Activision Blizzard, Inc.
Q2 2017 Earnings Call Transcript

Published: 4 Aug 2017

[Operator:]

Operator

[Amrita Ahuja:]

Good afternoon and thank you for joining us today for Activision Blizzard second quarter 2017 conference call. With us are Bobby Kotick, CEO; Coddy Johnson, COO; and Spencer Neumann, CFO. And for Q&A, Thomas Tippl, Vice Chairman; Dennis Durkin, Chief Corporate Officer; Mike Morhaime, CEO of Blizzard; Eric Hirshberg, CEO of Activision; and Riccardo Zacconi, CEO of King, will also join us. I would like to remind everyone that during this call we will be making statements that are not historical facts. The forward-looking statements given in this presentation are based on information available to the company as of the date of this presentation. And while we believe them to be true, they ultimately may prove to be incorrect. A number of important factors could cause the company's actual future results and other future circumstances to differ materially from those expressed in any forward-looking statements, including the factors discussed in the risk factor section of our SEC filings, including our 2016 annual report on Form 10-K which is on file with the SEC and those indicated on the slide that is showing. The company undertakes no obligation to release publicly any revision to any forward-looking statements to reflect events or circumstances after today, August 3, 2017. We will present both GAAP and non-GAAP financial measures during this call. However, as discussed on our July 29, 2016 conference call, due to updated compliance and disclosure interpretations issued by the SEC staff in May 2016, we are no longer able to present non-GAAP financial measures excluding the impact of deferrals. On this call and in the future unless otherwise specified, we will continue to provide non-GAAP financial measures which exclude the impact of expenses related to stock-based compensation, the amortization of intangible assets, expenses including legal fees, costs, expenses, and accruals related to acquisitions including the acquisition of King Digital Entertainment, expenses related to debt financings and refinancing, restructuring charges, and the associated tax benefits. These non-GAAP measures are not intended to be considered in isolation from, as a substitute for or superior to our GAAP results. We encourage investors to consider all measures before making an investment decision. Please refer to our earnings release which is posted on www.activisionblizzard.com for our full GAAP to non-GAAP reconciliation and further explanation with respect to our non-GAAP measures. There's also a PowerPoint overview, which you can access with the webcast and which will be posted to the website following the call. In addition, we will also be posting a financial overview highlighting both GAAP and non-GAAP results in a one-page summary. And now I'd like to introduce our CEO, Bobby Kotick.

[Robert A. Kotick:]

Thanks, Amrita. Q2 was another strong quarter. We exceeded our prior outlook and delivered record first-half revenues. The engagement of our communities remains strong and we believe our momentum can continue through the rest of the year. Our success continues to be the result of our focus on our players and our audiences. Investing in creative and commercial excellence is framed by the three pillars we have shared with you before – one, expand our reach; two, deepen engagement; and three, provide more opportunity for player investment. Our teams work tirelessly to deliver the most immersive and engaging experiences for our players. This content provides the connection between hundreds of millions of players around the world. We then enhance these connections with our franchises through initiatives like esports, television and film, and now consumer products. These additional touch points create more value for our shareholders by creating value and engagement for our audiences. Here are some of the ways we created value for our audiences this quarter. We released new updates across many of our leading franchises this quarter, driving engagement and delivering nearly $0.5 billion of segment operating income, the most we've achieved in a single quarter without new full game releases for any franchise. We also announced the first team sales for the Overwatch League, the first major global city-based professional esports league. We have the very best teams with the very best resources dedicated to celebrating and rewarding the world's best professional Overwatch players. Overwatch, with more than 30 million players has captured imaginations and driven strong global engagement. We organized our league around major cities, taking a proven model from competition in traditional sports. Our announced team owners and their locations, New England, New York, Los Angeles, Miami, Orlando, San Francisco, Shanghai and Seoul and the many more we expect to announce, represent the very best in esports and traditional sports. We continue to invest in improving our ability to execute and innovate across the company. This quarter, we made some exciting additions to our management team to equip our company with the leadership we need to capitalize on the biggest opportunities we see ahead. Coddy Johnson rejoined the company as our new President and COO. Coddy proved himself as a transformational leader during the eight years he previously spent with us including as Chief Operating and Financial Officer of Activision Publishing, and we're excited that he rejoined the company for this next growth phase of our business. Later, you'll hear from Spencer Neumann in his new role as CFO, bringing a wealth of experience from a long career at The Walt Disney Company, most recently as Chief Financial Officer and Executive Vice President of Global Guest Experience of the Parks and Resorts division. We're also joined by Thomas Tippl, our Vice Chairman; and Dennis Durkin, our Chief Corporate Officer, and all of our business unit heads. As always, our success is the result of the dedication of our players, fans, employees and partners. We cannot thank enough for their enthusiasm and support. Coddy will now review the highlights of our operations for this quarter.

