless the voting securities were acquired and are held in the ordinary course of business as an institutional investor and not for the purpose of causing, directly or indirectly, the election of a majority of the members of our board of directors, any change in our corporate charter, bylaws, management, policies or operations, or those of any of our gaming affiliates, or any other action which the Mississippi Commission finds to be inconsistent with holding our voting securities for invest purposes only. Activities which are not deemed to be inconsistent with holding voting securities for investment purposes only include: (i) voting on all matters voted on by stockholders; (ii) making financial and other inquiries of management of the type normally made by securities analysts for information purposes and not to cause a change in our management policies or operations; and (iii) other activities that the Mississippi Commission may determine to be consistent with investment intent.
If the beneficial holder of voting securities who must be found suitable is a corporation, partnership or trust, it must submit detailed business and financial information including a list of beneficial owners. The applicant is required to pay all cost of investigation.
Any person who fails or refuses to apply for a finding of suitability or a license within 30 days after being ordered to do so by the Mississippi Commission may be found unsuitable. The same restrictions apply to a record owner who fails to identify the beneficial owner, if requested to do so. Any stockholder found unsuitable and who holds, directly or indirectly, any beneficial ownership of voting securities beyond that period of time as may be prescribed by the Mississippi Commission may be guilty of a criminal offense. We are subject to disciplinary action and possible loss of approvals if, after we receive notice that a person is unsuitable to be a stockholder or to have any other relationship with us or any of our licensed Gaming Subsidiaries, we (i) pay that person any dividend or interest upon our voting securities; (ii) allow that person to exercise, directly or indirectly, any voting rights conferred through securities held by that person; (iii) pay remuneration in any form to that person for services rendered or otherwise; (iv) fail to pursue all lawful efforts to require the unsuitable person to relinquish voting securities including, if necessary, the immediate repurchase of the voting securities for cash at fair market value.
The Mississippi Commission may, in its discretion, require the holder of any of our debt security to file an application, be investigated and be found suitable to own any of our debt securities. If the Mississippi Commission determines that a person is unsuitable to own any of our securities, then under the Mississippi Act, we can be sanctioned, including the loss of our approvals, if without the prior approval of the Mississippi Commission we: (i) pay to the unsuitable person any dividend, interest or any distribution whatsoever; (ii) recognize any voting right by the unsuitable person in connection with that security; (iii) pay the unsuitable person remuneration in any form; or (iv) make any payment to the unsuitable person by way of principal, redemption, conversion, exchange, liquidation or similar transaction.
We are required to maintain a current stock ledger in the State of Mississippi which may be examined by the Mississippi Commission at any time. If any securities are held in trust by an agent or by a nominee, the record holder may be required to disclose the identity of the beneficial owner to the Mississippi Commission. A failure to make this disclosure may be grounds for finding the record holder unsuitable. We are also required to render maximum assistance in determining the identity of the beneficial owner. The Mississippi Commission requires that stock certificates of Registered Corporation bear a legend indicating that the securities are subject to the Mississippi Act but we have obtained waiver of that requirement.
We may not make a public offering of our securities without the prior approval of the Mississippi Commission if the securities or the proceeds are intended to be used to construct, acquire or finance gaming facilities in Mississippi, or to retire or extend obligations incurred for such purposes. Such approval, if given, does not constitute a finding, recommendation, or approval by the Mississippi Commission as to the accuracy or adequacy of the prospectus or the investment merits of the securities. Any representation to the contrary is unlawful. To this end, we received continuous approval of public offerings and/or private placements and related approvals (shelf approval) that are valid for a two (2) year period which can and will be renewed for subsequent 2 year periods.
Changes in control of Konami through merger, consolidation, acquisition of assets or stock, management or consulting agreements or any act or conduct by a person whereby he or she obtains control, may not occur without the prior approval of the Mississippi Commission. Entities seeking to acquire control of us must satisfy the Mississippi Commission in a variety of stringent standards prior to assuming control. The Mississippi Commission may also require controlling stockholders, officers, directors and other persons having a material relationship or involvement with the entity proposing to acquire control, to be investigated and licensed as part of the approval process relating to the transaction.
The Mississippi legislature has declared that some corporate acquisitions opposed by management, repurchases of voting securities and other corporate defense tactics that affect Mississippi gaming licensees and
publicly-traded corporations that are affiliated with those operations may be injurious to stable and productive corporate gaming. The Mississippi Commission has established a regulatory scheme to ameliorate the potentially adverse affects of these business practices upon Mississippis gaming industry and to further Mississippis policy to: (i) assure the financial stability of corporate licensees and their affiliates; (ii) preserve the beneficial aspects of conducting business in the corporate form; and (iii) promote a neutral environment for the orderly governance of corporate affairs. Approvals are, in certain circumstances, required from the Mississippi Commission before we can make exceptional repurchases of voting securities above the current market price and before a corporate acquisition opposed by management can be consummated. The Mississippi Act also requires prior approval if we were to adopt a plan of recapitalization proposed by our board of directors in opposition to a tender offer made directly to our shareholders for the purposes of acquiring control of us.
License fees and taxes, computed in various ways depending on the type of gaming or activity involved, are payable to the State of Mississippi and to the cities and counties where our subsidiaries conduct operations. Depending on the particular fee or tax involved, these fees and taxes are payable either monthly, quarterly or annually. Annual fees are payable to the State of Mississippi to renew our licenses as a manufacturer, distributor and operator of a slot machine route.
Any person who is licensed, required to be licensed, registered, required to be registered, or is under common control with such person, and who proposes to become involved in a gaming venture outside of Mississippi, is required to deposit with the Mississippi Commission, and thereafter maintain, a revolving fund to pay the expenses of investigation by the Mississippi Commission, and thereafter maintain, a $10,000 of revolving fund to pay the expenses of investigation by the Mississippi Commission of their participation in foreign gaming operations. This revolving fund is subject to increase or decrease at the discretion of the Mississippi Commission. As a licensee, we are required to comply with certain reporting requirements imposed by the Mississippi Act. The Mississippi Commission may require us to file an application for a finding of suitability concerning an actual or intended activity or association in a foreign gaming operation. A licensee is also subject to disciplinary action by the Mississippi Commission if the licensee knowingly violates any laws of the foreign jurisdiction pertaining to the foreign gaming operation, fails to conduct the foreign gaming operation in accordance with the standards of honesty and integrity required by Mississippi gaming operations, engages in activities that are harmful to the State of Mississippi or its ability to collect gaming taxes and fees, or employs a person in the foreign operation who has been denied a license or finding of suitability in Mississippi on the grounds of personal unsuitability.
New Jersey Regulations
The manufacture, distribution, and operation of gaming machines, and other aspects of casino gaming in New Jersey, are subject to strict regulation pursuant to the New Jersey Casino Control Act and the regulations promulgated thereunder (collectively, referred to as New Jersey Act). The New Jersey Act created the New Jersey Casino Control Commission (New Jersey Commission) and the New Jersey Division of Gaming Enforcement (the New Jersey Division). The New Jersey Commission is authorized to decide all license applications and other matters and to promulgate regulations. The New Jersey Division is authorized to investigate all license applications, make recommendations to the New Jersey Commission, and to prosecute violations of the New Jersey Act.
Under the New Jersey Act, a company must be licensed as a gaming related casino service industry supplier (CSI), or fulfill other requirements, in order to manufacture or distribute gaming devices to New Jersey casinos. In order for a CSI license to be issued, renewed or maintained, certain directors, officers, key employees and owners of a company must be found by the New Jersey Commission to possess by clear and convincing evidence good character, honesty, integrity and financial stability. Concurrent with our subsidiary Konami Gaming, Inc., we got a CSI license in 2004.
In its discretion, the New Jersey Commission may permit an unlicensed applicant for a CSI license to transact business with New Jersey casinos prior to licensure. In order to do so, we must maintain a completed
application for CSI licensure on file with the New Jersey Commission. In addition, the casino that desires to transact business with us must obtain the approval of the New Jersey Commission for each business transaction (transactional waiver) by filing a petition with the New Jersey Commission that demonstrates that good cause exists for granting the petition. The New Jersey Commission can not grant such a petition if the New Jersey Division objects to the petition.
A CSI license application consists of extensive disclosure forms for the applicant, each of its holding companies, and each individual required to be found qualified by the New Jersey Commission. The persons affiliated with an applicant who must be found qualified by the New Jersey Commission are certain officers, directors and management employees, all beneficial owners of five percent (5%) or more of the applicant, and any other person the New Jersey Commission deems appropriate.
