Good afternoon. My name is Philip and I will be your conference operator today. At this time, I would like to welcome everyone to the second quarter CY 2009 financial results conference call. (Operator Instructions) I would now like to turn the call over to Kristin Southey. Madam, you may begin your conference.
Good afternoon and thank you for joining us today for Activision Blizzard's second quarter calendar ’09 conference call. As always, I will start today’s call with a review of our Safe Harbor disclosure, followed by comments from Bobby Kotick, CEO; Thomas Tippl, Chief Corporate Officer and CFO; Mike Griffith, President and CEO of Activision Publishing; and Mike Morhaime, Chief Executive Officer of Blizzard Entertainment.
I would like to remind everyone that statements will be made during this call that are not historical facts are forward-looking statements. These forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties. The company cautions that a number of important factors could cause Activision Blizzard's actual future results and other future circumstances to differ materially from those expressed in any such forward-looking statements.
Such factors include without limitation sales levels of the company’s titles, shifts in consumer spending trends, the impact of the current macroeconomic environment, the seasonal and cyclical nature of the interactive game market, any further difficulties related to the transition of World of Warcraft in China from the former licensee to NetEase, the company’s ability to predict consumer preferences among competing hardware platforms, declines in software pricing, product returns and price protection, product delays, retail acceptance of our products, adoption rate and availability of new hardware and related software, industry competition, rapid changes in technology, industry standards and consumer preferences, protection of proprietary rights, litigation, maintenance of relationships with key personnel, customers, licensees, licensors, vendors, and third-party developers, counter-party risks relating to customers, licensees, licensors, and manufacturers, domestic and international economic, financial, and political conditions and policies, foreign exchange rates, integration of recent acquisitions and the identification of suitable future acquisition opportunities, our success in completing the integration of the operations of Activision and Vivendi games in a timely manner and our ability to realize the anticipated benefits and synergies of the transaction to the extent or in the timeframe anticipated.
These important factors and other factors that potentially could affect the company’s financial results are described in the company’s annual report on Form 10-K for the period ended December 31, 2008, and subject [inaudible] quarterly reports on Form 10-Q.
The company may change its intentions, beliefs, or expectations any time and without notice, based upon any changes in such factors in the company’s assumptions or otherwise.
The company undertakes no obligation to release publicly any revisions to any forward-looking statements to reflect events or circumstances after today, August 5, 2009, or to reflect the occurrence of unanticipated events.
I would also like to note that certain numbers we will be presenting today, including net revenues, operating income, EPS, manufacturing and distribution costs, product creation costs, sales and marketing expense, and G&A spending, inventory, catalog software, and intellectual property will be made on a non-GAAP basis excluding the impact of the change in deferred net revenues and related cost of sales. Expenses related to equity-based compensation costs, the operating results of products and operations from the historical Vivendi Games businesses that the company has exited or is winding down, one-time costs related to the business combination between Activision and Vivendi Games, the amortization of intangibles and the changes in cost of sales resulting from purchase price accounting adjustments and the associated tax benefits.
Please refer to our earnings release for a full GAAP to non-GAAP reconciliation.
In addition, due to the fact that our business combination was accounted for as a reverse acquisition, we will be presenting additional non-GAAP information that includes Activision standalone results for the periods prior to July 9th ’08, which we refer to as a non-GAAP comparable basis.
Please refer to our earnings release, which is posted on our website, at www.activisionblizzard.com for reconciliations and further explanations.
I would also like to highlight that for your convenience, we are now including some additional information in our reporting. This quarter we have begun adding a brief PowerPoint overview which you can access with the webcast and which will posted to the website following the call.
And now, I would like to introduce our CEO, Bobby Kotick.
Robert A. Kotick
Thank you, Kristen and thank you for joining us this afternoon. July 9th marked our one-year anniversary as Activision Blizzard. As a combined company, we’ve delivered better-than-expected financial performance for the fourth consecutive quarter. We are in a very unique position in our industry. We have the breadth of product portfolio and resources to deliver our short-term commitments of earnings growth and margin expansion and the ability to shift products to future release dates to increase our long-term financial returns and to ensure our product quality objectives are met.
Today we are reaffirming our full-year non-GAAP EPS outlook and we expect to achieve record non-GAAP operating margins of 26%. We also expect to deliver these results despite a weaker-than-expected retail environment and a number of strategic decisions that will have an impact on our short-term revenue outlook but which will strengthen our competitive advantage for the long-term.
Our margins are the highest of any third-party publisher and we expect our growth initiatives will continue to provide long-term opportunities. Our 17-year track record of growth is evidence that our long-term focus is working and has created significant shareholder value.
Over the past few months, we’ve made a number of strategic decisions that reflect our commitment to product quality and the investments required to capture large new market opportunities. With this in mind, we are repositioning the release of Blizzard Entertainment’s Starcraft 2 into the first half of 2010 to coincide with the launch of our new Battlenet game service which will be ready early next year.
A true online destination platform, Battlenet will become the foundation for connecting the tens of millions of members of the Blizzard community in a social gaming network across all Blizzard’s future games. This will begin with World of Warcraft and Starcraft 2.
To put Battlenet into context, it will be a service similar to Xbox Live and it will leverage the technologies, infrastructure, and expertise that Blizzard has developed over the last decade in multi-player play and social networking. And as Mike Morhaime will discuss later in the call, there is no better opportunity to launch this strategic initiative than through the launch of Starcraft 2.
