Activision Blizzard, Inc.
Q1 2015 Earnings Call Transcript

Published: 7 May 2015

[Operator:]

Good day, and welcome to the Activision Blizzard Quarter 1 2015 Earnings Conference Call. Today's conference is being recorded. At this time for opening remarks and introductions, I would like to turn today's call over to Amrita Ahuja. Please go ahead, ma'am.

[Amrita Ahuja:]

Good afternoon, and thank you for joining us today for Activision Blizzard's First Quarter 2015 Conference Call. Speaking on the call today will be Bobby Kotick, CEO of Activision Blizzard; Dennis Durkin, CFO of Activision Blizzard; Eric Hirshberg, CEO of Activision Publishing; Mike Morhaime, CEO of Blizzard Entertainment; and Thomas Tippl, COO of Activision Blizzard. 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 Factor sections 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 slide that is showing. The forward-looking statements in the presentation are based on information available to the company as of the date 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, 2015, 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, including legal fees, costs, expenses and accruals related to the 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, Amrita. Usually I end my remarks by thanking our incredibly talented, extraordinarily committed employees around the world, but today I'm leading with it because they are, in fact, the reason we remain one of the world's most successful game companies. And also, during this quarter, for the first time we were recognized by Fortune as one of the 100 best companies to work for. Inclusion on this list is largely determined by employee survey results and to be recognized as a great place to work by a respected institution like Fortune is gratifying and rewarding, but being acknowledged as a great institution by our own people means more to me than just about anything. And I'd like to thank our wildly talented, inspired, driven, and hard-working teams for everything they do to capture the imagination of tens of millions of people day after day. Our talented teams around the world continue to create experiences that inspire our players, drive deeper levels of engagement in our games by our massive and growing global community's events (3

[Dennis M. Durkin:]

Thanks, Bobby. Good afternoon, everyone. Today I will review our better than expected Q1 financial results, our outlook for Q2, and our increased outlook for 2015. Q1 was a great quarter that displayed strong trends on our year-round monetizing franchises. We overperformed our non-GAAP February guidance by over $60 million on revenue, $100 million on operating income, and $0.11 on EPS. Even though we had a relatively lighter slate in Q1 this year, non-GAAP revenue and EPS were flat to Q1 last year on a constant FX basis given strong digital trends. Non-GAAP digital revenues comprised a record percentage of overall revenues, up 800 basis points year-over-year. Turning to our financial results. Please refer to our earnings release for full non-GAAP to GAAP reconciliation. 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 $1.3 billion, up 15% year-over-year, an operating margin of 43% up from 37% last year, and a record quarterly GAAP EPS of $0.53, up 33% year-over-year and up $0.16 versus our February guidance. For the quarter on a non-GAAP basis, we generated revenues of $703 million, an operating margin of 29% and EPS of $0.16. Of the $0.11 in non-GAAP EPS overperformance versus guidance, about $0.05 was related to timing for costs that shifted out of the quarter, and about $0.06 was related to strong franchise momentum including digital sales and engagement trends with our large community of fans. Activision Publishing had a strong season pass, downloadable content, and expansion attach rates on both Call of Duty and Destiny. Console full game downloads represent a high teen share of total units and continue to increase year-over-year. Blizzard Entertainment had steady and strong performance on Hearthstone with ongoing engagement on the Q4 expansion Goblins vs Gnomes. As mentioned during our February earnings call and consistent with our experience following prior expansions, we saw a decline in World of Warcraft subscribers. Subscribers ended the quarter at 7.1 million. World of Warcraft's revenue performance at constant FX has been more stable driven by continued strong uptake on value-added services and price increases in select regions, which partially offset the subscriber declines particularly in the east. Moreover, Blizzard has successfully expanded their portfolio over the recent past and continues to do so. Growth from franchises like Hearthstone and Diablo have boosted Blizzard's top line and have pushed Blizzard's non-World of Warcraft revenue stream from 30% of total revenue in 2013 to 40% of total revenue in 2014, even while the World of Warcraft revenues also increased in that period. And new franchises like Hearthstone and Heroes of the Storm are expected to further expand non-World of Warcraft revenue to more than 50% share of the Blizzard business in 2015. So strong recurring franchise diversification is in process inside the Blizzard portfolio, which sets us up for a bright 2016 and beyond. Turning to specific P&L items, please note that all percentages are based on revenues except for the tax rate. For Q1 GAAP product costs were 20%, operating expenses were 37%, and operating margin was 43%. GAAP and non-GAAP interest expense was $50 million and our GAAP tax rate was 20%. Our GAAP and non-GAAP fully diluted weighted share count was 741 million including participating securities. On a non-GAAP basis for the quarter, product costs were 21%, operating expenses were 50%, and operating margin was 29%. Our adjusted EBITDA margin was 32%. Our non-GAAP tax rate was 24%. In terms of cash flow in Q1, we generated strong cash flow with non-GAAP adjusted EBITDA of $223 million, operating cash flow of $209 million, and free cash flow of $188 million after CapEx. We also repaid $250 million of our term loan in February, and next week, on May 13th, we plan to pay a $0.23 per share cash dividend or approximately $167 million in aggregate to shareholders of record as of March 30. Turning to the balance sheet, as of March, 31, we had approximately $4.5 billion in cash and investments of which over $1 billion was held domestically. We had total debt of $4.12 billion and net cash of $360 million. Turning to FX. Please note that as discussed on our February call, currency fluctuations continue to be a headwind that we will monitor. In Q1 the year-over-year impact of the strengthening dollar was $68 million on revenue and $0.03 on EPS. As mentioned, both revenue and EPS would have been flat year-over-year at constant FX. In summary, Q1 was a very strong start to the year for Activision Blizzard. So, now let's turn to our slate and our outlook for Q2 and for the balance of 2015. Our expected Q2 slate from Activision Publishing includes additional downloadable content releases from Call of Duty and Destiny and continued live operations during the open beta for Call of Duty Online in China. Blizzard Entertainment's Q2 slate is a robust offering across the portfolio including Hearthstone's new adventure, Blackrock Mountain, Hearthstone's important iOS and Android smartphone releases, Diablo III's launch in China, StarCraft