[Collister Johnson:]

Thank you, Bobby. It's great to be back at Activision Blizzard at such an exciting time of growth and opportunity for the company. As Bobby mentioned, we have incredible communities of players and fans. The joy of our work, what we do each day is to support our teams in building out some of the world's best creative environments and strongest commercial capabilities on behalf of those communities that they can play, connect and engage as deeply as possible. When we get that right, we have the ability to serve our hundreds of millions of audience members with an ongoing stream of content, features, events and products that they love. The business strategy underlying that work is based on the three pillars you heard from Bobby. We invest in creative and commercial excellence in order to expand reach, deepen engagement and provide more opportunity for player investment which then allows for reinvestment in creative and commercial excellence and for the growth cycle to continue. We saw this strategy work especially well this quarter with our teams providing more regular content and feature updates across our franchises in our library, leading to our biggest first half of the year in company history, with record revenues driven by digital growth. In Q2, our revenues exceeded our outlook by more than $200 million and earnings per share surpassed our expectations by $0.17. Given this sizable over-performance and confidence in our plans, we are raising our outlook for the year. Let's start with audience reach, which was 407 million monthly active users this quarter. Blizzard did not have any new full game releases this quarter, yet a strong stream of content updates across Blizzard franchises drove an all-time MAU record of 46 million, up 38% from last year and up 12% from the last quarter. Blizzard's community has now more than doubled in MAUs since early 2015, underscoring the ability to grow audience reach across the portfolio of platforms, regions, genres and business models. Notably, the Overwatch community continues to grow its MAUs up each and every quarter since launch and, in Q2, set another all-time MAU record with the release of two seasonal events, and Hearthstone MAUs increased to an all-time record for the franchise, fueled by the new expansion, Journey to Un'Goro. Activision had 47 million MAUs for the quarter, driven by Call of Duty which continues to have a large and active player base across a number of its titles, many of which received updates during the quarter. In particular, the release of Zombies Chronicles, Activision's first large content drop to a community in year two after a game launch, helped to grow Call of Duty

[Spencer Adam Neumann:]

