Activision Blizzard, Inc.
Q3 2012 Earnings Call Transcript

Published: 8 Nov 2012

[Operator:]

Good day, and welcome to Activision Blizzard's Q3 2012 Results Conference Call. Today's call is being recorded. At this time, for opening remarks and introductions, I'd like to turn the call over to Ms. Kristin Southey. Please go ahead.

[Kristin Mulvihill Southey:]

Good afternoon, and thank you for joining us today for Activision Blizzard's Third Quarter 2012 conference call. With me today are Bobby Kotick, CEO of Activision Blizzard; Thomas Tippl, COO of Activision Blizzard; Dennis Durkin, 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 are forward-looking statements that are based on current expectations and assumptions that are subject to risk and uncertainty. As indicated in this 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 statements. Such factors include, without limitation, sales levels; current macroeconomic and industry conditions; increasing concentration of titles; shifts in consumer spending trends; our ability to predict consumer preferences among competing genres and hardware platforms; maintenance of key relationships, including the ability to attract, retain and develop key personnel and developers that can create high-quality hit titles; the seasonal and cyclical nature of our industry; changing business models, including digital delivery of content, competition, including from used games; possible declines in prices, 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; counterparty risks; economic, financial and political conditions and policies; foreign exchange and tax rates; and potential changes 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 ending December 31, 2011, 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 forward-looking statements in this presentation are based on information available in the company as of the date of this presentation and, while we believe them to be true, may ultimately prove to be incorrect. The company undertakes no obligation to release publicly any revision to any forward-looking statements to reflect events or circumstances after today, November 7, 2012, or to reflect the occurrence of unanticipated events. I'd 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 stock-based compensation, expenses related to restructuring, the amortization of intangibles and impairment of intangible assets and goodwill and the associated tax benefits. Please refer to our earnings release which is posted at www.activisionblizzard.com for a full GAAP to non-GAAP reconciliation and further explanation. 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 12-quarter financial overview, highlighting both GAAP and non-GAAP results on a one-page summary sheet. And now I'd like introduce our CEO, Bobby Kotick.

[Robert A. Kotick:]

Thank you, Kristin, and thank you for joining us today. 2012 is on track to be another record year for Activision Blizzard. For the first 9 months of 2012, we achieved new records for non-GAAP revenues, operating income and earnings per share. And for 3 consecutive years, we’ve produced over $1 billion of operating cash flow for the trailing 12-month period ending September 30. We continue to strengthen our franchises and expand our portfolio of leading interactive brands. Year-to-date, Diablo III is the top-selling game overall based on an estimated digital and retail sales in North America and Europe. Diablo III has already sold an excess of 10 million copies, proving once again that investing in key talent and our top franchise is worth the wait. Our newest intellectual property, Skylanders, is the top-selling console and handheld game at retail in North America and Europe and has already generated life-to-date revenues in excess of $500 million. Call of Duty is one of the world's most popular entertainment franchises and continues to set records for online engagement. And World of Warcraft remains the most successful massively multiplayer online game ever created. Our franchises and the extraordinarily talented Activision Blizzard employees around the world who oversee them drove our record results for the first 9 months, and their efforts and commitments to excellence will likely result in another year of record results for all of 2012. Based on our strong execution year to date and increased visibility of markets and products in the fourth quarter, we are raising our 2012 outlook and expect to deliver increased non-GAAP revenues year-over-year and double-digit non-GAAP EPS growth for the third consecutive year. We also continue to strengthen our competitive position by doing what we do best, staying focused on driving our business by prioritizing our biggest opportunities and not getting distracted by initiatives unlikely to result in the creation of great interactive entertainment and superior shareholder returns. Our track record of identifying the largest opportunities, aligning our talented employees against those opportunities and building leading franchises, is unrivaled in our industry. While we have a promising pipeline of great games based on proven franchises, as well as exciting new projects like our collaboration with Bungie, we recognize that duplicating this year's success will be difficult. Nevertheless, we'll remain focused on delivering the very best games, ensuring that our company is the very best place to work, providing an environment that fosters the commitment to excellence we have become well-known for and, of course, over the long term, providing superior returns to our shareholders. As we look to calendar 2013, we remain cautious in light of a challenging worldwide macroeconomic environment, the ongoing console transition and difficult year-over-year comparables as a result of Blizzard's record-shattering success with Diablo III in 2012. Over the past 20 years, we and our stakeholders have benefited greatly from focus, discipline and an unyielding commitment to excellence, coupled with a long-term view of value creation. We'll continue to acknowledge and honor the dedication and hard work of our incredibly talented employees, the continued enthusiasm of our audiences and the patience and support of our shareholders as we maintain our position as the world's leading interactive entertainment company. And now I'd like to pass the phone over to Dennis, who will take you through the results of the quarter and balance of the year.

