Activision Blizzard, Inc.
Q4 2011 Earnings Call Transcript

Published: 10 Feb 2012

[Operator:]

Good day, and welcome to the Activision Blizzard's Q4 and Calendar Year 2011 Conference Call. Today's call is being recorded. At this time, for opening remarks and introductions, I would like to turn today's call over to Ms. Kristin Southey. Please go ahead, ma'am.

[Kristin Mulvihill Southey:]

Good afternoon, and thank you for joining us today for Activision Blizzard's Fourth Quarter 2011 Conference Call. With me today are Bobby Kotick, CEO of Activision Blizzard; Thomas Tippl, COO and CFO of Activision Blizzard; Eric Hirshberg, CEO of Activision Publishing; and Mike Morhaime, CEO of Blizzard Entertainment. I would like to remind everyone that during this call, 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 risks and uncertainties. As indicated in the slide that is 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, sales levels; increasing concentration of titles; shifts in consumer spending trends; current macroeconomic and industry conditions and conditions within the video game industry; our ability to predict consumer preferences among competing genres and hardware platforms; the seasonal and cyclical nature of our industry; changing business models, including digital delivery of content; competition, including from used games; possible declines in pricing; product returns; price protection; product delays; adoption rate and availability of new hardware and related software; rapid changes in technology and industry standards; litigation and associated costs; protection of proprietary rights; maintenance of key relationships, including the ability to attract, retain and develop key personnel and developers that can create high-quality hit titles; counterparty risk; economic, financial and political conditions and policies; foreign exchange and tax rates; and identification of acquisition opportunities; and potential challenges associated with geographic expansion. These important factors and other factors that potentially could affect the company's financial results are described in the company's Annual Report on Form 10-K for the period ended December 31, 2010, and in the company's other SEC filings. The company may change its intentions, beliefs or expectations made at any time and without notice, based upon any changes in such factors, in the company's assumptions or otherwise. The company undertakes no obligation to release publicly any revisions to any forward-looking statements to reflect events or circumstances after today, February 9, 2012, or to reflect the occurrence of unanticipated events. I'd also like to note that certain numbers we will be presenting today will be made on a non-GAAP basis, excluding the impact of the change in deferred net revenues and related cost of sales with respect to certain of our online-enabled games; expenses related to share-based compensation; expenses related to the restructuring; the amortization of intangibles, and impairment of intangible assets and goodwill; and the associated tax benefit. Please refer to our earnings release, which is posted at 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 on the website following the call. In addition, we will also post a 12-quarter financial overview highlighting both GAAP and non-GAAP results and along with a summary sheet. And now I'd like to introduce our CEO, Bobby Kotick.

[Robert A. Kotick:]

Thank you, Kristin, and thank you all for joining us today. 2011 was another record year for Activision Blizzard. In 2011, we generated nearly $1 billion in operating cash flow. And over the last 3 years, we've generated over $3.5 billion in operating cash flow, and we've returned more than $3 billion in value to our shareholders through dividends and stock repurchases. In the U.S. and Europe, we remain the largest and most profitable third-party interactive entertainment company and the largest and most profitable third-party interactive entertainment digital publisher. We again delivered better-than-expected financial results and achieved multiple financial and operational records, as we have for the last few years. We achieved record operating margins and record EPS, which grew more than 17% over the prior year, and as I mentioned, we generated nearly $1 billion in operating cash flow, which allows us to continue to invest thoughtfully in our future growth and return capital to our shareholders. With that in mind, we're increasing our dividend 9% to $0.18 per share, and our Board of Directors has authorized a new $1 billion stock repurchase program. Our strong performance is a testament to the hard work and incredible talent of all of the Activision Blizzard employees around the world. Their commitment to excellence, teamwork and inspired creativity continues to drive our superior performance. Today, we're going to highlight a few important achievements from 2011 and provide some greater detail about our plans for 2012 and beyond, including our strong lineup, our expansion into new markets and new business models, and our development initiatives for new platforms. 2011 was a very competitive year. There were many great products released, and gamers had more entertainment choices on more platforms than ever before. Despite these choices and new competitors, Blizzard Entertainment's World of Warcraft remains far and away the world's largest online subscription-based massively multiplayer game, ending the year with 10.2 million subscribers. World of Warcraft has a very loyal group of players and later in the call, Mike Morhaime will share some of this year's plans for the franchise. Perhaps the greatest challenge we always face in our business is the launch of large, sustainable, inspired, new franchises. Skylanders is one of the most innovative products we've ever created, and its success could continue for many years to come. Two days ago, we announced our next iteration, Skylanders Giants, and the success we've had with Skylanders demonstrates this unique ability we have as a company to create franchises with enduring value. It is equally difficult to make certain that a franchise delivers groundbreaking innovation, compelling new gameplay and the special sauce that engages new and existing audiences. Call of Duty

