Activision Blizzard, Inc.
Q4 2012 Earnings Call Transcript

Published: 8 Feb 2013

[Operator:]

Good day, and welcome to the Activision Blizzard's fourth quarter 2012 results 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 the Senior Vice President of Investor Relations, Kristin Southey. Please go ahead, Kristin.

[Kristin Mulvihill Southey:]

Good afternoon, and thank you for joining us today for Activision Blizzard's fourth 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 and are subject to risk and uncertainty. 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 statements. Such factors include, without limitation, sales levels; current macroeconomic 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; the console transition; adoption rate and availability of new hardware and related software; rapid changes in technology and industry standards; the current regulatory environment; 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 most recent Annual Report on Form 10-K for the period and on 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 to 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, February 7, 2013, 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 to introduce our CEO, Bobby Kotick.

[Robert A. Kotick:]

Thank you, Kristin, and thank you all for joining us today. 2012 was another great year for Activision Blizzard. We achieved record fourth quarter and annual results. And in 2012, on a non-GAAP basis, we generated approximately $5 billion in revenues, a 34% operating margin and EPS growth of 27% over the prior year. We increased our operating cash flow by 41%. Our strong cash flow has given us the flexibility to invest in our portfolio and product pipeline, while also returning $3.8 billion to investors since 2009 through dividends and share repurchases. Today, we announced our Board of Directors has increased our annual cash dividend to $0.19 a share. Our 2012 results are due to the drive, passion and creativity of our employees around the world. Their efforts, aligned with our focused long-term strategy and investment discipline, produced strong creative and financial results for our company. In the U.S. and Europe, we were the #1 video game publisher at retail, with the #1 title overall, the #1 console title and the #1 PC title. We were also the #1 independent Western Digital game publisher and had the #1 subscription-based MMORPG. Skylanders, our newest franchise, which is both toys and video games, has life-to-date sold in excess of $100 million toys and generated revenues of approximately $1 billion. This week, Activision Publishing revealed the third game in the Skylanders franchise for holiday 2013. And while there are new entrants in the category and challenges from slower than expected adoption of the Wii U, we remain enthusiastic about Skylanders' future prospects. Our success in 2012 was also attributed to the significantly better performance of Blizzard's Diablo III. And while we had a strong 2012, we recognize that 2013 is a transition year, as we enter the ninth year of the current generation of console video game systems. We encounter new threats from unproven business models, and we compete against new category entrants. We aren't immune to unfavorable market dynamics, but we have navigated through the transitions many times before, and we are well prepared to do so again. Our discipline and focus have served us well and we believe they will continue to do so for the very long term. In 2013, we'll continue to execute against the proven strategy of investment in our established franchises, selectively introducing new concepts like Skylanders, and managing our costs very carefully. Activision Publishing will continue to invest in Call of Duty and Skylanders, along with Bungie's new universe and Call of Duty online for China, each of which is being developed with quality and innovation that has the potential to redefine their respective categories for the future, and we hope will add value for our shareholders in future years. Blizzard plans to launch StarCraft II

[Dennis Durkin:]

