Activision Blizzard’s (ATVI) CEO Bob Kotick on Q2 2014 Results – Earnings Call Transcript

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 statements to reflect events or circumstances after today, August 5, 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 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 in a 1-page summary sheet.

And now, I’d like to introduce our CEO, Bobby Kotick.

Robert A. Kotick – Chief Executive Officer, President and Director

Thank you, Kristin, and thank you all for joining us today. I’m pleased to report that Activision Blizzard delivered better-than-expected Q2 results. On a non-GAAP basis, we generated $658 million in revenues, with a record 73% from digital channels and earnings per share of $0.06.

For the first half of the year, we generated strong earnings and cash flow, we repaid $375 million of principal to reduce our term loan and we paid our highest ever dividend of $0.20 per share.

Based on our strong results this quarter and better visibility for the balance of the calendar year, we’re raising our full-year outlook and expect to grow our non-GAAP revenues year-over-year and deliver record non-GAAP earnings per share this year.

We control some of the most valuable and iconic entertainment franchises, and we maintain some of the largest and most engaged online communities in the world, including Call of Duty, Skylanders, World of Warcraft, Diablo, StarCraft, and now, Hearthstone. And all of these franchises are leaders in their respective categories.

Our teams continue to be among the very best in the world at innovating within our known franchises and creating exciting new franchises like Hearthstone and Destiny. We’re seeing more opportunities to create great content for new platforms, new higher-margin business models and new geographies. And we’re embracing these opportunities for growth with the same commitment to excellence we have demonstrated over the last 20 years.

As the world’s most successful interactive entertainment company, we’ll remain focused on the creation of the most compelling, engaging games for our dedicated committed audiences and providing superior returns for our shareholders, as we have for more than 2 decades.

I’m grateful for the continued determination and extraordinary efforts of our employees around the world and the continued support of our audiences and shareholders. And now, Dennis will share the results of our second quarter and provide an update on our view with the balance of 2014, which is shaping up to be an extraordinary year for Activision Blizzard.

Dennis Durkin – Chief Financial Officer

Thanks, Bobby. Good afternoon, everyone. Today, I’ll review our better-than-expected Q2 financial results and then our outlook for Q3 and our increased outlook for 2014.

Starting with our financial 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.

For the quarter, on a GAAP basis, we generated better-than-expected revenues of $970 million, and operating margin of 32% and EPS of $0.28. On a non-GAAP basis for the quarter, we generated revenues of $658 million, including a record 73% from digital channels, which drove an overall operating margin of 17% and EPS of $0.06.

Our strong performance was driven by 5 distinct franchises, which highlights the increasing breadth and depth of our expanding portfolio. Blizzard Entertainment’s strong results were driven by World of Warcraft subscriptions, Warlords of Draenor prepurchases and paid character boost, Diablo III: Reaper of Souls expansion pack sales and sales of Hearthstone cards.

On the Activision Publishing side, performance was driven by Call of Duty: Ghosts, and Skylanders SWAP Force.

Turning to specific P&L items. Please note, all percentages are based on revenues except for the tax rate. For Q2, GAAP product costs were 25%, operating expenses were 43%, and operating margin was 32%, above our outlook, driven by higher-than-expected revenues and the timing of expenses. GAAP and non-GAAP interest expense was $52 million and our GAAP tax rate was 22%. Our GAAP and non-GAAP weighted average share count was 725 million, and for EPS purposes, we also include 16 million of participating securities for a total of 741 million fully diluted shares.

On a non-GAAP basis for the quarter, product costs were 27%, slightly higher than expected due to over performance in our low-margin distribution business. Operating expenses were 56%, better than expected, and operating margin was 17%, above our outlook for the same reasons I mentioned for GAAP.

Our adjusted EBITDA margin was 20%, and our non-GAAP tax rate was 29%.

In terms of EBITDA and cash flow, in Q2, we generated non-GAAP adjusted EBITDA of $131 million, which we define as non-GAAP operating income and then add back depreciation, as well as strong operating and free cash flow of $106 million and $81 million, respectively.

On a trailing 12-month basis, we generated nearly $1.1 billion of operating cash flow. We also paid out approximately $147 million related to our $0.20 per share dividend in May.

Turning to the balance sheet. As of June 30, we had $4.2 billion in cash and investments, of which over $650 million was held domestically. With total debt of $4.4 billion, our net debt was approximately $150 million.

Now let’s turn to our slate and our outlook for Q3 and for full year 2014.

For Q3, Blizzard launched the first content pack for Hearthstone, Curse of Naxxramas, for PC, Mac and iPad in July, and expects to launch Diablo III: Ultimate Evil Edition later this month for consoles. In September, Activision Publishing plans to release Destiny, which we believe will be one of the biggest selling titles of the year, and will establish yet another iconic franchise in the Activision Blizzard portfolio.

