Activision F3Q06 (Qtr Ending Dec 31, 2005) Earnings Conference Call Transcript (ATVI)

Activision (ATVI)
Q3 2006 Earnings Conference Call
February 6th 2006, 4:30 PM.

Executives:

Kristin Southey, Vice President of Investor Relations
Robert Kotick, Chairman and Chief Executive Officer
Thomas Tippl, Chief Financial Officer
Michael Griffith, President and Chief Executive Officer of Activision Publishing

Analysts:

Elizabeth Osur, Citigroup
Michael Wallace, UBS
Brian Pitz, Morgan Stanley
Heath Terry, Credit Suisse
Edwards Williams, Harris Nesbitt
Anthony Gikas, Piper Jaffray
Jeetil Patel, Deutsche Bank
Justin Post, Merrill Lynch

Presentation

Operator

Good day everyone and welcome to the Activision Third Quarter Fiscal 2006 Earnings Conference. Today’s call is being recorded. At this time for opening remarks and introductions, I would like to turn the call over to the Vice President of Investor Relations, Kristin Southey. Please go ahead.

Kristin Southey, Vice President of Investor Relations

Thank you, good afternoon and thank you all for joining us today for Activision’s third quarter 2006 conference call. As always I will start with today’s call with a review of our Safe Harbor disclosure followed by comments from Bobby Kotick, Chairman and CEO; Thomas Tippl, our Chief Financial Officer; and Mike Griffith, President and CEO of Activision Publishing. With regards to our Safe Harbor disclosure, I would like to remind everyone that the statements made during this call that are not historical facts are forward-looking statements. These forward-looking statements are based on current expectations and assumptions that are subjects to risks and uncertainties. The company cautions that there are number of important factors could cause Activision’s actual future results to differ materially from those expressed in any such forward-looking statements. Such factors include, without limitation, sales of the company's titles during the remainder of fiscal year 2006 consumer spending trends, the seasonal and cyclical nature of the interactive game market, the company's ability to predict consumer preferences among competing hardware platforms including next-generation hardware, software pricing, product returns and price protection, product delays, retail acceptance of our products, delays in hardware launches, industry competition, rapid changes in technology and industry standards, protection of proprietary rights and maintenance of relationships with key personnel vendors and third-party developers, international economic and political conditions, integration of recently acquired subsidiaries and identification of suitable future acquisition opportunities. These important factors and other factors that potentially could affect the company's financial results are described in our filings with the SEC, including the company's most recent Annual Report on Form 10-K and Quarterly Reports on Form 10-Q. The company may change its intention, belief or expectation at any time and without notice, based upon any changes in such factors in the company's assumptions or otherwise. The company undertakes no obligation to release publicly any revisions to any forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. And now, I would like to introduce Bobby Kotick our chairman and CEO

Robert Kotick, Chairman and Chief Executive Officer

Thank you Kristin, and first a word of gratitude as many of you may know Kristin gave birth last week to very healthy baby girl, and she did not missed a beat-working the entire weekend to prepare for our call today. So Kristin, thank you.

For the quarter, net revenues in for the first 9 months for the fiscal year were the highest in our history. For the quarter we finished as the #2 publisher overall as measured by NPD. And we had $765 million in cash and 1.2 billion in shareholders equity, our financial position remains exceptionally strong. As we said throughout last year, if the pricing environment deteriorated dramatically and titles like True Crime performs substantially below our expectation, earnings with software. The combination of the rapid decline in pricing and consumption, some key titles performing below expectations and the lack of 360 hardware to mitigate these negative markets factors, contributed to lower results than we planned for. In addition, we increased our variable selling and marketing spending to unusually high levels and an effort to mitigate these negative market conditions, which magnified costs beyond historical levels. While this spending likely resulted in better brand awareness for our franchises, it didn’t help the quarter’s operating results.

