Activision Blizzard, Inc.
Q2 2016 Earnings Call Transcript

Published: 5 Aug 2016

[Operator:]

Good day, ladies and gentlemen, and welcome to the Activision Blizzard's Q2 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. As a reminder, this conference is being recorded today, Thursday, August 4, 2016. I would now like to turn the conference over to Amrita Ahuja, Senior Vice President of Investor Relations. Please go ahead, ma'am.

[Amrita Ahuja:]

Good afternoon, and thank you for joining us today for Activision Blizzard's second quarter 2016 conference call. With us are Bobby Kotick, CEO; Thomas Tippl, COO; and Dennis Durkin, CFO. And for Q&A, Eric Hirshberg, CEO of Activision; Michael Morhaime, CEO of Blizzard; and Riccardo Zacconi, CEO of King, will also join us. I would like to remind everyone that during this call, we'll be making statements that are not historical facts. These are forward-looking statements that are based on current expectations and assumptions that are subject to risks and uncertainties. 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 factors section of our SEC filings including our 2015 Annual Report on Form 10-K, which is on file with the SEC and those indicated on the slides that is showing. The forward-looking statements 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. The company undertakes no obligation to release publicly any revisions to any forward-looking statement to reflect events or circumstances after today, August 4, 2016. We will present both GAAP and non-GAAP financial measures during this call, however, as discussed on our July 29 conference call, due to updated compliance and disclosure interpretation issued by the SEC staff on May 17, 2016, in the future, we will no longer be able to present non-GAAP financial measures excluding the impact of deferrals. As a result, this will be the last call where we provide such information. On this call and in the future, we will continue to provide non-GAAP financial measures which exclude the impact of expenses, related stock-based compensation, the amortization of intangible assets, expenses, including legal fees, cost expenses, and accruals related to acquisitions, including the acquisition of King Digital Entertainment, expenses related to debt financings and refinancings 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 a full GAAP to non-GAAP reconciliation and further explanations. 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 and a one-page summary sheet. And now, I'd like to introduce our CEO, Bobby Kotick.

[Robert A. Kotick:]

Thanks, Amrita, and thank you all for joining us today. We delivered record second quarter performance with revenues up more than 100% and EPS up more than 300% year-over-year on a non-GAAP basis as previously defined. As a result, we're raising our full-year guidance. Our continued success comes from the efforts of our over 10,000 employees. Their passion, dedication and focus are the reasons we're able to entertain hundreds of millions of players around the world and deliver value to our stakeholders. This quarter was a record quarter in large measure because of the unique capability we have as a company to create new franchises. The truly extraordinary team at Blizzard launched Overwatch to incredible audience success. Overwatch already has over 15 million players who have spent about 0.5 billion hours playing the game and it has achieved success throughout the world including in China and Korea, where Overwatch is now the number one game in terms of share of playtime. We remain focused on the priorities that we have outlined to you before

[Thomas Tippl:]

Thank you, Bobby. Our creative and commercial teams across our five operating divisions delivered a very strong first half of 2016 with broad-based record results. To expand on what Bobby mentioned, our results are driven by focus and execution against our three strategic pillars

[Dennis M. Durkin:]