The title is likely to be the most anticipated groundbreaking realtime strategy game of all time and the Battlenet platform is an investment in the future of gaming and an opportunity that we are uniquely positioned to capitalize on.
Today we have more people in more countries playing online games than any other company and we intend to continue our leadership position through franchises like Blizzard Entertainment’s World of Warcraft and Starcraft 2, as well as Activision Publishing’s Call of Duty franchise.
Another great area of opportunity for us is China. We continue to strengthen our position there with Blizzard Entertainment’s partnership with Netease, the premier China based videogame company. This is a long-term investment with a very capable and committed partner. Netease has already made significant investments in upgrading the technical infrastructure of the World of Warcraft service. In fact, from a quality of hardware and network perspective, China is our most advanced geography in technical capability. Mike will also give you more details about our progress in China later in the call.
This flexibility to make long-term investments without compromising near-term results puts us in an enviable position. We’re not preoccupied with dramatic restructurings, burdensome investments to develop online game making capabilities, or the significant risks and expenses associated with entering new geographies like China or Korea. This gives us an exceptionally deep advantage and is the basis for our industry-leading operating margins today and provides us the ability to expand operating margins in the future.
Our cultural focus on thrift is driving further cost reductions throughout our business and our incredibly strong balance sheet has enabled us to repurchase more than $650 million worth of shares since we began our repurchase program. Today we announced that our board of directors has authorized an additional $250 million to our buy-back program to $1.25 billion, further illustrating our long-term focus and commitment to providing superior returns to our shareholders.
I thought it would be useful to remind you of the five key advantages that will enable us to provide superior returns to our shareholders in the future.
First, our focus on a select number of proven franchises and genres, our strong marketing and sales programs, and our ability to find ways to broaden our franchises through innovative business models, new genres, and new markets. Our leading online capability and first mover advantage and access to fast-growing Asian markets, our industry-leading operational capability and the most talented group of employees by far in our sector. And finally, our exceptional balance sheet, which is the result of our continued focus on margin expansion, operational excellence, and rigorous cost control.
It has taken 18 years to create these competitive advantages but today we are better positioned than any of our competitors to capitalize on the long-term opportunities afforded by our industry and we will continue exploring new market opportunities and business models that should enable us to continue growing our operating margins and delivering long-term value to our shareholders as we have over the last 18 years.
Now I would like to turn the call over to Thomas Tippl who will provide a review of Activision Blizzard's financial results for the quarter and review our outlook for 2009. Thomas.
Thanks, Bobby. Today I will begin with a review of Activision Blizzard's June quarter results and then I will review our updated outlook for the third quarter and calendar 2009.
Before I get into the numbers, I would like to remind everyone that due to reverse merger accounting, our historical GAAP financials are those of Vivendi Games only. Activision’s results are only included as of the date of the merger, July 9, 2008. In order to help you with year-over-year comparisons, we have included in our press release a set of schedules which provide non-GAAP comparables by business segment, and these will be the numbers that I will refer to unless otherwise noted. Also, please refer to our earnings release for a GAAP to non-GAAP reconciliation.
Focusing on the core business results, for the quarter, GAAP net revenues were $1.04 billion. GAAP operating income was $218 million and earnings per share were $0.15. As expected, GAAP results for the quarter are ahead of our non-GAAP results as revenues and costs that were deferred from online enabled games in the December quarter were still being recognized this quarter.
On a non-GAAP comparable basis, June quarter net revenues were $801 million, non-GAAP operating income was $156 million, and non-GAAP EPS was $0.08, $0.02 ahead of our outlook.
Our performance was driven primarily by continued sales of our three wholly-owned franchises, World of Warcraft, Guitar Hero, and Call of Duty, and our new releases, Prototype, Transformers, and Wolverine. In addition, we benefited from lower operating expenses due in part to the cost containment strategies we implemented and cost efficiencies generated from our European restructuring, including a lower tax rate.
As anticipated, our quarterly results were lower than the prior year due to tougher market conditions, incremental investments made by Blizzard for product development and customer service initiatives, and the strong performance of Guitar Hero in the prior year.
With respect to specific line items for the core business, I will refer only to non-GAAP numbers. In the June quarter, non-GAAP product costs, including cost of sales for MMOGs, were 36% of net revenues, higher than our outlook due in part to better performance in our distribution business which carries a lower gross margin.
Non-GAAP product creation costs, which include software royalties and amortization, intellectual property licenses, and product development were 22% of net revenues.
Non-GAAP sales and marketing expense was 14% and non-GAAP G&A was 8% of net revenues.
In total for the quarter, non-GAAP operating expenses came in at 44%, approximately 5 points lower than expected. The favorability was due to business mix, lower royalties, and continued over-delivery of our cost reduction efforts, which leveraged the current buyer’s market across most of our procurement areas. Our effective non-GAAP tax rate was 28%. This is lower than anticipated as we benefited from lower taxes on foreign income resulting from our successful European integration and legal entity restructuring.
Now turning to the balance sheet, on June 30, we had no debt and approximately $2.9 billion in cash and investments. This quarter we repurchased 19 million shares. As of quarter end, we were about two-thirds through our original $1 billion authorization and have purchased a total of 64 million shares for $668 million at an average price of $10.41 per share. And as announced today, we have added an additional $250 million to our program.