Turning to the numbers. In Q3, on a GAAP basis, we expect net revenues of $650 million, product costs of 27%, and operating expenses of 76%. We expect GAAP and non-GAAP interest expense of $52 million, a GAAP tax rate of 30%. And with significant GAAP revenue deferrals in the future periods, we’re expecting a GAAP loss of $0.07 in the quarter.

Note, we are using basic weighted average share count of 719 million shares for GAAP EPS. We expect a GAAP loss in the quarter. For Q3, on a non-GAAP basis, we expect record revenues of $975 million, product cost of 25%, and operating expenses of 60%. Note this includes heavy launch marketing costs for Destiny, as well as marketing expenses for our large Q4 lineup.

In addition, there will also be significant amortization of capitalized software development expenses for Destiny in both Q3 and Q4.

Finally, we expect a non-GAAP tax rate of approximately 19%, a non-GAAP fully diluted share count of 745 million and non-GAAP EPS of $0.11.

In Q4, we expect to launch Skylanders: Trap Team on October 5, and Call of Duty: Advanced Warfare on November 4. And for planning purposes, our outlook assumes a Q4 launch of the World of Warcraft: Warlords of Draenor expansion.

Now to our full year 2014 numbers.

On a GAAP basis, we expect increased revenues of $4.24 billion, product costs of 28% and operating expenses of 47%. For both GAAP and non-GAAP, we expect interest expense of $208 million. Our GAAP tax rate is expected to be 22%. We expect $750 million fully diluted shares, both for GAAP and non-GAAP, and GAAP EPS of $0.91. For 2014, on a non-GAAP basis, we expect increased revenues of $4.7 billion, representing 8% revenue growth year-over-year, product costs of 26%, operating expenses of 43%, operating margin of 32% and a non-GAAP tax rate of 25%. Today, we are raising our full year non-GAAP EPS outlook by $0.02 to a record $1.29, representing 37% reported EPS growth year-over-year.

In summary, Activision Blizzard’s expanding portfolio of industry-leading franchises delivered better than expected financial results during the first half of the year, and in the back half, we expect to deliver what we believe to be the strongest lineup in our history.

Today, we have more opportunities than ever before to increase our portfolio of premium content and to continue growing our large, socially connected communities worldwide by expanding our reach to new consumers, platforms and geographies. We also remain laser-focused on execution, while keeping a keen eye on cost, all of which should deliver long-term growth, strong margins and cash flows for our various stakeholders.

Now I will turn the call over to Eric Hirshberg to discuss Activision Publishing.

Eric Hirshberg – Chief Executive Officer of Activision Publishing, Inc

Thanks, Dennis. In Q2 Activision Publishing had the #1 selling title left to date on the next-generation consoles with Call of Duty: Ghosts, and the #2 title in the industry year-to-date with Skylanders SWAP Force. We believe our blockbuster launch this fall with Destiny, Skylanders and Call of Duty could deliver the largest second half revenues in Activision Publishing’s history.

First up is Destiny, which we plan to launch on September 9, and the game is looking great. Our beta test attracted over 4.6 million players and the feedback was almost universally positive.

With that great consumer response, strong first-party support from Sony, very strong demand from our retail and digital distribution partners and a strong future pipeline of digital content, we believe more than ever that Destiny will become the biggest new IP launch in video game history, and over time, Activision’s next billion-dollar franchise.

Preorders continue at a record pace for new intellectual property and other leading indicators like purchase intent and awareness are showing strength as well. On October 5, we plan to release Skylanders: Trap Team, a great game from our wholly-owned studio, Toys for Bob, the originators of both the franchise and the toys-to-life genre. In Trap Team, we’re not only letting kids bring their toys to life, as we have in past games, we’re also letting them bring life to their toys. This time, when you defeat bad guys, you can capture them in a crystal trap and make them fight for you, bringing yet another breakthrough innovation to the toys-to-life genre.

I think, this is our most magical Skylanders game yet. Since we revealed Trap Team, we have seen a 50% increase in our Skylanders YouTube channel views compared to last year. And while we have strong competition, we also have breakthrough innovation, a new lineup that has more price points and options for the consumer and unprecedented support from both first and third-parties, including Nintendo, General Mills and McDonald’s.

We therefore expect Skylanders to continue to lead the toys-to-life category this fall and determining one of the most successful kids entertainment franchises in the world.

On November 4, we intend to launch Call of Duty: Advanced Warfare, our incredibly talented wholly-owned studios, Sledgehammer Games, is delivering a truly extraordinary experience, with innovation across every game mode. Our best graphics ever and a campaign anchored by great story, as well as two-time Oscar winner, Kevin Spacey.

We also have an open launch window and we’re taking full advantage of this with strong first-party support from Microsoft, highly engaged distribution partners and some of most our focused and we expect effective marketing programs ever.

Adding to this momentum is an active Call of Duty player community that has actually grown since our last earnings call. This is an unusual trend at this time of the year, which typically sees declining active player count.