[Dennis Durkin:]

Thanks, Bobby. Good afternoon, everyone. Today, I will begin with a recap of our better-than-expected third quarter and year-to-date results. I'll then cover our increased outlook for 2012 and provide some initial comments on 2013. Starting with our results. Please refer to our earnings release for full GAAP to non-GAAP reconciliations. For the third quarter, on a GAAP basis, strong consumer demand for our premium content and services drove better-than-expected and record results, with revenues of $841 million, digital revenues of $430 million and EPS of $0.20. For the third quarter on a non-GAAP basis, revenues increased 20% versus the prior year to $751 million. Digital revenues set a third quarter record at $427 million, guiding an operating margin increase of 690 basis points, while EPS more than doubled over the prior year to a record $0.15. Turning to specific P&L items, please note all percentages are based on revenues except for the tax rate. For the quarter, GAAP product costs were 24%, and GAAP operating expenses were 49%, below our outlook due mainly to revenue outperformance. Our GAAP tax rate was near 0 due to a one-time benefit from a discrete item of $46 million, or $0.04, resulting from the closure of a premerger IRS audit related to net operating losses from Vivendi Games. Non-GAAP product costs were 26%, and operating expenses were 53%, below our outlook also due mainly to revenue outperformance. Our non-GAAP tax rate was also near 0 due to the one-time discrete item I just mentioned. For the first 9 months of the year, strong retail and digital sales of our 4 mega franchises, World of Warcraft, Diablo, Call of Duty and Skylanders, drove new records for non-GAAP revenues, operating margin and EPS. In terms of the balance sheet, on September 30, we had no debt and $3.4 billion in cash and investments, or approximately $2.85 per fully diluted share. For the trailing 12 months ending September, our operating cash flow was over $1.2 billion and after capital expenditures, our free cash flow was $1.15 billion, a level that far exceeds other independent interactive entertainment companies, and this represents our third consecutive year of generating operating cash flow and free cash flow in excess of $1 billion for the trailing 12 months, and that's after making significant investments in our strong multiyear pipeline and back end infrastructure. Our ability to not only invest but also generate high returns on investment is what continues to set us apart from most of our competition. As we laid out at the beginning of the year, we continue to focus on driving execution against the following objectives in 2012

[Eric Hirshberg:]

Thanks, Dennis, and hello, everyone. Today, I'll briefly touch on the macro industry trends we're seeing and then get into our recent performance and our blockbuster Q4 launches. The retail trends that we've seen over the past few years are continuing this year with the top 5 games in North America and Europe, growing 15%, including toys and accessories. However, this growth has come at the expense of the rest of the industry. While challenging, these trends play to our strengths, given our laser-focus on our largest and best franchise opportunities, and our performance this year so far continues to validate that strategy. So let's get into it. Skylanders

[Michael Morhaime:]