Thanks, Coddy. I'm thrilled to be here with all of you today and to be part of the Activision Blizzard team. I come here with a deep appreciation for the power of beloved global franchises that build enduring emotional connections with the community. That's the foundation of Activision Blizzard and it's why I believe we have such a bright future. Today, I'll review our better-than-expected Q2 results, which capped off a record first half. I will also review our outlook for Q3 and our raised outlook for the full year. To review the quarter, I would like to start with our segment results. As a reminder, our segment results, unlike our consolidated results, are still presented excluding the impact of deferrals as they always have been. Each of our segments contributed to our over-performance this quarter. We outperformed our outlook due to the combined power of our franchise breadth, a steady stream of content serving our uniquely engaged community and our talented teams. At the aggregate level, we delivered combined segment operating income of $476 million which, as Bobby indicated, represents a record for a quarter without a new full game franchise release. Activision generated operating income of $87 million, roughly flat year-over-year with strong Call of Duty performance across the overall franchise, offsetting expected lower performance on Infinite Warfare. Our strategy of providing content wherever our players engage drove this upside, as did improved performance across Activision's catalog, including a very positive reception to Crash Bandicoot. Blizzard's $225 million of operating income was the largest segment earnings contributor in the quarter, led by the strength of the Overwatch, World of Warcraft and Hearthstone franchises. Operating income was down year-over-year as expected given the comp to last year's significant Q2 Overwatch release. And King delivered $164 million of operating income in the quarter, which was slightly down year-over-year, but relatively flat sequentially. Continued growth in per-player engagement and player investment led to stable year-over-year revenues with Candy Crush franchise. Now let's turn to our consolidated results. Unless otherwise indicated, I'll be referencing non-GAAP as redefined figures, which include the impact of deferrals. If you'd like to calculate metrics as we used to report them, you would add the impact of deferrals to our non-GAAP as redefined figures. Please refer to our earnings release for full GAAP to non-GAAP reconciliations. For the quarter, we generated GAAP revenues of $1.63 billion, $206 million above our May guidance. This includes the net recognition of deferred revenues of $213 million for the quarter. We generated GAAP EPS of $0.32 and non-GAAP EPS of $0.55 in Q2, which was $0.17 above guidance. These figures include the net recognition of deferrals of $0.12. The over-performance in the quarter versus guidance was driven largely by business over-performance as well as some expense timing. From a capital structure perspective, we continued our positive rating agency momentum and received another upgrade from S&P to BBB. We also entered into a leverage-neutral $1.2 billion refinancing that locked in attractive long-term interest rates, bringing our blended cost of debt to 3.6% and provided a better staggering of debt maturities. We delivered Q2 operating cash flow of $265 million, finishing the quarter with approximately $3.3 billion in cash and investments, about one-third of which is held domestically and approximately $4.4 billion of aggregate debt outstanding for a net debt position of approximately $1.2 billion at quarter-end. Lastly, we paid a cash dividend of $0.30 per common share, which was up 15% year-over-year for a total $226 million in aggregate to shareholders of record as of March 30, 2017. Now let's turn to our slate and outlook for Q3. Our Q3 slate continues our strategy of delivering a steady stream of content and services to our community, including Blizzard's Hearthstone expansion, Knights of the Frozen Throne, additional maps for Activision's Infinite Warfare, and new features and live ops across King titles. In addition, Blizzard is launching a remastered version of the original StarCraft on August 14. This will offer new and veteran players the same classic StarCraft game play with 4K graphics, modern conveniences like cloud saves, and connectivity to Blizzard's updated Battle.net ecosystem for an enhanced social and competitive experience. And of course, Activision has two major releases in the back half of the year. We'll launch Destiny 2 on console on September 6 with the PC launch to follow on October 24. We'll also continue the marketing ramp for the November 3 release of Call of Duty

[Operator:]

Thank you, sir. And we'll take our first question from Colin Sebastian with Robert Baird.

[Colin Alan Sebastian:]

Great. Thanks and congratulations on another strong quarter. Now that you've announced the first group of team sales for the Overwatch League, I was hoping you could expand on the longer term opportunities and perhaps more specifically a timeframe around some of the key milestones that we should be looking for in the coming quarters. Thank you.

[Robert A. Kotick:]

I'll take that, Colin. Look, there is great momentum that we're seeing in the league. And when you think about what we have planned in terms of the next round of team announcements, that will continue the momentum. That, to me, was the biggest milestone, was getting that great blend of endemic teams of professional sports owners. And if you think about whether it's in tech or in esports or in professional sports, we're assembling the very best owners for all of these sports. We've announced the first seven and I think what you're going to see is that probably the most important milestones are, as we get towards the latter part of the year and we start to kick off competition, when you see what we're doing in terms of the broadcast rights and sponsorship opportunities, but from every perspective, I think we think we've organized the league in the best way that will allow us to celebrate our players and our fans. And if you think about over 30 million players today, this is a very large audience. Even if your spectators were only coming from your player population, that is a very, very large audience to be able to have advertisers and sponsors and partners for it. So I'd say we're off to a really great start. And you'll hear more about future team sales over the balance of the year, but we couldn't be happy with the progress that we've made so far and it's really exciting.

[Operator:]

And we'll take our next question from Mike Olson with Piper Jaffray.

[Mike J. Olson:]

All right. Good afternoon and thanks for taking my question. Can you talk about early learnings from the Destiny 2 beta? How are you feeling as far as pre-orders at this point, particularly for the package that includes first year DLC? Thank you.