This speaks to the continued strength of the Call of Duty franchise and healthy appetite for Call of Duty content as we head into Advanced Warfare’s launch. And according to YouTube, our reveal trailer was the most viewed entertainment trailer in the second quarter, ahead of not only every other game, but also every movie and television show in North America. We expect Call of Duty to be the most pre-ordered game of the year and we’re currently seeing strong purchase intent, in line with our past top-performing titles.

Finally, our development for Call of Duty Online in China is going great and gaining momentum. This is our first major free-to-play initiative and has just entered large scale testing, which means hundreds of thousands of gamers in China will be playing a closed beta over the coming months. This is part of our rollout strategically with Tencent, which is by far the largest gaming community in China. Call of Duty online is a major opportunity to expand our reach and to bring the franchise to a massive new player community.

So in closing, Activision Publishing had a strong second quarter and looks forward to delivering what could be our biggest second half ever. We expect our AAA launches to materially expand our portfolio and our reach, both this fall and in the future, with top line growth and increasing margins as the next-gen consoles continue to grow and expand our opportunities to drive high-margin digital revenues.

Thanks. And I’ll now turn the call over to Mike to talk about Blizzard.

Michael Morhaime – Chief Executive Officer of Blizzard Entertainment, Inc and President Blizzard Entertainment, Inc

Thanks, Eric. Blizzard had a busy second quarter, reaching milestones on a number of projects. This includes the start of beta testing on World of Warcraft: Warlords of Draenor, the release of Hearthstone on iPad, and ongoing testing of new content for Diablo III, and our unreleased team brawler, Heroes of the Storm.

Starting off with World of Warcraft. The franchise remains healthy with revenues up year-over-year. This is due in part to ongoing interest in Warlords of Draenor presales, which now exceed 1.5 million, and the character boost, which suggests strong support for the expansion by the community.

As we mentioned on the previous call, we anticipated fluctuation in subscribership due to seasonality and the fact that the current game content is at the end of its life cycle. And as expected, we did see a decline in subscribers, which mostly came out of the East. This pattern is right in line, percentage-wise, with the drops that we saw at Cataclysm’s cycle in Q2 2012. That drop in 2012 was followed by an uptick in subscribers just ahead of Mists of Pandaria’s launch. So we’re hoping to see players return once we draw closer to the release of Warlords of Draenor later this year.

On the development side for World of Warcraft, we did begin beta testing for Warlords of Draenor in Q2. Q2 was also a big quarter for Hearthstone with the iPad version of the game launching in April. That version has been popular, bringing millions of new players into the Battle.net ecosystem, and building on momentum from Q1’s PC launch. Hearthstone has also been growing in popularity on the e-sports side, with a number of big tournament events taking place around the globe. We also announced our year-long Hearthstone competition, which will collect competitors from around the world to compete at a yearend tournament at BlizzCon for a $250,000 prize pool. A few weeks ago, we launched Curse of Naxxramas, our first adventure mode content for Hearthstone, and it’s now available around the world on Windows, Mac and iPad. The content is split into 5 parts released over 5-week period, and it includes single player challenges, as well as cards that players can use in head-to-head competition. Players can purchase the weekly content à la carte for in-game gold or real money or as a bundle for real money. The community has responded with enthusiasm to Curse of Naxxramas, fueling Hearthstone’s biggest week ever in terms of both engagement and revenue. We’re pleased with the results and we look forward to continuing our support for Hearthstone going forward.

Moving on to Diablo III. We’re pleased to show that the game has reached more than 20 million in unit sales, including digital. This figure includes the base Diablo III game on PC and console, and the Reaper of Souls PC expansion pack. We’re looking forward to delivering the expansion content to players on next and current-gen consoles with the release of the Diablo III Ultimate Evil Edition, which we expect to ship on August 19. In addition to the Reaper of Souls content, the Ultimate Evil Edition includes all of the updates that we made to the core Diablo III experience on PC, as well as some console-exclusive features that make it even easier and more rewarding for friends to play together.

And lastly, we just announced plans with NetEase to bring Diablo III to Mainland China.

Rounding out our game update for this call is Heroes of the Storm, our upcoming hero brawler. Alpha testing continued in Q2 and was expanded to include players from other regions around the world. We’re incredibly excited about the prospects for Heroes of the Storm. As we head back into the back half of 2014, we’re looking to close out the year strong with BlizzCon and the release of Warlords of Draenor, in addition to the ongoing content that we’re in the process of adding to Hearthstone, Diablo III and Heroes of the Storm.

We’re proud to be offering more gaming options that appeal to a wide range of players across more platforms than ever before.

Thanks. And I’ll turn the call back over to Kristin.

Kristin Mulvihill Southey – Former Vice President of Investor Relations

Thanks, Mike. And I think, we’ll open up the call for questions now. Operator?

Question-and-Answer Session

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