Thank you, Bobby. Good afternoon, everyone. Today, I will begin with a recap of our better-than-expected Q4 and full year 2012 financial results and then, I'll review our outlook for 2013 and for Q1. Beginning with our Q4 results, please refer to our earnings release for full non-GAAP to GAAP reconciliations. Also, the numbers I'll be quoting are compared to the prior year unless otherwise noted. Q4 was a record quarter for the company. Our combination of incredible people, deep global franchises and the largest-ever hardware installed base were all key factors in not only executing against our plan, but exceeding it. First, let's walk through the Q4 numbers, which were largely driven by the Call of Duty and Skylanders franchises. For the quarter, on a GAAP basis, we generated better-than-expected revenues of $1.8 billion and EPS grew to a fourth quarter record of $0.31. On a non-GAAP basis, we generated better-than-expected revenues of $2.6 billion, digital revenues increased 22%, our operating margin expanded over 750 basis points to 44%, operating income exceeded $1 billion for the first time in a quarter and EPS grew 26% to a record $0.78. Turning to specific P&L items. Please note that all percentages are based on revenues except for the tax rate. For the quarter, GAAP product costs were 31%, GAAP operating expenses were 42%, below our outlook, due mainly to revenue overperformance. Our GAAP tax rate was 27%. Non-GAAP product costs were 28% and non-GAAP operating expenses were 27%, again below our outlook due mainly to revenue outperformance. And our non-GAAP tax rate was 23%. Our solid execution in Q4 anchored what was a record year for Activision Blizzard. For the full year, on a GAAP basis, we generated revenues of $4.9 billion an operating margin of 30% and EPS of $1.01. On a non-GAAP basis for the calendar year, we generated better-than-expected revenues of nearly $5 billion. We expanded our operating margin 380 basis points to 34% and grew EPS 27% to $1.18, both records. We exceeded our initial non-GAAP EPS expectations of $0.94 based on the large scale success of Diablo III and Skylanders. In terms of cash flow in 2012, we generated over $1.3 billion in operating cash flow, an increase of more than $390 million over the prior year. Over the last 4 years, we have generated more than $4.8 billion of operating cash flow. And today, as Bobby mentioned, the Board of Directors approved, once again for the third straight year, an increase to our cash dividend, which now stands at $0.19 per share. Now moving to 2013. We expect 2013 will be a competitive and challenging year given the macroeconomic conditions and the uncertainty that surrounds console transitions. For those of you who remember, the last transition was disruptive, volatile and financially difficult to predict. Additionally, we had some tough year-over-year comparisons given Blizzard's unprecedented success with Diablo III and our favorable tax benefits in 2012. That said, our product lineup is expected to be anchored by 4 of our top franchises

[Eric Hirshberg:]

Thanks, Dennis. I'm pleased to announce that in 2012, we delivered Activision Publishing's most profitable year ever, even better than the record year we had in 2011. We ended 2012 with 4 of the top 10 games in the U.S. and Europe combined, including toys and accessories. And we delivered revenues of over $3 billion and a record 32% operating margin. Of course, none of this would be possible without the talent, passion and commitment of the best teams and employees anywhere in the entertainment industry, as well as all of our retail partners around the globe. And I want to thank each of them for helping us achieve this record milestone. In 2012, in the U.S. and Europe combined, Call of Duty was the #1 video game franchise and Skylanders was the #3 video game franchise. 1 year ago on our earnings call, I said that we believe Skylanders is on its way to becoming our next billion-dollar franchise. And today, I'm pleased to announce that Skylanders has crossed the $1 billion threshold in revenues just 15 months after its debut. This year, our consistent focus in deep investment has once again paid off. Black Ops II was the biggest game of the year and the fastest entertainment property ever to reach the $1 billion mark, which it did in just 15 days. Based on unique users, Black Ops II was the most played game on Xbox LIVE during 2012. And despite strong competition from new games, Call of Duty

[Michael Morhaime:]

Thanks, Eric. 2012 was a busy year for Blizzard Entertainment. We had some very ambitious goals and successfully shipped 2 games, Diablo III and World of Warcraft

[Kristin Mulvihill Southey:]

Thank you. Operator, we'll be ready to take some questions.

[Operator:]

[Operator Instructions] We'll take our first question from Eric Handler with MKM Partners.

[Eric O. Handler:]

My question deals with Skylanders, and how you think about the franchise going forward if, in fact, we do have a new console cycle. What percentage of people are playing Skylanders on the Wii, and if people start transitioning more, Nintendo's starts losing some share to new consoles for Sony and Microsoft, how the game might be impacted that way?

[Robert A. Kotick:]

Look, I think that's a very good question, Eric. And as you know, we were somewhat disappointed with the launch of the Wii U, and I think it's a challenging environment this year. And one of the things we are concerned about is what the installed base of hardware will be like for 6- to 11-year-olds. But we have a lot of confidence in the franchise for the long-term. I think we're delivering another great product this year. And Eric, you may want to say a little bit more -- but it's something we are concerned about.