[Eric Hirshberg:]

Hey, Mike. It's Eric. I'll take that. So the beta went great and there is a lot of excitement about Destiny 2 overall and a lot of positive signs pretty much anywhere you look. First of all, we have a tremendous amount of confidence in the game at its closing. We think it's going to be a great game. And we received almost universally positive feedback from both the press and the fans after people got their hands on the beta. And I think it's also worth noting that Destiny won 45 awards at E3 and we think it's continuing to close strong. We also have very strong pre-orders. And Coddy mentioned this broadly, but the specifics are the number one position on Nielsen's unaided awareness and next choice purchase intent. And while no one of those data points is ever predictive in a vacuum, we found that when you have all three of those trending positively, it's usually a very good thing. And then there are also several firsts at Destiny 2, the way we're going to market that are designed to bring the franchise to a broader audience starting with the fact that we've got a great PC game. Of those 45 awards, one of them is the official Best of Show for PC at E3. We've actually added a number of languages and localizations to make the game more appealing and accessible to more audiences around the world. And of course, I think our watershed partnership with Blizzard is going to bring Destiny to the most passionate PC fans anywhere in the world, so puts it on the best possible stage. And finally, maybe most importantly with a game like this, Destiny is so engaging that the follow-on content is almost as important if not as important at the main game. And as I mentioned on earlier calls, we've completely changed our approach to tapping that by widening our stable of AAA developers so that we can keep up with the demand, it's a high class problem, but we haven't been able to do that in the past, keep up the demand for more content. And I think that fans agree with the importance of that, which is evidenced by the fact that such an overwhelmingly high percentage of the pre-orders thus far are from one of our elevated SKUs which include the Season Pass and the follow-on content. So, lots of good signs. The beta being just one of them and we're really excited and have confidence we have a great game.

[Operator:]

And we'll take our next question from Tim O'Shea with Jefferies.

[Timothy O'Shea:]

Yes. Hi. Congratulations on the quarter and thank you for taking my question. So how do you think about audience reach on the King network versus engagement and how do you grow it? Thanks.

[Riccardo Zacconi:]

Hi, Tim. It's Riccardo here. So when we think about our network, we think primarily about audience reach and audience engagement. And we're focused on increasing both. In the live games, we have been primarily focused on increasing the audience engagement and we have done this through fresh content, new features and live operations. And we have seen great results, with impact reflected in the high DAU and MAU ratio as well as in the retention of the most engaged players. And this has resulted in an increase – in a continued increase of our player monetization. Candy Crush, which is a title which is now five years old, has recently hit again the number one grossing in the U.S. App Store charts. And we also see great results in our other live games. In regards to audience reach, we think we have more work to do and this will take some more time. But we are very focused on it. The audience reach we know that we can, let's say, impact the audience reach with new titles. Here, we have our teams focused on developing multiple new titles for the long term, in particular focusing strategically first of all on our casual genre for our existing audience. But we're also looking at extending into new genres, in particular at mid core. Here we have of course big opportunities within the company, the wider company and we are exploring mobile opportunities for some of the company's existing powerhouse franchises, like the partnership we have announced recently with Activision Publishing for Call of Duty. In the near term, we're also working on a social casino title in partnership with PlayStudios and we expect to release this title by the end of the year. In regards to audience reach, we also believe that there are opportunities to stabilize and grow the audience reach in the live games. The team so far has been focused on engagement and monetization features, and they will continue to focus on engagement and monetization features where we've been successful, but we will also start focusing more on features that can impact reach as well.

[Operator:]

Thank you. We'll take our next question from Doug Creutz with Cowen and Company.

[Doug Creutz:]

Thanks. Could you maybe talk a little more about the structure of the Overwatch economics? How you're sharing revenue with the team owners? So, what were some of the key points that encouraged your partners that they could make money off this over the long term? Thanks.

[Spencer Adam Neumann:]

Hey, Doug. This is Spence. I'll take a shot at this one. So we were really deliberate in structuring this business to attract the best owners and players in order to position the Overwatch League for long-term success. And that starts with optimizing alignment between the league which we own with the teams and our players. So at the league level, we're establishing a pool of shared league-wide revenues composed of media rights and consumer products, league-level sponsorship and a portion of league-related digital in-game merchandise. And then we'll net those league costs like marketing and production and league operations against those revenue streams and share the resulting amount 50-50 between the league and the teams. And then at the team level, we've got these fantastic entrepreneurial owners, and we wanted to be sure we developed the structure that enabled those owners to not only fund player and team operations, but also create real incremental value at the local level. So in addition to their league participation, the teams have their own local revenue streams including the more traditional areas like ticket sales and concessions and local sponsorships and local merch sales. But they'll also have more unique opportunities such as the ability to host certain nonprofessional Overwatch matches. And so – and then lastly when we think about the players, we established minimum salaries, benefits and bonuses for players so that we're providing a security and stability required to attract the best talent on the planet. So I guess if we step back, we position the league and the team owners to invest alongside one another to build value at both the league and the local level, leveraging the capabilities and infrastructure that we each bring to bear for the benefit of our players and our fans. So we've got plenty of work to do here and we're getting ready for the launch later this year and we look forward to sharing more progress soon.

