Good day, everyone, and welcome to the Activision Blizzard Second Quarter 2011 Earnings Conference Call. Today's call is being recorded. At this time, for opening remarks and introductions, I'd like to turn today's call over to Kristin Southey. Please go ahead, Kristin.
Good afternoon, and thank you for joining us today for Activision Blizzard's Second 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 will be shown, a number of important factors could cause the company's actual future results and other future circumstances to differ materially from those discussed 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 delivery of content; competition including from used games; possible declines in prices; 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 challenges 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, August 3, 2011, or to reflect the occurrence of unanticipated events.
I would 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 share-based payments, expenses related to the restructuring of our Activision Publishing operations, the amortization of intangibles and impairments 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 is also a PowerPoint overview which you can access with the webcast and which will be posted to the website following the call. In addition, we will also be posting a new 12 quarter financial overview highlighting both GAAP and non-GAAP results.
Finally, I'd like to welcome Peter Ausnit who has joined us as Vice President of Investor Relations.
And now I'd like to introduce our CEO, Bobby Kotick.
Thank you, Kristin, and good afternoon. I'm pleased to announce that Activision Blizzard delivered another quarter of better-than-expected growth. In June quarter, we increased revenues over the prior year and set new records for operating margins and EPS. Our momentum continues to gain strength. For the first 6 months, revenues increased year-over-year and we significantly expanded our non-GAAP operating margins to a new record 26% and increased EPS by more than 50%.
Our growth has been fueled by our continued online expansion. For the first 6 months of the year, revenues from online channels grew more than 20% and for the trailing 12 months, they're up 25%. Our digital growth is reflected on the top line, as well as increased profitability and higher return on invested capital. Because of our continued growth as the leader in online gaming and our financial discipline and the prudent allocation of our capital, we are again raising our revenue and EPS outlook for the year.
We continue to shift our business toward digital delivery of content and services that established direct ongoing relationships with our audiences across an increasingly wider range of devices and in more geographies than ever before. Our product plans for the remainder of the year is consistent with the strategy that we have articulated for the last few years. Now indeed with the very best experiences for our audiences. This fall is no exception. We expect to release the most innovative connected social game experiences we have ever created. Modern Warfare 3 is a stellar experience in every way, and we'll also launch Call of Duty Elite, our new online service that we believe will extend the multi-player experience and unite the worldwide Call of Duty community in response to the interest of our audiences.
In addition to the innovation we're bringing to Call of Duty, we'll also launch Skylanders, a breakthrough new play experience that brings toys to life across a broad array of platforms. Skylanders is being heralded as one of the best new toy lines in years, perhaps the most exciting new interactive entertainment for kids ever.
Last week, Blizzard Entertainment plans to launch that Diablo III beta in the third quarter. Later in the call, Mike Morhaime will share some of the most exciting new developments at Blizzard, including in-game auction house for Diablo III.
Beyond this year, our opportunities continue to expand as there are more ways than ever before for more players in more countries to access the connected interactive entertainment we uniquely create. In just a few years, the installed base of hardware has grown to a record level. Gaming on the PC has never been more popular and the installed base in smartphones and tablets is in the hundreds of millions and is rapidly growing.
We have the resources, capital and development capabilities that should allow us to leverage these strong and dynamic market fundamentals and to satisfy bigger audiences than ever before. The majority of our incredibly talented employees are now dedicated to online development and service operations, making the total interactive entertainment experience more fun, accessible and seamless and allowing us to continually respond to the changing demands of our audiences.
Our deep capital resources, long-term view of our business and the methodical deliberate way we invest our capital provides us the unique ability to continue investing methodically in the major new growth and margin expansion opportunities afforded by the Internet, without being distracted by short-term perceptions.
Our strong growing multi-year pipeline of online-enabled franchises and unique service capabilities, including Activision's future Call of Duties and the elite online service, Bungie's new universe, Blizzard Entertainment's World of Warcraft, StarCraft II expansions, the new Blizzard MMO and Battle.net should allow us to continue our industry leadership position for a long time to come.
Over the next few years, our expanding footprint and online leadership, our strong franchise portfolio, our long-term approach to investment, our continued investing in our strong financial foundation should enable us to extend our outstanding track record of performance and deliver long-term growth for our shareholders as we have over the last 20 years.
Now I'd like to introduce Thomas Tippl who will provide a review of Activision Blizzard's financial performance. Thomas?