Thanks, Thomas. It's been an incredible first half of the year and across nearly all parts of our business we saw strong performance in the quarter. This performance further validates many of the important growth themes we've discussed around opportunities in mobile, digital, fee-per-player investment and our ability to launch new world-class intellectual property. Before we go into the results as a reminder, we hosted a quick call last week to discuss changes to our external non-GAAP reporting in response to the SEC staff's updated interpretations. And I'd encourage you to review those materials if you haven't done so already. These interpretations affect external reporting for numerous companies but do not affect our strong underlying business fundamentals or cash flows. As we explained, starting this quarter, we will be sharing some reporting metrics and we will continue to provide you with supplemental disclosure to help you calculate relevant metrics for year-over-year comparisons. Our disclosures can be found in the tables in our earnings press release and the Excel model posted to the IR website following this call. Turning to our Q2 results in highlights, we will now for one last time refer to our non-GAAP results as we have previously defined them, excluding deferrals. We generated revenues of $1.61 billion in the quarter, $234 million above May guidance and $850 million or 112% above Q2 last year. We generated EPS of $0.54, $0.16 above guidance and $0.41 or 315% above Q2 last year. The over performance versus guidance was composed of $0.04 of cost timing and $0.12 of business over performance, with the key drivers being the successful launch of our newest franchise, Overwatch, which is obviously off to a resounding start, continued momentum of the Call of Duty digital business and continued growth of the Candy Crush franchise. In addition, digital momentum continued to be a strong business driver in Q2, producing record quarterly digital revenues and operating margins for the company. Digital revenues were $1.4 billion, growing 129% year-over-year and 76% quarter over quarter, and as Thomas mentioned, a remarkable $1 billion of this came from in-game content sales. Excluding King, digital revenues were also up a record – up over 50% year-over-year. Our digital performance drove operating margins to a Q2 record of 37%, up from 28% operating margin last quarter and 23% in Q2 of last year. So we have continued strong tailwinds on the digital front which bodes well for the future across the business. Now let's take a look at the business results for each of our three segments. Let's start with Blizzard. The launch of Overwatch drove engagement to record highs, leading to their biggest revenue quarter ever with quarterly operating income that was nearly triple Q2 of last year. Blizzard also had its biggest quarter in China with the meaningful increase in revenues versus the previous high last year. World of Warcraft, Hearthstone and Overwatch success in Asia shows the depth of Blizzard's resonance in important growth markets. Overwatch was the fastest selling PC game ever in China, and the Warcraft film had the biggest Hollywood launch ever in China as well. On the Activision front, the team delivered record MAUs and operating income for both Q2 and the first half of the year, driven by the continued strength of Call of Duty and in particular, digital in-game content. Turning to King, the Candy Crush franchise continues to perform well showing growth year-over-year and quarter-over-quarter. King's Q2 segment operating income was also up quarter over quarter on a full quarter basis. With all that as a backdrop, let's now turn to our detailed financial results and to our updated external reporting format. Please refer to our earnings release for full GAAP to non-GAAP reconciliations. Please note non-GAAP redefined includes deferrals. For the quarter on a GAAP basis, we generated revenues of $1.57 billion, up 50% year-over-year, an operating margin of 15% and EPS of $0.17. For the quarter, on a non-GAAP basis as redefined to include deferrals, we generated an operating margin of 31% and EPS of $0.45, up 45% year-over-year. Turning to the specific P&L items, please note that all percentages are based on revenues except for the tax rate. For Q2, GAAP product costs were 25%, operating expenses were 60%, interest expense was $65 million and our GAAP tax rate was 24%. Our GAAP and non-GAAP fully diluted weighted average share count was 753 million shares including participating securities. On a non-GAAP basis as redefined, which includes deferrals, product costs were 25%, operating expenses were 45%, interest expense was $64 million and our non-GAAP tax rate was 18%. In terms of cash flow, in Q2 we generated strong cash flow with non-GAAP adjusted EBITDA of $511 million, up 37% year-over-year, operating cash flow of $479 million, up 255% year-over-year and free cash flow of $435 million after CapEx, up 307% year over year with continued strong cash conversion. For the first half of the year, we delivered $788 million of operating cash flow, up 129% year-over-year and $717 million of free cash flow, up 143% year-over-year. Turning to the balance sheet, on the back of that strong cash flow performance, we ended June 30 with approximately $2.3 billion in cash and investments, of which roughly one-third was held domestically. We also paid down $816 million of our outstanding debt in the quarter, bringing the total pay down so far this year to $1.3 billion. We ended the quarter with $5.1 billion in aggregate debt outstanding. Please note that our $1.5 billion of 2021 notes become callable during the third quarter of 2016. In light of our recent upgrade to investment-grade, we believe it will be advantageous to call the bonds and refinance that debt during the quarter. As such we've included the call premium and estimated transaction costs in our GAAP guidance for Q3. On the dividend front, in Q2 we paid a $0.26 per share cash dividend, or approximately $195 million in aggregate to shareholders of record as of March 30, 2016. So in summary, Q2 and our first half were an incredibly strong start of the year for the company and set us up well for the upcoming quarters and years ahead. Now, let's turn to our slate and our outlook for Q3 and full year 2016. Blizzard is launching Hearthstone's next adventure, One Night in Karazhan next week, and launching World of Warcraft's next expansion, Legion, globally on August 30. Activision is launching Destiny's Rise of Iron expansion on September 20 at the $30 price point as well as a map pack for Call of Duty Black Ops III in Q3. We expect Skylanders Imaginators to launch on October 16, followed by Skylanders Academy, an animated show which is expected to debut on Netflix. In Q4, Activision also plans to release the fourth map pack for Call of Duty

[Operator:]

Thank you. Ladies and gentlemen, at this time, we now begin the question-and-answer session. And our first question comes from the line of Mike Olson with Piper Jaffray. Please go ahead.