With respect to security holders, the New Jersey Commission may waive the qualification requirement for institutional investors, as defined in the New Jersey Act, of an applicant if: (i) there is no reason to believe that the institutional investor may be unqualified; (ii) the institutional investor holds less than ten percent of the outstanding securities; (iii) the securities were acquired for investment purposes only, and (iv) the holder has no intention of influencing the affairs of the applicant, other than voting its securities. The New Jersey Act defines an institutional investor as (i) any retirement fund administered by a public agency for the exclusive benefit of federal, state or local public employees; (ii) an investment company registered under the Investment Corporate Law of 1940; (iii) a collective investment trust organized by banks under Part Nine of the Rules of the Comptroller of the Currency, (iv) a closed end investment trust; (v) a chartered or licensed life insurance company or property and casualty insurance company; (vi) banking or other licensed or chartered lending institutions; (vii) an investment adviser registered under the Investment Advisers Act of 1940, and (viii) such other persons as the New Jersey Commission may determine for reasons consistent with the policies of the New Jersey Act.
In connection with a license application, the New Jersey Division conducts an investigation of the applicant and its individual qualifiers to determine their suitability for licensure. In order for a CSI license to be issued by the New Jersey Commission, the applicant and its individual qualifiers must demonstrate by clear and convincing evidence their good character, honesty and integrity, their financial stability, integrity and responsibility.
The application fee for a CSI license consists of a non-refundable deposit of $5,000 and an obligation to pay an additional $5,000 if the processing of the application requires more than 1,000 but less than 2,000 hours and a further $5,000 if the processing of the application exceeds 2,000 hours, plus the expenses of the New Jersey Commission and New Jersey Division. The same fee structure applies to any renewal application.
The New Jersey Commission has broad discretion regarding the issuance, renewal, suspension or revocation of CSI licenses. If our CSI license application is denied, we will not be able to transact business with New Jersey casinos. There is no guarantee that we will be granted an initial license or that, following the issuance of an initial CSI license or any renewal thereof, we will continue to be granted renewals of the license. The New Jersey Commission may impose conditions on the issuance of a license. In addition, the New Jersey Commission has the authority to impose fines or suspend or revoke a license for violations of the New Jersey Act, including the failure to satisfy the licensure requirements. A CSI license is issued for an initial period of two (2) years and is thereafter renewable for four (4) year periods.
In addition to our required licensure, the gaming equipment manufactured, distributed or sold by us to New Jersey casinos is subject to a technical examination by the New Jersey Division and approval by the New Jersey Commission for, at a minimum, quality, design, integrity, fairness, honesty, suitability and compliance with rigorous technical standards. The approval process includes the submission of a model of the machine to the New Jersey Division for testing, examination and analysis and for comparison with documentation of the schematics, block diagram, circuit analysis and written explanation of the method of operation, odds determination and all other pertinent information. All costs of such testing, examination and analysis are borne by us.
As part of this approval process, the New Jersey Commission may require that the manufacturer of any component of the gaming equipment which the New Jersey Commission, in its discretion, determines is essential to the gaming aspects of the device submit to licensing. Such components would include the computer control circuitry which causes or allows the device to operate as a gambling device. The failure or refusal of such a manufacturer to submit to licensing or the denial of a license by the New Jersey Commission to such manufacturer would result in our inability to distribute and market that gambling device to New Jersey casinos.
Prior to a decision by the New Jersey Commission to approve a particular model of machine, it may require a trial period to test the machine in a licensed casino. During the trial period, the manufacturer and distributor of the machine shall not be entitled to receive revenue of any kind whatsoever. Once a model is approved by the New Jersey Commission, all machines of that model placed in operation in licensed casinos shall operate in conformity with the model tested by the New Jersey Division. Any changes in the design, function or operation of the machine are subject to prior approval by the New Jersey Commission in consultation with the New Jersey Division.
Each of the other jurisdictions in which we do business requires various licenses, permits and approvals in connection with the manufacture and/or distribution of gaming devices typically involving restrictions similar in many respects to those of Nevada.
Federal United States Registration
The Federal Gambling Devices Act of 1962 (the Act) makes it unlawful for a person to manufacture, transport, or receive gaming machines, gaming devices or components across interstate lines unless that person has first registered with the Attorney General of the US Department of Justice. We are so registered and must renew our registration annually. In addition, gambling device identification and record keeping requirements are imposed by the Act. Violation of the Act may result in seizure and forfeiture of the equipment, as well as other penalties. We have complied with the registration requirements of the Act.
Native American Gaming Regulation
Gaming on Native American lands is governed by federal law, tribal-state compacts, and tribal gaming regulations. The Indian Gaming Regulatory Act of 1988, or the IGRA, provides the framework for federal and state control over all gaming on Native American lands and is administered by the National Indian Gaming Commission, or the NIGC, and the Secretary of the US Department of the Interior. IGRA requires that the tribe and the state enter into a written agreement, a tribal-state compact, which governs the terms of the gaming activities. Tribal-state compacts vary from state-to-state and in many cases require equipment manufacturers and/or distributors to meet ongoing registration and licensing requirements. In addition, tribal gaming commissions have been established by many Native American tribes to regulate gaming related activity on Indian lands. We manufacture and supply gaming equipment to Native American tribes who have negotiated compacts with their state and have received federal approval. As of June 30, 2007, we have received approvals to supply gaming equipment and component to 18 states of Native American.
Certain foreign countries permit the importation, sale and operation of gaming equipment in casino and non-casino environments. Some countries prohibit or restrict the payout feature of the traditional slot machine or limit the operation and the number of slot machines to a controlled number of casinos or casino-like locations. Each gaming machine must comply with the individual countrys regulations. Certain jurisdictions require the licensing of gaming machine operators and manufacturers.
We manufacture and supply gaming equipment to various international markets including Australia, Canada, Malaysia, New Zealand, the Philippines, and South Africa. We have obtained the required licenses to manufacture and distribute our products in the various foreign jurisdictions where we do business.
Video Game Software
Japan. No governmental entity in Japan is authorized to censor the content of computer entertainment software. The Computer Entertainment Suppliers Association, or CESA, is a Japanese industry association that conducts market surveys, research and other activities to promote the computer entertainment software industry in Japan. CESAs members are corporations and individuals engaged in projects relating to the development, manufacture and sale of computer entertainment software and organizations comprised of such individuals or organizations. We are a member of CESA and our Chief Executive Officer, Kagemasa Kozuki, had been the Chairman of CESA since its establishment in 1996 for three terms over six years.
The Computer Entertainment Rating Organization, or CERO, was established in 2002 and CERO started regulating home game software distributed in Japan through a rating system based upon the users age. CERO reviews expressions and contents of software based on its ethical guidelines upon request of software manufacturers. Expressions containing violence, anti-social behavior, sexual behavior and hazardous language or thought are subject to CEROs rating. Each game software is categorized and labeled either as game software or educational/database software and those categorized as game software must label age classification mark based on the rating. CERO has adopted a five tiered game software age classification, including category A for persons all age, category B for persons 12 and older, category C for persons 15 and older, category D for persons 17 and older and category Z for sales prohibition to persons younger than 18, thereby indicating that contents of each categorized software are subject to persons in categorized age group.
International. The content of video game software is not subject to federal regulation in the United States. However, many video game software publishers comply with the standardized rating system established by the Entertainment Software Rating Board, or ESRB. The ESRB is an independent entity established in 1994. It rates video games, websites and online games and reviews advertising created by the video game industry. Video game software publishers such as us include ESRB ratings on their game software packages and Nintendo and Sony include the meanings of these ratings on their game console packages.
In Europe, Pan European Game Information, an age rating system applied in 29 countries (primarily those in the EU), conducts voluntary age rating inspections using standards developed by the Interactive Software Federation of Europe, a Europe-based industry group. Furthermore, in Germany, the Unterhaltungs Software Selbstkontrolle (USK) conducts morals inspections pursuant to the countrys Minor Protection Law.
Pachinko Machines (Pachinko, Pachinko Slot)
Standards for pachinko and pachinko slot machines are regulated under the Law Regulating Adult Entertainment in Japan. The Security Electronics Communication Technology Association is the only entity authorized to test new models of pachinko and pachinko slot machines and determine whether such models meet certain specified technical criteria. Those who expect to produce new models are first required to pass such model test and then to obtain verification that such model complies with applicable standards from the prefectural Public Safety Commission in the prefecture in which such models would be distributed and operated.
The following table sets forth information, as of March 31, 2008, with respect to our principal establishments:
In addition to the above facilities, we lease floor space in office buildings in various locations around the world including Japan, China, the United States and Europe.
In April 2007, we consolidated our business offices located in Tokyo into our current address at the newly-opened Tokyo Midtown.
