Michael Morhaime - Chief Executive Officer of Blizzard Entertainment and President Blizzard Entertainment
Thomas Tippl - Chief Operating Officer and Chief Financial Officer
Robert Kotick - Chief Executive Officer, President and Director
Kristin Southey -
Eric Hirshberg - Chief Executive Officer of Publishing Unit
Michael Hickey - Janco Partners, Inc.
Eric Handler - MKM Partners LLC
Brian Pitz - UBS Investment Bank
Edward Williams - BMO Capital Markets U.S.
Daniel Ernst - Soleil-Hudson Square Research
Atul Bagga - ThinkEquity LLC
Jeetil Patel - Deutsche Bank AG
Brian Karimzad - Goldman Sachs Group Inc.
Activision Blizzard (ATVI) Q1 2011 Earnings Call May 9, 2011 4:30 PM ET
Good day, and welcome to the Activision Blizzard's First Quarter 2011 Earnings Conference Call. Today's call is being recorded. At this time, for opening remarks and introductions, I would like to turn today's call over to the Senior Vice President of Investor Relations, Ms. Kristin Southey. Please go ahead, ma'am.
Good afternoon, and thank you for joining us today for Activision Blizzard's first quarter 2011 conference call. With me today are Bobby Kotick, CEO of Activision Blizzard; Thomas Tippl, COO and CFO of Activision Blizzard; Eric Hirshberg, CEO of Activision Publishing; and Mike Morhaime, CEO of Blizzard Entertainment.
I would like to remind everyone that during this call, we will be making statements that are not historical facts. These forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties. As indicated in the slide that is showing, a number of important factors could cause the company's actual future results and other future circumstances to differ materially from those described in any forward-looking statement. Such factors include, without limitation: Sales levels; increasing concentration of titles; shifts in consumer spending trends; current macroeconomic and industry conditions and conditions within the video game industry; our ability to predict consumer preferences among competing genres and hardware platforms; the seasonal and cyclical nature of our industry; changing business models, including digital and used games; competition; possible declines in pricing; product returns; price protection; product delays; adoption rate and availability of new hardware and related software; rapid changes in technology and industry standards; litigation and associated costs; the effectiveness of our restructuring efforts; protection of proprietary rights; maintenance of key relationships, including the ability to attract, retain and develop key personnel and developers that can create high-quality hit titles; counterparty risk; economic, financial and political conditions and policies; foreign exchange and tax rates; identification of acquisition opportunities; and potential changes associated with geographic expansion.
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 ending December 31, 2010, and in the company's other SEC filings. The company may change its intentions, beliefs or expectations made at anytime 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, May 9, 2011, or to reflect the occurrence of unanticipated events.
I'd also 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 the share-based payments, expenses related to restructuring of our Activision Publishing operations, the amortization of intangibles and impairment of intangible assets and the associated tax benefit.
Please refer to our earnings release, which is posted at 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.
And now I'd like to introduce our CEO, Bobby Kotick.
Thank you, Kristin, and good afternoon. We're pleased to announce that Activision Blizzard delivered another quarter of better-than-expected financial results and established new first quarter records for net revenues, operating margin and EPS, which increased more than 40% year-over-year. Our solid financial performance is driven by a 30% increase in revenues in digital channels year-over-year. Because of our leadership and growth in online gaming, our focused execution and our financial discipline, we have started the year with strong momentum and we are raising our revenue and EPS outlook for the year.
We continue to shift our business towards Digital delivery of content and establishing direct ongoing relationships with our audiences. While this quarter, 50% of our revenues were Digital we are still scratching the surface when it comes to the role that digital delivery will play in our products and franchises. We're seeing the benefits of this focus in the development of new capabilities, the release of even better products with greater audience engagement and in our financial performance.
Our deep capital resources and long-term view of our business provide us the unique ability to continue investing in the major new growth and margin expansion opportunities we continue to find or create. The largest and most rewarding opportunities by creating billion-dollar franchises or building successful digital delivery platforms can often take years to develop, require significant financial and development resources and necessitate management continuity, discipline and focus.
The long list of hurdles and obstacles are why so few companies pursue these large-scale opportunities and why there are still only just a handful of billion-dollar franchises and successful digital platforms. Today, we develop and support 2 of the largest online communities in all of consumer entertainment, collectively serving more than 30 million people. The scope and engagement of the World of Warcraft and Call of Duty communities is massive. In addition, the relaunch of Battle.net has given our audiences fantastic new functionality and connectivity across the entire Blizzard portfolio.
In terms of retail performance, our leadership remains unmatched. Of the top 10 highest grossing North American titles of all time, 5 are Activision Publishing's and 4 are Nintendo's.
Looking ahead, we remain excited about our prospects as there is significant potential to engage audiences and leverage our strengths. As we have done historically, we continue to prioritize our focus in order to maximize the many opportunities that we have.
