Activision Blizzard, Inc.
Q3 2013 Earnings Call Transcript

Published: 7 Nov 2013

[Operator:]

Good day, and welcome to the Activision Blizzard's Q3 2013 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 Senior Vice President of Investor Relations, Ms. Kristin Southey. Please go ahead, Kristin.

[Kristin Mulvihill Southey:]

Good afternoon, and thank you for joining us today for Activision Blizzard's third quarter 2013 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 risks and uncertainties. As indicated on the slide that is showing, a number of important factors that 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, but are not limited to

[Robert A. Kotick:]

Thank you, Kristin, and welcome, everyone. Today, we're hosting our earnings call as an independent public company for the first time in 5 years. As of October 11, the majority of our shares are now held by public shareholders. The transaction we completed on October 11 is representative of the focused approach to creating shareholder value that we've employed for more than 2 decades. As you'll hear in detail today, there are immediate benefits to our shareholders in the form of earnings per share accretion, and most importantly, our transaction provides the strategic and operational independence we need to drive long-term stakeholder value. The management team is more energized and empowered than ever, and we remain committed to generating long-term superior returns and effectively managing our capital structure. Our return to independence could not come at a more important time. This month, Sony and Microsoft will launch new consoles for the first time in more than 7 years. These consoles will enable our games to be even better, richer, more immersive, more engaging and more entertaining. PC games like Diablo III have established new records for sales and for engagement, and tablets and mobile devices are now starting to provide opportunities to create differentiated and compelling new types of games and access to new audiences and new geographies. All of these trends are resulting in larger audiences around the world for games. Platform transitions have always presented great opportunities, as well as short-term challenges. We're well prepared to capitalize on these new opportunities, and we've been very adept at managing through the risks of hardware and business model transitions for over 22 years. Our industry-leading capabilities embodied in the most talented group of employees in all of video games have enabled us to create the very best interactive content across varied platforms and varied business models, always with the ability to prioritize these investments against the opportunities that will provide the highest returns to our stakeholders. And we continue to, of course, establish new bars for creative excellence. While our focus is always on the long term, we did have another quarter with better-than-expected financial results as a result of the continued success of our most popular games. Call of Duty generated record results both in Q3 and for the year-to-date, and we shipped over $1 billion of Call of Duty

[Dennis Durkin:]

Thanks, Bobby. Good afternoon, everyone. Today, I will start with a brief recap of the Vivendi transaction, followed by a review of our better-than-expected September quarterly results and our increased outlook for the full year. On October 11, just after the end of the quarter, Activision Blizzard closed our share purchase and recapitalization transaction with Vivendi. On that date, Activision Blizzard brought back approximately 429 million shares or around 38% of our outstanding shares for $13.60 per share in cash, reflecting a 20% discount to the October 11 closing price of $17.08. Activision Blizzard funded the deal, including transaction fees and upfront interest, with approximately $1.2 billion of balance sheet cash and $4.75 billion of newly issued debt. Our financing included $2.5 billion of 7-year bank debt, $1.5 billion of 8-year notes and $750 million of 10-year notes. In addition, we established a $250 million revolving credit facility, which was undrawn at closing. All in, our weighted average interest rate came in at the low end of our August estimate at just less than 5%. On closing, the company paid Vivendi approximately 5.83 billion shares for the shares that were repurchased, which left us with more than $3 billion in cash on hand, approximately $500 million of which is held domestically. This significant cash balance helps secure our future financial stability. Going forward, we believe that our free cash flow generation will support the debt we have while also allowing us the flexibility to continue to invest in our business and drive value for all of our stakeholders over time. So all in, we had a very solid execution and closing at favorable financing rates a shareholder-friendly transaction. I'd like to thank both our internal teams and our external advisors for their tireless efforts in getting this deal over the goal line. It is nice to, once again, be an independent company with a newly optimized capital structure, a lower weighted average cost of capital and a higher return on equity for our shareholders. Now let's turn to business and our better-than-expected Q3 results. Please refer to our earnings release for full GAAP to non-GAAP reconciliations. For the third quarter, on a GAAP basis, we generated revenues of $691 million, including a record 59% of revenues from digital channels, and operating margin of 10% and EPS of $0.05. On a non-GAAP basis for the quarter, we generated revenues of $657 million, with 61% of revenues coming from digital channels. We generated an adjusted EBITDA margin of 22%, with adjusted EBITDA being defined as non-GAAP operating income before depreciation. We also delivered an operating margin of 19% and EPS of $0.08. Revenues in the quarter were driven by Activision Publishing's Call of Duty and Skylanders and Blizzard Entertainment's World of Warcraft and the launch of Diablo III on consoles. As expected, our results were below last year, when we had the Q3 launch of the World of Warcraft

[Eric Hirshberg:]