We are involved in a number of actions and proceedings in Japan and overseas in the ordinary course of our business. However, we are not involved in any legal or arbitration proceedings, nor, so far as our Directors are aware, are there any legal or arbitration proceedings pending or threatened involving us that, if determined adversely to us, would individually or in the aggregate have a material adverse effect on us or our financial condition and results of operations.
Breakdown of Total Revenues by Category of Activity and Geographic Market
See Item 5.A of this annual report.
C. Organizational Structure.
The table below shows our principal subsidiaries (companies in which we hold, directly or indirectly, more than 50% of the issued share capital and where we exercise control) and affiliates (companies in which we hold, directly or indirectly, 20-50% of the issued share capital and where we have significant influence) as of March 31, 2008. Except where stated otherwise, each of these companies is accounted for as a consolidated subsidiary. The issued share capital of each of these companies is fully-paid.
D. Property, Plants and Equipment.
The information required by this item is set forth in Item 4.B of this annual report.
We are a large accelerated filer as defined in Rule 12b-2 under the Securities Exchange Act of 1934. There are no written comments which have been provided by the staff of the Securities and Exchange Commission regarding our periodic reports under that Act not less than 180 days before the end of the fiscal year ended March 31, 2008 and which remain unresolved as of the date of the filing of this Annual Report with the Commission.
A. Operating Results.
You should read the following discussion of our financial condition and results of operations together with our consolidated financial statements and other information included in this annual report. Fiscal 2008 herein refers to the fiscal year ended March 31, 2008, and other fiscal years are referred to in a corresponding manner.
This discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including, but not limited to, those set forth under Item 3.D and elsewhere in this annual report.
We are a global entertainment products, health products and services provider. We publish and distribute video game software for use by customers with home and handheld video game systems, principally those manufactured by Sony, Nintendo and Microsoft, and also produce and distribute Internet-based entertainment contents. We also offer a variety of other digital entertainment products by producing toys, including card games, manufacturing and distributing amusement games and token-operated games for amusement arcades. Some of these products use characters from or inspired by characters in our home video game software and other products. Since February 2001, we have also run the largest chain of fitness clubs in Japan. Furthermore, we produce and market a variety of entertainment and exercise machines and components, including fitness machines, gaming machines and LCDs for pachinko machines. We earn revenues and income and generate cash from sales of these products and services.
Effective the first quarter ended June 30, 2005, we divided our worldwide operations principally into three business segments for financial reporting purposes: Digital Entertainment, Health & Fitness and Gaming & System. The net revenue of these segments, before elimination of intersegment revenues, accounted for 60.2%, 29.1% and 6.2%, respectively, of our total net revenue in fiscal 2008. Our consolidated net revenue for fiscal 2008 was ¥297,402 million.
With the increasing use of the Internet and the enhancement of digital technology, differences among businesses in the digital entertainment industry have been disappearing. The recent emergence of the online game market is further intensifying this trend. In this environment, in order to respond to diversifying customer needs, in April 2005, we merged, in addition to our three home video game software production consolidated subsidiaries, Konami Computer Entertainment Studios, Inc., Konami Computer Entertainment Tokyo, Inc. and Konami Computer Entertainment Japan, Inc., and also Konami Online, Inc., which engaged in the planning, production and distribution of mobile and online games and Konami Media Entertainment, Inc., which engaged in the music and publication business with and into Konami. Furthermore, in April 2005, we re-positioned five of our businesses, Computer & Video Games, Toy & Hobby, Amusement, Online and Multimedia, as Digital Entertainment Businesses, and set up a framework to maximize the synergies among these businesses. With this new focus, we reorganized our business into three segments: the Digital Entertainment segment, Health & Fitness segment and Gaming & System segment.
Due to the nature of the entertainment industry, our results of operations have largely been, and will to a considerable extent remain, affected by individual products or a series of products that are hits with consumers such as video game software and card game. See Factors Affecting Our Results of OperationsHit Products. We have been working to reduce volatility in our results by building a solid and well-balanced business portfolio with multiple segments, featuring a growing number and variety of products and services. We are also diversifying our revenue sources by expanding our businesses overseas. Our Digital Entertainment segments have been active in the North American and European markets and our Gaming & System segment has actively developed its operations particularly in the North American market, the biggest gaming market in the world with high future growth potential.
The entertainment industry in Japan has been expanding, reflecting an increasing social recognition of the importance of developing intellectual property and the rapid advance of technology.
Within the Japanese entertainment industry, the video game software industry has become increasingly competitive and more hit products-oriented, with the size of the market fluctuating depending on the number of hit products produced and distributed in a given year. The toy industry in Japan faces problems, including a
declining birthrate, children growing out of toys at younger ages due to earlier maturity, a decrease in disposable incomes due to the sluggish economy and an increase in spending on other entertainment. The toy industry is holding firm, however, without any sharp decline in sales, due to an increase in expenditures per child and an increase in demand for toys targeting adults in line with the aging of society. The amusement arcade industry has been sluggish, reflecting intensifying competition with other entertainment options, but it has recovered recently due primarily to the development of large-size amusement arcades that attract new consumers. Also, with the increasing use of the Internet and the advancement of digital technology, the mobile phone and online game market has been expanding as a new entertainment business.
In the Japanese health industry in which our Health & Fitness segment operates, due to the enforcement of health-related laws and regulations, there has been a growing interest in nursing care prevention as Japans population grows older. Measures to tackle lifestyle related diseases have been taken at the national level and steps to maintain good health are underway. We believe there will be an increasing demand for health-related services among middle-aged and senior consumers and that the market may grow further.
In our business, hardware manufacturers have now released their next-generation computer entertainment systems such as Nintendo Wii, Sony Computer Entertainment PLAYSTATION 3 and Microsoft Xbox 360, and handheld game consoles such as Nintendo DS and the PlayStation Portable have been well received by a broad range of users regardless of age or gender, and the home game market in Japan and abroad has been strong. Moreover, we have also been actively expanding overseas, taking advantage of opportunities for growth in foreign markets, such as North America and Europe, and we are increasingly dependent on our overseas business. For example, in the sports video game category, soccer titles such as the Winning Eleven series, including WORLD SOCCER Winning Eleven (called Pro Evolution Soccer in Europe), continue to gain popularity in Japan and Europe and recorded sales of over 8.4 million units worldwide in fiscal 2007 and over 9.4 million units in fiscal 2008. We seek to continue expanding our business by introducing products that were hits in the Japanese market into overseas markets, as well as developing and introducing products that reflect the unique customer preferences and the competitive environment in each market.
Our main business strategies for each segment are as follows:
In our Computer & Video Games business, we are striving to strengthen our content lineup and make it attractive to customers not only in Japan, but also worldwide in North America, Europe and Asia, by developing products that respond to the characteristics of each market.
In our Amusement business, we plan to further enhance our e-AMUSEMENT service, which links amusement arcades on line throughout Japan, by strengthening existing content and introducing new titles.
In our Card Games business, we are aiming to develop and acquire highly recognized characters and contents both produced by us as well as licensed by third parties, in order to expand our product lineup.
In our Online business, we plan to continue providing intangible services, taking advantage of the new value made possible by the Internet, by planning, producing, operating and distributing Internet-based entertainment contents, including mobile games and PC online games.
In the Health & Fitness segment, we are focusing on improving the quality of our services, rather than giving discounts, by offering a wide range of health-related value-added services in order to develop our operations effectively.
In the Gaming & System segment, we aim to increase our revenue through development of competitive slot machine and system offerings, better services for clients and improvement of client training for our casino management systems.
Factors Affecting Our Results of Operations
Factors Affecting Combined Results of Operations
A number of factors affect revenues and expenses across several of our segments, and therefore have a substantial impact on our combined results of operations. These factors include the importance of hit products that respond to trends in popular culture, intellectual property licensing, seasonal fluctuations, investments and acquisitions.
Most of our non-fitness related revenues come from sales of entertainment software and devices and are dependent on our ability to anticipate or influence the kinds of games and products that are popular with consumers. Revenues for our Digital Entertainment and Gaming & System segments are strongly affected by whether individual products or a series of products become hits with consumers. A single hit product can generate very substantial revenues, which can continue over an extended period through the release of sequel products and through expansion and extension of the concept or characters from a popular games.
Previously, our strategy was to develop a large number of titles for various platforms, in order to limit fluctuations in sales. However, due to recent changes in the business environment, such as the spread of online games, and our expansion into overseas markets, we have decided to adopt a new strategy of increasing revenues for each title through streamlining and enhancing the versatility of our content. Accordingly, we are cutting the number of titles through a process of Selection and Concentration, which we expect will provide a more consistent stream of revenues from each hit title. We have also decreased the volatility of our net revenues by entering the fitness club business, which we believe provided a more stable base of revenue.