Today, the majority of our employees are dedicated to our online product development and service operations and initiatives. Our disciplined approach should enable us to continue raising the high bar we created and further improve the experiences we delivered through our community of always connective players, whether it be through World of Warcraft and Call of Duty, which are accessible through multiple online touch-points; Battle.net, for the upcoming Call of Duty micro-transaction game for Asia; our Call of the Duty digital platform, for the new Bungie universe, which are just a few of our announced online initiatives.
With respect to our release plans this year, we expect like the last few years, only a handful of franchises are likely to generate the vast majority of industry profits as players continue to gravitate to the very best entertainment experiences. This year's Call of Duty has a very high bar to exceed, yet we believe that this year's Call of Duty initiatives will result in the best overall Call of Duty experiences we have created to date.
We'll be releasing more details on the various Call of Duty initiatives for this year and the coming weeks. And we expect to support these with the largest integrated marketing and retail campaign we have ever executed. We will once again set a new benchmark for best-in-class execution in conjunction with our partners around the world, who are equally invested in making Call of Duty the must-have entertainment experience of the year.
We will also launch Skylanders Spyro's Adventure, a breakthrough new play experience that brings your toys to life. Some of the most successful collectible toys that have interactive capabilities have sold in the billions of units. Later in the call, Eric will share with you some of our plans about Skylanders, which is one of the biggest investments we've ever made in a new intellectual-property.
And of course, the amazingly talented people at Blizzard are hard at work developing new content for World of Warcraft, StarCraft and Diablo as well as their next-generation MMO. Collectively, our multi-year pipeline has never been stronger. And looking ahead, our clear leadership in Digital, our strong franchise portfolio and our long-term business strategy, coupled with continued investments and our strong financial foundation, position us to extend our outstanding track record of performance and continue to deliver long-term growth and shareholder value.
Now I'd like to turn the call over to Thomas Tippl who will provide a review of Activision's financial performance. Thomas?
Thank you, Bobby. I'll begin with a recap of our record first quarter results, followed by a review of our outlook for the second quarter and our increased outlook for 2011. For your reference in our press release is a set of schedules, which provides non-GAAP comparables and these will be the numbers that I would refer to unless otherwise noted. Also please refer to our earnings release for our GAAP to non-GAAP reconciliation.
For the first quarter, our GAAP results reached new heights with revenues increasing to $1.4 billion, our GAAP operating margin increasing to 47% and our GAAP EPS increasing to $0.42, up 40% over the prior year. On a non-GAAP basis, it was also our largest and most profitable first quarter. Non-GAAP revenues grew to $755 million, exceeding the prior year. Non-GAAP EPS grew to $0.13, up 44% versus the prior year. In addition, we expanded our non-GAAP operating margin by approximately 600 basis points over the prior year to a record 29%, again exceeding most major media companies and several leaders in Internet and software.
Our record results were again driven by our products' online integration and digital revenue strengths. Blizzard Entertainment achieved first quarter record revenues and earnings driven by World of Warcraft and Call of Duty, which not only maintained its momentum at retail but shattered previous DLC records with the launch of the first Black Ops online content pack, First Strike.
For the quarter, GAAP revenues from high-margin digital channels increased by 30% and accounted for 30% of total revenues. On a non-GAAP basis, revenues from digital channels increased 30% over the prior year and accounted for more than 50% of total revenues.
Before I review the P&L line items for the March quarter, I want to highlight that I will quote all percentages based on net revenues, except the tax rate. For GAAP, product costs were 25% and operating expenses were 28% and our tax rate was 26%. In the first quarter, non-GAAP product cost were 30%, as expected. Non-GAAP operating expenses were 41%. This is lower than our prior outlook of 50% due to operating leverage from strong digital top line performance and the timing of certain expenses that were planned for the March quarter and will now be incurred in the June quarter.
We delivered a 29% non-GAAP operating margin and our effective non-GAAP tax rate was also 29%.
Finally, we generated operating cash flow of $134 million for the quarter, which brings me to the balance sheet. On March 31, we had no debt and about $3.4 billion in cash which is relatively in line with year end, despite investing approximately $340 million in the purchase of our stock during the quarter. Our receivables balance on March 31 was $95 million, a record low since the merger.
Receivables were down significantly versus year end as expected and down $39 million versus prior year. Inventories were also a record low since the merger, totaling $103 million. They rebound slightly versus year end and down $91 million versus the prior year due to a significant reduction in the value of our peripherals inventory.
Capitalized software development costs were $194 million, a decrease of $27 million versus the prior year due to fewer titles in 2011. $49 million of the capitalized software development costs relate to deferral balances.
Today, our balance sheet is stronger than ever and we continue to see working capital improvements driven by the increased percentage of our business coming from digital channels. The strength of our balance sheet and consistency of our cash flows afford us the ability to return value in the form of dividends and share repurchases and invest for future growth in our highest organic and external return on invested capital opportunities.