Thank you, Bobby. I'll begin with a recap of our second quarter results and [indiscernible] followed by a review for our outlook for the back half of the year and our increased outlook for 2011. For your reference in our press release is a set of schedules that provide non-GAAP comparables and these will be the numbers that I'll refer to unless otherwise noted. Please refer to our earnings release for a GAAP to non-GAAP reconciliation. Also note that the numbers I'll be quoting are compared to the prior year unless otherwise noted.
So for the second quarter on a GAAP basis, revenues increased 19% to a record $1.15 billion. We expanded our operating margin 1,000 basis points to a record 41% and grew EPS 71% to a record $0.29. For the second quarter on a non-GAAP basis, we grew revenues to $699 million and expanded our operating margin by 900 basis points to a record 24%. In addition, we increased non-GAAP EPS by 67% to a record $0.10, representing our 12 consecutive quarter of non-GAAP EPS generation. This level of consistent earnings generation and margin expansion is what you would typically expect from an online service provider and is something most video game companies continue to struggle with.
Our strong performance for the quarter and year-to-date has been driven by our products with online integration and digital revenue streams, including Blizzard's World of Warcraft and Activision's Call of Duty, which not only maintained its momentum in retail, but share all previous digital revenue and earnings records.
For the first 6 months, GAAP revenues from high-margin digital channels increased to $851 million, up 28% over the prior year and accounted for 33% of total revenues, driving a record 44% operating margin.
For the 6 months on a non-GAAP basis, revenues from digital channels increased to $864 million, up 21% over the prior year and accounted for 59% of total revenues, driving a record 26% operating margin.
Today, the vast majority of our digital revenues come from subscriptions, value-added services, downloadable content and full game downloads. The double-digit growth in revenues from digital channels for the first 6 months drove an increase in total revenues and new records for operating margin in EPS, which is up over 50% over the prior year.
Now turning to the P&L line items for the June quarter. I want to highlight that I will quote all percentages based on net revenues, except the tax rate. For GAAP, product cost were 24%, operating expenses were 36% and our tax rate was 29%. In the second quarter, non-GAAP product costs were 28%, non-GAAP operating expenses were 49% lower than our prior outlook of 59% due mainly to operating leverage from strong digital top line performance. We delivered a record 24% non-GAAP operating margin and our effective non-GAAP tax rate was 29%.
Turning to the balance sheet. On June 30, we had no debt and approximately $3 billion in cash and investments. This was lower versus the prior quarter, mainly because we returned about $350 million of cash to shareholders through our dividend and stock repurchases. Our receivables balance was $140 million, this is down $50 million versus the prior year due in part to higher digital revenues which we collect upfront. Inventories of $93 million were a record low and down $64 million versus the prior year due to a reduction of our peripherals inventory. Capitalized software development costs were $216 million, a decrease of $33 million versus the prior year due primarily to fewer titles in 2011.
Today, our balance sheet is stronger than ever and even with revenues increasing year-over-year, we continued to see working capital improvements driven by the increased percentage of our business coming from digital channels. The strength of our balance sheet and 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 on to our outlook. As we have said this year, we are focused on 3 initiatives to drive operating margin expansion and long-term growth, so let me recap our progress to date. First, we continue to focus on our high-margin digital business and online-enabled franchises. To put our digital strength in perspective, last year, our Digital business alone generated about double the revenues in operating income than Xanga did and in the first half of this year, we grew Digital revenues 21% over the prior year and generated more than 2x the operating income and 3x the operating margin that Netflix posted for the same during. Even more importantly, we are setting the stage for future growth as we have more online products and services in development than ever before.
Our second initiative to drive operating margin this year is to streamline the Activision Publishing business for higher profitability and online expansion. We continue to benefit from the restructuring through less spending and a lower fixed cost structure. Year-to-date, Activision Publishing achieved record earnings and operating margin and on its own, delivered more operating income than the next 3 largest independent publishers combined.
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 internal investments to our biggest franchises and online product and service capabilities, including Call of Duty and the new elite online service, the new Call of Duty micro-transaction game for China, Bungie's new gaming universe, World of Warcraft, StarCraft, Blizzard's next-generation MMO, Battle.net and Diablo III with its new real money auction house model just to name a few.
So in summary, for the first half of the year, we executed against each of our stated goals and our focus drove top line growth of more than 4%, operating income growth of more than 40% and EPS growth of more than 50%. This record financial performance gives us confidence in our plan for the rest of the year and beyond. So now on to the numbers.