[Eric Hirshberg:]

Yes, you pretty much covered that. We've done well on all platforms, is all I wanted to day. The franchise has done well on all platforms and historically, the strongest franchises going into a console transition are the ones that fare the best. So I think that positions us well for Skylanders future.

[Robert A. Kotick:]

Well, we haven't had any competition in the category. We have a new competitor and we are likely to have more. But we've invested a lot against it, we achieved a lot of good success so far and we have high expectations for the franchise going forward.

[Operator:]

We'll take our next question from Brian Pitz with Jefferies.

[Brian J. Pitz:]

What do you think about the World of Warcraft and MMO community? Do you think the audience essentially remains strong and willing to play? Or do you think they're essentially in need of a new game? Can you talk about, really, the fatigue factor both in the MMO, as well as with specifically for the game, and then, I just have a follow-up question.

[Eric Hirshberg:]

Well, we have seen an evolution in player behavior since the launch of Cataclysm. Players consume content quickly. There are more apps that come and go from the community, which is why we are targeting more frequent content updates. We are currently testing our second major update since Mists of Pandaria. I think that another thing to note is, if you compare the months following Cataclysm and the months following Mists of Pandaria, the trailing months have been stronger with Mists. And we have seen an increase in engagement in all regions with the launch of Mists of Pandaria.

[Brian J. Pitz:]

Bobby, a quick one. You've been a vocal supporter of games direct to the TV. With more Smart TVs out there and also, the pending launch of consoles, how should we be thinking about this kind of direct-to-TV phenomenon with respect to games?

[Robert A. Kotick:]

I'm not exactly sure I understand the question or what I supported historically. But I would say, another thing that we are concerned about is, as you start to see Internet-enabled televisions and the App Store reach the television with more -- with a much larger base, it's very hard for us to compete against free. I think there are challenges even at the $0.99. And so to the extent that you see a lot more Internet-enabled televisions, we're going to have the start thinking differently about the content that we would deliver to those Internet-enabled televisions.

[Operator:]

We'll go next to Neil Doshi with Citi.

[Neil A. Doshi:]

Dennis, it looks like we saw record high operating margins in Q4, both on the total company side, as well as on the Activision side. What drove this, and do you feel like this is kind of a long-term potential for the overall business? And then, Mike, if you can give a little more color on the China market, it seems like there's continuously intense competition there and most of the declines seem to come from the East. Is there anything you could do to be more competitive in that competitive market? And then any learnings you could share with the Activision side as they go in and launch Call of Duty China.

[Dennis Durkin:]

Sure. Neil, let me give you a couple of points on margins. Obviously, it was a very strong quarter margin-wise, and I think it speaks to our long-term strategy about being very focused and trying to build enormous franchises. And we saw that in Q4, and you can really see the scale benefits of that happening on our margin structure across the business. And yes, these are record margins for our business that we've ever had. So going forward, though, I think one of the things to think about -- and you'll see this in our guidance is relative to how margins play out over the next 12 to 24 months. Last year we had the benefit of being late in the console cycle, which gives you a lot of benefits from a development perspective and from a monetization perspective. And margins, traditionally, in past console cycles which you see our guidance compressed a little bit as you kind of work your way through the transition of that. So you'll see that reflected in our guidance from an OpEx perspective as revenue comes down relative to some of those new platforms and then, in out years it starts to grow again and margins expand. So that's kind of the, at least, the high level in terms of how we see margins playing out over time, but last year was really the benefit of being late in the cycle and having the largest franchises. Mike, I don't know if you want to...

[Michael Morhaime:]

Yes, so with respect to competition, we've always had competition for World of Warcraft in all markets. I think it's fair to say that competition has increased, but I think it's also important to point out that World of Warcraft is competing against, really, all forms of entertainment for leisure time. And so that just underscores the need for us to continue creating new content, to keep up engagements. With respect to China, in spite of the decline in subscribership, it is important to note that the engagement levels of the core audience did increase with the launch of the expansions and I think that, that suggests increased engagement by our core players.

[Operator:]

We'll go next to Brian Karimzad with Goldman Sachs.