So let me now move to our outlook. This year, we're again reallocating our company-wide resources against the biggest opportunities. Accordingly, we are focused on 3 initiatives to drive operating margin expansion and long-term growth. Let me quickly review them and our progress against each in the first quarter.
First, we continue to focus on our high-margin Digital business and in the first quarter, we achieved this goal with 30% revenue growth year-over-year. And looking ahead, we have more online-enabled projects in development than ever before. Second, we have streamlined the Activision Publishing business for higher profitability and online expansion. The first quarter, we saw the initial benefits of our restructuring, less spending and a lower fixed cost structure. And for the full of year, we expect run rate cost savings of more than $75 million. In addition, Activision Publishing achieved record first quarter earnings and operating margin driven by online expansion.
And finally, we're investing for the future to extend our Digital leadership and expand our core brands. This quarter, we continue to allocate the vast majority of our income investments to our biggest franchisers and online product and services capabilities such as Call of Duty and its online platform, Bungie, World of Warcraft, StarCraft, Diablo, and scaling up Blizzard's next-gen MMO game.
So in summary, for the first quarter, we executed against each of our stated goals, which resulted in our record financial performance and gives us confidence in our plan for the rest of the year and beyond. So now on to the numbers.
As I mentioned on our last call, given Blizzard Entertainment has not confirmed the launch date for its next global release, our outlook at this time does not include a new game from Blizzard in 2011. Should Blizzard not release a major title this year, we would expect, for planning purposes, to launch a minimum of 2 Blizzard titles in 2012.
For calendar 2011, given our momentum in the first quarter, we're increasing our financial outlook. We now expect GAAP revenues of $4.05 billion, up $100 million from our prior outlook and GAAP EPS of $0.61, up $0.05 from our prior outlook. For the calendar year, we expect GAAP product cost of 27% and operating expenses of 48%. We project a GAAP effective tax rate of about 29% and a diluted share count of about 1.2 billion, both of which can be used for all quarters.
On a non-GAAP basis, we now expect revenues of $3.95 billion, up $50 million from our prior outlook and non-GAAP EPS of $0.73, up $0.03 from our prior outlook. For the year, we expect non-GAAP product cost of 26%, resulting in the highest gross profit margin in our history driven by our continued transition to digital products and services.
We also expect non-GAAP operating expenses of about 43%. This is higher than our prior outlook due to an increase in expected marketing spending for Call of Duty and our new IP Skylanders. Year-over-year, we expect operating expenses more than $150 million, including the significant investments we are making in Blizzard and Call of Duty. We project the non-GAAP effective tax rate of about 30% and a diluted share count of about 1.2 billion, both of which can be used for all quarters.
For the calendar year, we still expect the combination of our strong Digital business and the streamlining of our Activision Publishing business will result in a record GAAP operating margin, 25% and non-GAAP operating margin of 31%. And we see more opportunity for future margin expansion as we continue growing our share of Digital revenues, which today produced operating margins in excess of 50%.
Now moving to the June quarter. On May 3, we released Black Ops Escalation, the second add-on content pack for the Xbox. And still to come is our first Kinect title Wipeout In The Zone. Black Ops Escalation for the PS3 and PC and our only multiplatform release Transformers: Dark of the Moon. For comparison purposes, last year, in the June quarter, we launched a Call of Duty Map Pack and 4 multiplatform titles: Shrek, Transformers, Singularity and Blur.
For the June quarter, we expect to generate GAAP revenues of approximately $985 million with product cost of 28% and operating expenses of 41%. We expect GAAP earnings per share of $0.19. For the June quarter, we expect non-GAAP revenues of $575 million, revenues will be down versus the prior year, due primarily to a smaller product lineup and the expected loss of high-margin revenue due to the temporary the PlayStation network shutdown.
We expect non-GAAP product cost of 29%, lower than the prior year due to favorable mix. We expect non-GAAP operating expenses of 59%, higher than the prior year on a percentage basis due to increased investment in Blizzard and Call of Duty and development expenses for the Diablo 3, our media expenses and marketing expenses that are planned for the March quarter that are now expected to be incurred in the June quarter as I mentioned earlier.
Finally, for the quarter, we expect non-GAAP EPS of $0.04. With respect to the September quarter, our reschedule is more in line with the June quarter and very light as compared to the September quarter last year. In the upcoming September quarter, we expect to release only 1 major title, X-Men Destiny, as compared to the prior year when we launched Spider-Man and the record-breaking StarCraft II.
In summary, we started the year with great momentum and we think that our strength in the retail and digital online segments combined with our continued cost-containment efforts, position us in 2011 for another year of operating margin expansion and returning value to shareholders and most importantly, for profitable growth in 2012 and beyond.
So now, let me hand it over to Eric to discuss our Activision Publishing business.
Thanks, Thomas, and hey, everyone. Before I get into the specifics of our slate, let me start with some high-level comments on the industry, which provide the foundation for where we're focusing our time and resources. Overall, the major themes remain consistent with what I said on my last call, starting with Hardware. We ended the quarter with an installed base of current gen systems in North America and Europe of 277 million and we expect to end the year at 312 million units, the highest ever in gaming, and up 44 million units or 16% over the prior year.