[Thomas Tippl:]

Thank you, Bobby. Today, I'll begin with a recap of our record December quarter and calendar year results, followed by a review of our outlook for 2012. Please refer to our earnings release for a full GAAP to non-GAAP reconciliation. Also, the numbers I'll be quoting are compared to the prior year unless otherwise noted. For the calendar year, on a GAAP basis, we generated record revenues of $4.8 billion, record operating margin of 28% and record EPS of $0.92. On a non-GAAP basis, for the calendar year, we generated significantly better-than-expected revenues of nearly $4.5 billion. We expanded our non-GAAP operating margin 170 basis points to a record 30.3%, and we grew EPS 18% to a record $0.93. Despite challenging retail conditions, tough comps for Call of Duty and no frontline releases from Blizzard, we set new record results for the industry and exceeded our going-in expectations for 2011 by a wide margin. Since our merger with Blizzard in 2008, our operating margins have increased by more than 625 basis points and reflect profitability well exceeding other interactive entertainment companies, most major media companies and several leaders in Internet and software. Additionally, since the merger, we have grown EPS double digits every year, and this year marks our largest increase yet. Finally and most importantly, this year, we generated nearly $1 billion in operating cash flow, which enables us to invest in our growth opportunities and return significant value to shareholders in the form of buybacks and dividends. Over the last 3 years alone, we have invested over $3 billion in product development and sales and marketing, generated $3.5 billion in operating cash flow, and returned $3.1 billion in value to shareholders. All of these financial milestones further demonstrate that the opportunities in interactive entertainment far outweigh the challenges for us, and that we continue to focus our investments appropriately against the largest opportunities. Now moving to the details of our fourth quarter results. On a GAAP basis, we generated revenues of $1.4 billion and earnings per share of $0.08. On a non-GAAP basis, we generated revenues of $2.4 billion and increased earnings per share by 17% to a new quarterly record of $0.62. Our strong performance for the quarter and year-to-date has been driven by our products with breakthrough innovation, online integration and digital revenue streams, including Blizzard's World of Warcraft, Activision's Call of Duty, and our newest IP, Skylanders. In 2011, our products with online integration and digital revenue streams also drove record digital revenues of approximately $1.6 billion, and this was accomplished despite the lack of frontline releases from Blizzard. Turning to the specific P&L line items for the fourth quarter. Please note, all percentages are based on revenues, except the tax rate. For GAAP, product costs were 38% and operating expenses were 60%. Our GAAP tax rate was negative due to strong profit performance abroad where corporate tax rates are lower and tax reserves rolling off after the statute of limitations expired. For the quarter, non-GAAP product costs were 31%. This is up from our prior outlook due to the over-performance of our distribution business. Non-GAAP operating expenses were 32%, lower than our prior outlook, due mainly to leverage from strong top line performance, including over-performance of Skylanders toys. Investment income was negative as a result of FX hedges for the fourth quarter. Finally, our tax rate came in at 18%, which is lower than expected for the same reasons I mentioned a minute ago. Now turning to the balance sheet. On December 31, we had no debt and a record $3.54 billion, or nearly $3 per share, in cash and investments. This is despite significant investment in the most robust pipeline of new products and services we have ever had and returning about $875 million in value to shareholders through dividends and share repurchase in 2011. The strength of our balance sheet and the consistency of our cash flows are major competitive advantages that afford us the ability to first, invest for future growth in opportunities with the highest organic return on invested capital like this year's successful launches of Skylanders and Call of Duty Elite, which established 2 new vectors for long-term growth; second, invest for future growth through the allocation of capital to attractive external opportunities, for example, with our 10-year exclusive agreement with Bungie; and finally, return value in the form of dividends and share repurchases. And today, we were pleased to announce that the board authorized a new $1 billion repurchase program to begin in April and increased the cash dividend by 9% to $0.18 per share. So let me now move on to the outlook for 2012. As we've done historically, we begin the year with a reasonably conservative approach, due in part to the continued uncertainties in the broader macroeconomic environment and volatility in foreign exchange markets. We entered the year with financial strength, strong market fundamentals for digital and an expanding portfolio of category-leading franchises and unique online service capabilities that offer expansion opportunities for the long term. Accordingly, we are focused on strengthening operations at retail, expanding our digital footprint and adding innovation and new business models to each of our properties to continue driving growth. Specifically, this year, we expect growth from Blizzard. In addition to World of Warcraft, which provides a strong foundation, Blizzard plans to launch at least 2 titles this year, including Diablo III with its real money auction house. Business pipeline has never been stronger, including World of Warcraft

