Activision Blizzard, Inc.
Q2 2010 Earnings Call Transcript

Published: 6 Aug 2010

[Operator:]

Good day, everyone, and welcome to Activision Blizzard's Second Quarter Current Year 2010 Earnings Conference. [Operator Instructions] At this time for opening remarks and introductions, I would like to turn today's call over to Ms. Kristin Southey. Please go ahead, Kristin.

[Kristin Southey:]

Good afternoon, and thank you for joining us today for Activision Blizzard's Second Quarter Calendar 2010 Conference Call. With me today are Bobby Kotick, Chief Executive Officer of Activision Blizzard; Thomas Tippl, Chief Operating Officer and Chief Financial Officer of Activision Blizzard; and Mike Morhaime, Chief Executive Officer of Blizzard Entertainment. I would like to remind everyone that we will be making statements that are not historical facts. These forward-looking statements are based on current expectations and assumptions that are subject to risk and uncertainties. As indicated in the slides, they're showing 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 statement. Such factors include, without limitation

[Robert Kotick:]

Thank you, Kristin, and thank you, all, for joining us today. We are quite pleased to announce that we outperformed our EPS outlook for the quarter, and we're reaffirming our calendar year revenue and EPS expectations, which would result in the most profitable year in our history and our highest operating margins to date. Our results this period once again affirmed our business strategy and superior worldwide execution. Our focus on the largest and most profitable opportunities and our ability to extend our leadership in the fast-growing online segments continue to provide us with a competitive advantage and recurring profitability that is unmatched in our industry. In addition to our second quarter results, you'll hear more today about our blockbuster lineup for the balance of the year, including a recap of our first major launch of 2010 Blizzard Entertainment StarCraft II, which was released worldwide in July 27. The game is off to a superb start and with the relaunch of Battle.net players around the world are enjoying a significantly enhanced online experience. StarCraft is one of the highest quality, and it's further confirmation of the unique talent that is embedded in Blizzard. This will again become clear with the launch of Cataclysm later this year. Our unrelenting commitment to quality, our resources and our proven skills in providing compelling content for gamers provide a unique competitive advantage. Our success continues to reflect the early and thoughtful way our management team anticipated, recognized and reacted to significant shifts taking place in audience needs and how we adapted to deliver more compelling games for our players. As a result, we continue to see a shift to the high-margin digital side of our business, which yields faster growth, better returns on invested capital and reduces our exposure to the volatility that has historically characterized video game companies. In fact, this is the first quarter that our sales from online channels outweighed our retail sales. Our continued successful results reaffirm our strategy. Clearly, leading franchises are strengthening. However, this only happens where there is great innovation, and StarCraft II is certainly confirmation of this. Today, players and retailers alike are more selective than ever before and are choosing to concentrate their entertainment spending on fewer higher-quality experiences. This is a trend not just in video games but across all media, where we continue to see the largest and most successful properties, when superbly executed, gain disproportionate share of audience attention. Online technologies like voice over IP and video over IP, as well as new motion-sensing technologies like Move and Kinect, are offering players exciting new ways to interact. These new experiences are more immersive than prior technologies, and games that capitalize on these innovations are optimally positioned to attract much, much larger audiences. With gaming becoming one of the most popular uses of the Internet, more gamers in far broader demographics than we have ever seen before are emerging as new consumers. This will drive growth and will reward companies like ours that have deep expertise and understanding in making surely interactive entertainment. As in-home broadband penetration increases globally, Internet-connected televisions become a reality and the ubiquity and capability of portable devices is rising. We should continue to see dramatic extensions in the reach and functionality of today's leading entertainment content as a result. Game quality will obviously be crucial for long-term success, and for us, quality begins with focus and talent. Our decision last February to organize a separate business unit focused on Call of Duty was an example of a recognition of the need to dedicate the best resources towards the tens of millions of players who are playing Call of Duty games. In Call of Duty

[Thomas Tippl:]