Within that, we expect with the installed base of online-enabled consoles, mainly the Xbox 360 and the PS3, will increase even faster by 24% to 92 million.
With regard to the PlayStation network issues Sony is facing, we always we are hopeful that they will be up and running as soon as possible. We're planning on launching the Call of Duty Escalation content pack for the PS3 later in the quarter and I'm hopeful that this situation will be resolved by then.
Digital division continues to be the fastest-growing, most profitable part of the industry. We estimate the Digital sales in the U.S. and Europe alone grew double-digit in the first quarter and we expect a similar rate of growth for the full year, driven by higher broadband penetration, increased consumer adoption and additional content.
We believe that the largest installed base of hardware ever, combined with continued and rapid growth in digital, create significant global opportunities for the best games with the most passionate audiences to grow, especially high-margin, online-enabled franchises.
In 2011, we again expect the biggest titles will continue to take consumer mind share and will generate the majority of the industry's profits. And in fact, we're seeing this ourselves with Call of Duty which continues to grow. I'm proud to announce that in March, Call of Duty: Black Ops became the best-selling game of all time in the U.S. and Europe across the 360, PS3 and PC, which is an incredible feat for a game that was launched just 5 months ago. I would like to congratulate and thank everyone at Activision and at Treyarch on this amazing accomplishment. Success of this magnitude only happens when we bring together the very best and most innovative creative products with the best marketing and execution in the industry. This is an achievement that should make everyone at Activision feel proud.
And for the quarter, Call of Duty: Black Ops is once again the number one title overall in the U.S. and Europe, generating more retail revenue than each of the new major product releases from our competitors. This strong consumer response enabled us to increase our total retail share in the U.S. and Europe over last year despite a very light release schedule and lower sales of peripheral base games. With respect to online, our Call of Duty: Black Ops First Strike content pack shattered Xbox LIVE launch record, surpassing 1.4 million downloads in the first 24 hours, a 20% increase over Modern Warfare 2 Stimulus Pack and to date, the content pack continues to outsell the Stimulus Pack by more than 20%.
Our strategy of creating more in-depth and quality gaming experiences within fewer, better franchises appears to be paying off. As our unprecedented strength in digital and online play shows. We no longer think about our product releases simply as launch events but as long-term, ongoing relationships with our players. We feel that we're providing the best downloadable content ever in our history and the response from our fans underscores the success of this approach.
We made some difficult decisions last quarter in order to focus the creative talents of our exceptional people and our capital investments on fewer, better creative opportunities and on the areas of greatest passion for our fans. We entered 2011 a leaner, more focused organization and we're devoting our time and resources to the areas where we believe we have the ability to make gaming experiences that are the best in the world.
Our product lineup is expected to be both more focused and more profitable by delivering richer, deeper content and more connected experiences for our community of players than ever before. This strategy is already working as evidenced by our first quarter results.
The best way to achieve success is to provide gamers with the highest possible creative quality and this should have several incredible opportunities in front of us, starting of course with Call of Duty.
By any measure, Call of Duty is one of the biggest entertainment franchises in the world and we expect this year's game will set a new standard for this incredible franchise. The creative excellence and sheer scale of the game we are making and the unprecedented online universe that will accompany it will reset the bar for this genre, giving players a new level of immersion, connectivity, community and of course epic action. The game today has exceeded every internal milestone and we look forward to sharing this with you soon.
The momentum of Call of Duty continues to grow as well, be it sales, status of the online community, hours of the online play, performance of DLC, consumer awareness and intent or the fact that we just passed the milestone of 10 million fans on Facebook.
Today, Call of Duty is part of the cultural landscape. The passion people are showing for this franchise is truly humbling and we're absolutely committed to making their experience even better. We're investing heavily back into our community to the take experience of playing Call of Duty to an entirely new level, creating even more opportunities for long-term growth in the process.
On our last call, I told you we had formed a wholly-owned development studio called Beachhead to lead the creation of an all-new connected digital universe for the Call of Duty franchise. This platform will include a suite of services and content plan that will unite and ignite the community like never before. The platform will support in-game integration and bring online experiences and console play together for the first time. It's been in development for almost 2 years and we're very excited about this increase in value and excitement that we can bring to our community through this platform. We look forward to sharing more specifics on this exciting new endeavor in the coming weeks.
Our next expansion opportunity this year is downloadable content. We started the year with a record launch for Black Ops First Strike and we're equally excited about the recent release of Black Ops Escalation for the Xbox 360. With the release of the Escalation content pack, we accepted Map Pack preorders for the 360 for the first time and results were incredible. The new content pack was only released a few days ago and it is already outselling the second Modern Warfare 2 Map Pack by over 20%. I think it's fair to say that the downloadable content for Call of Duty has more commercial potential on its own than most standalone console games and we're seeing that prove true in its first quarter.
