Activision Blizzard, Inc.
Q1 2014 Earnings Call Transcript

Published: 7 May 2014

[Operator:]

Welcome to the Activision's Blizzard's First Quarter 2014 Results Conference Call. Today's call is being recorded. I would now like to turn the call over to Kristin Southey. Please go ahead.

[Kristin Mulvihill Southey:]

Good afternoon, and thank you for joining us today for Activision Blizzard's First Quarter 2014 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. 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, including the factors discussed in the Risk Factors section of our SEC filings, including our 2013 Annual report on Form 10-K, which is on file with the SEC, and those indicated on the slides that is showing. The forward-looking statements in this presentation are based on the information available to the company as of the day of this presentation. And while we believe them to be true, they ultimately may prove to be incorrect. The company undertakes no obligation to release publicly any revisions to any forward-looking statement to reflect events or circumstances after today, May 6, 2014, or to reflect the occurrence of unanticipated events. I would 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, the amortization of intangible assets, expenses related to purchase transaction and related debt financing and the associated tax benefits. Please refer to our earnings release, which is posted on 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 financial overview highlighting both GAAP and non-GAAP results and 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. I'm pleased to report that Activision Blizzard delivered better-than-expected first quarter results. On a non-GAAP basis, we generated $772 million in revenues, with a record 68% of those revenues coming from digital channels. We had record operating margin of 31% and record earnings per share of $0.19. During the quarter, we generated strong cash flow and as a result, repaid $375 million of our term loan. As of March 31, we have nearly 0 net debt, and in a little over -- a week from now, on May 14, we plan to pay our highest dividend ever of $0.20 per share. Our success in the first quarter is due to the remarkable talent and relentless commitment to excellence of our employees around the world. Their efforts align with our long-term strategy and operating discipline, continue to produce industry-leading creative and commercial results. We have some of the most valuable entertainment franchises and online communities in the world and we plan to expand our portfolio in 2014 with some of the most innovative new games from both Activision Publishing and Blizzard Entertainment. Life to date, Call of Duty remains the #1 franchise on the new PlayStation 4 and Xbox One consoles, which is important as we grow our online communities on these growing platforms. Last Friday, we revealed Call of Duty

[Dennis Durkin:]

Thanks, Bobby. Good afternoon, everyone. Today I will review our better-than-expected Q1 financial results and then our outlook for Q2 and our increased outlook for 2014. Starting with our financial results. Please refer to our earnings release for a full non-GAAP to GAAP reconciliations. Also the numbers I'll be quoting are compared to the prior year, unless otherwise noted. For the quarter, on a GAAP basis, we generated revenues of $1.1 billion and operating margin of 38% and EPS of $0.40. On a non-GAAP basis for the quarter, we generated revenues of $772 million, including a record high 68% from digital channels which drove a record Q1 operating margin of 31% and record Q1 EPS of $0.19. Our strong performance was driven by 5 distinct franchises, highlighting the increasing breadth and depth of our portfolio. Blizzard Entertainment produced record results, including strong sales of the Diablo III

[Eric Hirshberg:]

Thanks, Dennis. I'm going to start my remarks by talking about the console industry overall. The next-gen console transition continues at a record pace, with Sony recently announcing over 7 million units sold through worldwide for the PS4, and Microsoft announcing 5 million units sold in for the Xbox One. Both of these milestones were achieved faster in this cycle than in comparable points for the PS3 and the Xbox 360 in the last console cycle. This is, of course, good news for our business. Both platforms offer faster computing power, richer graphics and more compelling online social experiences, which play directly into our strengths as the industry's biggest creator and publisher of AAA games. Second, both platforms improve the consumer experience of buying digitally, which we believe, over time, will increase our high-margin digital business. However, this transition to the next-gen platforms will take time. In the interim, we've seen industry software sales decline year-over-year, particularly on current-gen hardware, and the current-gen versions of our own games have not been immune. In spite of that, Activision Publishing has delivered another quarter of industry-leading performance and is set up for success throughout the rest of this year. In Q1, in particular, including toys and accessories, Activision Publishing had the top 2 titles in North America and Europe combined. Skylanders SWAP Force is #1 and Call of Duty

[Michael Morhaime:]

Thank you, Eric. Blizzard Entertainment kicked off 2014, with a busy and record-setting quarter. We closed out March with record revenues and operating income for any Q1 in Blizzard history. Our success was fueled by the launch of Diablo III

[Kristin Mulvihill Southey:]

Thanks, Mike. Operator, we're ready to take some questions.