Thank you, Bobby. Today, I'll begin with a recap of the June quarter results followed by a review of our outlook for the third quarter and calendar 2010 and will close with a review of the Activision business before handing it over to Mike Morhaime, who will discuss Blizzard's performance and plans. For your reference, in our press release, there are schedules which provide non-GAAP comparable by business segment, and this will be the numbers I'll refer to unless otherwise noted. Also please refer to our earnings release for a GAAP to non-GAAP reconciliation. For the second quarter, GAAP net revenues were $967 million, GAAP operating income was $300 million and earnings per share was $0.17, $0.06 ahead of our prior outlook primarily due to lower revenue deferrals and equity expense. On a non-GAAP basis, June quarter net revenues were $683 million, non-GAAP operating income was $101 million and non-GAAP EPS came in at $0.06, $0.02 ahead of our prior outlook. The quarter was driven by Blizzard Entertainment's World of Warcraft and Activision's Call of Duty. In addition, we also released Shrek, Singularity, Blur and Transformers. As expected, non-GAAP revenues and earnings were down as of the prior year due to a smaller release slate and continued weakness at retail in the Casual and Music genres. As compared to our prior outlook, non-GAAP revenues were slightly lower due to the negative impact of foreign exchange and lower sales of our new releases, which were largely offset by the continued momentum of our core franchises Call of Duty and World of Warcraft. Non-GAAP EPS looked higher than our outlook driven by the strength of our core franchises, specifically, by the, strong, continued digital revenue performance over the Call of Duty Map Packs and Blizzard's value-added services both of which have helped deliver year-to-date non-GAAP operating margin expansion of 100 basis points. With respect to the P&L line items, in the June quarter, GAAP product costs were 30% of revenues. And GAAP operating expenses, including royalties, was 39% of revenues. Our GAAP tax rate was 27%. In the June quarter, non-GAAP product costs were 32% in line with our outlook. Non-GAAP operating expenses came in better than expected at about 54% due mainly to lower G&A expenses related to better-than-expected realization of savings of our March quarter organizational realignment. Finally, our non-GAAP tax rate was 29%. Now turning to the balance sheet. On June 30, we had no debt and approximately $2.9 billion in cash and investment. This quarter, we repurchased $242 million worth of stock, bringing this year's total purchases under the $1 billion authorization to approximately 31 million shares worth $334 million. And we also paid our first-ever dividend of $187 million. Now let me turn to our other key balance sheet positions as of June 30. The accounts receivable balance was $190 million, an increase of $56 million worth at the prior quarter end. The increase was primarily due to the late quarter releases of Transformers and Singularity. Inventories were $157 million, down $37 million versus the prior quarter and down $41 million worth at the prior year due mainly to a reduction in Guitar Hero inventory. Our Guitar Hero inventory and total inventory's position represents our lowest inventory level in years. Capitalized software development cost was $249 million, an increase of $28 million worth at the prior quarter due to upcoming releases. Of the $229 million, approximately $38 million is related to deferrals for online-enabled games. Capitalized intellectual property cost were $59 million. Excluding deferrals, capitalized intellectual property costs were $54 million, $5 million above the year ago due in part to cost related to upcoming license releases. And to cash flow for the trailing 12 months, we have generated approximately $1.2 billion in operating cash flow. So in summary, our financial position remains very strong and puts us in an excellent position to capitalize on invested opportunities both internally and externally for long-term growth. Before turning to our financial outlook, I'd like to highlight a couple of items. We continue to focus on a few key building blocks, to drive earnings growth and operating margins. And I will take a minute to review those building blocks and remark on our progress to date. First, we are heading into the strength of our 2010 lineup. For our financial perspective the key drivers of our calendar year 2010 results remain Blizzard StarCraft II, which launched last week, and World of Warcraft

[Michael Morhaime:]

Thanks, Thomas. With two games shipping in the same year for the first time since 1998, 2010 is shaping up to be Blizzard Entertainment's biggest year yet. Two quarters in, we have much to look forward to and anticipate a strong finish to the back half of the year. To start things off, I'll discuss our performance in Q2 before talking about specific areas such as StarCraft II, World of Warcraft and BlizzCon. Blizzard has shown continued strength in the second quarter of 2010. Worldwide subscription numbers for World of Warcraft are holding steady at more than 11.5 million players despite the struggling economy and pressure on European currencies through the first half of the year. We were still able to grow our business year-over-year both in terms of revenue and profit. As a reminder, the results from Q2 don't include sales from StarCraft II, which was just launched a week ago. Star Craft II is currently one of the highlights of our year with the game launching across five different continents and in 11 languages. The response by both players and press from around the world has been outstanding. As a matter fact, Metacritic's currently rate StarCraft II a 94 out of a possible 100, making it one of the top scoring games of all time. Preliminary sales numbers have begun to roll in, and I'm pleased to say that StarCraft II is already the fastest-selling strategy game of all time. We sold more than 1.5 million copies worldwide in the first two days of release, making StarCraft II the best-selling PC game so far this year. Just to put that number in perspective, if we compare the day one sales of StarCraft II in North America and Europe combined, the day one sales of World of Warcraft in those two regions combined, StarCraft II more than doubled the sales of World of Warcraft. We are very pleased with the StarCraft II's retail sell-through to date. What's more, the excitement over StarCraft II has actually driven consumer interest in our other games. Amazon's North American PC sales data for the week of July 29 shows that the top five was a clean sweep for Blizzard

[Kristin Southey:]

Operator, we can open up for questions.