Now let met turn to our other key balance sheet positions -- the accounts receivable balance was $282 million, an increase of $97 million versus the prior quarter end, due to the late quarter releases of Transformers, Prototype, and Ice Age. Inventories were $198 million, down $32 million from March 31st which marks the third consecutive quarterly decline. Although keep in mind that inventories will go up as usual at the end of the September quarter as we start to build for the big holiday launches.
For the quarter, capitalized software development costs were $247 million, in line with the prior quarter end. Of the $247 million, approximately $13 million is related to deferrals for online enabled games.
Capitalized intellectual property costs were $56 million, up slightly versus the balance on March 31st due to the changes we made to our agreement with DreamWorks. The revised agreement will result in lower guarantees, lower effective royalties paid on future releases, and therefore delivers a return on investment of more than 20% to us.
In summary, our balance sheet remains strong and puts us in an excellent position to capitalize on investment opportunities for long-term growth.
Before turning to our financial outlook, I would like to highlight a few items -- our outlook is subject to significant risks and uncertainties, including declines in demand for the our products, fluctuations in foreign exchange rates, and counter-party risks relating to customers, licensees, licensors, and manufacturers, and current macroeconomic conditions increase those risks and uncertainties.
Our outlook is also based on assumptions about sell-through rates for our products, our new slate of products and associated market pricing. As a result of these and other factors, including any further difficulties related to the transition of World of Warcraft in China from the former licensee to NetEase, actual results may deviate materially from the outlook presented today.
So now to the outlook -- given the continued economic uncertainty, as well as high unemployment, we are monitoring the retail and consumer environment carefully. We remain cautious despite the strengths of our franchises, the quality of our slate, and the best-in-class execution we are bringing to the distribution of our titles, both online and offline.
Having said that, our long-term company-wide focus on profitability is still expected to yield another year of operating margin expansion and EPS growth. However, as a result of moving two titles into next year and the impact of lower software market expectations for the calendar year, which Mike Griffith will discuss shortly, we are adjusting our calendar year revenue outlook. For calendar 09, we now expect GAAP net revenues of $4.05 billion as compared to our prior outlook of $4.3 billion; and non-GAAP net revenues of $4.5 billion as compared to our prior outlook of $4.8 billion.
For calendar ’09, we are reaffirming our non-GAAP EPS outlook of $0.63. We expect that lower revenues will be offset in part by the stronger than expected performance of a few of our higher margin titles and related online revenues, better-than-expected synergy savings, and a lower effective tax rate.
Our GAAP EPS outlook has increased by $0.02 to $0.26 per share due mainly to the expected decrease in deferrals from online enabled games.
For the calendar year, we expect GAAP product costs, including cost of sales for MMOGs of approximately 35% of net revenues and operating expenses including royalties of about 55% of net revenues. We project the GAAP effective tax rate of about 19% and a diluted share count of about 1.32 billion.
On a non-GAAP basis, we expect product costs, including cost of sales for MMOGs of 37%, which is a significant improvement over the prior year, driven by cost reductions for Guitar Hero hardware and the mix shift to software for the franchise.
Gross manufacturing margins will also expand due to smaller contributions to our business mix from our distribution and co-publishing businesses which carry a much higher cost of goods.
We expect non-GAAP operating expenses, including royalties of almost 37% of net revenues. This is above year ago due to our larger publishing slate, which includes a number of new intellectual properties resulting in higher product creation costs and higher sales and marketing expense year over year.
Also, as we mentioned on our last call, Blizzard is increasing their investment in product development and customer service to drive long-term growth.
For the calendar year, we now expect a non-GAAP record operating margin of 26%, one step closer to achieving our long-term goal of 30%. We expect our effective non-GAAP tax rate to be in the range of 29%, which as I mentioned earlier is being positively impacted by the completion of our European legal entity restructuring.
We expect a diluted share count of about 1.32 billion. Please note that our share count could vary depending on the amount of repurchases executed in the remainder of the year.
Now moving to the September quarter -- this quarter we have only three releases, Guitar Hero 5, Marvel Ultimate Alliance 2, and Wolfenstein. For the quarter, we expect to generate GAAP net revenues of approximately $680 million. We expect GAAP product costs of approximately 29% and operating expenses including royalties of about 70% of net revenues. We project the share count of about $1.27 billion and GAAP loss per share of $0.03.
We expect non-GAAP net revenues of $700 million. This is below a year ago due to a weaker software market, lower distribution of affiliate revenues, the World of Warcraft transition in China, and negative FX year over year. To put this in perspective, if you just exclude the impact of distribution, affiliate revenues, and foreign exchange impacts, revenues in Q3 will be up 9% and that doesn’t even adjust for the short-term China transition impact.
For the September quarter, EPS will also be down year over year for the reasons I just mentioned, and the fact that we will increase our marketing spend to support our large lineup in the back half of the year in addition to significantly lower investment income as yields continue to decline.
We expect non-GAAP product costs of 35%, non-GAAP operating expenses of 56%, and a non-GAAP effective tax rate of 31%. We also project a diluted share count of 1.31 billion and non-GAAP earnings per share of $0.03.
So in closing, we are reaffirming our short-term EPS outlook and we have strengthened our business for the long-term by growing our market share, investing for the future, and by increasing our earnings per share realization through efficient cost management and share repurchases.