For calendar 2011, given our momentum in the second quarter, we are again increasing our financial outlook. This still does not include the release of Blizzard Entertainment's Diablo III. In terms of our GAAP outlook, we expect revenues of $4.18 billion, up $130 million from our prior outlook and EPS of $0.68, up $0.07 from our prior outlook. For the calendar year, we expect GAAP product cost of 26% and operating expenses of 47%. We project a GAAP effective tax rate of about 28% 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 are increasing our revenue outlook to $4.05 billion, up $100 million from our prior outlook and we're increasing our non-GAAP EPS outlook to $0.77, up $0.04 from our prior outlook. Since February, when we gave our initial calendar year outlook, we have increased our EPS expectation by 10% and now trail last year's record EPS by only $0.02, again assuming no Blizzard frontline product releases in 2011.
For the year, we expect non-GAAP product cost of 27%, 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 42%. We project the non-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.
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 of 27% and a record 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 margin in excess of 50%.
Now moving to the September quarter. As we said on our last call, our release schedule is very light compared to the September quarter of last year when we had a number of releases including the record-breaking StarCraft II, Guitar Hero and Spider-Man. This year, we will release only 1 major multi-platform title X-Men and we will begin to invest in marketing for the all-important holiday quarter. In terms of GAAP, we expect revenues of $650 million, product cost of 27%, operating expense of 60% and GAAP EPS of $0.05.
For the September quarter in terms of non-GAAP, we expect revenues of $530 million and EPS of $0.01, which reflects the portion of digital revenues that were accelerated into Q2 given the timely resolution of the PlayStation Network outage versus our prior planning assumptions. For the quarter, non-GAAP product cost, I expected to be 31% and operating expense to be 33%. And as expected non-GAAP revenues and earnings are down versus the prior year, due primarily to last year's record-breaking launch of StarCraft II.
In summary, we started the year with great momentum and have further strengthened our financial outlook for the full year. We believe that our strength in the retail and digital online channels, 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.
Thank you, Thomas, and hey, everyone. Today, I'm going to start with some high-level comments on the industry, which will provide the foundations for where we're focusing our time and resources, and then I'll discuss our slate.
Overall, the major themes remain consistent with what I said on the previous calls. The biggest titles in the industry continue to generate a disproportion percentage of the profits and revenues in the industry. Our hardware installed base continues to grow and shows strength, gamers continue to spend more and more time and money with the few must-have games. For these reasons, we feel our strategy continues to be very well aligned with the market opportunity. Specifically, we're focusing more resources innovation, new gameplay modes, more connected stickier universes and more investment to both time and capital into our most differentiated and highest potential existing and new franchises. It is inarguable that more people than ever are choosing immersive, high production value interactive games as their entertainment mediums of choice. And they thirsty to go deeper into and connect more with the titles they play than ever before. This is the strategy we've been pursuing and our record results thus far, give us confidence that we're on the right track.
Let's start with the trends we're seeing in Hardware. We ended the quarter with installed base of current gen systems in North America and Europe of 283 million and we expect to end the year at 312 million units, the highest ever and up 16% over the prior year. Within that, we expect installed base of online-enabled consoles Xbox and PS3 specifically will increase even faster by 24% to 92 million. In terms of retail software in the U.S. and Europe software for HD platforms and PC grew a strong 7% during the quarter. Today, digital continues to be the fastest-growing most profitable part of the industry. We estimate the digital sales in the U.S. and Europe grew double digits in the second quarter and we expect the similar rate of growth for the full year.
Today, our addressable market continues to expand with the largest installed base of gaming hardware ever, the mega installed base of PCs worldwide and rapidly growing new segments like smartphones and tablets, all of which creates significant growth opportunities for the best games with most passionate audiences to grow, especially high-margin online-enabled franchises.
For the first half of the year Call of Duty has been the driving force behind retail and digital sales. Call of Duty: Black Ops was the #1 overall title in the U.S. and Europe generating more retail revenue than any of the new major retail console releases. In addition to retail strength of Black Ops, revenues from Call of Duty digital content grew significantly during the quarter and for the first half of the year. We started the year with digital momentum with the release of the record-breaking launch of First Strike, the first Black Ops content pack, followed by Call of Duty: Black Ops Escalation and Annihilation content packs in the second quarter.
In total, we have sold more than 14 million units of Black Ops DLC up more than 40% versus Modern Warfare 2 Map Packs and more than any other new release title this year. And despite its low price point, Call of Duty's digital content on its own this year has generated as much revenue as a top 3 console title in U.S. and Europe.