[Eric Hirshberg:]

Thanks, Dennis. Activision Publishing is off to a great start, and in Q1 we significantly outperformed last year's results with revenues up 28% year-on-year. We have two of the top five video game franchises globally year-to-date. We continue to have three of the top five next-gen games life to date, with Call of Duty

[Michael Morhaime:]

Thanks, Eric. Compared to last year's launch of Hearthstone, Diablo III

[Thomas Tippl:]

Thanks, Mike. Before we open the call to Q&A, I'll take a moment to summarize the key takeaways from today's call. First, 2015 is off to a great start. We over-delivered the plan for Q1 and raised our full year guidance, which now projects year-over-year EPS growth from operations. And even more important for the long-term prospects of our business, we saw a 25% increase in the size of the player community that engages with our games. That leads me to the second key takeaway from today's call. We are successfully transitioning our business to a digital year-round engagement model, where our community can play and invests in their experiences not just at launch but throughout the year. This is important because it allows us to improve the player experience by delivering fresh content on a frequent basis while at a time creating value for our shareholders through deeper and higher margin monetization of the audiences we serve. Lastly, our strategic investments in new franchises, platforms, and geographies continue to pay off, and along with growing engagement and better monetization sets the stage for growth ahead. We are well underway to expanding our franchise portfolio from five to over ten, with four new intellectual properties already in market. The two IPs we launched last year, Destiny and Hearthstone, combined now have over 50 million registered players and nearly $1 billion in non-GAAP revenues to life to date. We have two new free-to-play franchises if beta, Call of Duty Online and Heroes of the Storm. We also recently announced that this fall, the beloved Guitar Hero franchise will return, with product innovation that we couldn't be more excited about. And Overwatch is on the horizon with a beta this fall. We have an increasing focus on mobile and tablet, with Hearthstone's release on iOS and Android smartphones, and Guitar Hero Live's planned release to also include mobile and tablet at launch. Finally, we are positioned for growth in new geographies and in particular in the large and fast-growing China market. We now have six franchises in the market in China, World of Warcraft, StarCraft, Hearthstone, Heroes of the Storm, Diablo, and Call of Duty Online, up from two at the beginning of last year. So now let's take a few questions.

[Amrita Ahuja:]

Operator?

[Operator:]

Thank you, sir. And we will take our first question from Eric Handler at MKM Partners. Please go ahead.

[Eric O. Handler:]

Yes, thanks for taking my question. First for Mike, with regards to Hearthstone, I think you touched on this briefly, but with the addition of the smartphone SKUs, how is that increased player engagement as well as impacted on monetization? And then I wonder if you have a data about how many players are actually playing on multiple devices?

[Michael Morhaime:]

Okay, thanks for the question. The response to the phone version has really been very positive globally. We've seen an increase in new players. As I said, it's pushed us past the 30 million player mark. We're very excited about that. Overall engagement and revenue levels have increased meaningfully with the release of the phone version, and they continue to be strong. So we're not breaking down usage across platforms, but I think it is important to note that Hearthstone is a little bit unique, and that is a shared ecosystem. So many of our players do choose to play across multiple platforms and they have access to the same cards regardless of which platform they're playing on.