[Brian Karimzad:]

I guess, quickly first, what's changed such as you're willing to publicly consider putting dead-on for strategic options? And then, Dennis, I have a housekeeping question on the add-up for guidance.

[Robert A. Kotick:]

Well, I can't say that there's anything we can answer with respect to that disclosure. But we always are -- contemplating, always, to return capital to the shareholders.

[Brian Karimzad:]

Fair enough. Dennis, I think I -- maybe I have a number transposed or something, but when I take the non-GAAP guide here, so $4.175 billion on the revenue side and then, it sounds like you're adding up to a 31% margin. And then, put the tax rate on that because it really, generally, isn't much in between, I'm getting to -- closer to $0.85 in EPS, so can you help me understand what I'm missing here?

[Dennis Durkin:]

Sure. Let me take you through our full year numbers on the GAAP side. I'm not sure where your math is breaking down, but I think we were pretty specific in terms of our announcement on that. So I can walk you through, I mean, I'd say it's probably best that we walk you through the numbers right after the call in terms of all the specifics, because it's -- if $0.80 is relative to what we have in there on our margin structure, COGS structure, revenue and totals.

[Operator:]

We'll go next to the Daniel Ernst with Hudson Square Research.

[Daniel Ernst:]

Bobby, relative to your comments about connected TVs and the efforts that you've had to date in console gaming with, first, you tried it with Call of Duty, tried the service for Wii and then it's transferred more to the Season Pass. In digital, on iOS, we have seen some interesting success with episodic content, specifically, the Walking Dead, and I wonder if that's a way that -- an issue you might be addressing, creating some more of a consistent revenue stream from consumers without the big ticket $60, $70 price tags for games. And then that brings me to related questions. When we look at next gen, in the last gen, we saw prices rise, because development costs were rising. Do you see the same upward pressure in development costs for this coming generation? Will it be the need for an upward trend in pricing, or is it not to be that traumatic this time around?

[Robert A. Kotick:]

Okay, so that's a lot of questions. I would say, the first the thing is that what we've seen today on our iOS-related content, relative to the business that we're in, we're not really moved to dial that significantly. Having said that, we're investing in a variety of initiatives. We're looking at those things carefully. There's nothing that we see on the near-term pipe pricing that's going to have a meaningful impact on our financial results. But we're an opportunistic company and we're always exploring new areas that could be reasonable returns for our shareholders. You know what? I don't really know how to answer your second question, to tell you the truth. Maybe you could be a little more specific.

[Daniel Ernst:]

Do you expect development costs to rise on a like-for-like basis for this coming next gen?

[Robert A. Kotick:]

So this is my 22nd year doing this, and in every single console transition, we've seen an increase in development costs. Over long periods of time, it gets smoothed out, but I would say this is not a transition where that's going to be an exception. We're going to have to figure out how to take advantage of the unique capabilities of new hardware, and that requires new skills and investment in tools and technology and engines and so yes, that's likely.

[Operator:]

We'll go next to Michael Olson with Piper Jaffray.

[Andrew D. Connor:]

This is Andrew Connor in for Mike. I promise I will not ask you any questions about the consoles. But my question is really about Call of Duty and the reacceleration that we saw in the month of December. I'm curious if that has anything to do with the focus on the multiplayer component of Call of Duty versus the single player campaign and whether that's a strategic focus for the franchise going forward?

[Eric Hirshberg:]

Well, I wouldn't say we're any more or less focused on multiplayer this year than we have been in years past. We delivered an extensive campaign, as well as a very deep multiplayer experience. I think that Treyarch did deliver an exceptional multiplayer game and it followed up with exceptional DLCs so far. And I think, as always, the quality of the content is the thing that drives our results the most.

[Operator:]

We'll go next to Doug Creutz with Cowen.

[Douglas Creutz:]

I wonder if you could talk a little bit about where you are in Call of Duty China? I think last year, you had said that you expect to launch in 2013, and maybe even in the first half of 2013. And just, are you sort of on your launch plan? Do you still expect to get it out this year? You mentioned in your guidance, you don't have anything in for, but is that just a measure of conservatism around the revenue, or are you actually contemplating the idea that you might not ship it this year?