Lower overall sell-through resulted in a significantly increased provision for price protection and returns and higher product raise in costs which further impacted our margins, on balance however for the quarter and the year-to-date we substantially improved our competitive position. We finished the year at the clear #2 publisher overall as measured by NPD and perhaps most importantly we are the #1 market share publisher of Next Generation software, we have 32% share of the Xbox 360 market. This was accomplished to a focus strategy of a small number of high quality releases with Call of Duty capturing the #1 position on the platform. We also achieved a number of other important successes during the quarter, we had 8 title selling in excess of 1 million units each, 3 of the top 10 titles overall, the #1 new intellectual property for the 3rd year in a row, the number #2 overall PC title, the #1 Xbox 360 title, as I mentioned we are the #1 market share publisher for Xbox 360. This quarter, the Tony Hawk franchise surpassed the $1 billion mark and Tony Hawk’s American Wasteland became the 7th consecutive title in the franchise’s history to make to holiday top 10.

We extended the long-term right to 3 of our most important franchises Spider-Man, X-Men and Shrek. In November, we entered into a long-term agreement to expand all rights to the Spider-Man and X-Men franchises through 2017. Having the long-term rights to our strongest brands gives us a significant competitive advantage in terms of planning, development and profitability for the long-term. We also announced the new multiyear, multi-property licensing agreement with The DreamWorks Animation. The deal extends the rights to the valuable Shrek franchise and gives us the rights to 4 additional DreamWorks animated films. To-date, we’ve shipped over 13 million units of DreamWorks licensed titles including over 3 million copies of Madagascar this year alone.

We are focused on leveraging our next generation leadership and we’ve adjusted our product development investments in release strategy to capitalize on the opportunity these new platforms will afford us over the next few years. While this year and next are likely to be volatile, the opportunities presented by the launch of the various new consoles and handheld platforms, the new Vista operating system which is likely to energize PC gaming much like Windows 95, did 10 years ago. The emergences of new revenue sources like in-game advertising, online gaming and the host of wireless markets developing, we find ourselves in the strong position to leverage our competitive strengths over the next few years. We truly take advantage of the strong market fundamentals of the future; we’ll require investment and focus today. We intend to use our deep management strengths and our strong balance sheet to enhance our opportunities for the future. Michael shared the implications of these investments on fiscal ’07 and the benefits that are likely to accrue in fiscal ’08 and beyond. But first, Thomas will provide a review of the operating results for the quarter. It’s now my pleasure to introduce our new CFO, Thomas Tippl, who will share the quarterly results and outlook for the balance of the fiscal year review.

Thomas Tippl, Chief Financial Officer

Thank you Bobby, for the December quarter net revenues were record $860 million, up 136 million or 20% over the prior year due to our large holiday lineup. Our revenue performance was driven by the market platform releases of Call of Duty 2, Tony Hawk’s American Wasteland, Call of Duty 2: Big Red One, GUN, Shrek, True Crime and Quake. Also contributing to the quarter were our catalog titles Ultimate Spider-Man, X-Men Legends II and Madagascar.

For the quarter ending December 31, we have diluted earnings per share of $0.23, which was $0.35 in the prior year. Earnings were lower than the prior year in our November outlook, due mainly to challenging market conditions, half for our creation costs and increased sales and marketing spend. In the December quarter, manufacturing and distributions expense was 45% of net revenues, down versus 47% in the prior year due to improved mix as we had high publishing revenue. This was partly offset by inventory write-downs and higher price protection return reserves due to weaker market conditions.

Product creation cost for the quarter was 23% of revenues versus 16% in the prior year. We define product creation cost as the sum of cost of sales software royalties and amortization, cost of sales intellectual property licenses and product development expense. This increase was due in part to have development cost per title, driven mainly by the addition of next-gen SKUs, the slate capitalization of next-gen development cost and for slate revisions. During the quarter, we made the decision not to release several of our franchise titles in fiscal ’07, but to release them in fiscal ’08 and beyond to better our line our portfolio with the expected market growth. In addition, we cancelled the movies slated for the console in fiscal ’07 due to under performance on the PCs and the aim in SKUs in development as we’ve reverted those rights to model.