[Operator:]

And we'll go next to Matthew Thornton with SunTrust.

[Matthew C. Thornton:]

Hey. Good afternoon. Thanks for taking the question. The Activision segment was really strong this go around. Maybe can you talk a little bit about Call of Duty, how that's tracking, and in particular as we think about World War II in 4Q, maybe just how we're tracking relative to prior releases? Any color there would be helpful. Thanks.

[Eric Hirshberg:]

Hey, Matt. So the trends are really good in World War II, and I'll talk about those, but I think it's also perhaps first important to step back and look at the Call of Duty franchise overall, which remains incredibly strong. We had strong MAUs this quarter with audiences at a relevant scale across multiple titles. And importantly, despite the headwinds that we talk about on IW, both MAUs and OI are both in line with our record Q2 performance from last year despite those headwinds. So our strategy of bringing content and adding content wherever our players choose to play is really paying off, and I think that's what drove the positive performance you referenced in the quarter. We had that for Infinite Warfare and Modern Warfare Remastered. We continue to season the content that was scheduled for those, we also brought the Zombies Chronicles which Coddy mentioned, which was remastered, some of our most beloved content from the Black Ops Zombies canon, and that also speaks to the strength of that catalog and our ability to continue to delight fans with new versions of that. So it really does speak to the size and strength and stability of Call of Duty that we can do this across multiple titles and I can't think of another franchise that can. On World War II specifically, probably most importantly, we think we have the right game at the right time. And I can tell you that those who have played it, the return to boots on the ground, the return to human scale, authentic military content and context for the franchise is a welcome change and very well timed. And everything that fans have touched by the way is a lot more than unusual. We had multiplayer hands-on at E3 for only the second time in our history this year. Everything that consumers have put their hands on, we've gotten really positive response from fans as well as from critics. And there's a couple of data points which show that. First of all, the reveal trailer was the most liked video in Call of Duty history, and we've got a pretty great history with that. And we had the most organic views of any CoD reveal trailer ever. The hands-on multiplayer at E3 was well received and the Zombies trailer that we revealed at Comic-Con went on to become our most liked Zombies trailer ever with an overwhelmingly positive sentiment as well. So the good news is you don't have to take my word for any of this. Our beta starts on August 25 on PlayStation and I hope all of you are going to join us and play.

[Operator:]

And we'll take our next question from Evan Wingren with KeyBanc Capital Markets.

[Evan Wingren:]

Thanks. You talked a little bit about King advertising in your prepared remarks and I wonder if you would just give us an update on how the rollout of King ads is going.

[Riccardo Zacconi:]

Hi, Evan. It's Riccardo again. Sure. So we are continuing to work to build out this new business, and our first priority is to build a very strong team. As you heard earlier, we made significant progress recently, adding a great new leader to drive this business forward. And in terms of update on the business itself, we put the player experience first. So our focus is, first of all, on creating a really compelling ad format. And we define this as an ad format which is well integrated into the game play and that provides value for the player as well as value for the advertiser. And currently, we are evaluating the results of these first ad format tests, and we are continuing the work on creating more premium video ad products. We're also widening the variety of ad formats beyond video. As you heard before, we had signed a partnership with Facebook to offer their image ad product, and so we are introducing image ads, and this format will allow us to monetize our global audience. So, overall, we feel very excited about this opportunity. We think it's a very substantial opportunity given the size and the engagement of our network. And so I will give you an update at a later date on further progress.

[Operator:]

Thank you. And we'll go next to Brian Nowak with Morgan Stanley.