And looking to the balance of the year, this holiday, our 2 major launches, Modern Warfare 3 and Skylanders Spyro's Adventure will offer the most expansive connected experiences we have ever created. Today, Call of Duty remains one of the biggest entertainment franchises in the world and we expect this year's game will set a new standard. This sheer scale of the game we are making and the unprecedented innovation in choices that our new online service Call of Duty Elite will offer should reset the bar for multiplayer, giving players a new level of immersion, connectivity, community and of course, the most thrilling action game which is Call of Duty's hallmark.
The teams Infinity Ward and Sledgehammer Games have worked tirelessly to create Call of Duty: Modern Warfare 3, which is expected to be by far the most epic Call of Duty game yet. The passion and energy of our developers is reflected in everything about the title from the innovative gameplay to the cinematic intensity, to continuing Call of Duty's tradition of setting the gold standards for multiplayer, including several new gameplay modes, as well as completely reinvented stack ups.
We expect stack ups [ph] in MW3 to become truly a third leg on the stool for the Call of Duty franchise, alongside a thrilling campaign and the best multiplayer experience in the industry. In Modern Warfare 3, the game is in 60 frame per second engine delivers an incredible level of precision and the best person shooter gain experience across all platforms and game modes. 60 frames per second is part of Call of Duty's secret sauce. It takes more processing power, but delivers the smoothest, most precise, most approachable gameplay experience and gameplay experience is what we have always prioritized.
In addition, we're pleased to have recently confirmed that we will release Modern Warfare 3 we skew this year so as not to leave any of our community out of the excitement. Since we revealed Modern Warfare 3 just a few months ago, consumer buzz and demonstrable momentum behind the franchise has been nothing short of amazing. YouTube views and Facebook followers are of multiples. Map Pack sales are more than 40% ahead of last year and today, preorders for Modern Warfare 3 are significantly ahead of last year's record pace for the comparable period and are on pace to set a new record for the video game industry by a substantial margin. We also expect MW3 pre-orders to be multiples ahead of the next most pre-ordered title in the industry.
This industry-leading consumer momentum continues when comparing Call of Duty even to the most popular social games. For example, more people pay to play Black Ops than any Facebook games and they pay more per player than any Facebook games. And they are more engaged. The percentage of Call of Duty's monthly unique players that play the game every day is higher than that of the top 3 Facebook games. This is all because the Call of Duty franchise consistently delivers epic action, gameplay design and a visual experience that is unmatched by any other game. By any dispassionate measurement this is franchise that continues to be on the rise. And as I have said before, the passion people have shown for this franchise is truly humbling and we are committed to making their experience even better by introducing more new features and services to support the game's launch than ever before this fall, which will set a new standard for the industry.
Even with the significant progress we've made in driving digital growth, we're only just beginning to deliver the types of content and services we can offer fans in an always-connected environment and we believe that there's a tremendous opportunity for us ahead. Simply put, our digital objective is to create long-term ongoing direct relationships with our players by providing compelling content experiences in 24/7 online entertainment services via every significant device and touchpoint. The massive number of hours played and the strong multiplayer community that is formed on Call of Duty digital content is the reason that we decided to invest our resources to elevate the multiplayer experience for our players due to the creation of Call of Duty Elite. We believe the new online service will reset the bar for multiplayer and create an even more connected and take the community around Call of Duty like nothing else in the industry.
Call of Duty Elite adds new choices for those who want to get even more out of the game. Many of the services key features will be free to all Call of Duty players. The free elements of Call of Duty Elite alone will be superior to any free service currently available in the industry. Additionally, many of Elite's free features will debut -- which will debut with Modern Warfare 3 will be industry-first and offer new level of innovation. The premium membership of Call of Duty Elite will include all DLC content for Modern Warfare 3 and will set a new gold standard for what multiplayer and community experience for a console game can achieve. Call of Duty Elite should give players unprecedented control over their multiplayer experience, transforming it into a true social and customizable experience. The innovative online service ups the ante for any online service by offering a range of innovations on well-established multiplayer features. Several other lead features will be completely new to the industry. For example, with Elite's new groups features. Players will be able to custom groups based on their likes, interests or affiliations and then have those groups follow them directly into the game. Additionally, players will be able to customize weapons, attachments and perks and push them directly into the game menu from their smartphone, tablet or PC. And Elite will offer unprecedented access and mobility customized for a number of platforms, dedicated applications for iPhone, iPad, Android, Xbox 360 and PlayStation 3 in addition to web browsers and in game with Modern Warfare 3.