[Eric Hirshberg:]

Thanks, Thomas, and hello, everyone. 2011 was an incredible year for Activision Publishing. I'm proud to say that, especially given that last year, at this time, many doubted whether we could deliver the best-selling game of the year, launch a new online digital service and launch a new intellectual property, creating a new multi-platform franchise in the process. So I'm happy to say that we not only achieved all of these goals but exceeded them and ended the year stronger and more profitable than ever. These achievements would not have been possible without the hard work and dedication of everyone at Activision Publishing worldwide, and I want to thank them for their efforts. Without their focus, drive and creativity, we could not have had the largest entertainment launch in history for the third consecutive year, delivering the highest grossing game ever in a single year with Call of Duty

[Michael Morhaime:]

Thank you, Eric. I want to quickly recap our activity from 2011. We launched both StarCraft II and World of Warcraft

[Robert A. Kotick:]

Kristin?

[Michael Morhaime:]

Kristin?

[Kristin Mulvihill Southey:]

Yes. And now we're going to let the operator take questions.

[Operator:]

[Operator Instructions] And we'll take our first question from Jeetil Patel with Deutsche Bank.

[Jeetil J. Patel:]

A couple of questions. Can you talk about -- I guess, when you look at this year, your online business did $1.56 billion in revenue. If we kind of look at your guidance for the year, is it safe to assume online is going to be the fastest-growing segment, probably more like mid-teens type of growth as we look at that $4.5 billion number? And then second, as you look at Call of Duty Elite premium, you've got about a 20% pay rate. Do you think that this pay rate picks up? Or for 20% participation, Elite premium picks up as we progress the year and the different updates come out throughout the year?

[Thomas Tippl:]

Jeetil, let me take the first question, online growth. We think that outside of World of Warcraft subscription revenue, all other digital revenue streams will show significant growth year-over-year. But as you know, we're starting the year with a lower WoW subscriber base. So I think -- our planning assumption at least doesn't include that we're going to lap the strong numbers we have delivered in 2011 on WoW subscriptions.

[Robert A. Kotick:]

With respect to Elite, Jeetil, it's early days. When you look at the value, if you just take the value of downloadable content and the discount that would be applied to all the DLC, Elite is an enormous value. And I think as you start to roll out the service on multiple platforms, you'll start to see that, that rate has a possibility of improving.

[Operator:]

And next we'll go to Neil Doshi with Citi.

[Neil A. Doshi:]

Mike, I was wondering if you could provide us a little more detail around the subs for World of Warcraft. What was the impact from some of your marketing efforts? And then how many subs did you add from Brazil? And if you have any comments on trend that you could share with us, that would be great.

[Michael Morhaime:]

Okay. So we were very pleased with the results of the marketing initiatives in Q4. The Chuck Norris spot was very effective. We've got over 29 million views of the spot on YouTube. And I think, just looking at how well the subscribership held up during our most competitive quarter ever, we're very happy with that. Engagement of the player base is very strong. We do not break down regional. We do not provide regional breakdown of subs, but we're off to a good start in Brazil. And I don't have any detail on churn.

[Operator:]

And next we'll move on to Brian Pitz with UBS.

[Brian J. Pitz:]

Just a follow-up question from the last one on World of Warcraft, given the subs. Obviously, the competitive launch was very late in the quarter. Can you give us any indication on what users have actually done since the end of the quarter? Have you seen churn ramp up post that launch? And then a quick question on Call of Duty. Despite strong results, very strong results for the franchise, if you look at the NPD numbers for December, they’re actually below last year's levels for Black Ops. Can you give us any color there?

[Michael Morhaime:]

Well, the most significant thing from the World of Warcraft standpoint for us was the launch of our free content update at the end of November where we made significant improvements to the end game, which is extremely important for long-term player retention. And the community response to the update has been very positive. And as we've seen with other updates like that, it has been successful in driving engagement. And I don't -- we don't provide interim updates in terms of post-quarter end, other than to say our strongest competitor did launch in December, and December was a good month for us.

[Eric Hirshberg:]

And as for Call of Duty and the NPD data you cited, I would answer by saying that we had a very effective launch. And part of that launch was our most effective and aggressive pre-order program ever, which drew a lot of the business forward. So I think it's not unexpected that the shape of the curve looks a little bit different than years past immediately following that. But the launch was the most effective ever. The pre-order program was the most effective ever, and it's the best-selling game ever in a single year.

[Robert A. Kotick:]

If you recall, we did $1 billion in 16 days, which, for any entertainment medium, was a record.

[Operator:]

And next we'll hear from Ben Schachter with Macquarie.