[Operator:]

[Operator Instructions] And your first question will come from Jeetil Patel with Deutsche Securities.

[Jeetil Patel:]

Can you first talk about StarCraft? It's launched in the U.S. and U.K. market predominantly. There's probably some purchases out of Korea, but can you talk about how many are in beta today and maybe the timing of when that goes into open sale as opposed in beta? Second, it looked like in the quarter, you cut back marketing on Blur and Singularity. Do you think that was more a function of trying to manage earnings? Or kind of what was the strategy rational behind that? Lastly, do you need cut back your software product line up further and focus on your bigger titles since that seems to be the theme in the industry of driving profitability and gearing everything towards the holiday season?

[Michael Morhaime:]

This is Mike. So first I'd like to clarify that the StarCraft II launch was a worldwide launch. It wasn't just U.S. and U.K. Actually, we launched throughout Europe, we launched in Latin America and in Southeast Asia as well. The places that are in open beta right now are Taiwan and Korea, and we have not announced an ending date for the open beta yet, but typically, these things last for a few weeks.

[Thomas Tippl:]

And then, with regards to your question, we have made a very significant investment behind the establishment of Blur as a new IP. So I think the marketing plans was very strong, probably stronger than for most of our franchises. Unfortunately, the racing genre was not particularly responsive, at least so far this year, despite the number of good releases. On Singularity, the bar in the shooter genre these days is very high. I think we made the right size investment against this opportunity, and that's how we expect to continue to look at the amount of marketing support we put behind all of our launches. With regards to the lineup, certainly making fewer games there, but bigger has been our strategy for a long time now. I think it's what the market has been rewarding, and we constantly evaluate our plate as part of our three-year planning process and decide which market segment we want to participate in, where do we have consumer-proven concept, great development talent that can deliver those concepts. And as a result, our slate, if you look into the future, is likely going to continue to grow.

[Operator:]

Your next question will come from Heath Terry from FBR Capital Markets.

[Heath Terry:]

I was wondering if you could give us, now that the game is out and you're up and running and Korea, a little bit more of the sense of what you expect the breakdown on users in Korea to look like between the packaged good, between the cafe side of things? And just give us a little bit more of a sense on what the business model is going to look like in those markets relative to the U.S.

[Michael Morhaime:]

So while we don't disclose specific breakdown and haven't in the past for World of Warcraft, we do expect the usage patterns to be fairly similar to what they have been for our previous games. So you'll see a fair number of players playing the game from home as well as people playing from the IGRs [Internet Gaming Room]. Since we are still in open beta, it's too early to get a sort of indication of the number of people that will choose to go out and purchase the game versus just playing in the IGRs. One thing I'll point out, so the model, the way it works in Korea, players have a lot of choices. So they can purchase the game digitally for the same price as we're offering in the U.S. It comes to be about 69,000 Korean won. They also have the option of purchasing a digital subscription for either one day or 30 days, or they can go to a game room and play. And if they play in the game rooms, we actually bill the game rooms for usage time and the model with the game room is actually very common for games in Korea, and our pricing is competitive.

[Heath Terry:]

And then just, Mike, can you give us a sense -- I know you've released kind of first 48-hour numbers. Can you give a sense of kind of what -- how things are trending since then relative to your expectations, not just from a pure sales standpoint but also the reaction that you're getting from the community and from usage levels that you're seeing as you had at Battle.net?

[Michael Morhaime:]

The reaction has been very positive for the game. Players around the world really appreciate the game. Players in Korea, the response has been very positive. One thing we're seeing is that StarCraft I remains very popular in Korea, and I think we're going to see a transition period because right now, you're still seeing a lot of StarCraft I pro tournaments broadcast on live TV. Our partner in Korea made an announcement yesterday about the StarCraft II leads that they'll be running through the end of this year, which was received extremely positive by players not only in Korea but around the world. So there's a lot of excitement about this, and I think that the broadcast of StarCraft II tournaments and seeing their favorite pro players playing StarCraft II is really going to drive a lot of interest. But there will be a transition period.

[Operator:]

From UBS, we'll hear from Brian Pitz.