Our next opportunity this year is our new genre-bending family entertainment franchise Skylanders Spyro's Adventure. Skylanders truly defies categorization and creates an entirely new genre of play, bringing the world of Digital and analog play together like never before. We unveiled the game at Toy Fair and the buzz around the title was incredible. You'd be hard-pressed to find a best of toy fair list from a major publication, which did not include Skylanders.
We unveiled the game with strong support from Toys "R" Us and Gerry Storch, the CEO of Toys "R" Us, called Skylanders amongst the most exciting properties he has seen at any toy fair worldwide this year. Skylanders lets players transport real-world toys into virtual worlds. These toys with brains come to life inside the game across every major gaming platform from Xbox to PS3 to Wii, as well as on handheld gaming devices, mobile devices, on the PC, and on the web.
Whatever achievement and level-ups the character's gained are written back on to the toy's memory and travels with them wherever they go. The game marks a wholesale change in the interaction between toys and video games opening up new possibilities to our players and new revenue streams for the company. We've been working on this concept for more than 2 years, bringing together top talent from the worlds of video games, toy design and Hollywood, to create a franchise like no other. And to launch Skylanders, we assembled a team with the best-in-class experience from both the worlds of video games and toys.
The starter pack will include the game itself, 3 toy figures and a portal which transports the toys into the game. The 3 characters from the starter pack will let you enjoy the game from start to finish, but there will be more than 30 other characters which further expand and enhance the experience. Each toy you buy unleashes new powers, new worlds and new experiences within the game. You'll be able to buy the toys separately for less than $10 a piece.
Today, the Skylanders property has tested incredibly well, has generated tremendous buzz and support from our retail partners as it is expected to launch in the holiday quarter.
Finally, this year we have a number of exciting licensed property launches. In the second quarter we will released Transformers: Dark of the Moon, which will be released timed to the upcoming movie as well as our first Kinect title Wipeout In The Zone, which will be in stores to coincide with the TV show season. Wipeout is a natural for Kinect and might be the best use of motion-based technology we've seen yet.
For the balance of the year, we plan to launch games based on the best-selling X-Men and Spider-Man franchises, James Bond and the toy phenomenon Bakugan as well as the latest release in the long-standing Cabela's Hunting franchise, which we're expanding this year to include new peripherals and an incredible Kinect experience.
This year, our slate is more focused and we believe it is well aligned against both the market opportunities and the passions of our players. Our company-wide focus on providing the very best interactive entertainment experiences to players around the world and we continue to make the necessary investments to enhance our leadership position, invest in our community, which in turn should allow us to continue delivering industry-leading returns for our shareholders.
I'm looking forward to updating you on our plans and performance as this exciting year unfolds. And we'll have a lot more details on our upcoming releases to share with you in the coming weeks and in E3.
With that, I'll now turn the call over to Mike Morhaime who will provide you an update on Blizzard Entertainment.
Thanks, Eric. Blizzard Entertainment has come off its most successful year ever in 2010. Shipping 2 record-breaking games in World of Warcraft: Cataclysm and StarCraft II: Wings of Liberty. As we drive deeper into 2011, we are looking to build off of that momentum by providing even more epic experiences for our players. And we're also working hard on our exciting pipeline of new games.
On the financial side, we grew the business year-over-year in Q1, with $357 million in revenue and $170 million in operating income. We are pleased with the growth in the Blizzard community over the past year and expect it to grow further with the upcoming launch of the Diablo 3.
Looking at the World of Warcraft side of the business, we were pleased to see record sales following the Cataclysm launch in the United States and Europe which helps drives growth and subscribership. During the first quarter of 2011, as players have eagerly consumed the new content, we have seen subscribership return to prelaunch levels in the West. We finished the quarter with more than 11.4 million subscribers worldwide. Moving forward, our objective is to continue delivering new content to players in all regions to further energize our community.
Our partners at NetEase are continuing to drive towards launching Cataclysm in China a little bit later this year, which should reinvigorate that community with some new exciting content. For all our other regions, we recently launched the first content update for Cataclysm. This update includes new dungeons, special rewards for guilds and a feature to help players find a guild to join.
Player feedback has been positive and as a result, we are seeing increased player engagement and higher daily concurrency. In addition, we have another major update already in testing that includes new rate and quest content, as well as an exciting new dungeon journal that will make raids and dungeons more approachable for all players.
I also have some news to share with regard to our value-added services. We recently launched several value-added services for World of Warcraft players in China, allowing our Chinese community access to most of the services available to players in other regions. We also launched a mobile guild chat system. This new feature allows subscribers of our premium World of Warcraft remote service to chat with their guild mates through mobile devices.
Finally, we announced the new premier mount that will be offered in the Blizzard store in the near future.