Sales and marketing expense for the quarter was 19% of revenues, up from 16% in the prior year. Sales and marketing spend were significant in the quarter due to our large line up, as well as our plans to drive demand given big market conditions and competitive pricing actions. The high levels of trade and consumer activity increased revenues although the spending did not raise proportionate expected sales volumes. Over the past 2 years, sales and marketing spend has been growing rapidly to increase brand awareness of our franchises and this will be a focus of future efficiency improvement.

G&A as a percentage of revenues was up modesty versus the prior year due to the infrastructure investments, to support territory expansion and cost-related to management team additions. Investment income for the quarter was higher than the prior year mainly due to the sales of the cautions taken to development. Our effective tax rate for the quarter was 27% versus 31% last year, the reduction is primarily due to tax credit accounting for a larger portion of pretax income. This completes the year-over-year P&L comparison.

I would also like to provide some perspective from the variance, from the outlook we provided in November. Manufacturing and distribution costs came in higher than expected that drive off 5% point of revenue, as a result of negative product mix, the previously mentioned provision for inventory and higher than anticipated requirement for price protection returns reserves. The costs of higher operating expenses are principally the same as those that drove the year-over-year increase.

Now turning to the balance sheet. On December 31, we had 765 million in cash and short-term investments, an increase of 51 million versus last year, cash and short-term investments were also up $14 million versus last quarter, including up from payments for our new license agreements. As of December 31, we had 941 million of working capital, an increase of 40 million versus last year and up 36 million versus September 30. The accounts receivable balance was 414 million, up 70 million versus the prior year due to higher revenues. Day sales outstanding were 47 base and inline with the prior year. The accounts receivable reserves of 175 million were 30% of gross receivables up versus the prior year as a result of previously discussed requirements for higher price protection in returns reserves.

Inventories were $85 million, up 43 million versus last year driven by weaken unexpected reorders of certain titles. On December 31, inventory for the publishing business was $63 million and $22 million for the distribution business. Capitalized software development cost were 36 million, a decrease of $39 million versus last year and down $87 million versus last quarter. The sequential reduction reflects a normal seasonal pattern given the amortization of our large Q3 lineup.

Capitalized intellectual property cost were 85 million, up 54 million versus the prior year and 56 million versus September 30, due to the recently announced long-term licensing arrangements with Marvel and DreamWorks. In summary, we ended the quarter with a strong cash position and financial base, which gives us the flexibility to invest and leverage the many opportunities that the next few years will yield. Before turning to our financial outlook, I would like to begin by saying that our outlook represents our users of today, and there are number of internal and external factors that could cause our actual results to differ materially. I refer you to our financial filings with the SEC for a full review of our risk factors.

Now to Q4, as I said in November, we have no new title slated for release since our last conference call, weakened market conditions and limited supply of next-gen hardware that laid up to significantly reduce our product performance expectations. For the quarter, we expect revenues of between $125 million and $135 million and a loss per share between $0.07 and $0.09. For the quarter, we expect manufacturing and distribution cost of between 60% and 65% of net revenues with operating expanses including royalties of between 63% and 66%. We project the tax rate of about 23% and a basic share count of about 278 million. For the full fiscal year, we expect revenues in the range of $1.405 billion and $1.415 billion and earnings per share between $0.09 and $0.11. Now, I would like to turn things over to Mike Griffith, President and CEO of Activision Publishing who will provide his talks on fiscal year ’06 earnings and our outlook for fiscal ’07 and beyond.

Michael Griffith, President and Chief Executive Officer of Activision Publishing

Thanks Thomas. Today I am going to focus my comment in three areas. First, our Q3 earning; second, what we will do differently in the future; and three, what we plan to deliver in fiscal 2007 and 2008. From a competitive position, we are very pleased with our performance in Q3. International publishing revenues increased significantly during the quarter, and in North America, we were decisively the #2 publisher overall with a largest market share gain of any publisher. Additionally, our average game ratings improved year-over-year, and Call of Duty for the Xbox 360 was the highest rated title overall. Well, not every title exceeded our expectations. Our commitment to quality product development help drive a number of our titles to a leadership position in their respective categories as Bobby highlighted earlier.