Thanks, Eric. The third quarter for Blizzard was a very successful one, thanks in large part to the launch of Mists of Pandaria at the end of September. As of the first week, more than 2.7 million copies sold through, and subscribership had grown to over 10 million at the end of the quarter. We also launched the game in China just one week after the other regions, which as far as we are aware, is the first time any game has officially released in China as part of a global launch. Overall, it was a successful launch, and we were very pleased with the reaction from players and critics. The team worked hard to create a good variety of deeply engaged content for a wide range of players. The challenge mode and the new raids had been very appealing for hard-core players, while our other new features, such as the pet battle system, have been popular with players across the board. This breadth of new content, combined with a vast amount of existing content in World of Warcraft, has resulted in a game that has a lot to offer for veterans as well as newcomers to online gaming. We're looking forward to maintaining engagement by providing more frequent content updates. The first major update to Mists of Pandaria is already in public testing, with additional updates to follow. We have other initiatives planned for the holiday season that we hope will maintain momentum from the launch and continue growth in the community. Moving on to Diablo III. The game continued to sell very well in the quarter, riding the momentum from its record-breaking launch in May. We've updated the game several times to add new features, and these changes have been received well by the community. Next on the slate for Blizzard will be Heart of the Swarm, the first expansion to StarCraft II. With 6 million copies of Wings of Liberty sold to date, we have a large community of players eagerly awaiting the next installment of StarCraft. Beta testing for Heart of the Swarm is well underway, and the development team has been collecting great feedback from the community. Just last week, we made a major content update to the beta in order to test some important community features, which have been well-received by players. These features are designed to improve the social aspect, as well as the overall user experience for StarCraft players. We're working hard towards a first half 2013 launch for Heart of the Swarm. We plan on closing out 2012 with one more major initiative, our Battle.net World Championship event, which will take place on November 17 and 18 in Shanghai, China. This event is the culmination of months of intense eSports competitions, involving dozens of online tournaments and live events across 5 continents. The global finals will be very much like a World Cup of eSports with more than 60 top pro gamers in StarCraft II and World of Warcraft competing at the event. The sold out Battle.net World Championship will be broadcast online to a global audience. Live streams and information about the tournament can be found at www.battle.net/bwc. In closing, we're very pleased with the success of Mists of Pandaria, and Diablo III continues to be a top seller on the PC charts. Heart of the Swarm is well on its way, and we have other exciting projects in the pipeline. BlizzCon will be returning next year as well, adding to what will be a busy 2013 for Blizzard. We continue to build on our infrastructure for long-term growth and remain focused on creating high-quality content for all of our players around the world. Thanks, and I'll turn the call back over to Kristin.

[Kristin Mulvihill Southey:]

Okay, operator, we will take questions.

[Operator:]

[Operator Instructions] First will be Mike Olson with Piper Jaffray.

[Michael J. Olson:]

I realize there's not a ton that you can really say about the next gen consoles, but can you give us a flavor for kind of whether some of your key titles, Call of Duty, et cetera, are bumping up against limitations of the current hardware? In other words, will a more powerful processor and whatever else is incorporated in the new consoles be materially beneficial to a title like that?

[Robert A. Kotick:]

Yes, Mike, thanks for the question. There's really nothing that we can say about next generation hardware.

[Michael J. Olson:]

Okay. And then, I guess, maybe quickly then on Skylanders. I'm guessing you don't want to announce a kind of unit number right now, but is there any indication on that front that you can give us for how that's tracking? Secondly, you mentioned on Call of Duty that pre-orders are up. We're seeing some kind of conflicting data points there with some third-party sources saying that pre-orders are down. So just anything that you can say to kind of reconcile what's out there and what you may be seeing?

[Eric Hirshberg:]

I'll start with your second question first. I can confidently say that my comments were accurate and the pre-orders are in fact tracking ahead of MW3 for Black Ops II, so I don't know what data you're receiving, but that's the case. On Skylanders, as I said, we're tracking well ahead, and we have a situation where we've got the brand momentum behind us, we've got higher awareness, a better assortment of toys, and the wind's at our back. So we can't provide more detail than that at this point, but we're feeling good.

[Operator:]

And moving on, our next question comes from Daniel Ernst with Hudson Square Research.