Moving on to StarCraft II. The first quarter was an eventful one for this franchise. In addition to releasing new ladder and custom map content for our players, we also launched the game in China. Already, the China region is one of our largest communities for StarCraft II in terms of concurrency and east force is off to a great start in the region. We have signed with several partners to run StarCraft II tournaments in China, as well as a Chinese broadcast partner to televise Korean GSL matches in Chinese. As we look to the future of StarCraft II the development team is also hard at work on the first expansion, Heart of the Swarm. We will be showcasing that game through worldwide press later on this month.
On the Diablo III front, I am pleased to report that we begun internal company-wide testing last week. The game is looking great and we are currently targeting a Q3 launch for external beta testing. The development team is working hard to try and launch Diablo III this year. But I want to be clear that we do not have an official release date or window yet. As always, we will not compromise the quality of the game in order to hit a window.
Lastly, I want to talk a little bit about BlizzCon. Tickets will be going on sale later this month and as in the past we expect these to sell out quickly. We also offer the show via Internet stream and DIRECTV pay-per-view to reach our players who can't make it out to the show. Last year, we had more than 95,000 paid viewers join us via DIRECTV or the live Internet stream. As always, we look forward to sharing exciting news with our community at this year's show.
Moving into the back half of 2011, we'll continue to deliver new content and experiences to our huge community of gamers, while maintaining development focus on our exciting pipeline of future games.
Thank you, and I'll turn the call back over to Kristin.
Thanks, Mike. Operator, I think we're ready to take some questions. If everyone could limit their questions to one per caller, that would be great.
[Operator Instructions] And our first question will come from Brian Pitz from UBS.
Brian Pitz - UBS Investment Bank
A couple of questions on Blizzard. Would you comment on roughly what percentage of expansion packs for WoW were sold via the online channel? Was it 50% or better? And maybe you can comment if this was a significant source of any upside in margin for the quarter? Second, on StarCraft, are you starting to see a ramp up in interest in Korea as more of the professional players continue to shift to the latest version, maybe you can give us an update on the professional market over there?
Okay. Well, for competitive reasons, we don't provide specific data on Digital versus retail sales. But I can say that Cataclysm's digital performance exceeded our expectations. Digital availability is a convenience that more and more of our players expect and it's a growing part of the business as a result. But retail is still important and accounts for a large majority of our full game sales. With respect to Korea, the Korean e-sports, our partner GOMtv is running GSL. It continues to be very popular. But we are seeing that StarCraft I has maintained popularity and so the transition to StarCraft II has been slower than we anticipated.
And our next question will come from Edward Williams from BMO Capital Markets.
Edward Williams - BMO Capital Markets U.S.
Just a couple of thoughts here. Can you give us a little bit of color, so what's your thoughts are on with the significance of Call of Duty to online play for Xbox LIVE and PlayStation network, what steps could you take are you taking about taking to try and further monetize the success of that particular brand to maybe capture some of the institutional expertise that you have with Battle.net on the Blizzard side?
Well, we haven't yet released the details of the business model of Beachhead. You'll certainly see that, that is a response to the patterns that you're talking about. The passion that people have for the game, the amount of time they're willing to engage with one another in a connected way. Our goal has been to create an experience that was amplifying enough and energizing enough and igniting enough to that community to be able to be monetized.
And we'll now go to Mike Hickey from Janco.
Michael Hickey - Janco Partners, Inc.
I'm curious if you could talk about how you are able to maintain such a strong digital margins when it seems to me your competitors aggressively grow digital sales but seemingly looking at a sort of 10% margin structure?
Yes, Mike, this is Thomas. I think, while I'm not privy to the details of our competitors' cost structure approach, we have a digital effort that's very focused against large franchises and large online communities. And as a result, we generate tremendous operating leverage behind the content development costs there as well as the back office infrastructure cost and all the customer service capability that we've built over time. And that has allowed us not only to grow at a 30% clip this quarter, but to do so with margins close to 50%, which is a big component of what's driving our overall margins up as this part of the market continues to grow disproportionately.
I will say, Mike, having looked at some of our competitors financials, it is actually hard to actually understand why the margins aren't better at some of those other businesses.
And we'll now go to Brian Karimzad from Goldman Sachs.
Brian Karimzad - Goldman Sachs Group Inc.
I guess, one, would be you guys mentioned some new levels of connectivity with the Call of Duty initiatives this year. And I don't want to steal any thunder from announcements over the next few weeks but is it out of the realm of possibility for some of the Beachhead features to be part of this fall's release? And then for Mike, on the World of Warcraft side, any sense there on how the return to prelaunch levels before Cataclysm on the subscriber side compare your expectations and maybe a little bit of color on what you're seeing with the competitor that launched around March?
Can you repeat the first question for me. Then Michael...
Brian Karimzad - Goldman Sachs Group Inc.
Yes, exactly. So if the -- you guys have mentioned that you're going to have a new level of connectivity with Call of Duty this fall, the initiatives there, is it out of the realm of possibility that the Beachhead initiatives will be part of that this fall?