[Eric Hirshberg:]

Well, as I've said, we don't have any dates to announce or specifics to announce, and also I would note, that there a lot of things beyond our control with this project, a, that we're working with a partner; and b, that we have government approvals to contend with. So there are a lot of variables at play here. And our guidance is our guidance for a reason and that's all we really have on the topic today.

[Operator:]

And we'll go next to Drew Crum from Stifel, Nicolaus.

[Andrew E. Crum:]

I wonder if you could talk about the discussions you're having with retailers, planned shelf space for Skylanders, given the increased competition you referenced in your preamble. And then also, can you talk about your plans for your shooter business given the impending launch -- or the eventual launch of the Bungie game against your Call of Duty franchise? In terms of cadence, would you launch 2 games in the same time period, same quarter? Just give your comments on that.

[Eric Hirshberg:]

In terms of Skylanders, if the response we're seeing from our retail partners at Toy Fairs' is any indication, we expect to increase our retail presence and strength, not decrease. And I do think that our retail execution has been one of the shining stars and reasons for our success on this franchise. So I don't see any reason why we would think that would change.

[Robert A. Kotick:]

I already said that we don't run out of competitors...

[Eric Hirshberg:]

Yes, I was just going to say, we take every competitor seriously. And we've had -- sort been a competitor to ourselves thus far, but Skylanders is a proven force and we feel very confident about our partner's continued support for the franchise. Could you repeat your second question?

[Andrew E. Crum:]

Yes, as far as the Bungie game, would you consider releasing it in close proximity to one of your Call of Duty releases, or do you need to create separation between the 2 in order to avoid cannibalization?

[Eric Hirshberg:]

Yes, we don't just have any announcements at this time, on our timing on Bungie. We really look forward to sharing it with you, just as soon as we are ready.

[Operator:]

And we'll take our last question from Edward Williams with BMO Capital Markets.

[Edward S. Williams:]

A couple of things. First of all, just a follow-up on Doug's question with regards to Call of Duty in China. Can you just let us know what steps need to be taken at this point before the game does release commercially? And since I'm last, I'll take advantage of that. A couple of other questions. First of all, looking at Skylanders, can you give us a sense as to what the attach rate is like from toys to games or a revenue split between toys and games? And then, thirdly, Bob if you can just -- going back to the comments with regards to potentially using debt or using cash and doing an acquisition, can you give some -- can you reiterate your philosophy around the acquisition strategy?

[Eric Hirshberg:]

So I'll start with the China and Skylanders questions. On Call of Duty Online, we really -- this is where our partnership with Tencent is going to come to the fore. They are really the pioneers in that category and in this market, obviously, so we're following their lead. There are a number of steps from alpha testing and beta testing and refining, and of course, there's the government approval process. And we hope that -- we expect all those to go as planned, with Tencent really driving the ship through those things. In terms of Skylanders, the question was?

[Robert A. Kotick:]

Skylanders attach rate.

[Eric Hirshberg:]

Attach rate, which we don't break out on the toys that we can -- we've shared a lot of data today on the strength and the number of toys that we've sold and obviously, it's a great business. If you just look at it as a toy business, it would be the best-selling action figure line and better-selling than Star Wars and Transformers combined. And the software sales have been strong as well. And our ability to continue to drive that attach ratings has been one of the secrets to our success.

[Dennis Durkin:]

I would just, just to add on that -- to build on than that comment. The Skylanders, one of the benefits of it is the forward-compatibility of the toys. So it is -- you get the added benefit of your installed base essentially so -- or when you buy the next games. So that's been a huge factor for us but -- so calculating the exact attach rate becomes tough when you have multiple SKUs in the market for at the same time.

[Robert A. Kotick:]

Ed, I really can't comment on any acquisitions.

[Kristin Mulvihill Southey:]

Okay. On behalf of everyone at Activision Blizzard, we want to thank you for your time and consideration today, and we look forward to talking with you soon. Good night.

[Robert A. Kotick:]

Thank you.

[Operator:]

That does conclude today's conference. We thank you for your participation.