[Daniel Ernst:]

Two questions, if I might. First, for Eric, I wonder if you could comment on your thoughts around the Wii U, specifically for Call of Duty, maybe not -- that's not something that someone who has an Xbox or a PS3 is going to transition to the Wii U to play that, but maybe a Wii family that now has a kid who's old enough who wasn't when they got the Wii to jump into Call of Duty, is that a platform you think is going to be viable for that franchise? And then second, on -- I'll try the -- for Bobby, the question on next gen a little bit different way. Dovetailing some comments you made in the opening remarks about not placing resources on things you didn't think we’re going to create shareholder value and where your franchise were going to do well, specifically things like Facebook or overbuying in the mobile space, and then a couple of years ago, there was a lot of fear there wouldn't ever be another console cycle because things like OnLive were going to divert energy from that space. And so now as we're approaching what appears to be another console cycle, you who have lived and grown through a number of them, are we going to have another console cycle? Is this going to be another successful period for the gaming industry where new hardware comes along and developers take advantage of that capability and come up with new experiences and grow the business?

[Robert A. Kotick:]

I wish I could give you a more complex answer, but the truth is we can't really talk too much about next generation console plans, but I think it's safe to say you have a Wii U coming out, and there will be another new console coming, and we expect that there'll be very successful as they have been for 135 years at Nintendo. And we always evaluate all platforms with an eye towards being able to create the most compelling differentiated content. And whether it's Facebook as a platform or tablets or mobile devices as platforms, once we think that we can put our best creative foot forward and we can deliver something that's compelling and engaging and meaningfully different and really capitalize on the capabilities of a new platform, we'll support it.

[Eric Hirshberg:]

And as for Call of Duty on Wii U, if you saw our presentation at the Wii U press event, I think most of the consensus, and we wholeheartedly agree, we think that Call of Duty looks great on the Wii U. We think it's a big step in the right direction for the types of games that we tend to make. The focus on a more robust online platform and the more -- the increased processing technology makes it a very legitimate experience. We think it will be a legitimate platform for the franchise.

[Operator:]

And our next question comes from Neil Doshi from Citi.

[Kristin Mulvihill Southey:]

Operator, do you want to put someone else on then?

[Robert A. Kotick:]

Thank you, Neil.

[Operator:]

Okay. Our next question will come from Brian Karimzad from Goldman Sachs.

[Brian Karimzad:]

First one, Dennis, I heard the free cash flow number, but I didn't hear a share repurchase number. It looks like the share count didn't change much in the quarter. Can you comment on that?

[Dennis Durkin:]

Yes, sure. Thanks, Brian. For obvious reasons, we don't really get into specifics on our buyback strategy. I guess I would note that year-to-date, we have returned more than $500 million to shareholders via dividends and buybacks. I think that over time we'll continue to focus on the long-term operating principles, which we've talked about and managed the business against for many years, which is focusing on a strong balance sheet, which we've mentioned on every call, strong cash flow and high return on invested capital.

[Brian Karimzad:]

By the way, has something changed kind of on your view on the intrinsic value, kind of where you want to participate on it, because it's a meaningful reduction in the buyback versus the prior base [ph]?

[Dennis Durkin:]

Yes, like I said, we just don't comment specifically about our buyback strategy.

[Brian Karimzad:]

Okay. And then on the factors that are unique to this year, the $0.25 add up there with Diablo and the tax benefit, you didn't include the payout to -- on the Infinity War judgment. Was that matter of that being confidential or -- help us with that a bit?

[Dennis Durkin:]

Yes, all of our legal agreement and settlements are obviously confidential. What we want to do is just call out a couple of the very important things that are impacting our great success this year and are not likely to recur next year. There's obviously a lot of puts and takes when you look at the 2013 plans relative to what will be inside of 2012. We're in the process, as a management team and as a business, of building our annual operating plans, which happens at this point every year and building that from the bottoms up, and we'll have a lot more details on the specifics of that in our next call. We really just want to call out those 2 specific items relative to the great record-shattering performance of Diablo III and then the discrete tax item that was about $0.25 [indiscernible].

[Brian Karimzad:]

Okay. And then on the Call of Duty Elite change, I understand the rationale you explained, but I'm curious, was this an opportunity as well to approach the console makers themselves, maybe have some discussions on the economics there, given the additional value you're providing free on a platform that consumers are actually paying them to be part of?