The Beachhead initiatives will be part of that this fall. It'll be an integral part to the innovation signature nature of the Call of Duty game that we're releasing this year. And as I said in my comments that we think we'll reset the bar once again for that genre and that franchise. The answer is yes. And I just wanted to backup on the earlier question make sure that I underscore that while we are attempting to deliver new incremental experiences that have yet heretofore been unseen by our players, we are not attempting to monetize or take any experience away that currently comes as part of the value proposition of buying the game.
I think, very importantly, our community of Call of Duty players is one that we celebrate and you will see a lot of new services and capabilities that will be provided free of charge to all of our customers.
Okay, and on the -- actually, would you mind repeating the question?
Brian Karimzad - Goldman Sachs Group Inc.
Yes, just how did the return to the prelaunch levels of subs, after Cataclysm, compare to your expectations? And do you have any color on how things have trended since that competitor came online in March?
Okay. As our players have become more experienced playing World of Warcraft over the many years, they have become much better and much faster at consuming content. And so I think with Cataclysm, they were able to consume the content faster than with previous expansions. But that's why we're working on developing more content. We launched our first update last week and we have another update that's already in test. The response that we've gotten so far from players has been very positive and we really think that we need to be faster at delivering content to players. And so that's one of the reasons why we're looking to decrease the amount of time in between expansions.
Brian Karimzad - Goldman Sachs Group Inc.
Okay, so you may have more frequent paid expansions though they may be a bit lighter than a typical one has been?
Well, we're not ready to talk about the content expansions at this stage but we are looking at ways to speed up the development process. In terms of additional competition, we knew that this year was going to be a year where we faced new competitors. It isn't the first time, though, that we have strong competitors enter the MMO market. What we have seen in the past is, we tend to see our players leave for some period of time, perhaps try out the new MMOs, and then good percentage of them historically have returned to World of Warcraft. And so, so far I haven't seen anything to indicate that this will be different.
And our next question will come from Jeetil Patel from Deutsche Bank Securities.
Jeetil Patel - Deutsche Bank AG
Two questions. One, you talked about just value-added service with both the Call of Duty and the Blizzard side of the business, it seems like at least Call of Duty it's a 90-10 split between, right now, between software and services. I guess, do you look at that business evolving towards being more 60-40 or 50-50 over time? And second, I guess maybe you can provide some insight as to how do you make a MMO so successful in terms of it's just not about the game play but it's a lot of other facets. So this maybe some insight into that given the scale at which you're looking at Diablo on that going forward? Thanks.
Okay. I think there were 2 parts to that question as it relates to World of Warcraft. The first part I think was about actually...
I think, why don't you can handle that the World of Warcraft question.
Okay, the World of Warcraft question was about basically the mix between value-added services and subscribership revenue which we don't break down. In terms of our philosophies on developing content, we think the most important thing is engagement. And so developing content that keeps our players engaged, there's no big priority. When we look at the types of value-added services to offer, we really try to create things that will help also drive engagement, and so things that players want. But that we want to have some barrier potentially so that everybody doesn't just go and get this thing as it could devalue the service or sometimes the value of the experience for everyone if there was no barrier. And so sort of, we try to create win-win type value-added services.
And then with regard to the Digital share properties, obviously it depends what kind of store [ph] you're talking about. During the holiday quarter, we have a lot of new releases that still generate the majority of revenue through retail. But if you look at a quarter like the March quarter, I think its indicative of the potential of changing up our relationship with our players who want from once a year be given that retail to a continuous relationship where we continuously provide content and services and keep the community engaged. And as you can tell from our financial statement, that's not just great for players but it's also very good for our shareholders. And I can't tell you how quickly that percentage will continue to accelerate but there's no doubt that all the market dynamics, as well as our internal development efforts, are geared towards making that happen.
Does that answer all your questions Jeetil?
I think he dropped off. Operator, can we take the next question?
Certainly. The next question is from Eric Handler from MKM Partners.
Eric Handler - MKM Partners LLC
Just a question on World of Warcraft, can you comment with Cataclysm now, and some of these other value-added services, how your revenue per user sort of on an annualized basis is improving? And also given that there's a lot more content with Cataclysm, are you seeing the level of post-release churn, maybe not as much as you would have for the prior 2 updates?
Okay, right. So the first question was about ARPU, which is something that we do not disclose for competitive reasons. One thing I can say, though is that during the last 5 months, we've bought a majority of our value-added services to China and we've been very pleased with the reception and the uptake on the services in China, which is something that is very encouraging. What was the second question?
Eric Handler - MKM Partners LLC
Are you seeing lower levels of churn relative to the prior 2 updates given you have more content with Cataclysm?
Yes. So what we have seen so far is that people have been consuming this content very quickly and so the subscriber levels have decreased faster than in previous expansions.
And our next question will come from Atul Bagga from ThinkEquity.