The Call of Duty out-of-the-box experience that our players have come to expect, a great single player campaign, co-op missions and the deepest most accessible multiplayer anywhere at no additional cost remains the same as ever. Gamers who want to continue to play multiplayer out of the box or purchase downloadable content a la carte throughout the year can continue to do so. On July 14, we launched an invitation-only public beta for Call of Duty Elite. While the full capabilities of the service will not be on display until the launch of Modern Warfare 3, the beta is giving users a taste of the experience and allows the service to be tested by gamers currently playing Call of Duty: Black Ops multiplayer. The beta already has over 3 million registrants and although it's still early going, it is -- the consumer feedback has been phenomenal.
This holiday, we expect to support the launch of Modern Warfare 3 and to lead with the largest integrated marketing and retail campaign that we have ever executed, and we plan to 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 property of the year.
Our next big opportunity this year is the new genre-bending family entertainment franchise, Skylanders Spyro's Adventure. Skylanders truly defies categorization and creates and entirely new genre of play, bringing the world of toys and video games and the Internet together like never before. Skylanders lets players transport real-world toys into virtual worlds in an unprecedented way. The game will deliver the first-ever cross-platform connected gameplay experience across the consoles, handhelds, iOS and Android Apps and through an expansive web world.
Each Skylander game figure will remember skill advancements and level ups, allowing players to take their leveled up Skylander to play on any of the other platforms. While Skylanders consumer marketing company is yet to begin, the game is already generating considerable buzz in both trade and consumer publications. My favorite quote comes from Forbes who said, "It's like these toys are real-world Pokémon. I think kids are going to go mad for them." The New York Post called Skylanders, “One of the deepest and most creative games in 2011.” Internationally, the Sun called Skylanders, “A magical game that pushes the boundaries of game play by successfully combining video gaming with real toys for the first time ever.” And within the business community, Jerry Storch, the CEO of Toys "R" Us has said, "this is a rare break-through product in my opinion. In any year, there are only 1 or 2, and this is clearly in that league." Skylanders will be launched with unprecedented support from our retail partners, with over 60,000 linear feet of shelf space in U.S. stores alone, as well as over 20,000 interactive demonstration kiosks worldwide. We will be supporting Skylanders with the industry's largest consumer marketing budgets for the year and a brilliant multimedia campaign currently in production.
Additionally, in the balance of the year, we'll have a number of exciting license properties -- exciting property launches, including games based on best-selling X-Men and Spider-Man franchises, which you may have seen at the recent Comic-Con where they generated an overwhelmingly positive response. We also expect to launch games based on James Bond, the TV phenomenon Wipeout, as well as the latest release in the long-standing Cabela's Hunting franchise which we are expanding this year to include all new peripherals and an incredible Kinect experience.
We feel our overall strategy of focusing more innovation, investment, creativity and new ideas on our highest potential franchises is paying off. Our performance thus far this year indicates that we're on the right track. And as we gear up for our launches of Call of Duty and Modern Warfare 3, the Call of Duty Elite and the entire interactive universe of Skylanders Spyro's Adventure, we feel our strategy of focused deep innovation will be rewarded even more.
We are supremely confident in the quality of the games and connected digital experiences that we're producing. And we're committed to providing the very best interactive entertainment experiences to our players around the world. We also continue to make the necessary investments to enhance our leadership position and invest in our commitments, 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 I'd now like to turn it over to Mike Morhaime to update you on what's going on at Blizzard.
Thank you, Eric. Since the last call, we launched Cataclysm in China and made some exciting announcements on both StarCraft II and Diablo III. I'll go into a greater detail about those in a moment. First, I'd like to talk briefly about the financial side of the business.
For the first half of 2011, Blizzard is up year-over-year in net revenue as we've added Cataclysm and StarCraft II to our product mix and have brought value-added services live in China. In addition, we have increased our investments in service and product development in order to better serve our community and strengthen our business for the long term.
Moving on to StarCraft II. Back in May, we've invited press from around the globe to get a first look at the upcoming expansion pack, Heart of the Swarm. We showcased a couple of levels from the game's campaign, and we have seen a lot of positive feedback and coverage about this sneak peak. We look forward to sharing more information and news about Heart of the Swarm at the upcoming the GamesCom later this month, as well as at BlizzCon in October.
We also just released the starter edition of StarCraft II this week. The starter edition lets players play through a portion of the single player campaign, and they can also play unlimited multiplayer battles as the Terran race on a few different maps for free. Our hope is that the Starter Edition will encourage more gamers to try out StarCraft II, and they'll eventually upgrade to the full edition.