[Robert A. Kotick:]

No, I think what we said is the most important is we want to deliver the best possible user experience to our players, and we felt that the features and functions that were incorporated into Elite should be available to all of our players.

[Brian Karimzad:]

Okay, but I mean, generally, as a philosophy, is that something you're still trying to pursue?

[Robert A. Kotick:]

What, as a philosophy, is something…

[Brian Karimzad:]

The idea of improving the economics on the console platform, given the scale of Call of Duty?

[Robert A. Kotick:]

I think we -- like we said, with respect to Elite, it really was a decision that was about our players. Generally, I think we -- whatever it is that we're evaluating as an opportunity is always with an eye towards improving shareholder value.

[Operator:]

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

[Neil A. Doshi:]

Mike, can you talk a little bit about how Mists of Pandaria is doing in China and what sort of traction you're seeing there? And then, also, could you guys comment on mobile? I know it's pretty small right now. We've seen a pretty nice uptick in terms of mobile games on iOS. At what point is -- I guess at what point do you see a tipping point where Activision Blizzard can get more religious on mobile? Is it more on the hardware side i.e. better graphics and better processing power? Or is it more in terms of adoption and how you can really bring the games to the mobile platform?

[Michael Morhaime:]

Okay. So on the first question, we're very pleased with the reception in China. Players seem to be really enjoying the game. We’ve seen an increased engagement in China as we have in all of the regions. Specifically with respect to China, I can share that we did hit a peak in currency over 1 million users, and so we're very happy to see that as well.

[Eric Hirshberg:]

And on mobile, I think that we're pleased with the fact that in our first year of this kind of prudent investment, we were able to release 4 top-rated and top-selling games on iOS, and it's a Software-as-a-Service, so it takes time to build the install base and to see the monetization really gain traction. I can't give any specific timings as to where that tipping point you referenced might come, but we think we're making investments at the right scale in line with the opportunity.

[Operator:]

And moving on to Brian Pitz with Jefferies.

[Brian J. Pitz:]

You beat non-GAAP revenue guidance by about $60 million or so, but you're raising guidance by about $175 million. Can you give as any color on what is driving the optimism as you head into the fourth quarter, maybe the top 2 or 3 drivers there. And just real quick on Skylanders, any update on tax rates compared with last year?

[Dennis Durkin:]

Sure. The second question was on Skylanders and tax rates. I'll -- it's Dennis speaking. I'll speak to that. Obviously we feel very good in raising our number, the $0.11 raise on non-GAAP for the full year getting up to $1.10. We have obviously better visibility now into what the pre-orders look like for Call of Duty and some more comfort relative to that. And then Skylanders is off to a very, very strong start. And I’d just say on both of those, with both of those properties we have better and stronger retail support than we've ever had. Eric talked earlier about the square footage of retail and the expansion of that. I think the merchandising is better than we've ever had. And when you look at our Q4 guidance year-over-year, a lot of that's attributable to the fact that the bullishness that we have relative to Skylanders in Q4 in particular.

[Operator:]

Next will be Colin Sebastian with Robert Baird.

[Colin A. Sebastian:]

I know this question may be a little bit unfair, but on Skylanders for some context, Eric, I'm wondering if we should think about the franchise as having a profile similar to Guitar Hero, which had a healthy business for a couple of years. Or does the game and toy integration like we have with Skylanders, does that potentially present a much longer shelf life in your view? And I have a quick follow-up.

[Eric Hirshberg:]

All I'll comment on is what I said in my earlier comments, which is that we have a pipeline already in development of just spectacular innovation. And we think that's the key to continued robust performance for the franchise, and we think that we can continue to surprise and delight and exceed kids' expectations. And as far as the reference to Guitar Hero, while there is a new play pattern that's been introduced with Skylanders, I think that's fair, I would say that this is a combination of 2 play patterns that have been pretty healthy for a long time. Toys have been in existence since the beginning of time, and video games are a pretty healthy industry, and we brought the 2 together in an unprecedented way. So we feel very bullish about the long-term potential of the franchise.