The market environment this quarter turned out tougher than we expected. We underestimated the decline in current generation software sales as the transition came on sooner and harder than expected and the supply of Xbox 360s in the market was lower than anticipated. So, a result of the softness, we saw more pricing pressure than we expected. We also aggressively supported our franchises although we didn’t see the incremental revenues needed to provide an adequate return. In fact, the additional investment in brands had a compounding effect on the reduction of operating margins. Looking ahead, we plan to better align our sales and marketing spend with expected market conditions. In fiscal ’07, we will adjust sales and marketing dollars versus the prior year, reflecting a smaller slate and to be consistent with our plan to return to our historical and proven investment levels.

Finally, two major releases underperformed our expectations, GUN and True Crime. However, we were pleased that GUN reined as the #1 new intellectual property in North America. So by market standards, this title would be considered a success. But it didn’t achieved our own return on investment targets as we spend significant development and marketing dollars against the launch of this brand. Even though we missed our internal expectations, make no mistake we were very excited about the future of this property and we’ll update you in the future on our plans.

Turning now to our box on the overall market, beginning with our hardware estimates. On December 31, the install base in North America for current generation systems including handheld was 97 million units. The install base over the next few years will be driven by lower price generation, current generation hardware, the new handhelds, the Xbox 360 and the launch of Sony PlayStation 3 and Nintendo revolution. With respect for the hardware market, there is still risk in the short-term with regard to first party plan, including next generation launch date enquiries, yearend install base estimates and reductions in current-gen hardware pricing and support.

For now, we expect the following hardware increases in North America during the calendar year. PS2, up approximately 4 million to 5 million units, Xbox up about 500,000 units, Xbox 360 up 4 million to 5 million units, GameCube, 800,000 units, handhelds which include GBA, Nintendo DS and PSP will grow approximately 10 million units, PS3 approximately 1 million units and Nintendo Revolution less than a million units.

Moving to software. We define our market to include all major platforms in North America and Europe. For calendar 2005, the combined North America and European software markets for current-gen and next-gen consoles, handhelds and PCs declined 4%, well below our beginning of the year expectations of flat to up 5%. For calendar 2006, we expect to combine North America and European software markets for current generation and next generation consoles, handheld and PC will decline approximately 0% to negative 5%, inline with 2005. With respect to software pricing, this still remains one of the major risk to our operating plans. We expect the software pricing for topline console titles will continue to be under pressure in calendar 2006, but the next generation software launch pricing will remain at 59-99.

Turing now to our fiscal 2007 preliminary outlook, in fiscal 2007 we plan to launch a more focused slate than in fiscal 2006, which should align well with the challenging current generation environment and slow ramp-up of next generation hardware. This will informally enable us to allocate more development resources against our large and growing fiscal ’08 line-up, when market conditions should be substantially more favorable. We will kick-off fiscal 2007 in Q1 with the release of two very exciting titles that will launch in conjunction with feature films. DreamWorks’s Over the Hedge and X-Men 3 from Fox Marvel Studios. We will launch Over the Hedge on the PS2, Xbox, GameCube, NDS, GBA and the PC and X3 on all the same platforms as well as in Xbox 360 SKU.

For the balance of the year, we are planning new console releases on our largest and proven franchises: Tony Hawk and Call of Duty. Additionally we will release, Quake Enemy Territory for the PC and Marvel Legends, a new super hero RPG slated for consoles. And throughout the year, we will also continue to support current Call of Duty 2 for the Xbox 360, order new launch title in fiscal ’07, given the small but growing hardware penetration and our #1 title status.

In terms of new intellectual property, we’re very excited about a title that’s testing well and targets the younger consumer. The game is an extension of the Tony Hawk brand called Tony Hawk: Downhill Jam, designed to reach different audience similar to our approach this year on Call of Duty 2 and Call of Duty: Big Red One, which gave us tremendous leverage with respect to our marketing dollars and was arguably our most successful program this year. So this will be a strong title in the absolute, but also complementary with our mainline Tony Hawk launch.

