Activision Blizzard's (ATVI) CEO Michael Morhaime on Q1 2014 Results - Earnings Call Transcript

| About: Activision Blizzard, (ATVI)

Activision Blizzard (NASDAQ:ATVI)

Q1 2014 Earnings Call

May 06, 2014 4:30 pm ET


Kristin Mulvihill Southey - Former Vice President of Investor Relations

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

Dennis Durkin - Chief Financial Officer

Eric Hirshberg - Chief Executive Officer of Activision Publishing, Inc

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


Colin A. Sebastian - Robert W. Baird & Co. Incorporated, Research Division

A. Justin Post - BofA Merrill Lynch, Research Division

Daniel Ernst - Hudson Square Research, Inc.

Christopher Merwin - Barclays Capital, Research Division

Benjamin A. Schachter - Macquarie Research

Arvind Bhatia - Sterne Agee & Leach Inc., Research Division

Stephen Ju - Crédit Suisse AG, Research Division

Michael Hickey - The Benchmark Company, LLC, Research Division


Welcome to the Activision's Blizzard's First Quarter 2014 Results Conference Call. Today's call is being recorded. I would now like to turn the call over to Kristin Southey. Please go ahead.

Kristin Mulvihill Southey

Good afternoon, and thank you for joining us today for Activision Blizzard's First Quarter 2014 Conference Call. With me today are Bobby Kotick, CEO of Activision Blizzard; Thomas Tippl, COO of Activision Blizzard; Dennis Durkin, 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 are forward-looking statements that are based on current expectations and assumptions that are subject to risks and uncertainties.

A number of important factors could cause the company's actual future results and other future circumstances to differ materially from those expressed in any forward-looking statements, including the factors discussed in the Risk Factors section of our SEC filings, including our 2013 Annual report on Form 10-K, which is on file with the SEC, and those indicated on the slides that is showing.

The forward-looking statements in this presentation are based on the information available to the company as of the day of this presentation. And while we believe them to be true, they ultimately may prove to be incorrect. The company undertakes no obligation to release publicly any revisions to any forward-looking statement to reflect events or circumstances after today, May 6, 2014, or to reflect the occurrence of unanticipated events.

I would like to note that certain numbers we will be presenting today will be made on a non-GAAP basis, excluding the impact of the change in deferred net revenues and related cost of sales with respect to certain of our online-enabled games, expenses related to stock-based compensation, the amortization of intangible assets, expenses related to purchase transaction and related debt financing and the associated tax benefits. Please refer to our earnings release, which is posted on for a full GAAP to non-GAAP reconciliation and further explanation.

There's also a PowerPoint overview, which you can access with the webcast and which will be posted to the website following the call. In addition, we will also be posting a financial overview highlighting both GAAP and non-GAAP results and a one-page summary sheet.

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

Robert A. Kotick

Thank you, Kristin, and thank you all for joining us today. I'm pleased to report that Activision Blizzard delivered better-than-expected first quarter results. On a non-GAAP basis, we generated $772 million in revenues, with a record 68% of those revenues coming from digital channels. We had record operating margin of 31% and record earnings per share of $0.19.

During the quarter, we generated strong cash flow and as a result, repaid $375 million of our term loan. As of March 31, we have nearly 0 net debt, and in a little over -- a week from now, on May 14, we plan to pay our highest dividend ever of $0.20 per share.

Our success in the first quarter is due to the remarkable talent and relentless commitment to excellence of our employees around the world. Their efforts align with our long-term strategy and operating discipline, continue to produce industry-leading creative and commercial results.

We have some of the most valuable entertainment franchises and online communities in the world and we plan to expand our portfolio in 2014 with some of the most innovative new games from both Activision Publishing and Blizzard Entertainment.