On the World of Warcraft side, we experienced a slight decrease in the subscribership during Q2, closing the quarter at 11.1 million subscribers worldwide. Since that time, we launched Cataclysm in China and have seen an increase in concurrency within the region. We're very excited to have delivered the latest expansion to Chinese players, and we look forward to working with our local partner NetEase to continue improving the rate at which we are able to release new content to our players there.
In addition, to the China launch, we also just announced that we will be releasing a Portuguese version of World of Warcraft in Brazil later this year. Aside from promoting World of Warcraft in other regions, we're taking other steps to bring more players into the community. With the new World of Warcraft Starter Edition, players are now able to play the game for free until Level 20 with no time restrictions. Since the launch of this program, we've seen a significant increase in new account creations, which we hope will allow us to continue attracting new players.
The World of Warcraft development team is also working on the next content update, which will include major new raid and dungeon content. We believe that this new end-game content will keep the game fresh for current players and provide compelling reasons for lapse players to come back.
Before moving on to Diablo III, I want to thank our World of Warcraft community for their warm response to our recent charity pet, the Cenarion Hatchling. We pledged that Blizzard would donate 100% of the proceeds from sales of this pet through July 31 to help Japan relief efforts. Through this initiative and the generosity of our players, Blizzard will donate more than $1.9 million to support ongoing earthquake and tsunami relief in Japan.
Many of you are already aware of the big news that we recently shared about Diablo III. Alongside the gold-based auction house, we will include an auction house within Diablo III that will allow players to trade items using real money. This auction house will be a secure and safe environment for players to trade their items over Battle.net. In the previous game, Diablo II, we did not offer such a feature, which resulted in many players turning to unscrupulous third-party services to purchase items. We felt that because players clearly wanted such a feature, it made sense for us to build it in to Diablo III so they could trade in a more convenient and secure manner than going through unauthorized third party.
Players who participate in this optional system will be able to list items on the auction house for a flat fee, with another charge for completed transactions. When listing an item for sale, players will have the ability to direct the proceeds either through their e-balance which will remain on Battle.net or to cash out through a third-party service. We have not disclosed specific fees, but we plan on keeping them nominal so that more players can participate in it, if they so choose. And so that players will opt to use our secure approved method of item trading and not churn through third parties.
We will also allow a limited number of free listings each week, so players can build up the balance without needing to deposit any funds to get started.
As for the upcoming beta, Diablo III is still on track to go into external beta testing later this quarter. And we are still working hard to ship the game before the end of the year. However, we're not ready to commit to a release date at this time. What I can tell you is that the press who visited us last week played a near final version of the beta content and the response has been overwhelmingly positive. We are very much looking forward to getting the beta into the hands of our players and collecting their feedback for the final phase of development.
Finally, I'd like to take a moment to talk about BlizzCon, where we will hold exciting StarCraft II and World of Warcraft tournaments and share news about all of our franchises. Once again, this year we sold out the show in a matter of seconds. I'm also very pleased to note that this year's BlizzCon will host a finals event for the Global StarCraft League, which is growing in viewership around the world. The GSL recently announced that they served more than 50 million videos-on-demand and live stream this year alone.
Another prominent eSports league, Major League Gaming, held a tournament in Anaheim this past weekend and served more than 30 million online streams of their eSports matches over 3 days. The interest in all of these leagues illustrates that eSports is becoming a truly global phenomenon, and it's great to see StarCraft II at the center of all the activity.
The rest of 2011 and beyond is looking very exciting for Blizzard. We are making great progress on Diablo III, and the StarCraft II team is hard at work on the Heart of the Swarm. As always, we are continuing to make adjustments to our infrastructure to better support our massive community of players and keep pace on all the products in our pipeline.
Thank you, and I'd like to turn the call back over to Kristin.
Thank you. Operator, I think we'll open up for questions.
[Operator Instructions] We'll first move to Brian Pitz with UBS.
Brian Pitz - UBS Investment Bank
Some questions about Elite. How should we think of Elite in terms of margin relative to the overall company? And can you help us understand the level of development so far that's got into the service? And what's going to be required going forward to continue to support the effort?
Well, the way we're thinking about Elite is, first, this is an opportunity to improve the overall Call of Duty experience and solidify Call of Duty's leadership position first and foremost. Having said that, it does cost money to run the service. It will cost money to book technologically. And from a customer service standpoint, to run the service and to do some of the things of that scale that we're attempting to do which are industry firsts. And I don't think we're ready to talk about what it means to the company from a margin standpoint.