In fiscal 2007, we will also remain committed to maintaining a leadership position on next generation platforms and we planned to release 5 PSP titles, 4 Xbox 360 titles, 3 PS3 launch titles and 1 Revolution launch title. Given our limited visibility with regard to the market, software pricing and first party hardware plans for current and next generation, we will be in better position to give more detail on our fiscal year guidance on our next call. But preliminarily, we believe revenues will slightly exceed $1 billion dollars, and diluted earnings per share excluding the impact of stock options, will be up modestly year-over-year despite the reduction in revenues. Fiscal 2007 will be a year of caution and investment as we manage through the remainder of the transition and focus resources to prepare for accelerated growth in the next cycle. We are focused on driving the breadth and quality of our slate, while at the same time, driving efficiencies in our business model.

Looking ahead, our performance over the next few years will be driven by directing our global resources and capital allocation for 1) building the breadth and depth of our pipeline more fully exploiting our strong IP status. 2) Expanding the strength in Europe and Asia, 3) operating with a more efficient cost structure, 4) wining bid with winning customers. First, we are focused on building and strengthening our product portfolio. We planned to accomplish this by continually reinventing our core brands through superior game play innovation and selectively acquiring, creating high quality intellectual property as we’ve successfully done over the past few years.

We make major progress in this area, as we re-sign the long-term rights, the 3 of our most important licensed franchises: Spider-Man, X-Men and Shrek. We will also remain focused on geographic expansion with particular emphasis on Europe. We have a lot of opportunity in Europe that we are just beginning to capture. We’ve had tremendous success this year in Italy, Spain and Netherlands, the 3 newest geographies we transitioned to our direct selling model. We continue to look for similar opportunities and in the short-term we see Portugal and Nordic as additional geographies where we will increase our direct selling capabilities this fiscal year. We are committed to operating with an efficient cost structure. Going forward, you will see a real focus on aligning our cost with market expectations and expected product performance especially in the areas of overhead and sales and marketing.

We will look to leverage the synergies that a global organization can offer. For example, we recently restructured a European business; previously we had 8 reporting segments and have streamlined them into 4, a similar structure that other multinational corporations utilize. Finally, we are relentlessly focused on winning with the customer, we are committed to leading best-in-class industry practices that improve our customers and Activision’s performance together.

So in summary, we continue to position ourselves for the long-term and the growth that should follow the new hardware. In fiscal ’08, we plan to leverage our large and growing slate against the strong industry growth that’s expected. Our slate leverages major movie launches, core franchises and new intellectual property. We will enter fiscal 2008 with two major movie supported releases: Spider-Man 3 and Shrek 3. The prequel of these 2 movies generated 1.7 billion in worldwide Box-Office sales and we sold in excess of 25 million Spider-Man units and 7.5 million Shrek units to-date. With more platforms and territories to exploit long release stance for development, closer links with movie marketing partners and sponsors and the biggest theatrical launches in the history of both DreamWorks and Sony. Spider-Man 3 and Shrek 3 will likely be in the biggest launches in our history.

Also anchoring our slate, we’ll be in a return of a number of our largest franchises including Tony Hawk, Call of Duty and X-Men. Additionally, we’ll have new movie-supported properties like DreamWorks theme movies. And we’ve just finalized a new multiyear agreement with Hasbro to support the transformer line, which will launch with the major motion picture in summer 2007, our Q2 of fiscal 2008.

Finally, we’ll launch our own internally developed intellectual property, our fiscal 2008 slate will exploit a greater percentage of next generation games as we move up the learning curve. It’s still early, but we expect that fiscal 2008 will be the biggest year in Activision history, with revenues expected preliminarily to exceed $1.6 billion with a sustainable plan for growth over the next few years.

We thank you for your time and the opportunity to share our initiatives with you for the future. And will now open up the call for your questions. Thank you.

Questions & Answers

Operator

Thank you very much, question and answer session will be conducted electronically, if you would like to ask a question today, you can do so by pressing “*