Intellectual Property Licensing
One means we use to increase the likelihood that our products will succeed is licensing the right to utilize ideas and images from popular culture, such as comic book characters, sports and entertainment personalities and high visibility events. Thus, to some extent our revenues are dependent on successful identification and acquisition of rights to popular ideas and images. We have steadily increased the number of intellectual property licenses we hold to 409 licenses in fiscal 2008.
These licenses typically require a guarantee of minimum future royalties. We may experience losses if sales based on licensed intellectual property do not produce sufficient revenues to cover our royalties expenses. In addition, games that are based on licensed ideas have lower margins than games that we develop independently.
In recent years, the entertainment industry has seen an acceleration in crossovers with other industries such as toys, films, music, comics, publishing and communications. When we are able to use intellectual property licenses in multiple segments, we are able to produce higher revenues. For example, our Yu-Gi-Oh! Trading Card Game originated from the popular Yu-Gi-Oh! comic in a prominent Japanese weekly magazine. Following our media-mix strategy, we made good use of the license for the game, making substantial sales of our Yu-Gi-Oh! Trading Card Game for our Card Games business and as a video game for our Computer & Video Games business.
Many of our products are in the greatest demand from November to January. These months correspond to the periods of childrens school holidays, and it is customary in Japan to buy such products as Christmas and New Year presents in December and January. In addition, demand in the U.S is highest from November, starting with Thanksgiving and through the Christmas season. However, our earnings may not necessarily reflect the seasonal patterns of the industry as a whole as a result of increased sales due to the occurrence of various sports events or the release of hit titles.
Investments and Acquisitions
We have sought growth and diversification through investments and acquisitions in sectors that are expected to result in increased revenue stability and growth. These investments and acquisitions affected the composition of our assets and liabilities and our results of operations, sometimes materially. Among other things, we recognized an increase in the amount of goodwill and intangibles with indefinite life on our consolidated balance sheet in connection with such acquisitions, which we test for impairment at least on an annual basissee Critical Accounting PoliciesValuation of Intangible Assets and Goodwill.
In particular, we have conducted the following transactions:
Foreign Currency Fluctuations
An increasing portion of our business is conducted in currencies other than yenmost significantly, U.S. dollars and Euro, as we increase our sales overseas. Our business is thus becoming sensitive to fluctuations in foreign currency exchange rates, especially the yen-U.S. dollar and yen-Euro exchange rate. Our consolidated financial statements are increasingly becoming subject to both translation risk and transaction risk. Translation risk arises from the fact that our foreign subsidiaries have different functional currencies than we do. Changes in the value of the Japanese yen relative to the functional currencies of these subsidiaries create translation gains
and losses on our equity investments in foreign subsidiaries which are recorded as foreign currency translation adjustments on our consolidated statements of shareholders equity and accumulated other comprehensive income until we dispose of, liquidate or take an impairment charge with respect to, the relevant subsidiaries.
Transaction risk arises when the currency structure of our costs and liabilities deviates from the currency structure of our sales proceeds and assets. A substantial portion of our overseas sales are made in U.S. dollars and Euros. Our sales denominated in U.S. dollars and Euro are, to a significant extent, offset by U.S. dollar and Euro denominated costs. Transaction risk remains for products sold in foreign currency to the extent that we must purchase parts for our products from Japan, the costs for which are denominated in yen.
We use foreign exchange forward contracts to manage foreign exchange exposure associated with short-term movements in exchange rates applicable to our payable commitments and receivables that we expect to pay or receive in foreign currencies. Changes in the fair values of our foreign exchange forward contracts are recognized as gains or losses on derivative instruments in our income statement. For a more detailed discussion of these instruments, you should read Item 11 herein and Note 17 to our consolidated financial statements included in this annual report.
Factors Affecting Results of Business Segments
In addition to the factors affecting our combined results of operations through several segments, there are other factors that affect the results of each of our segments independently. The factors affecting results in our business segments are as follows:
Digital Entertainment Segment
Net Revenues. In our Digital Entertainment segment, in addition to the production and distribution of video game software for home and handheld game platforms and personal computers, we are engaged in the production and sales of card games and boys toy products, the development, manufacturing and maintenance of video arcade games and token-operated games for amusement arcades, the production and distribution of software for mobile phones and online network, as well as the production and sale of books and music of our products. In fiscal 2008, net revenues from the Digital Entertainment segment were ¥178,939 million, accounting for 60.2% of consolidated net revenues before elimination of intersegment revenue.
Our video game software is sold mainly in the format of DVD-ROMs or proprietary discs for home video game platforms such as Sony PlayStation 2, PLAYSTATION 3, Nintendo Wii and Microsoft Xbox 360 and ROM-cartridges and other media for handheld video game platforms such as Nintendo DS and PlayStation Portable.
Our sales of video game software are strongly influenced by our ability to develop or acquire popular game content. See Factors Affecting Combined Results of OperationsHit Products, Intellectual Property Licensing. For instance, sales of video game software are significantly affected by sales volumes of video game systems. The potential market for a software product designed for a particular video game system is determined by the total number of such video game systems purchased by consumers, a number which is sometimes referred to as the installed base of such video game systems. When new hardware systems are introduced, we may experience a temporary decline in net sales attributable to video game software until we are able to produce one or more hit products that utilize the increased capabilities of the new hardware.
The home video game industry is characterized by rapid technological changes, which have resulted in successive introductions of increasingly advanced game consoles. As a result of the rapid technological shifts, no single game console has achieved long-term dominance in the home video game and computer game market. To respond to these rapid shifts in video game hardware technology, it is necessary for us to continually anticipate game console cycles, time our product pipeline so that we do not publish games for hardware that is no longer popular, and develop software programming tools necessary for emerging hardware systems.
Our net revenue sales from card games and toys are principally affected by our identification and acquisition of rights to characters of popular comic books and TV programs, our ability to produce unique games, the number of children in the population, the timing of market entry, market competition, lifecycle of products and general economic trends. The toy industry in Japan is now faced with such issues as a decline of birthrates, young childrens shift away from toys due to their maturing at a younger age, and an increase in household expenses for children or other amusement purposes. However, the toy industry has not experienced a rapid decline in sales, but has continued a steady growth because of an increase in expense spent per child and a growing demand for toy products for adults along with an ageing society. In response, in order to maintain the balance of our business portfolio and to make our lineup of products more attractive, we strive to diversify products targeted to the Japanese market. For instance, we enhanced our reputation through sales of a series of BUSOU SHINKI to which our original MMS figures are applied.
Net revenues from amusement arcade games are affected by market acceptance, the number and size of video arcades in Japan, introduction of hit titles and general economic trends. In addition, our e-Amusement service, which links amusement arcade throughout Japan online, is influenced by market acceptance of network-based interactive games, network stability, which is the backbone of our services, and general economic trends. In addition to creating new games, we believe that we may be able to increase margins and in this business by extending the life cycle of our existing arcade games by continuing to provide stable services after purchases of our machines. We also continue to benefit from sales of token-operated machines in Japan, mainly due to strong sales of SPINFEVER, which is a mid-sized pusher game, and GRANDCROSS, which is a large-scale token-operated gaming machine. We are proud of being one of the leading companies in the token-operated machine industry in Japan. Because the arcade game industry in Japan continues to be streamlined, the average scale of each amusement arcade is expanding along with a decrease in the number of amusement arcades. Accordingly, large-scale token-operated machines that attract a large number of customers have a tendency to gain popularity within large amusement arcades.
Our online services are affected by market acceptance of network-based interactive games, the number of mobile phone and Internet users, network system stability, which is the backbone of our services, and general economic trends. We make every effort to strengthen stability of our network-based services through such measures as server maintenance and improved stress tests.
We are engaged in publishing books and in the production and sales of music and video software. Such sales are influenced by market acceptance of each media, our ability to select, find and develop attractive contents and general economic trends. The sale of books and magazines in Japan has declined, and the value of audio record shipments has continued to decline. The markets for books, music and video are largely shaped by developments such as an increase in digitalization and in content distribution via the Internet and mobile phones. We are focused on maintaining stable sales of books on strategy for our game software, and are working on improvement of contents through planning and producing game software related music CDs.
Expenses. Costs and expenses that we incur in the development of new video game software are expensed as research and development costs until such games reach technological feasibility, at which point we begin to capitalize the expenses. We expense capitalized costs to cost of revenues upon commercial release, as the commercial life of our software for home video game platforms is of short duration.
The rapid technological advances in home game consoles have significantly changed the software development process. We expect the process to become even more complex and expensive with the advent of more powerful next-generation game consoles. Our cost of revenues from software also includes the costs of licenses from content licensors. While some of our content licenses include prepaid or guaranteed royalties, most of the royalties we pay are on a revenue basis. We amortize the cost of prepaid royalties based on the number the associated products sold. We evaluate the future recoverability of any prepaid royalties and capitalized software development costs on a regular basis based on actual title performance. We expense as part of product development costs those capitalized costs that we deem unrecoverable.