[Operator:]

[Operator Instructions] We'll take our first question from Colin Sebastian with Robert W. Baird.

[Colin A. Sebastian:]

Eric, I was wondering if you could provide, first off, some perspective on what aspects of the next-gen version of Call of Duty will particularly be unique and stand out this year, just given the 3-year development cycle, as well as the focus on the next-gen platforms? And then secondly, just curious if the performance of recent other next-gen releases gives you any hesitation with respect to the lack of a single-player mode for Destiny?

[Eric Hirshberg:]

Okay. I'll take your questions in order. First of all, the answer on Call of Duty is really a fairly long list. I think the answer is honestly several things. I'll just focus on a few of the most prominent. I think, first and foremost, is visual and graphic fidelity and polish. I hope you'd agree that you're seeing, even in the reveal trailer, a different level of graphic fidelity than we've had in the past. And it's our true -- first true next-gen -- pure next-gen development where we have access to the new hardware throughout the development process, unlike Ghost which was cross-gen. Second, it's allowed us more time for experimentation, creativity and iteration in the development process. So that led to things like us adding some of the first new mechanics in core gameplay in the franchise in a long time, things like boost jump and exo strength and new mechanics, which we have also had time to test with our players to make sure that they resonate and will create a compelling and balanced gameplay. IGN, I think, just ran an article talking about 11 game changers they were perceiving just from picking apart the reveal trailer frame-by-frame. So there's a lot of new ideas in it. And then third, it allowed us more time to put more emphasis on story and character. And you could see that in the trailer, too. We hope that the villain character being played by Kevin Spacey soon to become iconic. And also, you're seeing really state-of-the-art facial capture and animation. That's a full performance capture technology that we revealed last year at GEC. We've got some great acclaim from the 3-year cycle. It allowed us the time to move that from an R&D effort into real gameplay. As far as your question on Destiny, I think that the framing of your question actually plays to one of Destiny's strengths, which is that it does have a single-player experience, and it has multiple different ways to play the game. So we're not putting all our chips on multi-player the way some others have been offering a wide variety of content and game modes. So no matter what way you like to play, Destiny has a great experience for you.

[Operator:]

And our next question comes from Justin Post with Merrill Lynch.

[A. Justin Post:]

As we enter year 2 of the cycle, some of other companies in the space are seeing some operating leverage. And I -- we just wonder if you could talk about your operating leverage this year and going forward, how you see that? And are there some expense savings going forward?

[Dennis Durkin:]

Sure. Thanks, Justin. It's Dennis here. What you generally see in the console transition is that margins compress modestly at the beginning of the cycle. You're building software for multiple platforms, installed bases are not fully grown out yet, development tools and engines are not fully mature. So there's inefficiency that comes with the early years of the console transition cycle and your investments are spread across multiple generations. As you more fully transition in the later years of this cycle and focus on the next-gen, margins expand, obviously, as the installed base grows and you get more scale out of your development and marketing efficiency. You've seen this in our financials when you look in the past couple of years, in 2012, we had peak operating margins late in the last cycle, about 34%. And then last year, you saw a little bit of compression on that when we compressed down to 31%. This year, it's rebuilding up a little bit to 32%. So we expect, over the course of this generation, for those margins to continue to expand, and particularly on next-gen with all the new business models. And then digital, you heard about the record performance in Q1. We do expect digital to continue to drive that expansion.

[Operator:]

The next question comes from Daniel Ernst with Hudson Square Research.