I will now turn things over to Mike Griffith, President and CEO of Activision Publishing, who will provide his thoughts on the coming quarters.
Michael J. Griffith
Thank you, Thomas. Good afternoon. Today I will focus my comments on our projections for the hardware and software market and a review of key drivers for Q3 and the holiday quarter.
Starting with a review of the market, on June 30th, the installed base of hardware in North America and Europe for current gen systems including handheld was 179 million units, an increase of 54% year over year. However, for the quarter, console sales had been weak and were down 37% in the U.S. year over year. And interestingly, in the U.S., the two consoles that have not cut price are down roughly 50% year over year while the two that have cut price over the last year are down less than 1%.
For calendar 2009, we are adjusting our hardware installed base projections in North America and Europe to the following: we expect up 7 million units for PS3 and up 9 million for the Xbox 360, and we expect Wii to add more than 15 million units; and finally, we expect handhelds will grow in excess of 21 million units.
Net net, we’ve reduced our console estimates by about a million units, so we expect the installed base of current gen consoles and handhelds to grow by more than 52 million units during the year.
Due to slower hardware sales and a continued weak macroeconomic environment, and lower-than-expected software sales year-to-date, we are also revising our software market expectations. We now expect the combined North American and European retail software markets to be flat to down slightly this year. However, we continue to expect that Triple A launch pricing will continue to hold throughout the holiday season.
Retailers are increasingly selective with their open-to-buy orders and are taking a cautious approach to inventories as the weak economy continues to weigh on consumer confidence. Overall, we believe that we will see a similar scenario play out as last year where retailers will chase the winners and that top titles will benefit disproportionately.
Given our strong lineup, retailers are showing a strong commitment to our holiday launches and we expect our shelf-space allocations to remain strong throughout this holiday season. And to further support our slate, we have been working with retailers to better merchandise the gaming category in stores.
For example, for the first time, many of our top retailers this holiday will be designating multiple sections within the stores which will exclusively feature our products. Some of these sections will include a store within a store retail space, featuring our key franchises and demo stations. And this will enable our consumers to better navigate our game selection and increase their propensity to purchase.
So to summarize, while the hardware and software market dynamics remain challenging in the near-term, we expect this holiday will be stimulated by the launch of a number of triple A titles. We are well-positioned this holiday with our strong slate and we will continue to leverage our strong shelf space allocations with innovative merchandising supported by strong marketing for our launches.
Now turning to Activision more specifically, even during this difficult economic period we continue to improve our competitive position. For the quarter, we gained 2.8 points of market share in North America and Europe across all platforms, including PC, and we were the number one third party console and handheld publisher in the U.S.
Prototype was the number one selling new IP for the quarter and year-to-date on both the Xbox 360 and PS3 and Wolverine and Transformers were the number one and number two day-in-date best-selling movie game releases.
Before moving to the back-half of the year, I would like to take a moment to discuss our Guitar Hero business. Our strategy for growing the Guitar Hero franchise remains the same, with a focus on expanding our audience, growing international sales, and improving operating margins. We continue to extend our lead in this category.
Guitar Hero is the number one third-party franchise year-to-date in North America and Europe. Our share is growing. Year-to-date, we’ve increased our market share in the music and dance category by eight points to 53% in North America and Europe, and although the music category is down significantly, the Guitar Hero business has performed in line with the overall broader software market.
We are expanding in Europe. Year-to-date, we’ve grown our European sales 66% over the prior year, further extending our lead over our nearest competitor. And we accomplished all these results with no major releases to date. We have a strong competitive advantage as we enter the back half of the year and starting in September, there are significant growth opportunities for the music category with several major launches.
As we head into the important holiday season, we continue to improve our music inventory position at retail. We have strong marketing programs in place to reduce inventory and create space for our upcoming launches. Starting this week, we began offering the Guitar Hero World Tour band kit for $99. In light of the economic backdrop, this should create a lift for retailers, bringing new consumers to the brand and position us well for the upcoming launch of Guitar Hero 5 on September 1st. Early results are strong and retailer response has been supportive.
One of our main goals for the franchise this holiday was better product differentiation to limit retail and consumer confusion, and this holiday our three major releases are well-differentiated. The release dates are spread apart and all three target a different consumer and each is sold with its own unique set of peripherals.
Guitar Hero 5 is targeted for the rock-focused music gamer and can be enjoyed with a guitar or a traditional band set-up. However, it will be sold and featured as a guitar bundle or standalone software. One exciting feature is that players can now jump in or drop out of game play seamlessly using any combination of instruments without interrupting their session, addressing the number one feedback point from last year.
The game will ship with the largest variety of rock songs to date, including music from The Kings of Leon, White Stripes, and The Rolling Stones, appealing to consumers’ stronger interest in variety than single band play. Also, this holiday we have two differentiated products that will appeal to a broader demographic. In October, we’ll launch D.J. Hero, which we expect will expand the audience as the club dance genre is among the most popular in Europe and not yet been address. D.J. Hero will offer more localized content and talent than any other game in the franchise’s history and will ship with a unique turntable peripheral.