[Mike J. Olson:]

Hey, good afternoon and congrats on a strong quarter. I was wondering if you could provide some color on the monetization around Overwatch. Title seems to be a strong example of the change in the industry model from just kind of selling units to generating an ongoing digital ARPU from full-game downloads to cosmetic add-on content to other future DLCs. Thanks.

[Michael Morhaime:]

Hi. This is Mike from Blizzard. Thanks for the question. First, we're very pleased with Overwatch's launch results. I want to take this opportunity to thank all of our 15 million players around the world who've joined Overwatch so far. We really appreciate all their support and their incredible enthusiasm for the game. We've seen great momentum with the game across all the different engagement models, including digital and box sales, Korean Internet Game Rooms, which are time based, and cosmetic content, which can be earned or purchased. As Thomas mentioned, altogether, the game has generated about $0.5 billion life to date, excluding deferrals. But more importantly, in the past two months since launch, we've already provided some great content to the Overwatch community including a competitive play mode, a new hero, the recently launched Summer Games content, which drove record engagement yesterday as well as customization items. So, we're very excited about creating even more content for players moving forward. I also want to point out that while we had a great start with the game release, we really view this as just the beginning. We think we've created a strong character driven universe with big opportunities beyond just the game. We think Overwatch has strong potential as an esport. The recently announced Overwatch World Cup, which will take place at BlizzCon this year is a good first taste of that, but we'll be talking more about our Overwatch esports plans later in the year. We also look forward to telling more stories about the characters in the world of Overwatch through other media. You've seen some of this through the animated shorts and comics, but there's still more to come.

[Operator:]

Thank you. And our next question comes from the line of Brian Pitz with Jefferies. Please go ahead.

[Brian J. Pitz:]

Thanks for the question. Just wondering if Pokémon Go has had any impact on King games, and if you're seeing any learnings from its success out there. Thank you.

[Riccardo Zacconi:]

Hi, Brian. It's Riccardo here. So in terms of impact on the King games, we have not seen any meaningful impact on the network to date. What we see is that the core audience continues to stay very engaged with over 30-minute plays per day in average. As Thomas was mentioning earlier, the Candy Crush franchise has grown not only quarter on quarter but also year on year. And it is really testimony to not only to the longevity but also to the strength of the brand. In terms of learnings, Pokémon Go has been very successful in expanding the mobile games audience. They have brought the large Pokémon fan base to mobile. And I believe this is very good for the whole gaming industry. What it has also proven is that when you pair innovation to very strong branded IP, there is a huge potential. And so I think this is actually very good, and it's a great opportunity for Activision Blizzard on mobile.

[Operator:]

Thank you. And our next question comes from the line of Doug Creutz with Cowen and Company. Please go ahead.

[Doug Creutz:]

Hey, thanks. I wonder as we go through the launching plan and the launch of Call of Duty, if you could give a little color on how those are coming along, both Infinite Warfare and the Remastered version. I think you mentioned that preorders of the higher ARPU SKUs are the best you've ever had. Could you maybe comment on the digital SKU factored into that? Thank you.

[Eric Hirshberg:]