Card games have historically shown a higher margin than other toy products due to their relatively low manufacturing costs. Costs include raw material costs, manufacturing outsourcing, licensing, research and development and administrative costs. Furthermore, because our card games and toys business is typically based on previously developed intellectual property, research and development costs are comparatively low.
As for amusement arcade games and token-operated games, we incur more limited cost of parts and raw materials and therefore have higher margins when we provide new game software contents for existing machines rather than selling new machines, because of lower cost of parts and raw materials. We are currently working on further improving margins in our Amusement business through the introduction of the less expensive e-AMUSEMENT gaming machine, which links amusement arcades online throughout Japan, and other measures to decrease production costs.
Our cost of services rendered for mobile phones and personal computers game content consists of expenses incurred in the development of content, maintenance expenses for servers in our online services and service charge collection fees. We capitalize development and production costs and then amortize such costs as cost of services rendered for a period of two to three years or based on the expected length of services.
Costs and expenses related to publishing books and producing music are comprised mainly of costs to produce contents, costs paid for royalties on copyrights and royalties paid. Products in this business mainly use intellectual property rights that were developed in the past. As a result, the research and development costs of our Other business are comparatively low.
Health & Fitness Segment
Net Revenues. We are the largest fitness club operator in Japan according to Nikkei Marketing Journals article published on November 7, 2007. We also design, manufacture and sell fitness and health related products. As of March 31, 2008, we operated 209 fitness clubs that collectively served approximately 980,000 members and provided outsourced services to 110. In addition, in March 2008, we acquired Sportsplex Japan Co., Ltd. and added 13 additional facilities in the Tokyo metropolitan area to increase convenience for our members. Our Health & Fitness segment had ¥86,544 million in net revenues or 29.1% of our total net revenue, before elimination of intersegment revenues, in fiscal 2008.
While the majority of our Health & Fitness revenues come from membership fees, our fitness clubs also collect additional revenues from ancillary sales and services, sales of consumables including meals in our in-club restaurants and nutritional products in our in-club stores, and fees for services such as jazzercise and other fitness classes, massage, fitness counseling, work-out programs, personal trainers and tours for diving, skiing and marathon.
Expenses. Operating expenses for our Health & Fitness segment include, for our health and fitness club business, leases for facilities, salaries for trainers and other club employees, costs of fitness machines and other equipment, utilities charges, marketing expenses, costs for maintaining the facilities and depreciation. Upon opening a new fitness club, we often experience an initial period of operating losses with respect to that club for the first year. However, this period can vary depending on the individual club, and may be substantially longer than a year. However, since most of our expenses are fixed, operating margins tend to improve significantly with respect to each club as membership increases. Expenses for our fitness-related game and fitness equipment business are largely related to cost of parts and raw materials, manufacturing costs and research and development expenses.
In fiscal 2006, we recognized impairment losses of ¥19,713 million related to our Health & Fitness segment, consisted of long-lived assets of ¥10,533 million and identifiable intangible assets of ¥9,180 million as a result of our annual impairment assessment. These impairment losses for long-lived assets were attributed to the deterioration of the operating performance of certain club locations after a review of fiscal 2006 and the additional establishment of facilities during such fiscal year.
Gaming & System Segment
Net Revenues. In fiscal 2008, net revenues from the Gaming & System segment, before elimination of intersegment revenues, were ¥18,471 million, accounting for 6.2% of consolidated net revenues. The main revenue source for the Gaming & System segment is the sale of video slot machines and software contents in Australia and sales of video and mechanical slot machines, casino management systems and software contents in North America. Revenues for the Gaming & System segment are affected by the timing of the introduction of products, timing of regulatory approvals in various markets, the ability to penetrate into foreign gaming markets, the number of gaming players, gaming regulations in relevant markets, our competitiveness in these markets, the average product life cycles and general economic trends.
Our sales of gaming machines are conducted overseas, primarily in North America and in Australia. Casinos are authorized to operate in more than 130 countries, and the number of countries authorizing casinos has been increasing each year. We believe that the market will continue to grow in 2009.
Expenses. Expenses in our Gaming & System segment are largely related to cost of parts and raw materials, manufacturing costs and research and development expenses. In recent years, we have attempted to decrease our cost of revenues for the Gaming & System segment by acquiring parts and producing our machines in the markets in which they are sold, thereby reducing shipping costs and foreign exchange risks.
Results of Operations
The table below shows our consolidated statements of income for the periods indicated:
Comparison of Fiscal 2008 with Fiscal 2007
Net revenues increased by ¥17,123 million, or 6.1%, to ¥297,402 million for fiscal 2008 from ¥280,279 million for fiscal 2007. This increase mainly resulted from the increase in net revenues from our Digital Entertainment segment.
Net revenues of our Health & Fitness segment from external customers decreased by ¥2,130 million, or 2.4%, to ¥86,196 million in fiscal 2008. This decrease was due primarily to a decline in membership by 1.1% as compared with the prior year. Please see Segment Information later in this section for further discussion.
Net revenues of our Gaming & System segment from external customers increased by ¥1,727 million, or 10.3%, to ¥18,471 million in fiscal 2008. This increase was due primarily to an increase in revenues from sales of casino gaming machines and casino management systems such as the K2V series and Advantage5 series at our U.S. subsidiary, Konami Gaming, Inc.
Net revenues of our Digital Entertainment segment from external customers increased by ¥13,582 million to ¥178,382 million, accounting for 60.0% of the total. In our Computer & Video Games business, the WORLD SOCCER Winning Eleven (called Pro Evolution Soccer in Europe) series continued to gain high popularity in Japan and abroad, resulting in increased sales compared with the previous fiscal year, and with aggregate sales of over 9.43 million units for the entire series. In the Amusement business, MAH-JONG FIGHT CLUB, a series of titles incorporating the e-AMUSEMENT service, which links amusement arcades online throughout Japan, continuously received favorable reviews and recorded increased sales. Due to solid growth in the net sales of the Card Game business, net revenue of the Digital Entertainment segment as a whole increased.
Net revenues of the Other segment from external customers increased by ¥3,944 million, or 37.9%, to ¥14,353 million in fiscal 2008 due primarily to strong sales of pachinko LCDs and pachinko slot machines.
Cost of Revenues
Cost of revenues increased by ¥11,682 million, or 6.0%, to ¥205,188 million for fiscal 2008, compared to ¥193,506 million for fiscal 2007.
This increase was primarily due to an increase in cost of revenues generated from manufactured goods and products which resulted from an increase in net revenues from our Digital Entertainment segment, and an increase in net revenues of pachinko LCDs, pachinko slot machines and related products.
Selling, General and Administrative Expenses
Selling, general and administrative expenses decreased by ¥253 million, or 0.4%, to ¥58,375 million for fiscal 2008 from ¥58,628 million for fiscal 2007, which was approximately the same level as 2007.
As a result of the foregoing, our operating income increased by ¥5,694 million, or 20.2% to ¥33,839 million for fiscal 2008 from ¥28,145 million for fiscal 2007.
As a percentage of net revenues, operating income has increased by 1.4% to 11.4% in fiscal 2008 from 10.0% in fiscal 2007. This increase resulted primarily from a significant increase in operating income generated by the increase in net revenues in the Gaming & System business and Digital Entertainment business, even while income in the Health & Fitness segment declined.
Other Income (Expenses), net
Other income (expenses), net, increased by ¥427 million to expenses of ¥1,005 million for fiscal 2008 from expense of ¥578 million for fiscal 2007, due to an increase of foreign exchange related losses.
Income Before Income Taxes, Minority Interest and Equity in Net Income (Loss) of Affiliated Companies
As a result of the foregoing, our income before income taxes, minority interest and equity in net income (loss) of affiliated companies increased by ¥5,267 million, or 19.1%, to ¥32,834 million for fiscal 2008 from ¥27,567 million for fiscal 2007.
Income taxes increased by ¥2,161 million to a tax expense of ¥13,080 million for fiscal 2008 from a tax expense of ¥10,919 million for fiscal 2007, due primarily to an increase in taxable income for fiscal 2008. The effective tax rate of 39.8% in fiscal 2008 was 0.2 points higher than the effective rate in fiscal 2007 of 39.6%. The increase in the effective rate is due mainly to the decrease in non-taxable income by 4.1 points from fiscal 2007. The effective tax rate of 39.8% in fiscal 2008, which was lower than the statutory tax rate of 40.9%, was primarily attributable to a 2.4 -point increase for unrecognized tax benefits in fiscal 2008 and a 6.4 -point decrease in valuation allowance due to good operating results of certain subsidiaries in fiscal 2008.