We will also release a special branded edition of the game featuring Jay-Z and Eminem that will include an advanced version of the game’s turntable controller, a metal traveling case that transforms into a performance ready D.J. stand, and two exclusive music CD compilations featuring greatest hits and new mixes from each artist. This title stole the show at E3 and captured the attention of all who attended when we did the live demos of the game in our booth.
And in November, we’ll release Band Hero, our first E-rated collection of top 40s music which should appeal to a family audience by offering a new genre of music and fun-to-play pop music hits. The game will be available only as a band bundle or software only. Last week we announced that best-selling artists of 2008, [Taylor Swift], will be an in-game character with several of her hits featured. In total, this is the most innovative and holistic launch program since the brand was first introduced.
So now turning back to the September quarter, in addition to Guitar Hero 5, we will launch two other titles -- Marvel Ultimate Alliance 2 features the largest army of superheroes and villains ever. We recently had a great reception for the game at ComicCon and pre-orders for the title are among the top five highest ever for Activision, well ahead of its successful predecessor. The game will launch on all console platforms and handhelds.
We will also release Wolfenstein for the PS3, 360, and PC which builds on ID Software’s well-established franchise.
And as previously mentioned, we decided to move Singularity, which would be competing with Modern Warfare 2 this holiday in the first person action genre, out of the September quarter and into Q1 2010. The new launch window, which has fewer competitive titles releasing, should improve the probability of achieving stronger results and establishing Singularity as a first-person action franchise for the company.
Developing and launching new intellectual property carries higher risk and especially given the growing demand for Modern Warfare 2, we believe that launching in the March quarter will provide a better opportunity just as we saw with the successful launch of Prototype in the month of June.
Turning now to the December quarter, we have strong buzz for our holiday slate, given our strong showing at E3. In addition to D.J. Hero and Band Hero, we’ll release Bokugan. This new intellectual property leverages the incredible Bokugan television and toy phenomenon. The worldwide retailer excitement around this title is strong and building and we expect that Bokugan will be the hottest kids property this fall.
In November, we’ll release our new racing game, Blur, from Bizarre Creations. Blur had a strong showing at E3 as well, including the nomination for best racing game. We’re excited to be entering this genre and we think the game itself sets us apart from the competition and will establish a new franchise for the company.
Next up is Tony Hawk Ride, which lets consumers experience the thrill of skateboarding like never before. The game comes with an authentic skateboard controller that introduces groundbreaking game technology with a motion sensing wireless peripheral that maps your every move. You can push the board with your feet, tilt the board, rotate it 360 degrees, and execute moves with your hands.
Our goal from the start was to reinvent this franchise and engage a broad mass market consumer and we feel very good about the strong reception so far.
To satisfy initial demand this holiday season for Tony Hawk Ride, we will only ship the game in North America, U.K., and Germany on the Xbox 360, PS3, and Wii. It will ship in other territories globally in early 2010.
And then last but not least on November 10th, the much anticipated title Call of Duty: Modern Warfare 2 will hit store shelves. This will be the must-have title of the year. The original Modern Warfare was released two years ago and has sold almost 14 million units worldwide life to date. The excitement for the next installment is evidenced by the largest pre-orders in Activision’s history.
We plan to launch a broad SKU lineup to leverage the major excitement and in addition to the main console and PC SKUs, we expect to launch two collectors’ editions, both in limited quantities, one of which will include night vision goggles. We will also release Call of Duty 4: Modern Warfare on the Wii and Call of Duty: Modern Warfare Mobilized for the DS.
In terms of online content, we plan to launch two separate map packs for this title. Map packs help extend the shelf life of the franchise, as evidenced by the strong catalog sales and premium pricing that we maintained a year-and-a-half after launch. Life to date, we’ve had strong success with map packs on this franchise, selling more than 8 million units for both the Xbox 360 and PS3.
In total, our lineup is exciting and stronger than last year’s and as always, we plan to launch all of our major releases before Thanksgiving. Looking out to 2010, calendar 2010, our slate is anchored by increased innovation for a number of our core proven properties, including a strong lineup behind the Guitar Hero franchise, and we also expect a strong year for Call of Duty behind the combination of new releases, online monetization, and what should be our best catalog year ever with Modern Warfare 2.
We will launch also new games based on James Bond, Tony Hawk, and Spider-man, along with games supporting the theatrical releases for DreamWorks Shrek 4 and How To Train Your Dragon.
In addition, as previously announced, we are planning to release an innovative property in the $4 billion action genre.
So in closing, this quarter and year-to-date, we succeeded in taking advantage of a tough economic backdrop by increasing our market share, leveraging our strong franchises, and focusing on operational discipline. We’ll continue to employ this successful strategy as we navigate through the remainder of the year.
Looking ahead, we remain optimistic about many long-term opportunities that our industry offers.
So now I would like to turn the call over to Mike Morhaime, CEO and President of Blizzard Entertainment.
Thank you, Mike. I would like to briefly discuss Blizzard’s Q2 performance and then give some insight on how the rest of the year is shaping up for us.
Our revenues for the second quarter were stable versus the same quarter last year, so despite the impacts that the strengthening dollar has had on our four markets year over year, we were still able to hold on to our sales position within a struggling global economy. Our non-GAAP operating income was down just under 6% from the second quarter of 2008. Foreign exchange and the global economy played a role here but we were also investing heavily in product development and customer service. As we have mentioned on previous calls, these are two key areas of focus for Blizzard that we view as critical to our long-term success.