[Brian Nowak:]

Thanks for taking my question. Could you talk at a high level how Blizzard is allocating its time and resources right now? What percent of man-hours are spent on new IP versus existing IP? And I guess I'd be curious to hear you talk about how you think about Blizzard's new IP pipeline the next three to five years. Thanks.

[Michael Morhaime:]

Hi, Brian. Thanks. This is Mike. First and foremost, I'd just say that the bulk of our focus continues to be supporting our existing players and releasing high-quality content for our existing games. This quarter is a great example of that approach. We delivered a consistent flow of updates and new content across all of our games, and that has driven record engagement even without a new game launch. We're also really excited about the future. In addition to supporting all of our live games, we're committed to incubating new initiatives and we're also thinking about different platforms, especially mobile. In terms of new IP, our pipeline is in a better position than ever before in our history. Last year, Allen Adham, who cofounded Blizzard with me and Frank Pearce, returned to the company to take on the task of coordinating our efforts in this regard. And this includes some great ideas that we'd already started to explore. So we now have multiple dedicated incubation teams that are being led by some of our most experienced game designers at Blizzard. I should say that creating new Blizzard-quality games on any platform will take time. And as we've shown in the past, we're not going to release any games that we don't feel live up to our expectations or those of our players. When we do bring new experiences to current or new platforms for new and existing IPs, there're going to be ideas that our teams are passionate about and that we think there's a large audience for.

[Operator:]

And we'll take our final question today from Ray Stochel with Consumer Edge Research.

[Raymond L. Stochel:]

Great. Thanks for taking the call, and congrats on the success of Crash. I'm wondering what do you see as the long-term opportunity in remastered nostalgic titles. And do you see opportunities within your own portfolio of owned IP? Thanks.

[Eric Hirshberg:]

Hey, Ray. It's Eric. So first, we knew that there was a passionate audience out there for Crash. Full disclosure myself among them, but we had no idea – it's hard to tell whether that's a vocal minority or whether that's a real mass audience until you put something out there. And Crash has surpassed all of our expectations by a pretty wide margin. And a couple of stats that underscore that point where it was the number one selling console game in June based on units, even though it was only available for two days during that month. And Sony reported this morning, well timed, I guess for this call, that Crash is the most downloaded game on the PlayStation store in July. So as to your broader question, I think this is just another example of us really listening to our communities and our fans and offering them great content where they want to engage which is one of our core strategies. So we think we have other great IP in our portfolio that we're considering of course, but we've already – this isn't new behavior for us. We've already shown the power of this with Modern Warfare Remastered last year with Zombies Chronicles that we talked about. Obviously, Crash Bandicoot is another great example. So this is a strategy that clearly has our attention, and while there are no new announcements today, I think you can be confident that there will be more activity like this in the future with more great IP. The other opportunity beyond remastered is to look at some of our classic IP and ask whether or not it could be reborn on a new platform like what we're going with Skylanders on mobile. So I think that our IP library is an asset that, when done right, can be very powerful.

[Collister Johnson:]

I'll jump in just for a second. Ray, it's Coddy. Echo Eric's points, but even more broadly across the company, in looking ahead, Spence already shared the Blizzard plans to release a remastered version of StarCraft in Q3. We wind up additional releases of that kind of beloved fan favorite content going forward. Eric said, no announcements today, but there's just a beloved IP out there that our communities love to engage in, and it's worth a further step back, which is we are really in a transition – a tailwind, strong transition to game to the service model where we have these passionate and deeply engaged, digitally connected communities to which we can provide an ongoing stream of services, features, events, content. And it is a really strong model, both for our fans and our players and their communities, and a chance to really connect online with each other, but also for the company as a business. And you can expect us to continue to pursue this, to look for additional ways to engage our digitally connected audiences, hundreds of millions of fans and players both on our large franchises which we're doing and Eric mentioned as well as in our most popular nostalgic intellectual properties and also new opportunities. And that's powerful combination between the digitally connected audience that very few engage and our ability to have inspired teams deliver content to them is it's a strong model and I think we're still in the early days of exploring it. And I think you'll see us continue to pursue that in the calls to come.

[Robert A. Kotick:]

I think that wraps. Thanks, everyone, for your time today. We'll look forward to speaking with you next quarter. Thanks.

[Operator:]

And that does conclude today's conference. Thank you for your participation. You may now disconnect.