Additional detailed information is described in Note 13 to the accompanying consolidated financial statements.
Minority Interest in Income (Loss) of Consolidated Subsidiaries
Minority interest in income (loss) of consolidated subsidiaries increased by ¥1,014 million to income of ¥1,589 million for fiscal 2008 from a income of ¥575 million for fiscal 2007, due primarily to an increase in income at HUDSON SOFT COMPANY, LIMITED.
Equity in Net Income (Loss) of Affiliated Companies
Equity in net income (loss) of Resort Solution Co., Ltd. was at approximately the same level as fiscal 2007.
As a result of the foregoing, our net income increased by ¥2,134 million, or 13.2%, to ¥18,345 million for fiscal 2008 from ¥16,211 million for fiscal 2007.
Comparison of Fiscal 2007 with Fiscal 2006
Net revenues increased by ¥18,142 million, or 6.9%, to ¥280,279 million for fiscal 2007 from ¥262,137 million for fiscal 2006. This mainly resulted from the increase of net sales from our Health & Fitness segment and Gaming & System segment.
Net revenues of our Health & Fitness segment from external customers increased by ¥7,209 million, or 8.9%, to ¥88,326 million in fiscal 2007. This increase was due primarily to an increase in our members of 3.0% and to an increase in revenue per member of 2.1% compared to fiscal 2006 due to further improvements in the quality of our services and our offering of a wider range of value-added health-related services to our members.
Net revenues of our Gaming & System segment from external customers increased by ¥6,123 million, or 57.6%, to ¥16,744 million in fiscal 2007. This increase was due primarily to a significant increase in revenues from sales of gaming machines and casino management systems at our U.S. subsidiary, Konami Gaming, Inc.
Net revenues of the Digital Entertainment segment from external customers increased by ¥1,176 million to ¥164,800 million, accounting for 58.8% of the total. In our Computer & Video Games business, the WORLD SOCCER Winning Eleven (called Pro Evolution Soccer in Europe) series continued to gain high popularity in Japan and abroad, resulting in increased sales compared with the previous fiscal year, with aggregate sales of over 8 million units over the life of the series since it was originally released. In the Amusement business, MAH-JONG FIGHT CLUB, a series of titles incorporating the e-AMUSEMENT service, which links amusement arcades online throughout Japan, consistently received favorable reviews and recorded increased sales. While there was a decrease in the net revenue of the Card Games business, net revenue of the Digital Entertainment segment as a whole increased.
Net revenues of Other segments from external customers increased by ¥4,780 million, or 70.6%, to ¥11,555 million in fiscal 2007 due primarily to strong sales of pachinko LCDs and the related products.
Cost of Revenues
Cost of revenues increased by ¥8,762 million, or 4.7%, to ¥193,506 million for fiscal 2007. This primarily resulted from an increase in the cost of revenues generated from manufactured goods, products and services, with the increase of net revenues from our Health & Fitness segment and Gaming & System segment, and to an increase in production expense, due to the start up of a production function at a U.S. subsidiary in our Digital Entertainment segment, to develop products that respond to the characteristics of the market in North America.
Impairment of long-lived assets and goodwill
We recorded no impairment charges of long-lived assets or goodwill for fiscal 2007, which amounted to ¥10,533 million and ¥9,180 million, respectively, for fiscal 2006.
Selling, General and Administrative Expenses
Selling, general and administrative expenses increased by ¥3,429 million, or 6.2%, to ¥58,628 million for fiscal 2007 from ¥55,199 million for fiscal 2006, due primarily to an increase in selling expenses, the increase in net revenues, an increase in expenses related to obtaining intellectual property of approximately ¥536 million, and an increase in expenses attributable to our moving offices in Tokyo of approximately ¥458 million.
As a result of the foregoing, our operating income increased by ¥25,664 million, or 1,034.4% to ¥28,145 million for fiscal 2007.
As a percentage of net revenues operating income has increased by 9.1% to 10.0% in fiscal 2007 from 0.9% in fiscal 2006. This increase primarily resulted from the impairment charges in our Health & Fitness segment which were recognized in fiscal 2006, while we did not have such charges in fiscal 2007. Excluding the impact of impairment, the Health & Fitness segment significantly increased its operating income by improving its profit structure from directly owned facilities due to scrapping and building, which is our effort to periodically close, relocate and reconstruct unprofitable club facilities, and to opening large facilities next to train and subway stations and other attractive locations. Also, our Gaming & System segment increased its operating income due to significant progress in sales.
On the other hand, start-up production activities at a U.S. subsidiary in our Digital Entertainment segment resulted in an increase in operating loss of ¥1,249 million, to ¥3,595 million for fiscal 2007 in North America, which offset an increase of operating income in the Health & Fitness segment and the Gaming & System segment.
Other Income (Expenses), net
Other income (expenses), net, decreased by ¥6,535 million to other expenses of ¥578 million for fiscal 2007 from other income of ¥5,957 million for fiscal 2006, due to a gain on the sale of holding shares of Takara in fiscal 2006.
Income Before Income Taxes, Minority Interest and Equity in Net Income (Loss) of Affiliated Companies
As a result of the foregoing, our income before income taxes, minority interest and equity in net income (loss) of affiliated companies increased by ¥19,129 million, or 226.7%, to ¥27,567 million for fiscal 2007 from ¥8,438 million for fiscal 2006.
Income taxes increased by ¥21,189 million to a tax expense of ¥10,919 million for fiscal 2007 from a tax benefit of ¥10,270 million for fiscal 2006, due primarily to a reversal of accrued income taxes in fiscal 2006 to reflect the benefit derived from the tax deduction recognized upon completion of the reorganization into a holding company structure, in the amount of ¥17,051 million, investment tax credits in fiscal 2006 which were available until the end of fiscal 2006 and an increase in taxable income for fiscal 2007. Additional detailed information is described in Note 13 to the accompanying consolidated financial statements.
Minority Interest in Income (Loss) of Consolidated Subsidiaries
Minority interest in income (loss) of consolidated subsidiaries increased by ¥4,842 million to an income of ¥575 million for fiscal 2007 from loss of ¥4,267 million for fiscal 2006, due primarily to impairment losses on long-lived assets and identifiable intangible assets in the Health & Fitness segment for fiscal 2006 and the fact that Konami Sports & Life Co., Ltd. became a wholly-owned subsidiary as of March 1, 2006.
Equity in Net Income (Loss) of Affiliated Companies
Equity in net income (loss) of affiliated companies increased for the fiscal 2007, due primarily to the fact that, as of March 10, 2006, Resort Solution Co., Ltd. became an equity-method affiliate.
As a result of the foregoing, our net income decreased by ¥6,797 million, or 29.5%, to ¥16,211 million for fiscal 2007 from ¥23,008 million for fiscal 2006.
Based on the applicable criteria set forth in Statement of Financial Accounting Standards No. 131, Disclosures About Segments of an Enterprise and Related Information, or SFAS No. 131, we have three reportable operating segments for which separate financial information is available and reported in our consolidated financial statements. Our chief operating decision maker regularly evaluates this data in deciding how to allocate resources and in assessing performance. The operating segments are managed separately as each segment represents a strategic business unit that offers different products and serves different markets. As required by SFAS No. 131, we present our business segment information in the accompanying consolidated financial statements as it is presented in reports to our management, derived from our U.S. GAAP financial statements.
Effective the first quarter ended June 30, 2005, we reorganized our five business segments into three: Digital Entertainment, Health & Fitness and Gaming & System.
The following tables present net revenues, including both customers and intersegment revenues, operating expenses and operating income (loss) for fiscal 2006, 2007 and 2008, by segment, which are the primary measures used by our chief operating decision makers to measure our operating results and to measure segment profitability and performance. The year-to-year comparisons following the tables discuss comparisons of net revenues, before elimination of intersegment revenues, operating expenses and operating income (loss) for each year.
Comparison of Fiscal 2008 with Fiscal 2007
Digital Entertainment segment
Net revenues of our Digital Entertainment segment, before elimination of intersegment revenues, increased by ¥13,895 million, or 8.4%, to ¥178,939 million in fiscal 2008 from ¥165,044 million in fiscal 2007 due primarily to the increase in sales of our Computer & Video Games business and an increase in net revenues from our Amusement business.
In our Computer & Video Games business, we recorded strong sales of the Winning Eleven series for PlayStation 2, PlayStation 3, Xbox 360, PlayStation Portable, Nintendo DS and PC, with total sales of over 9.4 million units worldwide. We also recorded solid sales of the Dance Dance Revolution series in North America, including Dance Dance Revolution Hottest Party (Wii). Therefore, sales of our titles taken as a whole increased to 23.33 million units in fiscal 2008 from 22.50 million in fiscal 2007. With respect to arcade games for our Amusement business, we recorded higher volume of sales of the MAH-JONG FIGHT CLUB series and QUIZ MAGIC ACADEMY series, as well as e-AMUSEMENT products. In addition, revenues from all card games including the Yu-Gi-Oh! Trading Card Game series, increased steadily.