Thanks, Dennis. I'll start with a quick recap of our Q3 performance, and then I'll discuss current industry dynamics, our slate and our pipeline. I'm pleased to announce that Activision Publishing produced a record Q3 and year-to-date performance in terms of operating income. I want to thank our tremendously talented and passionate employees who continually find ways to deliver best-in-class execution and record results, even during a challenging console transition year. Today, market fundamentals are mixed. Demand for many annualized AAA titles are down as consumers continue to show hesitation ahead of the launch of next-gen consoles. In fact, some games based on top-selling franchises are significantly down versus last year. While we don't expect to be immune to these industry-wide patterns and while we expect the sales curve to be shaped differently this year given the mid-quarter launch of next-gen consoles and the fact that Black Friday is later this year, we also know that purchase intent and awareness for our key titles are strong. We're also seeing increased supply and demand for next-gen consoles, and we believe consumers will reward those who have breakthrough next-gen games ready at launch, and we do. Historically, following console transitions, the top franchises have emerged stronger than when they entered the cycle. We believe that our 2 top 5 franchises, Call of Duty and Skylanders, are well positioned and will emerge stronger over the long term. For both Call of Duty and for Skylanders, one of the keys to our success has been our ability to keep players engaged with new content all-year long. Year-to-date, Call of Duty digital revenues set new franchise records. The franchise also set a new record for online engagement with over 4 billion hours played online. Put simply, players are spending more of their time and money online with Call of Duty than ever before. In fact, in the last 12 months, Black Ops II, including digital sales, has generated more revenue than any other console game ever has in a single year. If you took Black Ops II digital revenue alone this year and judge it as a standalone game, it would be the third largest game at retail this year, behind only GTA V and Skylanders Giants, including toys and accessories. Call of Duty has long had the largest and most engaged console player base in the industry. We now offer multiple ways for our players to stay engaged with the game, including à la carte DLC packs, micro DLC and Season Pass, and these additions have proven to have value to our players. And they have transformed our revenues from a simple equation of units times price to the equation of players times revenue per player. By providing tremendous value and variety to our players, we are now able to monetize play all year round better than ever before, and our record digital revenues this year proved that out. Yesterday, we launched our new Call of Duty game, Call of Duty

[Michael Morhaime:]

Thank you, Eric. Q3 was an eventful quarter for Blizzard. We launched our first console game in many years with Diablo III. We also announced an expansion pack for Diablo III, Reaper of Souls. Additionally, beta testing for Hearthstone kicked off, and we released a significant new content update for World of Warcraft. All of this activity has netted out to a strong quarter, where we ended higher in net revenue and operating income versus Q2 mostly due to the Diablo III console launch in September. Revenues and income were down year-over-year, as expected, due to the successful launch of Mists of Pandaria and ongoing sales of Diablo III during the same quarter last year. Going into more specific detail with World of Warcraft, we're very pleased with the response to Siege of Orgrimmar, the massive content update we released in September. This update included a huge new raid dungeon with major story elements, as well as a new area to explore and features that improved the game's accessibility. Flexible rates now allow groups of variable size to participate in the endgame raiding dungeons. Meanwhile, the proving grounds feature trains players to improve at playing specific roles, preparing them to participate in endgame content. Player response to the content has been good, and we saw increased engagement that has contributed to maintaining relatively stable subscribership quarter-over-quarter. We'll continue to invest heavily in World of Warcraft to deliver frequent, high-quality content to our players. Moving on to Diablo III, we're pleased with the response to the game's launch on PlayStation 3 and Xbox 360. Lifetime sell-through of the game across all platforms has reached over 14 million copies, and reviews have been very positive about how the game plays on console. Much of the praise has been centered on changes we made to the loot system and our decision to keep the auction house off of the console platform. Players and critics alike have noted that these changes have resulted in a more fun and satisfying game experience. That reaction factored in our decision to remove the auction houses from the PC version of Diablo III effective next March, which players have also responded very positively to. We're building upon those design philosophies for loot and incorporating them into Reaper of Souls, the Diablo III expansion pack which is coming for PC and PS4 in 2014. In addition to the new loot system, Reaper of Souls will include an additional player class, the Crusader, and more gameplay modes for the endgame to keep players engaged. The reaction to Reaper of Souls at Gamescom was very positive, and we're looking forward to revealing more about the game at BlizzCon. It was also a busy quarter for Hearthstone, our free-to-play digital card game for PC and iPad based on the Warcraft universe. In Hearthstone, players build decks of cards that feature familiar spells and creatures from World of Warcraft and battle against each other using the cards. Players can collect cards simply by playing or by purchasing digital packs. They can also purchase entries into a special competitive mode of play called The Arena in exchange for either in-game currency or a small fee. We've seen a great response from the community with the closed beta test, which kicked off in August. Hearthstone quickly became one of the most popular streamed games on Twitch, and we have been expanding the beta test to encompass more regions and a wider group of players. We're continuing to work on polishing the game as we drive towards open beta testing. Rounding out our big announcements since the last call is the name change of Blizzard All-Stars to Heroes of the Storm, which is our take on free-to-play hero brawlers. We've done an extensive internal test on Heroes over the past several months, and as the game has evolved, we felt it was appropriate to change the name to something more fitting of the gameplay experience. We're looking forward to sharing more details about Heroes at BlizzCon, which is taking place this weekend at the Anaheim Convention Center. This is another sold-out show, with more than 20,000 attendees coming to Anaheim from more than 40 different countries. Our global community will also follow along through DIRECTV, online pay-per-view on blizzcon.com and partner broadcast in other regions. We'll be showcasing our biggest pipeline of games ever and showing our appreciation for our community through contests, meet-and-greets and of course, major eSports spectacles. The World of Warcraft Arena invitational and the global grand finals of the StarCraft II World Championship Series will be taking place, along with an invitational tournament for Hearthstone, featuring popular community personalities. All of us at Blizzard can't wait to get back to BlizzCon and connect with our players. We hope you'll join us there or follow along online with a virtual ticket available online at blizzcon.com. We're looking forward to celebrating a shared passion of gaming with our players, hearing their feedback on our newest game content and taking that energy and knowledge back to work as we drive toward an exciting 2014 for Blizzard. Thanks, and I'll turn the call back over to Kristin.