[Eric O. Handler:]

Great. Thank you.

[Operator:]

And we'll go next to Collin Sebastian at Robert Baird.

[Colin A. Sebastian:]

Thanks. And congrats on another good quarter. It sounds like the initial reception for Black Ops III has been quite positive, and wondering if you could add a little more specific color on how the three-year development cycle is benefiting the game. And then how it will be differentiated from prior versions of Black Ops and even from Advanced Warfare. I think on the surface at least there appear to be some similarities between the titles. Thanks.

[Eric Hirshberg:]

Thanks, Colin. Well, the first and I think most obvious advantage of the three-year cycle is just pure creative quality. That third year allows us more time to innovate and iterate and more time to polish and this is Treyarch's first Call of Duty game with that time period to develop. So, the first answer is it's just going to be a great game. Secondly, you've heard a lot of talk today about driving engagement being key to our business strategy, and as I mentioned Black Ops is the most played series in Call of Duty's history. But beyond just that pedigree of both Treyarch and the Black Ops series, the three-year cycle has also allowed us to put a deeper offering on the disk. The MP, the multi-player game is going to be the deepest and we think the stickiest we've ever made. The Zombies is going to be deeper than ever and it's going to have our first XP progression system, which we think will also drive engagement. And, of course, the campaign has big innovations in it as well. As I mentioned, you can play it as a single player game or as a co-op game with up to four friends. So, that drives not only increased engagement but replayability because there's more variability in the experience. In terms of the differences with past Black Ops games and Advanced Warfare, the answer is honestly we're building on the successes of all of those games, but we're also bringing a lot of fresh ideas. I understand what you mean when you say you see similarities with Advanced Warfare, I think the movement system in Black Ops III picks up where Advanced Warfare left off, but improves it and makes it more athletic and intuitive and smoother than ever before, and that's been a big theme we've heard from the press who got hands on with the game at Reveal, which we've never been able to do before, which is another good advantage of the three-year cycle. So, I think anyone who gets their hands on the game is going to agree, which is why we're doing hands on at E3 for the first time in MP in a long while as well as our first beta in years. So, we're really bullish on the content and think it's going to be a great experience.

[Colin A. Sebastian:]

Great. Thanks, Eric.

[Operator:]

We'll go next to Arvind Bhatia at Sterne Agee.

[Arvind Bhatia:]

Thank you very much and like to add my congratulations as well. Quick question on Heroes of the Storm. Just wondering – we appreciate all the commentary, Mike. Just wondering if you can maybe talk about the monetization opportunity here this year and then just the ramp you're expecting over the coming years and maybe how you differentiate versus your competition? Thank you.

[Michael Morhaime:]

Thanks. Well, first, we're really excited that the launch is just a few weeks away occurring on June 2nd. The team has really worked hard in fine-tuning the experience to make it fast, fun and easy to get into. And I do think that relative to some of the other options in the genre, it is easier to get into Heroes, and I think judging by the response that we've gotten from our recent Heroes of the Dorm tournament, I think it's easier to watch as well. The feedback that we've been getting from the closed beta tests has been very positive. There's a lot of great buzz around the game. We've had, like I said, over 11 million people signing up for the beta test, so there's a lot of anticipation there. As you know, it's a very popular genre. I think the fact that this is a digital game with long-term content, opportunities we're very optimistic about Heroes of the Storm and how it can grow to become another key game in our portfolio. And I think in terms of how the monetization curve will look, we expect to get started strong on June 2 and we are hoping that that will grow over time.

[Arvind Bhatia:]

Great. Thank you.

[Operator:]

And we'll go next to Doug Creutz at Cowen & Company.

[Doug L. Creutz:]

Thanks. Yeah, you guys only invest in projects if you believe there's a meaningful needle-moving opportunity. And obviously Guitar Hero was a property that moved the needle for you several years ago. But since then the market has changed a lot particularly relating to what casual gamers are doing these days. So, what do you see in the market now that leads you to believe that this can be a profitable investment for you? Thank you.