I would just add one thing here. This is Thomas. Obviously, it's going to be a digital product. All our digital products come with margins that are north of 50%, and I don't think this is going to be any different.
And we'll move next to Brian Karimzad with Goldman Sachs.
Brian Karimzad - Goldman Sachs Group Inc.
Mike, and I know you don't intend to speak in the same superlatives as Eric does, but can you help us frame how you guys are thinking about the lifetime value of a Diablo III player versus maybe some of your other franchises or maybe some of the stuff on the publishing side?
Okay. Well, what I would say is that Diablo III, at least in the West, is primarily going to operate off of a standard box revenue model, with a box and expansions to follow. The Auction House is really a big unknown for us. We really don't have any predictions on how popular it will be, although we do expect it to be a pretty integral part of the game. And we also expect it to drive engagement and longevity in the life of Diablo III.
Brian Karimzad - Goldman Sachs Group Inc.
Okay, that's helpful. And then, Thomas, I don't know if I missed it, but was there any change in the assumptions for the fall releases that are baked into the guidance?
Not really. I mean, we have raised the numbers for the year and largely because of our strong performance year-to-date. We've outperformed our plans in the first as well as in the second quarter, and that's really the driver of the guidance going up for the year.
And we'll move next to Arvind Bhatia with Sterne Agee.
Arvind Bhatia - Sterne Agee & Leach Inc.
Two questions is really -- I'm just trying to understand how much of the second quarter upside came from things you might have otherwise gotten in the third quarter. I think you hinted at some shift there. Can you maybe quantify that a little bit?
Yes, it was about $0.01 or $0.02.
Arvind Bhatia - Sterne Agee & Leach Inc.
$0.01 or $0.02. Got you. Just a quick follow-up on that Call of Duty. Can you guys give us the lifetime performance of Black Ops as of this point versus Modern Warfare 2?
I'd like to detail the Black Ops approximately $25 million, and that compares to Modern Warfare 2, 2 years out in development, at $22 million.
We'll move next to Edward Williams with BMO Capital Markets.
Edward Williams - BMO Capital Markets U.S.
A couple of quick questions for you. Can you comment a little bit, Mike, on Cataclysm in China, what you've seen relative to what you're targeting coming out of it? And can you also just talk a little bit about the subscriber levels? What you think is driving that number?
Okay. Also Cataclysm just launched a couple of weeks ago in China. We have seen concurrency levels increase substantially. I think that there's still big opportunities in China to continue growing there, especially as we focus more on the Tier 2 and 3 cities. And China represents -- in terms of broadband penetration, there are more broadband users in China than any other country in the world, and it's continuing to grow from there. So I think that presents a huge opportunity for us in the future. Especially as the Tier 2 and 3 gamers upgrade their systems to be able to support World of Warcraft. In terms of subscriber growth around the world, what I would say is what we have seen is that subscribership tends to be seasonal and driven by content updates, and so as we're heading further away from an expansions launch, it's normal to see some declines, where the team is currently working on our largest content update since Cataclysm and that will hit later this year. We are also doing things to continue driving growth like the recent Starter Edition for World of Warcraft, which lowers the barrier to trial by providing the first 20 levels free. We have seen an increase in new account creations from that. It's still too early to tell on conversions to subscribership, but I really believe that, that is an important direction for us to continue lowering that barrier to trial and reaching new players around the world. We're also looking at new markets. We had great success in Russia. We think that Brazil is really an emerging market that has a lot of potential in terms of the number of broadband users. They're a top 10 country. Their economy has performed very well compared to the rest of the world during the recession, and we already have some Brazilians playing in English, but we think the market can be a lot bigger in Portuguese. I think that there are other countries we're looking at beyond that as well, but I don't have anything that I can talk about.
Edward Williams - BMO Capital Markets U.S.
Okay, and just as a quick follow-up on China, if I could. How much of your penetration has -- how much has your subscriber base in China changed with regards to Tier 2 Tier 3 over the course of last couple of years? How significant has that become?
Yes, I mean, that's an area of growth for us, but we don't break down those numbers, sorry.
We'll move next to Jeetil Patel with Deutsche Bank Securities.