[Kristin Mulvihill Southey:]

Thanks, Mike. Operator, I think we'll open it up for questions.

[Operator:]

[Operator Instructions] We'll take our first question from Brian Pitz of Jefferies.

[Brian J. Pitz:]

I know we have to wait through the holiday to get a better sense for Skylanders' performance. Can you give us an idea for how the SWAP Force launch compared to Spyro's or to Giants maybe in terms of things like character tie ratios? And then really quickly, are you seeing a big difference for the -- in terms of developing and delivering on the different consoles, the next-gens? There's a lot of discussion right now around -- noise around native versus upscale 1080p. Is that something that really differentiates a platform, or can that be improved as your hardware partners do software updates that rejigger the -- and free up resources, GPU, memory, et cetera?

[Eric Hirshberg:]

I'll take both of those. First of all, on SWAP Force, as we've noted throughout the year, this is a year unlike past years, when we've launched games like Spyro's Adventure and Giants. And what we're seeing for SWAP Force this year is that some markets are down, some markets are up. Overall, we're down, which is not unexpected. The 2 main issues here is that we've invented a category 2 years ago, and for the past few years, we've had a competitive landscape completely to ourselves. This year, we've had 2 major competitors, with both Disney and Pokemon launching the day before us, as you guys know. And second, Skylanders is also not immune to the effects of the console transition year. In fact, our quantitative research has shown that this is one of the top reasons that parents who've shown an intent to purchase the game are hesitating. But there are a couple of things that are important to remember. One is the vast majority of our sales historically on this franchise have come in November and December, ramping up towards the holiday. Two is that we have a great game, the best game in the franchise's history. Three is that toy attach is as strong as ever. And four is that awareness and purchase intent are also as strong as ever. So we're staying in the pocket, looking forward to a great holiday. On the second question you asked related to the console, that's really a better question for the first parties since they've taken different approaches to the design of the hardware and have different allocations for processing power that are available to developers. And the issue you're raising has been consistent across multiple games in similar genres to ours. What I can assure you is that we've worked hard to maximize the performance on each and every platform that we've release the game on and that we think we have the next-gen launch title being Call of Duty

[Operator:]

Our next question comes from Colin Sebastian, Robert Baird & Co.

[Colin A. Sebastian:]

Great. I guess curious now that the transaction is behind you, I'm wondering how you're approaching further development plans and customer support, Mike, for World of Warcraft just given the changing mix of the user base towards Western markets. And with the content update, I'm wondering if you could provide a little more color on what the distribution of the users are geographically?

[Michael Morhaime:]

Well, in the last quarter, the user base has been pretty stable. I think that the way we're viewing customer service for WoW, of course, we want to maintain a high quality of service to our players, but I think we want to continue to look at more efficient and better ways of doing that. And so there are a lot of efforts going towards improving customer self-help so that our millions of players don't actually have to contact us directly. But in terms of the content and developing, we have more resources focused on developing content for World of Warcraft than ever before. So we expect to continue having a long and happy life.

[Operator:]

Our next question comes from Doug Creutz of Cowen and Company.

[Douglas Creutz:]

Your MMO costs of goods sold was down roughly significantly quarter-over-quarter. Was there some permanent cost reductions that might have happened that are driving that or was that just more of a normal fluctuation?