[Colin A. Sebastian:]

Okay. And then second, Bobby, you've been pretty consistent on your high-level comments, I think, about 2013. And I wonder how we should think about the impact on current gen software sales, whenever it is that the buzz really starts to build for new hardware and if that's a factor in your cautious remarks about next year.

[Robert A. Kotick:]

Well I think what we've seen historically is, as you get deeper into the cycle, you start to see pricing change for all but the most desired titles. And we've had a very long cycle for PlayStation 3 and Xbox 360, and it's probably prudent to be thinking about pricing changes as you continue to get deeper in the console transitions.

[Operator:]

The next question is from Justin Post with Merrill Lynch.

[A. Justin Post:]

First, on Call of Duty, does your outlook this year, I know you're revising it upward, can you tell us if you're expecting units or revenues to grow year-over-year versus last year for the total franchise? And then second, I appreciate the outlook for '13 and some help with that. I think, Eric, you mentioned in your comments that I think you're expecting the Call of Duty China launch and a Bungie launch. Were those -- were you meaning to say that those would be next year? And can you give as any framework around -- I know you won’t give us revenues, but maybe a framework around the opportunity for those 2?

[Dennis Durkin:]

Why don't I start? And Eric if you want to talk, [indiscernible], but I guess just as it relates to Call of Duty outlook for the year, as we said for -- since the beginning of the year, we have it forecasted to be modestly down, and we always plan very conservatively and prudently. We're optimistic about seeing the pre-order number, but in terms of our financials, that's how we do our forecasting. And then as it relates to the title, as we mentioned in that, there wasn't -- Eric, I think was talking about the pipeline. He wasn't talking about any specific launch date.

[Eric Hirshberg:]

Yes, we haven't confirmed any launch dates. I was speaking about our future opportunities, investments. We’ve still got a lot to do this year, and we're looking forward to talking to you about next year on next year's call.

[Operator:]

Next will be Doug Creutz with Cowen and Company.

[Douglas Creutz:]

For Mike, maybe I wanted to follow up. You mentioned you're at above 1 million peak in current users in China. I just wondered how that maybe compared to levels that you've hit after prior expansion launches. And then secondly, if you could just talk about where you are with DOTA All-Stars?

[Michael Morhaime:]

Sure. Let me start with the second one, which is Blizzard All-Stars is in development, and we're doing some great work. Some internal testing is underway. We're doing a lot of things to experiment with game play, and I don't really have anything concrete to announce on this call, other than we're very excited about the game. So with respect to China, I really don't have anything to announce in terms of historical comparables. I think -- other than to say that the engagement has increased with the launch of the expansion, and we're very happy with the reception.

[Operator:]

And our last question will come from Stephen Ju with Crédit Suisse.

[Stephen Ju:]

So, Mike, the prior iterations of Diablo seem to have had an expansion pack released about 1 year after the game itself came out. So wondering if you have anything you can share in terms of whether or not you have a similar plan for Diablo III to keep your users engaged. And I'll ask the Call of Duty Online question another way, if you can update us on the beta testing schedule if you can and subsequently when we can expect a commercial launch.

[Michael Morhaime:]

So we do have a plan -- an expansion planned for Diablo. I don't have any timeline to talk about. I think that the most important thing for us always comes down to the quality of the expansion and the gameplay, and so that will be a big factor in terms of driving our schedule.

[Eric Hirshberg:]

And as for China, while you used different words, I don't know if you succeeded in asking it a different way. We haven't made any announcements on either our beta schedule or our launch and don't have any announcements today.

[Operator:]

And that does conclude the question-and-answer session. I'll now turn the conference back over to you for any additional or closing remarks.

[Kristin Mulvihill Southey:]

Well, on behalf of everyone at Activision Blizzard, we want to thank you for your time and consideration. And we look forward to speaking with you again in February. Thank you.

[Operator:]

Thank you. And that does conclude today's conference. We do thank you for your participation today.