Jeetil Patel - Deutsche Bank AG
A couple of questions actually. First of all, on Diablo III, Mike, if you can comment on I guess what's the determinant on Diablo III coming out in 2011 versus 2012? Second, you've got 11.5 million subs, you did about $359 million of revenue which was up nicely versus a year ago. While subs are down, can you reconcile the incremental revenue from a product sales versus value-added services standpoint? And I have a quick follow-up.
Okay. So in terms of the timing on the Diablo III release date, really, it's just going to come down to there are a lot of moving parts in putting out a content release like the Diablo III. We talked about the new Auction House technology which has not been fully tested. We're not yet in beta. And really, it's just going to come down to when the game is ready for prime time. And so we'll know more when we hit beta, and we'll know more when we put some of these new systems into test. It's a brand new infrastructure and with a lot of complex moving parts. In terms of the World of Warcraft business, clearly, coming off of the Cataclysm launch, we have a lot of momentum coming into 2011, and that has certainly helped the revenue numbers. I think that, let's see, yes, I mean, there’s the value-added services, launching in China is certainly a factor. And yes, I think that those are probably the major factors driving revenue. We ended the year slightly up compared to last year. So we're pretty happy with the result.
Jeetil Patel - Deutsche Bank AG
And just, I guess, on overall operating margins or EBIT margins for Blizzard. I think they were at 38%, I guess anything in particular in terms of OpEx that you spent against for Blizzard, or your kind of continue spend against the we should be mindful of?
Yes, so we're increasing our investment in new projects that haven't necessarily been announced. And we have increased the investment in customer service, but I would say, I think we're at scale at this point. And there was -- we did enter beta for StarCraft II last year during the quarter, which allowed us to capitalize development expenses, and I think that helped us out on the OpEx side on the comparison.
But I think one thing to be mindful here is the increased investment on new products.
Next, we have Eric Handler with MKM Partners.
Eric Handler - MKM Partners LLC
Just a couple of quick things on the guidance. So am I understanding correct that the reason you didn't let all $0.06 of the upside relative to guidance or EPS flow through is because you pulled forward $0.01 to $0.02 from the third quarter into the second quarter? And then secondly, you had a big operating margin outperformance in the second quarter, yet you're keeping your full year operating margin guidance at 31%, is there a significant increase in expenses that you have in the back half of the year as a reason why you're not taking your operating margin guidance higher?
Yes, on the first question, and that's also reflected in the fact that December quarter number is probably lower than some have expected originally. And then on the second point, we are getting increasingly more confident in the potential for our product launches in the back half, particularly the game quality we are seeing on Skylanders is very encouraging. The retail feedback we're getting is very encouraging. So we have put aside some additional marketing funds to support the launch of the new IP. So those 2 things combined get you still to an increase in the top line and EPS largely driven by the overall performance in the first half of the year.
Eric Handler - MKM Partners LLC
Okay, and just one quick follow-up. Is there any opportunity to use an auction house type of services or similar value-added services for StarCraft II that you have for Diablo and World of Warcraft?
Yes. We really tried to design the features of these games to leverage the needs of the games. And so Diablo III is -- and previous Diablo games as well we're very item-centric games with the a lot of item trading, without a good mechanism really for doing that. And so, I guess the equivalent type of things for StarCraft II would be our map marketplace where players are able to create their own custom maps, and we do have plans to provide a marketplace where they'd be able to offer them up to other players for sale. Of course it's very complex system that is still being designed. I think that some of the things we're doing on the back end to support the Diablo III Auction House actually can be leveraged in StarCraft II to support that system which is great. On the World of Warcraft side, we really don't have plans to do something similar. It's a very different game, and it really isn't designed with this type of item trading in mind.
We'll take our last question from Doug Creutz with Cowen & Company.
Douglas Creutz - Cowen and Company, LLC
You guys had north of a 20% sequential revenue increase in Asia during the quarter. I know you launched StarCraft II in China and you also upped the value-added services. I was wondering if you could kind of talk about directionally, what was the biggest drivers of that revenue increase?
Yes, the biggest drivers for that were the popularity of World of Warcraft, especially in China, and the launch of the value-added services.
I think one of the things we're realizing though is that the success that we've had which is unique for Western publishers in China, we've learned so much about the opportunity that over the next 3 to 5 years, we'll continue to see investment and real opportunity for us in places like China that are not really opportunities for many of our competitors.
That does conclude our question-and-answer session at this time. I'll turn the call back over to our speakers for any final or additional comments.
Okay, well thank you, everyone. On behalf of everyone here at Activision Blizzard, we thank you for your time and consideration, and have a great day.
That does conclude our conference call for today everyone. We thank you all for your participation.
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