[Dennis Durkin:]

Yes, I'll take that. I mean, cost of goods sold can vary based on our mix in any one quarter, and so I wouldn't use that as sort of a long-term guidance. I think we're always looking across the capitals -- or across our expense base to drive efficiencies, but it's more the cost cash base [ph] than anything. So I'd just look at our forward guidance as the best barometer for what's to come relative to that. Obviously, Skylanders mix has a big play relative to overall cost of goods sold because of the...

[Douglas Creutz:]

I was referring specifically to the MMO line item.

[Dennis Durkin:]

Oh, okay. I'm sorry. We brought the MMO line item relative to the cost reduction and the savings that we've seen. I mean, it's kind of tied to the previous question, where we've actually been more efficient over time with -- in terms of driving cost out of our online operations and our customer service. It relates very much to what Mike's talked about before in terms of self-help and getting more efficient with that. And I think the team's done a great job of embracing new goals to become better at that over time. So I think that's certainly -- we think about optimizing our efficiency. That's an area across -- not only the Blizzard side but the Activision Publishing side that we're very focused on.

[Operator:]

Our next question comes from Avi Steiner of JPMorgan.

[Avi Steiner:]

Given the recent change in ownership, how should investors think about the pace of new game introductions, the international opportunities? And just related to that, any updated thoughts on maybe bringing some cash back?

[Robert A. Kotick:]

Yes, the benefit that we have now of not having a majority shareholder is operating independence, but that won't change the overall strategy of the company. We're continuing to be focused on investing in our franchises, building out new franchises, expanding new geographies, prioritizing our investments towards the greatest opportunities for the benefit of our shareholders.

[Operator:]

Our next question comes from Edward Williams of BMO Capital Markets.

[Edward S. Williams:]

A couple of questions. First of all, Eric, can you just kind of go back to Call of Duty and what your expectations are for kind of downloadable content as in the early stages of the game, looking at this year versus prior iterations of it? And then Bobby, just curious if you can comment a little bit about looking at the next platform cycle, having gone through a number of these cycles in the past, what your thoughts are as far as the early adoption is concerned for those cycles and what we could see with attach rates and the like?

[Eric Hirshberg:]

On the first one, it's too soon to tell. It depends on a lot of other factors. But I can tell you what we know so far. So far, attach rate on things like Season Pass has been very strong, and we're also seeing longer average session length so far, meaning more engagement with the players, with the millions of players who are already online enjoying the game. Historically, more engagement has meant better monetization over time because people are more engaged and more willing to do things like purchase DLC or purchase micro DLC or purchase a Season Pass. So we're pleased by those longer average engagement times. We also -- we're thinking ahead when we developed our third mode with Extinction. And obviously, we've seen how that third mode can play a big role in a long tail on a rich DLC season, and so you'll see a great slate of content coming our players' way in the wake of Ghosts, including a lot of Extinction content, so we'll have a fantastic season to look forward to.

[Robert A. Kotick:]

And with respect to the introduction of new the hardware, you know this almost better than anybody, but you've got 2 laser-focused large companies who have important future benefits that come from continued investment against the successful launch of these platforms. They've made more investments in the back office than ever before. I think you've got lots of efficiencies in manufacturing cost that can potentially drive hardware pricing down sooner in the cycle. But there's no indication from our perspective that you're going to see anything other than a very successful next 7 or 8 years.

[Operator:]

Our last question comes from Eric Sheridan of UBS.

[Eric James Sheridan:]

Longer term, now that the transaction's closed, maybe an update on how you think about the right level of leverage for the company, coupled with how you're thinking about shareholder returns in general and sort of balancing the 2 on a going-forward basis.

[Dennis Durkin:]

Sure. I'll take that one. This is Dennis. Thanks, Eric. Obviously, we're very comfortable with the level of debt that we took on as part of this transaction and sort of the cash flow generation that we have. We have a culture that's been very focused on cash generation, so it's not really a big change for us relative to sort of driving that. Going forward, debt service and sort of paying the amortization on the term loan will be our primary focus obviously. But as we've done every year and as we do every year, once we have visibility into how the holidays landed and how our annual operating plan looks, we'll make new capital allocation decisions in our January board meeting, and we'll talk more about that going forward. Frankly, we're very comfortable with the levels of debt that we have and the service ratios that we have to service that over time.

[Operator:]

And this does conclude our Q&A session. I'd like to return the conference back to Kristin Southey for any concluding remarks.

[Kristin Mulvihill Southey:]

Well, on behalf of everyone at Activision Blizzard, I want to thank you for your time and consideration. And hopefully, we'll see a lot of you at BlizzCon on Friday. So thank you.

[Operator:]

This does conclude our conference call for today. You may now disconnect your lines. And everyone, have a great day.