[Benjamin A. Schachter:]

Guys, I was wondering if I can get a sense of how big Skylanders might be as a percentage of revenue in 2012. And just in general, non-COD or World of Warcraft as a percentage of revenue in 2012? And then separately, there's just been a lot of discussion recently about online gambling, and I was just wondering how Activision could potentially play with that -- play in that with its current brands or even potentially just going into traditional casino games. Any thoughts on that would be great.

[Robert A. Kotick:]

It’s really 2 things, Ben. All we have to say about Skylanders in 2012, it’s going to be giant. And there won't be any Skylander gambling this year. So Skylanders, a lot of momentum. We had some limited supply last year on toys. We're working to correct that as quickly as we can. We think the product plan for Skylanders this year is outstanding, and we've been very pleased with the success so far. On online gaming, while we have expressed an interest and we think that there's opportunity, it's a very long-term opportunity.

[Operator:]

And moving forward, we will hear from Doug Creutz with Cowen and Company.

[Douglas Creutz:]

Another question on Warcraft. It looks like your subscription revenues, your revenues for the game, not just subscriptions, were down about 10% sequentially. And given that the subs were relatively flat, I was wondering if you can give some color around why, I guess, the ARPU was down so much.

[Thomas Tippl:]

Yes. One of the factors that impact that is our Annual Pass promotion where we effectively, for the combination of products, gave a certain discount through the free delivery of Diablo and amount. So we're applying that discount on a pro rata basis across all of those products. So we've been recognizing on both Annual Pass subscribers lower market subscription run rates...

[Eric Hirshberg:]

Effective at the time [indiscernible].

[Thomas Tippl:]

Than what you've seen before we started the Annual Pass promotion.

[Operator:]

And next we'll hear from Brian Karimzad with Goldman Sachs.

[Brian Karimzad:]

If you don't mind providing an update on the Call of Duty development in China and maybe how some of the coming releases of competitor titles there is causing you to maybe change course a bit on development? And then on free cash flow, Thomas, do you mind walking us through some of the factors in the decline? And was it the free cash flow itself that kept you at a lower realized buyback level in '11 versus '10? And how we might need to think about that for '12?

[Eric Hirshberg:]

On Call of Duty China, in relation to your question, the development is going very, very well. And we feel that the level of graphic fidelity and gameplay that we're seeing will be breakthrough for the competitive marketplace. In terms of other competitors entering the market, we simply feel that we come in with a tremendously strong advantage, and that Call of Duty is already viewed as the premium first-person shooter in China, very high awareness going in. And the game itself will over-deliver we believe for the competitive set.

[Thomas Tippl:]

And on your cash flow question, and you will note that last year, we delivered cash flow significantly above net income, which was possible because we made some significant improvements on the inventory front as we were unwinding the Guitar Hero business, so obviously, that's an event that doesn't happen every year. If you look at our free cash flow as a percentage of net income, we always said we should be trending above 80% of net income in terms of free cash flow. We continue to do that. And then cash flow, the free cash flow number for the year, the balance sheet item happened on one particular day in the year, which is December 31. There are always some shifts back and forth between the year from a receivables or a payables perspective. But I think our cash flow is fundamentally strong. Our net income to free cash flow conversion is strong and continues to track ahead of our 80% objective. So we feel pretty good about that.

[Operator:]

And our last question will come from Edward Williams with BMO Capital Markets.

[Edward S. Williams:]

A couple of questions on Call of Duty Elite. Can you talk a little bit about what the engagement is like of Call of Duty Elite from your paid subscribers versus the free users of it? And also, can you comment a little bit about the growth rate of paid subscribers since the game has launched? Is this something that should remain somewhat static between now and the release of the next Call of Duty title? Or should it build as we get closer to that title over time?

[Eric Hirshberg:]

I'll answer your second part of your question first. We think that there will be natural spikes surrounding the release of DLC, and that it's sort of, if the current patterns are any guide, it’ll remain somewhat constant between those spikes. But as more and more DLC becomes available to play, the value of the $50 subscription rate gains in value for subscribers. As far as engagement, it's very early going. We've seen strong engagement from our paid subscribers. We've seen, not surprisingly, slightly less engagement from our free subscribers. But overall, we had some technological bumps at the very beginning that led to some frustration in our user base. That's why we gave the first month away free. And since we've stabilized the service, we see the engagement increasing.

[Operator:]

And that is all the questions we have time for at this time. I'd like to turn the conference back over to management for any additional or closing remarks.

[Kristin Mulvihill Southey:]

Well, thank you all. On behalf of everyone at Activision Blizzard, we thank you for your time and consideration and look forward to speaking to you in the future.

[Operator:]

Thank you, ma'am. And that does conclude today's conference. We thank you for your participation. You may now disconnect.