[Brian Pitz:]

Actually does another follow up on StarCraft on Heath's question. Is there any impact regarding the lack of LAN availability for the game in places like North America and Europe among the hard core players? And then, maybe you could just touch upon some of the earlier comments in the call, where you mentioned both the casual and music genres kind of weaker in the second quarter. What kind of assumptions are you playing out in Q3, Q4 for those genres?

[Michael Morhaime:]

We really haven't seen any impact to sales. As we mentioned, StarCraft II is selling faster than any of our previous real-time strategy games. And even comparing it to the original World of Warcraft box, we're still selling much faster. The reviewers have been universally positive on the game. And I think most players, when they sit down and play the game, they find that the multiplayer support on Battle.net is actually quite good. So no, I would say we haven't really seen any impact.

[Thomas Tippl:]

And on the casual and music genre, the first half of the year, there were zero new releases coming out from our end and as a result, there were [indiscernible] catalogs. And obviously, the numbers as a result were down year-over-year. And as we move into the back half of the year, we made a number of adjustments to our plans, and we expect that retail and higher price points, games as peripherals, will continue to face some headwinds. And so that's baked into our plans.

[Operator:]

We'll hear from Edward Williams with BMO Capital Markets.

[Edward Williams:]

First of all, just looking at the $20 million Call of Duty map pack sales, can you give us some color as to what each succeeding map pack did? So what the uptick was like as you progress through them? And also, if you can provide a little bit of color as to what the reaction has been to the pricing, specially with more recent releases?

[Thomas Tippl:]

Starting with the last part of your question, obviously the success of the map pack speaks for the value that we are providing to the gamers is incredible, new contents coming out and millions of hours played on that content so the value creation we provide to players is great. And as a result, we've been selling a ton of them. Modern Warfare 2 map packs are on a very good trajectory, and they have not yet crossed the number of map packs we have sold with World of Warcraft, but that's probably going to happen within the next couple of weeks. It's going extremely well. We couldn't be more pleased.

[Michael Morhaime:]

I think one of the things I'd add also that's important, we have gotten an incredible amount of benefit from this very, very large installed base of players and the way people are reacting to the downloadable content. And a lot of that learning has now been incorporated into what you'll see in a lot of the functionality of Black Ops. And one of the things that we've really done is improve the quality of the multiplayer beyond anything that any customers have ever seen. And partly why we're so enthusiastic about our prospects for the back half of this year, but Black Ops is turning out to be one of the best products that we've ever created.

[Edward Williams:]

Can you describe a little bit as to what you're thinking right now in terms of the potential lifetime revenue you may be able to get out of the map pack type of sales or additional content sales on the console side? I'm not sure what it would be, but what's your percentage of overall sales may come from that? Or how critical it is it to the future of those games?

[Thomas Tippl:]

I think continued content delivery is going to be very critical for many reasons. One, it generates higher margin revenue, but more importantly, it makes our brands even stickier. It gives our fan base no reason to go play different games, or other brands. And as a result, we have today more resources than ever dedicated to creating additional content for Call of Duty, whether that's map packs, whether that's game modes and the whole host of new features that we're going to talk about when we get close to the launch of Black Ops.

[Operator:]

Your next question will come from Justin Post with Bank of America.

[Justin Post:]

Just thinking about the shape of the quarters, I think you did $0.06 this quarter and you have what is a very high margin PC title launching in 3Q. Maybe talk about why EPS is only $0.02 better on kind of a higher level basis? And then Bobby, over the years, you've really been able to innovate and kind of build new franchises that you didn't have, say, five years ago, how is that looking now with the industry changing? Is it already about building the franchises you already have? Or can you still create and come up with new things that kind of replace some of the franchises that are declining over time?

[Robert Kotick:]

We have sort of a dual responsibility. You have to have incredibly compelling innovation in the franchises that we own and control, and that's critically important. We've always known that. I think what we've been able to do is elevate the level of innovation in products beyond what we've been ever able to do before. We've talked a lot about the seven different pillars of success that we expect over the course of the next few years. And remember, we have two enormous investments

[Thomas Tippl:]

Justin, on the quarter-over-quarter EPS progression, yes, obviously Blizzard's contribution to Q3 is going to be higher than its contribution to Q2. At the same time, we have no new Call of Duty map packs in Q3. And as I just talked about, they've been extremely successful for us in the June quarter. So net-net, we are delivering 100% EPS growth in the September quarter year-over-year, and this is something that we feel pretty good about.