[Daniel Ernst:]

As we look at your R&D expense, and if I include -- if I would include the capitalized portion of that expense, now you have Call of Duty on a 3-year cycle, you've got a multi-year plan, I believe, for Destiny, could you give us a sense of how much of that R&D budget is geared for things that will see the next year, next 2 years, next 3 years with things that we see today and things that were -- that we don't yet get to see? How much spending is going towards those things in the future? And then a related question to that, how much of that investment will be on for IP that we know in the current portfolio versus new things that you have in the development?

[Dennis Durkin:]

Yes, no worries. Thanks, Dan. Good question. I guess I'll just start by highlighting the fact that -- you alluded to this, but we have -- our whole investment model is anchored on building franchise value over time. And so we plan our businesses and our franchises with multiple-year planning horizons, constantly evaluating what we're going to build, who's building it, what the innovation is, when it will come to market, and we're really trying to build a consistent flow of content for our communities and growing franchise value over time. So with that in mind, we're always trying to managing the short, medium and longer term to make sure we're investing in innovation across each franchises, while also selectively layering in new franchises when we see big market opportunities and capabilities that we can exploit. Specifically to your question, it'll vary in any year, but generally speaking and directional for 2014, probably about 1/3 of our total cash spend is for future games that we'll release beyond 2014. And then relative to new IP, probably about 1/4 of our spend is on new IP on franchises like Bungie, Heroes, Hearthstone, Call of Duty Online, et cetera. So that gives you directional mix in terms of how our cash spend in 2014 lays out against sort of near term and long term, as well as existing and future IP. So appreciate the question.

[Operator:]

Our next question comes from Chris Merwin with Barclays.

[Christopher Merwin:]

So it looks like you've had a lot of early success with Hearthstone. I think you reported about 10 million users. And now that, that game has been launched on iPad, can you quantify at all for us what type of uptick you've seen in users so far and how those iPad users been converting any better than the desktop ones? And then lastly, just in terms of monetization for the games, is it possible to share what type of payer rates you're seeing for Hearthstone as compared to the typical mid-core mobile game?

[Michael Morhaime:]

We'll we're not ready to discuss specific impact on the total player base or specifics around monetization yet. I can say that it's monetizing very well compared to other free-to-play games, at least from what I've seen. One thing to point out, since it is a cross-platform game and we have users that joined us on multiple platforms, you are seeing players that joined on the PC purchasing both on the PC and the iPad and vice versa. And so the way that we look at the ecosystem there is as really one-player base that has the ability to play on multiple platforms. And we think that judging by the rapid rise of the download popularity on the iPad charts and the positive reviews that we've been getting, we're very pleased.

[Operator:]

The next question comes from Ben Schachter with Macquarie.

[Benjamin A. Schachter:]

Do you think that some of the large-platform companies like Apple, Amazon and Google are going to pursue exclusive content as they try to basically build their app store market share? And how is this going to be different than what we've seen over many years for Microsoft and Sony in how they use exclusive content?

[Robert A. Kotick:]

Yes, and they already are pursuing exclusive content. And I just think it'll add more opportunities for companies like ours that has the kind of content that they would like to have exclusively. And you're going to start to see more of that as there become more platforms available to create content for.

[Operator:]

And our next question comes from Arvind Bhatia with Sterne Agee.

[Arvind Bhatia:]

Maybe just a couple of questions. First, I was wondering if you guys could share some thoughts on capital allocation? And then I know a bunch of questions on Hearthstone have been asked, but could you help us maybe size the market and the audience size from your perspective?