Operating expenses increased by ¥8,769 million, or 6.5%, to ¥143,579 million in fiscal 2008 from ¥134,810 million in fiscal 2007 due primarily to an increase in the cost of sales for video game software and amusement arcade games with an increase in those sales, while selling, general and administrative expenses in fiscal 2008 was approximately the same level as fiscal 2007.
As a result, operating income increased by ¥5,126 million, or 17.0%, to ¥35,360 million in fiscal 2008 from ¥30,234 million in fiscal 2007.
Health & Fitness segment
Net revenues of our Health & Fitness segment, before elimination of intersegment revenues, decreased by ¥1,915 million, or 2.2%, to ¥86,544 million in fiscal 2008 from ¥88,459 million in fiscal 2007. Despite an overall increase in demand, due to factors such as the diversification of health trends and changes in the age composition of people who play sports, the number of competing facilities has also increased, and such industry trends were a major reason for the overall decrease. Although we established sports facilities that were originally outsourced to us at eight new locations, there was a decrease in revenues due to the same negative industry trends affecting our directly owned facilities, leading to a decline in membership although revenue per member stayed about the same as the last fiscal year. We also did not open any new stores during this fiscal year.
Operating expenses increased by ¥314 million, or 0.4%, to ¥81,251 million in fiscal 2008 from ¥80,937 million in fiscal 2007. This increase was due primarily to the fact that reductions to administrative expenses through the consolidation of facilities and streamlining of businesses did not offset the price increases in utility fees and supplies expenses due to the steep rise of the price of oil in recent years, increases in costs due to the rise in rents as well as expenses incurred from ongoing renovations, which place the highest priority on safety.
As a result, we recognized operating income of ¥5,293 million in fiscal 2008, compared to the operating income of ¥7,522 million in fiscal 2007.
Gaming & System segment
Net revenues of our Gaming & System segment increased by ¥1,727million, or 10.3%, to ¥18,471million in fiscal 2008 from ¥16,744 million in fiscal 2007 . This increase was due primarily to an increase in revenues from sales of gaming machines and casino management systems by our U.S. subsidiary, Konami Gaming, Inc. In North America, sales of the K2V video slot platform series and our first five -reel mechanical slot machines, Advantage 5, were in great demand. Demand was also fueled both by the acquisition of new licenses from some
jurisdictions and by growth in existing markets. The sales from overseas markets decreased at our Australian subsidiary, Konami Australia Pty Ltd., and in spite of the regulations affecting purchase of gaming products, domestic sales in Australia increased slightly.
Operating expenses increased by ¥1,103 million, or 7.6%, to ¥15,677 million in fiscal 2008 from ¥14,574 million in fiscal 2007. This increase was primarily due to an increase in the costs of sales, and to an increase in administrative expenses and development costs. Compared to the rate of increase in the net revenue, the rate of increase in the costs of sales was kept lower.
As a result, operating income increased by ¥624 million or, 28.8% to ¥2,794 million in fiscal 2008 from ¥2,170 million in fiscal 2007, which mainly reflects the fact that revenues increased.
Comparison of Fiscal 2007 with Fiscal 2006
Digital Entertainment segment
Net revenues of our Digital Entertainment segment, before elimination of intersegment revenues, decreased by ¥232 million, or 0.1%, to ¥165,044 million in fiscal 2007 from ¥165,276 million in fiscal 2006 due primarily to the decrease in net revenues from all card games including the Yu-Gi-Oh! series in Card Games business, which offset the strong sales of business-use game machines for amusement arcades and increased net revenues from online services.
In addition, we recorded strong sales of the Winning Eleven series for PlayStation 2, Xbox 360, PlayStation Portable, Nintendo DS and PC, with total sales of over 8 million units worldwide. We also recorded solid sales of game music in North America, with more than 1.3 million units of the Dance Dance Revolution series, including Dance Dance Revolution SuperNOVA (PlayStation 2). Therefore, sales of our titles taken as a whole increased to 22.50 million units in fiscal 2007 from 22.21 million in fiscal 2006. Revenues from all card games including the Yu-Gi-Oh! Series significantly decreased from the fiscal 2006. However, with respect to games for amusement arcades recorded higher sales of the MAH-JONG FIGHT CLUB series and BASEBALL HEROES series, as the e-AMUSEMENT products.
Operating expenses increased by ¥3,384 million, or 2.6%, to ¥134,810 million in fiscal 2007 from ¥131,426 million in fiscal 2006 due primarily to increase in production expense, from the starting up of a production function in the North American market to develop products that respond to the characteristics of that market, which resulted in an increase in operating loss by ¥1,249 million to ¥3,595 million for fiscal 2007 in our business in North America.
As a result, operating income decreased by ¥3,616 million, or 10.7%, to ¥30,234 million in fiscal 2007 from ¥33,850 million in fiscal 2006.
Health & Fitness segment
Net revenues of our Health & Fitness segment, before elimination of intersegment revenues, increased by ¥7,250 million, or 8.9%, to ¥88,459 million in fiscal 2007 from ¥81,209 million in fiscal 2006. This increase was due primarily to an increase in number of our members by 3.0% and an increase in revenue per member of 2.1% due to further improvements in the quality of our services and our offering of a wider range of value-added health-related services to our members. We revised our fee-based programs and made progress in installing a proprietary IT health management system in our fitness clubs. These efforts enabled us to provide our members with a more satisfactory level of service, which translated into an increase in the number of our members and an increase in revenue per member. Additionally, the increased number of sports facilities outsourced to us brought in 40.5% increase in such revenues. The revenues generated from sales of goods, such as Kenshin Keikaku 2, the most recent software which jointly manages the data of e-walkeylife2, the multifunctional pedometer, AROMA@FITNESS, our original supplement and BIOMETRICS WATER, also increased.
Operating expenses decreased by ¥17,331 million, or 17.6%, to ¥80,937 million in fiscal 2007 from ¥98,268 million in fiscal 2006. This decrease was due primarily to impairment charges of long -lived assets or goodwill for fiscal 2006, which amounted to ¥10,533 million and ¥9,180 million, respectively. However, excluding the effect of the impairment, operating expenses for fiscal 2007, resulted in an increase. This increase was due primarily through establishment of five new facilities and four renovations. Although, the rate of increase in operating expenses was kept lower than that for net revenues. With respect to such expenses as those for promotional campaigns, we believe we were also able to implement effective promotional activities while holding down such expenses. We were also able to hold down repair-related expenses by reconsidering priorities, while still giving the highest priority to safety.
As a result, we recognized operating income of ¥7,522 million in fiscal 2007, reflecting the fact that the increase of net revenues exceeded that for operating expenses, compared to the operating loss of ¥17,059 million in fiscal 2006.
Gaming & System segment
Net revenues of our Gaming & system segment increased by ¥6,121 million, or 57.6%, to ¥16,744 million in fiscal 2007 from ¥10,623 million in fiscal 2006. This increase was due primarily to a significant increase in revenues from sales of gaming machines with a variety of game contents developed during the year and casino management systems at our U.S. subsidiary, Konami Gaming, Inc. In North America, sales of the new K2V video slot platform series were strong due to an increase in demand. Demand was fueled both by the increasing number of jurisdictions where gaming has been legalized and by growth in existing markets. With respect to the Australian market, although sales from overseas market decreased at our Australian subsidiary, Konami Australia Pty Ltd., partially due to changing regulations, domestic sales in Australia increased slightly.
Operating expenses increased by ¥4,011 million, or 38.0%, to ¥14,574 million in fiscal 2007 from ¥10,563 million in fiscal 2006. This increase was primarily due to an increase in the costs of manufacturing, and to an increase in selling expense and development costs for gaming machines and of management systems. Compared to the rate of increase in the net revenue, that in selling, general and administration expenses was kept lower.
As a result, operating income increased by ¥2,110 million or, 3,516.7% to ¥2,170 million in fiscal 2007 from ¥60 million in fiscal 2006, which reflects the significant increase in revenues that was far greater than the increase in expenses.
Critical Accounting Policies
The preparation of our consolidated financial statements in conformity with U.S. generally accepted accounting principles requires our management to make assumptions and estimates about expected future cash flows and other matters that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Note 1 of the notes to our consolidated financial statements includes a summary of the significant accounting policies used in the preparation of our consolidated financial statements. We consider some of our significant accounting policies to be critical to our reported results because they require our management to make complex judgments in making assumptions and estimates about the effects of matters that are inherently uncertain and therefore subject to change. Changes in such assumptions and estimates could have a material effect on the amounts reported in our financial statements. We believe that among our significant accounting policies, the following policies may involve a higher degree of judgment or complexity.