Yeah, hey, Doug. It's Eric. I'll take the question. So first of all, on the quality, both of the games, both Infinite Warfare and Modern Warfare Remastered are really looking amazing, and we're very excited that we found a way to deliver both the breakthrough innovation that has been such an important part of Call of Duty's success over the years as well as a return to the classic gameplay that people love so much in one amazing package at an incredible value, and that combination, that value has really led to the performance that we're seeing in the preorders for both the Legacy Edition and the Digital Deluxe Edition, both of which are kind of registering far higher percentages for our higher priced SKUs than we have ever seen before. So the way we think about it is that Modern Warfare Remastered is the best bonus content we have ever offered in one of our Collector's Editions and we think that's driving that player performance for both the Legacy Edition and the Digital Deluxe Edition. On Infinite Warfare, specifically, the team at Infinity Ward is just tremendously passionate about the game and that passion is really showing through and how the game is closing. It's fresh, it's inventive, it looks great and it has a ton of new gameplay mechanics for the franchise. There's often initial skepticism when you push for bold innovations in the context of something that's so well-established as Call of Duty, but the good news is the more people are seeing at the game the more they're getting really excited about it. We showed eight uninterrupted moments of gameplay at E3 and that generated the highest positive sentiment from the usually hard to please gamer press that we've ever seen on the franchise at E3 since we've been measuring it. And we showed another 12 minutes of gameplay at Comic-Con and again got the highest positive sentiment from the press we've ever seen for Call of Duty at that event. The reason that's particularly good news is because people actually haven't seen that much of this game yet relative to previous years. As Thomas mentioned, we're taking a little bit of a different approach to the marketing this year centered around Call of Duty XP, and that's both allowed us to focus on Black Ops 3, which I'll just deliver that record first half of the year that Thomas mentioned, but it's also allowing us to put all eyes on our launch titles in September at XP, where we will have a pretty incredible list of reveals and first hands-on including things like multiplayer in Infinite Warfare, multiplayer in Modern Warfare Remastered, the first zombies mode in the main game that we've had in an entrée art title with Infinite Warfare as well as more reveals on Campaign as well. And for context, all of the modes had been revealed at this time last year. So we think we've got a winning combination, I think we've got a great game of Infinite Warfare and a second great game with Modern Warfare Remastered.

[Operator:]

Thank you. And our next question comes from the line of John Taylor with Arcadia Investment Corporation. Please go ahead.

[John G. Taylor:]

Hi. Congrats on a great quarter. I had a question, I think we're all kind of hungry for some metrics on engagement or monetization trends with some of your big brands and I was just wondering maybe you could talk a little bit about Destiny specifically and talk about what you've been seeing lately with that audience and then give us an update on what's going on with Rise of Iron and what we should expect there? Thank you.

[Eric Hirshberg:]

Sure. Hey. It's Eric again. So as I mentioned on the last call, our biggest challenge on Destiny has not been generating demand for more content from our communities. It's actually been our ability to keep up with that demand, and I'm happy to say that we've made real progress working together with Bungie on that front and as a result, in addition to the update that we've already had this year that drove increased engagement, we also have an awesome expansion coming on September 20 with Rise of Iron. As I think Thomas mentioned, pre-purchases and preorders on Rise of Iron are actually ahead of last year's expansion The Taken King, which is evidence of the continued passionate engagement for this game and this universe from our community, and we'll also have more updates planned for this year to continue to keep people engaged. As for the future, the majority of the team at Bungie is actually focused entirely on creating Destiny 2, which is still on track for release next year and it's going to be awesome.

[Operator:]

Thank you. And our next question comes from the line of Neil Doshi with Mizuho Securities. Please go ahead.

[Neil A. Doshi:]

Great. Thanks for taking my question. I think you guys talked about having record operating income on certain franchises. Wanted to know how we should think about overall core Activision Blizzard operating income moving from kind of the low to mid 30% range to kind of higher 30% or maybe even 40% range excluding King? What are some of the levers you can push on the revenue side as well as on the cost side to get there? Thanks.

[Dennis M. Durkin:]

Yeah, hey, Neil. It's Dennis. Thanks for the question. On a consolidated basis, we had Q2 record 37% operating margin, which is non-GAAP as previously defined. And in fact, Activision Publishing and Blizzard, those two segments combined were above that at 39% in terms of operating margin this past quarter. So you have and can see some of the sight lines to how we might get there and then try to sustain that over time. I'd probably call out maybe three things that are really key for that, and that are going to be really important for us to get to those levels and to sustain them going forward. The first one is just scale. In our business, we have a large opportunity to drive upside once we recover the fixed spend that we have to bring our games and our content to market, being very focused on how we do that and all the costs enable us to really scale those incremental margins as we do that. And it's a combination of those that once you get past that fixed cost base, really drives margin accretion for every incremental sale that you have. The second part beyond scale is just digital growth, which really has two aspects. The first is just the trend that we're going to continue to see around the shift from retail to digital on full game sales, and that will continue. But even more importantly and a bigger driver as you saw in Q2 is the deeper player investment that we see once we have players inside of our experience and new opportunities to add micro-transactions, advertising, other things into those experiences, which are all really contribution margin and accretive to the overall margin of the company. And then lastly, I'd just say as a competitive point relative to others, obviously owning our own IP is a huge factor in scaling those margins. That gives us a huge structural margin advantage relative to others and really gives us the flexibility to respond quickly as business models evolve and it'll help us build long-term value around our margin structure. So I'd say those are probably the three things that are most important to driving that. Thanks for the question.