Atul Bagga - ThinkEquity LLC
A couple of questions. One, on call of Duty free to play version that you guys are talking about, is it just for China or is it for any emerging market? Would you also consider launching this kind of title even, let's say the [indiscernible] markets like U.S. and Europe? And then the second question is about the linearity of the subscriber base for World of Warcraft and maybe if you can share what your expectation is on the sublevel, say, by the end of this year?
We'll start with the Call of Duty product that we're creating that is specific for the Chinese audiences. The product that we announced today is being developed just for China. That's not to say it might not have applicability outside but what we're doing right now is focused on China.
And then on WoW subscribers, we don't provide an outlook on the specific subscriber numbers. All I would say to this point is that, obviously, we take the WoW subscriber trends is and factor that together with our content release schedule, whether that's free patches or paid content like Cataclysm in China into our outlook numbers.
So this is Mike again. You specifically asked about the linearity of subscriber growth. I think it's important to understand that historically, subscriber growth with World of Warcraft has not been linear. It's been driven by new content and seasonality throughout the course of World of Warcraft's history. And so we have a lot of reasons for optimism going into the balance of the year. We still have Cataclysm in China that we're working to launch. That seems to be going very well. We also have additional new free content that we're working on, as well as additional value-added services. In addition, there are new territories that we will continue looking at. And we think that there continue to be opportunities for growth in new markets.
Atul Bagga - ThinkEquity LLC
Mike, thanks for clarifying. If I may, just a follow-up on that, in terms of the churn, are you seeing churn reducing as you're getting too closer to the end of this quarter and starting this quarter?
Yes, we don't provide any guidance on churn. Sorry.
And our final question for the day will come from Daniel Ernst, Hudson Square Research.
Daniel Ernst - Soleil-Hudson Square Research
If I look at the marketplace for digital distribution, it's split up in my mind between PC, which is broad-based; social, which is a subset of PC behind kind of a wall garden; mobile; and console. In 3 of those areas, you're paying a platform fee to somebody, whether it's Facebook, it's Apple, whether it's Xbox or PlayStation. And one of them you guys kind of own primarily to Battle.net. As digital distribution becomes the primary part of your business, it's 50% this quarter it's going north in the following years. How do you see that kind of mix shifting? And then within areas where you're paying a platform fee like joint consoles where you have one of the most popular games for play online and to have DLC 4 [ph] in the first place, do you have leverage in that model with the console makers as you try to build out a greater direct-to-consumer business? And so that's my kind of my first question, where do you see the mix and where do you have leverage points? And then a follow-up to that is, do you have an ability to take that content? I know that you can now and so maybe you haven't before go cross-platform. So you have Blizzard games going down to social and mobile and vice versa. Is that part of a longer term strategy to have a cross-platform Digital business?.
Sure. Good question. We've always taken the approach of essentially platform agnosticism. And the important thing for us is if we can deliver an experience across a device that has a display and a microprocessor and it will satisfy our audiences, then we'll invest against that. We do have to prioritize the resources that we allocate to various platforms based on opportunity. I think we do a very good job of that. If you look out though over the next 3 to 5 years, there continue to be a lot more displays with microprocessors that are capable of playing games that I think it's one of the great dynamics of the business that we're in and why we are so excited about our prospects for the future is that regardless of the device, if it has a microprocessor and a display, our content has applicability to that device. And I think when you look at some of the great franchises that we own and control, whether it's in geography or a variety of different platforms, you've seen us very thoughtfully take those franchises and make them available for customers in a variety of different ways, in a variety of different platforms. We'll continue to do that very successfully. But I think there are a greater number of devices that are game-enabled than ever before, which makes our addressable market that much more interesting. As far as platform leverage, sometimes people forget that the Sonys and the Microsofts and Nintendos and the Facebooks invest billions and billions of dollars in these platforms. And when you think about it over long periods of time, they continue to invest billions of dollars to make the experiences really satisfying for our audiences. They deserve to get compensated for that and while we, as the number one company in our category, always have the benefit of scale and we've been able to get a lot of leverage against that scale, it is important to recognize that you continue to invest billions of dollars against those platforms. So I will say this. You hit on what is probably the most interesting of the fundamentals that are affecting companies that create interactive entertainment, which is that more people are playing games than ever before. I think Facebook has done an exceptionally good job of introducing interactive entertainment to customers who, in the past, never actually engaged in game playing of any kind. When you think about the next generation of consoles that the Nintendos, Sonys and Microsofts are investing against, they're not just the expansion of their online capabilities, but in more enhanced graphics, more powerful microprocessors, those are enabling entertainment experience that we have not seen before and that combine the best of storytelling and the best of things that we haven't been able to use very successfully, like capturing that emotional connection between a player and what they see on the screen. And these are all the things that are really driving opportunities for us for the future. So it was an excellent question.
Okay, well, thank you, everyone. And as always, we appreciate your time and consideration and look forward to speaking with you in the future. Have a great day.
That does conclude our conference for today. Thank you for your participation.
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