We account for acquired businesses using the purchase method of accounting which requires that the assets acquired and liabilities assumed be recorded at the date of acquisition at their respective fair values. The
judgments made in determining the estimated fair value assigned to each class of assets acquired, as well as asset lives, can materially impact net income of the periods subsequent to the acquisition through depreciation and amortization, and in certain instances by impairment charges, if the asset becomes impaired in the future.
In determining the estimated fair value for intangible assets, we typically utilize the income approach, which employs discounting of the projected future net cash flow using an appropriate discount rate that reflects the risk factors associated with the cash flow streams. Some of the more significant estimates and assumptions inherent in the income approach or other methods include the projected future cash flows (including timing) and the discount rate reflecting the risks inherent in the future cash flows.
Determining the useful life of an intangible asset also requires judgment as different types of intangible assets will have different useful lives and
certain assets may even be considered to have indefinite useful lives. Intangible assets determined to have an indefinite useful life have been reassessed at least annually based on the factors prescribed in SFAS No. 142 Goodwill and
Other Intangible Assets
As a result of reassessment in 2006 made after termination of certain franchise contracts, intangible assets related to franchise contracts which were previously determined to have an indefinite life have been determined to have a finite life of 14 years based on the current expectation as to future renewals of the existing contracts. Intangible assets related to existing technology, customer relationships, membership lists and franchise and other contracts have been amortized over their estimated useful lives of 2 to 15 years.
Valuation of Intangible Assets and Goodwill
Under SFAS No. 142, we are required to perform an annual impairment test of our indefinite-lived intangible assets and goodwill. We also assess the impairment of intangible assets and goodwill whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. Some of the factors we consider important which could trigger an impairment review include the following:
When we determine that the carrying amount of intangible assets and goodwill may not be recoverable based upon the existence of one or more of the above indicators of impairment, we evaluate the carrying amount of the assets based on their fair value. If the fair value is less than the carrying amount of the assets, we record an impairment loss based on the difference between the carrying amount and the fair value of the assets.
We engage an independent appraiser to assist us in our determination of the fair values of our reporting units. In its determination of the fair values, the appraiser primarily utilizes a discounted cash flow analysis as well as other relevant valuation approaches including the stock price and market capitalization of the acquired entity and asset and liability structure of the reporting units. Significant assumptions used in this analysis include: (i) expected future revenue growth rates, profit margins and working capital levels of the reporting units; (ii) a discount rate; and (iii) a terminal value multiples. The revenue growth rates, profit margins and working capital levels of the reporting units are based on our expectation of future results. In evaluating the recoverability of other intangible assets which are allocated to the reporting units, we primarily utilize a discounted cash flow analysis as well as other applicable valuation approaches, and if applicable, independent valuations.
In the fourth quarter of the fiscal year ended March 31, 2006, we determined that the fair value of indefinite lived assets related to trademarks and franchise contracts recognized in the Health & Fitness reporting unit was lower than their carrying value as a result of our review based on the independent valuations. Accordingly, an aggregate non-cash impairment charge of ¥9,180 million was recorded in operating expenses for the year ended March 31, 2006. The impairment charge consisted of ¥3,478 million for trademarks and ¥5,702 million for franchise contracts. These impairment losses were attributed to the reporting units failure to meet previous growth expectations and the cancellation of certain franchise contracts by our review during 2006.
On March 31, 2007 and 2008, we evaluated the recoverability of goodwill and intangible assets and concluded that there was no impairment in the carrying value of such assets for any of our reporting units.
Valuation of Long-Lived Assets
Our long-lived assets are reviewed for impairment in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Factors we consider important which could trigger an impairment review include: significant underperformance relative to expected historical or projected future operating results; significant changes in the manner of the use of the acquired assets or the strategy for overall business; significant negative industry or economic trends; significant decline in the stock price of the acquired entity for a sustained period; and market capitalization of the acquired entity relative to its net book value. When it is determined that the carrying amount of assets to be held and used may not be recoverable based upon the existence of one or more of these indicators of impairment, recoverability is measured by a comparison of the carrying amount of an asset to future net cash flows (undiscounted and without interest charges) expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the estimated fair value of the assets.
The factors most significantly affecting the impairment calculation are our estimates of future cash flows. Our cash flow projections carry several years into the future and include assumptions on variables such as growth in revenues, and our cost of capital inflation, the economy and market competition. Any changes in these variables could have an effect upon our valuation.
In the years prior to 2006, we performed impairment reviews for our fitness club assets based on certain grouping of clubs in the same geographic area where club operations were characterized by interdependencies such as the sharing of costs and expenses. However, in fiscal 2006, in connection with changes in management of our Health & Fitness operation and in our operating structure of clubs, which eliminated these interdependencies among clubs, we reassessed our asset grouping for fitness clubs and changed our focus to an individual club operation level, which we consider to be the lowest level at which identifiable cash flows are largely independent of the cash flows of other assets. The carrying amount of the club assets is compared to the expected undiscounted future cash flows to be generated by those assets over the estimated remaining useful life of the club. Cash flows are projected for each club based on historical results and expectations. In cases where the expected future cash flows are less than the carrying amount of the assets, those clubs are considered impaired and the assets are written down to fair value.
Based on our review, we recorded a pre-tax impairment charge of ¥10,533 million for our Health & Fitness operation for the year ended March 31, 2006. The impairment charges related to club locations with operating performance that projected a deterioration in expected cash flows in 2008 and beyond or which had anticipated additions during forecasted periods that were found to be additionally impaired. The impairment charges related primarily to the carrying values of buildings, leasehold improvements and other tangible club facility assets that will continue to be operated by us.
Software Development Costs
We utilize our internal development teams to develop our software. We account for software development costs in accordance with SFAS No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed. We capitalize software development costs once technological feasibility is established and such costs are determined to be recoverable from future revenues. We expense software development costs incurred prior to technological feasibility to research and development. We evaluate the technological feasibility of our software in development on a product-by-product basis, based on our historical experience, whether the software is closely related to previously marketed software or uses existing technology, and other factors. For products where proven game engine technology exists, technological feasibility may occur early in the development cycle. We believe that our accounting policies for software development are critical for our financial statements as our decisions as to technological feasibility affect the timing of our recognition of the costs associated with development of our software products.
We derive revenue from primarily three sources: (i) product revenue, which includes packaged game software and other products, gaming machines and related casino management systems, and LCDs for pachinko machines; (ii) membership fee revenue from health and fitness club members; and (iii) sales and subscription fee revenue from mobile game contents.
For those sources that do not involve delivery of multiple software or other deliverables, Konami recognizes revenue in accordance with Staff Accounting Bulletin (SAB) No.104, Revenue Recognition which requires the basic criteria outlined below to be met:
Persuasive Evidence of an Arrangement.
For product sales, it is Konamis customary practice to have a written contract, which is signed by both the customer and Konami, or a purchase order or amendment to the written contract from those customers that have previously negotiated a standard purchase agreement.
For Konamis health and fitness clubs, members are required to sign a standard monthly membership agreement upon admission, which is automatically renewed unless the member provides advance notice of his or her intention to cancel prior to the tenth day of the month at the end of which the membership will terminate.
For mobile game contents, Konami enters into distribution agreements with mobile phone carriers for the sale or subscription of mobile game contents by the carriers to their subscribers. Konami recognizes as revenues the net amount the mobile phone carrier pays to Konami upon the sale of Konamis game contents, net of any service or other fees earned and deducted by the carrier.
Delivery Has Occurred.
Packaged game software and other products are physically delivered to customers, with standard transfer terms. Also, Konamis game machines and related equipment are physically delivered to customers as a fully-assembled, ready to be installed unit. These arrangements generally include an acceptance clause. Konami recognizes revenue from product sales upon delivery and acceptance, which is the timing the rights and risks are transferred to the customer. Generally, Konami does not permit exchanges nor accept returns of unsold merchandise except in the case of obvious defects. In certain limited circumstances Konami may allow returns, for which Konami estimates the related allowances based upon managements evaluation of historical experience, the nature of the software titles and other factors. Konami maintains detail listings of software titles in distribution channel, closely monitors their movements, and is able to reasonably estimate future credits to be issued for price protection. These estimates are deducted from gross sales.
Revenue from health and fitness club membership is derived primarily from monthly membership fees from club members. Revenue for those fees is recognized as monthly charges and are generally made to the members accounts in advance, at the end of each month, with respect to the following month