[Dennis Durkin:]

Sure, I'll take the first one on capital allocation and then Mike and I can probably pair up on the Hearthstone market size. On capital allocation, obviously, it's been a question that's been asked with our new capital structure and our first priority is around debt service. And you can see from our recent paydown and current net debt situation being almost 0 that we're in a very comfortable position with a lot of flexibility. So we have a lot of opportunities to use that excess cash in various ways. And we've historically paid a dividend, which, as we've mentioned -- as I mentioned in my prepared remarks, we'll pay next week a $0.20 dividend. It's up on a per-share basis versus last year, but down in aggregate versus last year due to our lower share count. So that stays on the list of our annual priorities. And then, we'll -- as we look across other uses of capital, whether it be investing in our businesses we're doing across the multiple new IPs that you see coming out in both content and infrastructure, M&A or other inorganic activities, we look at all of these with the focus of driving and increasing shareholder value as our top priority. So overall, I think those are generally the priorities that we have across the business and we'll be prudent and disciplined at how we look at capital allocation and continue to do that in the way that we think maximizes shareholder return for the long term.

[Michael Morhaime:]

Okay, and the sort of the sizing the Hearthstone opportunity -- market size opportunity for Hearthstone. I think it's very difficult to project something like that. Certainly giving the -- given the accessibility and depth of the game, we certainly believe that there's a lot of potential. Also when you consider that we still have the Android platforms and the iPhone to expand to, we see that as a big opportunity as well. And also we're continuing to build on the game experience, listening to player feedback and adding new content. So we're really excited about the upcoming release of Naxxramas.

[Operator:]

Our next question comes from Stephen Ju with Credit Suisse.

[Stephen Ju:]

So, Bobby or Eric, Destiny is being released at a the time of the year where we'll be competing with -- for consumer wallet share with annual iterations of franchises from your competitors, as well as perhaps new releases from others. So do you foresee this as being a headwind to initial sales, or is this apples and oranges in terms of the target customer? And from what you can tell, is the September release window more or less crowded versus years past?

[Eric Hirshberg:]

This is Eric, I'll take that. We think we have a great window to release Destiny. More importantly, we think we have a great game. As far as the window goes, I would just remind everyone, this is the same window essentially that Grand Theft Auto had last year. So I think that fairly decisively proves that a great action game can find a huge audience during that time period and they had all the same annual competitors to contend with as we will. But more importantly, we found that whenever your launch is, if you have a breakthrough game and you have a great experience, which is sticky and novel and deep for the variety of game players, we think we have all of that and then some with Destiny that we can find a meaningful audience. So we've got a breakthrough game. We think we've got a great window and we would have competition no matter when we launch it.

[Operator:]

The last question comes from Mike Hickey with The Benchmark Co.

[Michael Hickey:]

Mike, just give us some details on Heroes of the Storm. And I know it's early days here, I'm not sure how much more you can share, but I was hoping you could just, if possible, kind of size maybe the market opportunity as it relates to the game category? Or maybe the Blizzard audience. I mean, you've got 10 million, looks like, PC players almost immediately for Hearthstone. Is that kind of an initial reasonable range you think for Heroes of the Storm, or is it unique that maybe it doesn't appeal to the same player base? And then maybe this is way too early, but maybe monetization of the game and also as it relates or I guess compares to what you saw from Hearthstone?

[Michael Morhaime:]

Thanks for the question. So currently, we're in a very limited technical alpha testing, really, to test the infrastructure around the game and all the technical issues surrounding the game. It's also giving us the opportunity to test some of the game design innovations that we have been creating. And the response has been very positive. The game is already very fun. We're getting really good feedback from the people that are currently helping us test it. We're looking forward to expanding the number of -- the size of our test audience in the future. In terms of the opportunity, it is a proven genre. I mean, you can see that some of the existing games in the genre have achieved a very high level of success. We think that there's an opportunity to make the genre even more approachable for new players. I think that it can skew very hardcore, and there's definitely room for improvement in that area while still maintaining the depth and replayability that exist there. So let's see, in terms of monetization, we are still experimenting with monetization, but it will be free-to-play, we will have micro-transactions and we'll have more information about the offerings that we'll provide in the future.

[Kristin Mulvihill Southey:]

Okay. Well, carry on, and thanks, everyone. On behalf of everyone at Activision Blizzard, we thank you for your time and consideration, and we look forward to seeing some of you at E3. Thank you.

[Operator:]

Thank you for your participation. That does conclude today's call.