[Operator:]

Next, we'll hear from Colin Sebastian at Lazard.

[Colin Sebastian:]

I guess turning back to Call of Duty, the shooter and war genres are going to be a little bit more competitive this fall. And I know you've generally been pretty prudent there about in terms of financial expectations. You're suddenly a little bit more optimistic on this call and just curious how you're approaching the merchandising or the retail plans for Black Ops differently than, say, last year when there was a bit more of an open field?

[Robert Kotick:]

This across the board, the biggest investment that we've ever made in a launch of a title. And I think when audiences see the product, they'll see why we're doing it this way. But the market opportunity is bigger than it's ever been. The installed base of hardware is bigger than it's ever been. The product has incredibly broad appeal, but it also has a whole host of functions that are going to be unique to the core consumer. And from that perspective, we feel like it's the most appropriate Activision product to put these kinds of resources behind. And I think there's a lot of competition, not just from games but from a whole host of other things that you can do with your leisure times. And this is something that we think has the potential to break through and appeal to a much broader consumer base than ever before.

[Colin Sebastian:]

And then I guess, Thomas, just quickly one housekeeping, if you could quantify the impact on this currency on the top line for the quarter versus your original expectation?

[Thomas Tippl:]

It's about $20 million.

[Colin Sebastian:]

$20 million?

[Thomas Tippl:]

Yes.

[Operator:]

Next question will come from Jess Lubert with Wells Fargo Securities.

[Jess Lubert:]

First, I was hoping you could discuss some of the trends that caused the sequential decline in the Blizzard subscription revenue, and should we expect sequential growth there through the second half of the year? And then second, can you give us an update on your efforts to target the Used-Games business? This is something you'd alluded to at E3. Many of your competitors have implemented single-use codes. Any help there would be appreciated.

[Thomas Tippl:]

When you look at our platform breakout, and those are GAAP numbers so it's impacted by deferrals from a year ago. If you go back, we had to ramp up the Lich King expansion pack launch. And then, the following six months, benefited from the deferred revenue that was coming in. If you look at Blizzard, that's a segment revenue in the June quarter, and remember, our StarCraft is shipped in the third quarter. But there's no retail release in the second quarter. Blizzard has been growing our revenue and operating income as a result this very healthy subscriber trends, as well as strong performance in value-added services. So this is very healthy, subscriber numbers are very healthy, concurrency has been very strong. And this one thing that I don't think Mike has mentioned earlier, but we continue to see very strong concurrency numbers ever since the launch of the StarCraft, which is very encouraging.

[Jess Lubert:]

And then on the Used-Games business?

[Thomas Tippl:]

Can you repeat your question on the Used Games business?

[Jess Lubert:]

At E3, you had mentioned that you're looking to target Used-Games business and capture that opportunity. Can you give an update on your plans there?

[Thomas Tippl:]

We are still evaluating various possibilities for greater participation in the Used-Games business. What's been working the best so far is providing additional content and therefore limiting the supply to used games. So that's a proven strategy that we will continue. And any other initiatives, we will be talking about when we get closer to it.

[Operator:]

And we do have time for one more question. Your final question will come from Shawn Milne from Janney Capital Markets.

[Shawn Milne:]

I just wanted to go back to the question about just the third quarter earnings outlook. I think when you had moved StarCraft II before, you talk about $0.05 in terms of profitability. So all things being equal, you'd be looking at $0.05 over the prior period a year ago. Is there something else going on in third quarter? I think you mentioned maybe a little bit more investment on the Blizzard side in terms of customer experience. Is there some incremental spending there? And then, Mike, you touched upon it briefly, just on Battle.net. I know it's very early, but any other signs in terms of usage or hours or what you're seeing early on with the relaunch of Battle.net?

[Thomas Tippl:]

First of all, I don't think we have ever provided a guidance for our outlook number on StarCraft. I'm not quite sure where your $0.05 are coming from. So product performance is strong. I think it makes a significant contribution to Q3, but we also expect the product will have some significant lags in sales for many quarters to come.

[Michael Morhaime:]

Well, as Thomas mentioned, we've been watching World of Warcraft usage since the StarCraft launch and really haven't seen a big impact to the World of Warcraft usage, which is a great sign. And we're seeing StarCraft usage continuing to increase since launch. So it's all looking very great from our perspective.

[Kristin Southey:]

On behalf of everyone at Activision Blizzard, we thank you, all, for your time and consideration. And we look forward to talking to you later.

[Operator:]

Ladies and gentlemen, that does conclude today's presentation. We do thank everyone for your participation.