Looking at subscriber trends, a Q2 year-over-year comparison doesn’t make much sense right now because by quarter’s end, World of Warcraft was offline in China. However, we feel very positive about the fact that in the west, our subscriber numbers were up year over year, again despite the economic downturn.
Now I would like to give some perspective on how we were approaching the second half of the year. As most of you know, our focus at Blizzard has been on developing and publishing high quality online games for players around the world. We believe the key to understanding this market is to see that it is more than just a market. It is a community of gamers perhaps more connected to each other than any other community.
Like all communities, this community has expectations, some more critical than others. And one rule that holds this community together is that for those who build the game and run it, the players and the games must comes first. That means we must get the games right before we release them or we must work on them until they are right.
Like other Blizzard games, we want Starcraft 2 to be a game that our players enjoy for years, not just a few months. Integral to the Starcraft 2 game play experience is the launch of our next generation Battlenet game service.
Our vision for Battlenet is ambitious. As I have said before, we intend to make Battlenet the premiere online gaming destination. We view the next generation of Battlenet as strategically important to the future of our company. It’s the foundation for all future online games at Blizzard and will be the cornerstone of our community.
In addition to supporting tournaments, rankings, and multi-player game matching for Starcraft 2 and future Blizzard games, the next generation of Battlenet will add social networking features, cross-game communication, unified login and account management, and more. Battlenet will bring together players from across all of our games including World of Warcraft, eventually allowing them to connect, communicate, and share experiences with each other through the service regardless of which Blizzard game.
The new version of Battlenet is being integrated with Starcraft 2 more tightly than in any previous Blizzard game. Over the past few weeks, it has become clear that it will take longer than expected to prepare the new Battlenet for the launch of Starcraft 2. This means, as Bobby mentioned, that we will not be ready to launch Starcraft 2 in 2009. We recognize that we only get one chance to make a first impression. It’s much easier to retain a player that has a great initial experience than to bring them back after a mediocre one.
While we could rush into beta and launch an inferior game and service experience this year, fixing that experience over time, our track record has proven that there is a far greater value for us and for our players in making sure that the experience is great right from the start.
Looking at the monthly NPD charts from this year, you will see that our strategy has been reinforced over and over, with Blizzard games from six, eight, and even 11 years ago regularly appearing in the top 20 in sales. This is a direct result of our commitment to quality and to our players and it explains why it makes sense to spend the time we do polishing our games before we release them.
Once we release Starcraft 2 next year, we will move immediately on to the first of two expansions. We will also continue developing and implementing advanced Battlenet features, which I will discuss more on future calls.
For those who might not be familiar with it, let me make a point about the cultural phenomenon of Starcraft, which is important for understanding the existing landscape that Starcraft 2 will launch into.
Starcraft helped lay the foundation for the professional gaming, or e-sports industry. It is widely played throughout the world but especially in Korea, where it remains the number three online game in the country, more than 10 years after launch. Starcraft 2 is being designed to build on the e-sports elements that made the original Starcraft so popular around the world.
We will also be working to expand the popularity of competitive gaming in the west and other regions. We are already starting to see interest from mainstream media like ESPN who have begun to cover e-sports leagues.
Asia plays a large part in our strategies for Starcraft 2’s growth. In addition to the popularity of Blizzard strategy games in Korea, there is a vast existing player base in China. We plan to establish Battlenet as the platform of choice in China for Starcraft 2 and incentivize players to use legitimate copies instead of pirated versions.
We are optimistic about China. It is a market with tremendous potential and we are very pleased with our position there. We are the first western gaming company to develop a major presence in China. It will take years of experience for others to match our knowledge of the Chinese marketplace. While our competitors will be working to introduce and establish their brands, we are already in a great position to grow our audience there.
As an example of what I mean, our move of World of Warcraft to Netease will unify all of our player communities in China. Netease already holds the license for Starcraft 2 and Warcraft 3 in the Chinese market. We believe the partnership will allow us to maintain the consistency of quality and service and the operating efficiency that we will need to grow in this enormous market.
Netease has unparalleled distribution to second, third, and fourth tier cities which should help drive growth of our player base dramatically over the coming years.
While we await the green light to relaunch World of Warcraft in China, we are not forgetting our tremendous base of Chinese players. We are currently running a beta test with Netease on the new infrastructure in China that is only open to existing World of Warcraft players. In the past week, more than 4.2 million World of Warcraft accounts have already logged in to play during this period.
We feel that no game currently on the market in China matches the quality and depth of content that World of Warcraft offers. We anticipate that this will be reflected by considerable turnout of new, existing, and returning players when the game relaunches.
There’s one more piece of Warcraft related news I wanted to mention. As you probably know, we have been working with Legendary Pictures, the company behind The Dark Knight, on a movie based on the Warcraft universe. Just last month, we announced that Sam Raimi, director of the Spider-man series, has signed on to direct the Warcraft movie. This means that the movie is in the hands of someone who understands its audience and who has major blockbuster experience, which is great news for us and our players.
I’ve talked a lot about our player community. You may or my not be aware of how passionate and intense that community can be. A good opportunity to witness the Blizzard gaming community in action will be at our fourth Blizz-con convention, which will take place on August 21st and 22nd in Anaheim. Like our previous shows, this one sold out in minutes, despite the fact that we sold more tickets than ever before, 20,000 this time around.