[Eric Hirshberg:]

Thanks, Doug. Well, yeah, a lot has changed in the market in that time, and we think for the better in terms of our prospects with Guitar Hero. The first thing is that we think we have a great game innovation and that the franchise needs that. And we said when we put it on ice five years ago, that we wouldn't bring it back unless we really had a breakthrough creative way to bring it back and we think that we have that. In terms of the way the market itself has changed, first of all online social play has transformed gaming over the past five years, and GHTV is going to be constantly updated with new content to keep the game fresh and to keep people engaged and it also allows people to compete online with their friends in a highly social way. We think this has the potential to have the kind of sticky long tail engagement that defines the rest of our portfolio and our major franchises. Second, the game's been out of market for five years and during that time, we've had a console transition. We now have powerful new consoles in the marketplace that give us the opportunity to deliver that rock star fantasy in a more vivid and visceral way than ever before, which is what the live mode is really going to do. Third is mobile has had explosive growth over the last five years with casual players. And one of the breakthrough innovations is that you'll be able to have the entire experience on mobile, and this is a great experience both on the go, on the glass, or with the full experience with the guitar and your big screen TV. So we think that's a big innovation for us and a big opportunity for us as well. And finally, as I mentioned at the Reveal, we've improved and innovated on the guitar itself, managing to make it both easier and more accessible to a casual player, while also managing to make it more challenging than ever for an advanced player. So we think we're going to widen the appeal of the game in that score as well. And also we mentioned that guitar is going to be forward compatible with any additional games that come out. That's going to be a better consumer experience we think this time around. It's going to focus us on innovating on the software and keeping the game more engaging as opposed to the hardware like last time around.

[Doug L. Creutz:]

Terrific. Thanks Eric.

[Operator:]

Thank you. And we'll go next to Drew Crum with Stifel.

[Drew E. Crum:]

Okay, thanks. Good afternoon everyone. So as it relates to Destiny, Eric, can you talk about in more detail the plans around the more expansive DLC coming in the fall you that you alluded to and to the extent you're willing to discuss any updates on future console titles for this franchise? Thanks.

[Eric Hirshberg:]

Yeah, of course I would love to, Drew, but we don't have any new announcements today. But obviously, a constant stream of robust content is integral to our plans on Destiny. And I would say both the expansiveness of the universe as well as the innovation that Bungie has established with bringing together the best of both first person action games with MMORG (sic) [MMORPG] (37

[Drew E. Crum:]

Okay, thanks, Eric.

[Operator:]

And we'll go next to Brian Pitz with Jefferies.

[Brian J. Pitz:]

Thank you. A quick question on digital. What was your mix of digital business in the quarter? And can you provide any commentary on how this is trending? Thanks.

[Dennis M. Durkin:]

Hey, thanks Brian. It's Dennis here. Just regards to the digital mix, it's obviously the highest we've ever had on a quarterly percentage. It was at 76% for the quarter. And you look back a couple of years ago, our digital mix was in the mid-30%s for the full year 2013. In full year 2014 it got into the mid-40%s, and obviously we're out of the blocks really strong in the beginning of this year. It's really driven by the full game download on the console, which is obviously transitioning over time. We're now seeing in the high teens in terms of percentage mix of revenue. And then across the business and really across all of our franchises is the add-on digital content and services that we're seeing to drive ongoing player engagement that all of the guys have talked about today. So all of this is really driving that mix up, and we'll see that continue to grow north of 50% across this year. It will be a nice tailwind for the business in the coming years.

[Brian J. Pitz:]

Great. Thanks, Dennis.

[Operator:]

Thank you. And we'll take our final question today from Michael Olson at Piper Jaffray.

[Yung Rok Kim:]

Hi. Thank you for taking the call. This is Yung Kim in for Mike. Activision's made a significant push into eSports between Call of Duty, World of Warcraft, Hearthstone, and Heroes of the Dorm. How should we think about the opportunity there? Is it more marketing or is it directly monetizable?

[Robert A. Kotick:]

That's a great question. This is Bobby. For starters, what we've always found eSports has been a great way for us to celebrate our players, and that's really been the principal focus of the company's initiatives. There may be commercial opportunities in the future. In fact, we expect there will be more commercial opportunities in the future, but right now you have so many players around the world who dedicate so much of their time and their energy and their passion playing our games that we never really want to take that for granted, and this is a way to celebrate them. You've seen a lot of value created so far with star players. We have players who are earning over $1 million a year between endorsements and winnings. Then you've seen opportunities for shoutcasters at professional events who are also earning meaningful revenues. And then for our players themselves who are narrating their own game play and are now starting to develop millions of fans. And then we have gamers who are competing in prize events like Blizzard's Heroes of the Dorm that we just hosted last weekend. We gave away college scholarships to Berkeley, the winning team. And we recently also had the Call of Duty championships where we paid out $1 million dollars in prize money. So if you look at the numbers of spectators that are now watching gameplay, you're probably looking at just for our content alone last year somewhere around 1 billion hours of spectating of linear play. And so from a lot of perspectives it's something that when we look out into the future, we are incredibly excited about, both as a way to really recognize our player's investment and commitment but also from a commercial perspective.

[Yung Rok Kim:]

Great. Thank you.

[Amrita Ahuja:]

Operator?

[Operator:]

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