[Operator:]

Thank you. And our next question comes from the line of Chris Merwin with Barclays. Please go ahead.

[Christopher David Merwin:]

All right. Great. Thank you. I just have one for Ricardo. So you guys have been testing some mobile ads on King, and maybe can you just talk about some of the learnings that you've seen there so far? And I believe also you're looking to sell King ads mostly on a direct basis with a sales force. So I guess maybe could you also talk about why the direct sales model makes the most sense rather than say programmatic, and where you are in the process of hiring a sales force to ramp up direct sales by next year? Thanks.

[Riccardo Zacconi:]

Hi, Chris. Nice talking to you again, Christopher. And before I get to your questions, I just want to reiterate that because of the size of the network and the engagement of our players, we believe that advertising represents an attractive opportunity. So as you said, at the same time, as you know, we are extremely focused on providing a first and foremost a great user experience. And we will not compromise on this. So this is the key reason why we are testing extremely thoroughly and are taking time for testing in-depth. And currently we are testing in two games, and we expect to test also in Candy Crush later this year as Thomas was saying earlier. Besides testing, we are also hiring and we are hiring as selectively as we are hiring in the company, and we are hiring to bring the right experience to build this business for the long term. And in regards to the other question you had, the sales model, we are focusing not only on direct sales, but we will sell both programmatic and direct. So I hope I answered your questions.

[Operator:]

Thank you. And our next question comes from the line of Drew Crum with Stifel, Nicolaus. Please go ahead.

[Drew Crum:]

Okay. Thanks. Good afternoon, everyone. I wonder if you'd be willing to expound on your commentary concerning presales activity for Legion. The impact you've seen from the movie release, has that been more short lived or more sustainable in terms of the sub base? Thanks.

[Michael Morhaime:]

Thanks for the question. This is Mike. We've seen very positive trends with the game over the past month. That's a result of the excitement building up to the Legion launch and also as a result of the positive attention we've seen globally with the Warcraft movie. While we have good momentum everywhere, the uplift in China has been particularly strong. So we have double-digit growth in engagement compared to a year ago and last quarter. And while there's several weeks to go until the Legion launch, our presales have been tracking in line with the prior expansion. So we have good strong momentum heading into next week, where we're going to be releasing the Demon Hunter and then following that, the Expansion launch later in the month.

[Operator:]

Thank you. Our last question comes from the line of Colin Sebastian with Robert W. Baird. Please go ahead.

[Colin A. Sebastian:]

Thanks. I'll add my congratulations on a great quarter. Obviously, we're hearing a lot more about esports this year from you as well as other publishers. I wonder if your expectations are changing in terms of what you've seen thus far, but on the timeframe to ramp esports to material revenue contributor and longer term, how much in terms of potential incremental revenue and profit you could expect from that. Thank you.

[Robert A. Kotick:]

Sure. So I think the important thing, Colin, for us is that, all of our esports initiatives are in the service of celebrating our players. And you think about the investment and the commitment that our players make in our games, this is a great way for us to really recognize through organized competition being that investment. When you look at all the opportunities that present themselves, they're very franchise specific. There's a lot of work that needs to be done to get to a place where you have broad appeal watching, where you have the ability to broadcast content in an effective and successful way. And we're investing again all of the various opportunities that we think esports could present. It's a longer-term vision for what we're trying to accomplish. There's a lot of investment that's still going to be required. Having said that, more people are spectating on video games than ever before. There are more opportunities for spectators than ever before. The live event competitions are providing greater prize pools, greater recognition, greater opportunities for players. And we think that this is one of the areas that'll present great opportunities for us for the long-term. Getting from here to a place that will allow our franchises to resemble the NFL, the NBA, Major League Baseball, is going to take some time, but I could tell you the best minds of the company, the people who are in this room are all committed to continuing the efforts that we've made. And I think we have a genuine belief that in all of these sports, we've been the most successful. I think most of what you see is organized competition started out with Blizzard games a long time ago. And so we have a lot of belief and a lot of expectation that the promise of esports will continue to be something that we will excel at.

[Dennis M. Durkin:]

All right. Thanks, Bobby, and thanks, everyone, for joining us today. We look forward to talking to you again on our next call in early November.

[Operator:]

Thank you. Ladies and gentlemen, this concludes the Activision Blizzard's Q2 2016 Earnings Conference Call. Thank you for your participation. You may now disconnect.