At Blizz-con, the attendees will play our unreleased games, they will watch world champion gamers compete, they will hear panel discussions by our designers, and also share their thoughts about our games. And for those who weren’t able to buy tickets, we will offer the show live via pay-per-view on DIRECTV and over the Internet. If you are looking for a measure of the force of our gaming community and how it shapes our company, Blizz-con is it. I hope some of you will have the opportunity to attend this year and see for yourself.
Thanks, everyone. I will turn the call back over to Kristen now.
Thanks, Mike. Operator, we would now like to open up the call for questions and as always, we ask that you limit your questions to one per caller. Thank you.
(Operator Instructions) And our first question will come from Tony Gikas.
Tony Gikas - Piper Jaffray
As it relates to shifting Starcraft into 2010, does that mean that we will get two key Blizzard releases next year? And a second question, if you don’t mind, just your comfort level regarding pricing of some of your new games that have some expensive controllers and any feedback that you had from retail as we move through the holidays. Thanks, guys.
While we have not announced the release dates of any of the titles, I will confirm that the move of Starcraft into 2010 does not affect the release schedules of any of our other games.
Michael J. Griffith
And then on the second question, Tony, on the pricing, we’ve had for all of our launch titles in the back half of this year, some of which contain peripherals, as you point out, very strong retailer acceptance and support for all parts of our plan, including our merchandising plans, our marketing programs, and our price points.
Robert A. Kotick
And Tony, you know if it was left to me, I would raise the prices even further.
Your next question comes from the line of Jeetil Patel.
Jeetil Patel - Deutsche Bank
A couple of questions -- as you look at operating margin expansion, of which I think you mentioned a couple of times in your release and your presentation and your historical presentations, but I guess what would you -- would you expect as you look at the future, the margin expansion operating leverage to be more so on the core Activision side or the Blizzard side of the equation?
And then secondly, can you talk about I guess to the point of pricing, what are you guys seeing in terms of pre-order mix of prestige versus the other versions for the Call of Duty franchise?
Robert A. Kotick
I would say this, that we’re not discriminating between operating units, so we see opportunities for margin expansion across all of the franchises that we’re involved with.
As far as the premium priced product, you know, collector’s editions and things like that, I’d say we’re seeing probably more interest than we have in the past on the collector’s editions, so that’s a pretty good indication of the interest in these franchises.
Your next question comes from the line of Ben [Schacter].
Ben Schacter - Analyst
If we think about the business for the second half and exclude any music games, Call of Duty, and World of Warcraft, all that’s left over, what percentage of total revenue and operating income might come from that?
And then on Battlenet, is it possible that we may see Activision franchises on Battlenet in 2010 or 2011? Thanks.
So I think clearly we do expect Call of Duty and Guitar Hero to be the top selling franchises this holiday season based on the strengths of the games and the fan base that they have. Obviously we also continue to expect to make great progress on World of Warcraft, particularly once China comes back up and as you may also know, we still have the Wrath of the Lich King expansion pack ahead of us in China. So we expect that those will be the top-selling franchises, but we also have franchises we didn’t have last year like Tony Hawk, where we have high expectations and then we are believing that with Blur and the entry into the racing genre, we have another big opportunity for us and then lastly Bokugan I think will also contribute significantly to our operating results in the holidays.
So I think we’ve got a strong balanced lineup of very proven franchises, as well as new intellectual property introductions that are tackling large market segments and as a result should be able to contribute.
Okay, and with regard to the Battlenet question, we are completely focused right now on supporting the Blizzard titles and especially preparing for the launch of Starcraft 2.
Your next question comes from the line of Brian Pitz.
Brian Pitz - Analyst
Just regarding your Modern Warfare 2 demand, are you seeing in addition to high pre-order rates, are you seeing higher purchase order rates from retailers than you were a quarter ago? Or more generally, can you just comment on that? Have you been increasing your internal forecasts on the name based on the data that you are seeing? Thanks.
Michael J. Griffith
On the title Modern Warfare 2, we continue to see growing strength across all measures as this title materializes and frankly based on the growing Call of Duty consumer base and the growing installed base, both of which have contributed strongly to the anticipation of this. So we have continued strong pre-orders. As we mentioned, retailers are cautious on their open-to-buy and inventory positions but this is one that they know is going to turn extremely fast and so we are seeing continued retailer -- continued growing retailer interest in supporting this title.
And especially when you look at the competitive landscape, which has only opened up for this title over the last couple of months, you know, that’s increased our sense of confidence in the launch.
Your next question comes from the line of Heath Terry.
Heath Terry - FBR Capital
Great. Thank you. I guess first, I just want to clarify on the issue of Starcraft not having any impact for Diablo timing for next year. You’ve said that there would be one major release from Blizzard coming out every year. Does that imply that we will have two major releases coming out for Blizzard next year? And then secondly, Bobby, if you could just comment, you know, I would love your perspective on what the holiday season looks like this year. It seems like with so many of the pushes that we’ve had and delays in products that we’ve had this holiday season that there’s a pretty open playing field for the slate of titles that you’ve got. How would you kind of compare this holiday season from a competitive standpoint to what we’ve seen in recent years?
I would just like to reiterate that we haven’t announced any release dates on any future titles. And I will also reiterate that the move of Starcraft into next year does not impact the schedule and so it would be correct to conclude that you could expect two releases of Blizzard next year but I would not make any conclusion on what those titles are going to be.
Robert A. Kotick
And as far as the holiday, Heath, I would say we are very concerned. I think that you are going to see a concentration of purchasing in a smaller period of time. I think where we are with this economy, there’s a lot of reason to be concerned and cautious. Having said that, I think we are better positioned than any company in the category. I think we have a better slate with more differentiated products with more focused marketing programs and I think when you talk to retailers today, what they are saying is that we have the products that are going to drive consumption, that will drive people into the stores. These are the kinds of products that deliver a high level of value to consumers when you look on the cost per hour basis, and so while we are very cautious about consumption overall, I think we are very bullish about our product slate.
Your next question comes from the line of [Jess Lubert].
Jess Lubert - Analyst
Good afternoon. Thanks for taking my question. Can you give us a sense of whether Starcraft will now ship in early first half ’09 or closer to the middle of the year? And perhaps can you give us an update on the hardware supply for D.J. Hero and Tony Hawk? And how profitable do you believe these titles will be relative to the initial launches of Guitar Hero? Thanks.
Okay, well, we’re going to launch Starcraft 2 as soon as it’s ready. Our current launch window is first half of next year.
Michael J. Griffith
And then on your question on D.J. and Tony peripherals, you know, it is always an important balance with a peripheral supported game between meeting demand and avoiding excess inventory builds, so on both of these we are being cautious and certainly are going to support the launches that we have this year in full. But truthfully, we expect to continue to chase these titles into 2010 with additional peripheral quantities.
And with regard to the profitability, you know, we expect them to contribute not just to the top line but also the bottom line and I think our price points reflect the additional value we provide through the peripherals as part of the gaming experience and that’s how we have managed it in the past on Guitar Hero and we expect to continue to manage it for all of our peripheral based games.
Your next question comes from the line of Shawn Milne.
Shawn Milne - Janney Montgomery
Thank you. I wondered, Tom, if you could just give a little bit more color on if you look at the fourth quarter revenue guidance, it’s down about 3% year over year but expecting good strong operating margins. If you could bucket out what’s making you feel better about operating margins, whether it’s cost synergies or again the shift to higher margin titles?
And then looking at the third quarter earnings guidance, are you assuming that the World of Warcraft transition in China continues through the bulk of the quarter and that you are not getting any minimum royalties in Q3? Thanks.
Let’s maybe start with Q3 -- we are not 100% in control of when we will be able to go live in China. As a result, we have to plan conservatively in that case. We hope we are going to be up very soon, given that Blizzard and Netease got the okay to run the beta and the beta has been going well but we still do not have a final approval and a publishing number.
With regard to Q4, yes, we do expect margin expansion in Q4 and that is driven by a number of factors. We have made a lot of progress on bringing the cost of peripherals down compared to Guitar Hero World Tour, Band Hero band kit cost will be lower.
We’ve also had with Call of Duty Modern Warfare 2 a title that’s going to be huge and as you know, there’s a lot of operating leverage that is generated by that. We continue to see strong out-performance on the online components of our game, including in particular downloadable content on Call of Duty. That’s contributing positively.
So there’s a number of factors that are helping improve the margins and then as you know, we are running a pretty tight ship on all the overhead expenses.
And we’ll take one more question -- and your final question comes from the line of Ralph Schackart.
Ralph Schackart - William Blair
Good afternoon. Two questions, if I could -- first, Mike, you had said that Call of Duty was strong year-to-date. I was wondering if you could sort of give us a sense of where the pre-orders are this year versus last year. And then a second question as it relates to the industry outlook, can you sort of summarize what you think has changed since the last call in the industry that was looking at sort of flat to mid-single-digit percent growth? You know, an improving economic outlook, it’s just a lagging effect of unemployment, are we saturated with where hardware sales are with price points now but -- what do you think it’s going to take to really get the industry going?
Michael J. Griffith
All right, sure, Ralph. I think on your first question on Call of Duty, there have been a number of factors that have continued to strengthen this title as it gets closer to launch. One is that our overall franchise from previous launches continues to expand its user base. Catalog sales have been strong. Obviously the installed base of hardware has expanded since the previous launch. And as we started to release trailers and other game assets, the community has responded very well and I think the anticipated promise of the game is being realized and people are responding to that. So we are seeing stronger signals on many fronts, including pre-orders and retailer commitments.
On the industry in general, you know, I think we saw softer sales than we expected over the last month or two. Obviously we’ll see what happens with pricing action in the second half on the hardware side but overall I think we are just responding to the difficult macroeconomic environment, the more recent trends in the market that were a little bit softer on the catalog side of things and on the hardware side of things than we expected and projecting that into the holiday quarter.
But as we said earlier, we feel like we’ve got a very strong lineup and competitively we’re extremely well-positioned. Retailers are supportive and so we expect to see some stimulus to the category this holiday.
Robert A. Kotick
Can I just add that what you’ve increasingly seen is that it’s a smaller number of the highly promoted, highly desirable titles that are driving the margin expansion and opportunities for growth and we are in that fortunate position of having many of those titles.
Okay, Operator. I would like to say on behalf of everyone at Activision Blizzard that we thank you for your time and consideration and we hope to see you all at the upcoming Blizz-con.
This concludes today’s teleconference. You may now disconnect.
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