Life to date, Call of Duty remains the #1 franchise on the new PlayStation 4 and Xbox One consoles, which is important as we grow our online communities on these growing platforms. Last Friday, we revealed Call of Duty: Advanced Warfare, which is being developed by Sledgehammer. This is the first Call of Duty game that we built on a 3-year development cycle and we're now into the first full year of the console generation. We wanted to ensure that one of the most valuable franchises in all of entertainment has the very best graphics, most engaging story, great new play mechanics and is incredibly fun to play.

Life to date, Skylanders continue to lead the toys-to-life genre, which we created, and in the first quarter, Skylanders SWAP Force, including toys and accessories remain the #1 franchise in North America and Europe combined.

A few weeks ago, we revealed Skylanders Trap Team, the newest installment that will expand on the magic of bringing toys-to-life, letting kids pull characters out of the digital world and into the physical world by capturing them in magical traps. They can then send those villains back into the game to fight for good. We're very excited about the prospects for Skylanders Trap Team, which probably is the best of all the Skylanders games that we've made to date.

On September 9, Activision Publishing plans to release Bungie's highly anticipated game, Destiny, which we expect will become our next new $1-billion franchise. Destiny takes place in the shared online universe filled with other players. It's seamlessly social, but it has the pace and excitement of an action game. Pre-orders for the game are tracking towards setting an industry record for a new franchise.

Blizzard also has the most ambitious product plan in its history. World of Warcraft continues to be the world's largest subscription-based MMORPG and ended the quarter with approximately 7.6 million subscribers.

We've expanded the game's development team to accelerate content delivery, including expansions, while continuing to raise the bar on quality. As of today, I'm pleased to announce that pre-purchases for the next expansion, Warlords of Draenor, which we plan to launch later this year, have already exceeded 1 million purchases to date. This speaks to the enthusiasm from the World of Warcraft community for the exciting release that we have planned later for this year.

During the quarter, Blizzard also launched 2 new titles, Diablo III: Reaper of Souls and Hearthstone: Heroes of Warcraft. In its first week, the Diablo III: Reaper of Souls expansion sold through more than 2.7 million copies worldwide and during the quarter, was the #1 PC game in both North America and Europe. Blizzard intends to release Diablo for PS4 later this year.

Additionally, on March 11, Blizzard launched its new free-to-play game Hearthstone: Heroes of Warcraft. And with the early success, it is on-track to become Blizzard's first new franchise since World of Warcraft. Hearthstone already has registered over 10 million PC players across all regions with strong engagement and monetization. The game launched on iPad in April and quickly occupied the top spot for iPad downloads and also became a Top 10 grossing iPad game in numerous countries around the world, including the United States. Blizzard plans to release versions for iPhone and Android phones later this year.

Lastly during the quarter, Blizzard generated strong revenues through with the launch of Hearthstone in iPad, Blizzard had now expanded beyond PCs to the fast-growing tablet community, which represents a tremendous future opportunity for Blizzard.

As we look ahead, we're deep in development on 2 ground-breaking free-to-play titles that are designed to leverage our committed and passionate player community in new directions.

As we've talked about before, in partnership with Tencent, we'll be bringing Call of Duty to China in a format specifically for the Chinese market on the PC and as a free-to-play game. Blizzard is also developing Heroes of the Storm, which taps into a blooming genre with free-to-play online team brawler with characters from StarCraft, Diablo and the Warcraft universes.

Overall, 2013 was a transformational year for both the industry and our company. In the near term, 2014 and beyond, we expect to build on those changes. We have plans to launch 4 great additions to our franchise portfolio. These new additions show a balance of growth and diversification initiatives. Destiny is based on all new intellectual property, Hearthstone and Heroes of the Storm leverage existing characters from proven franchises for new modes of gameplay and Call of Duty Online takes an existing franchise to a new geography with a new business model.

Each of these 4 is designed to capitalize on emerging audience opportunities and to leverage the tremendously engaged and connected communities we have built around our franchises. We plan to deliver on the tremendous creative and commercial promise of these new initiatives, even as we push our existing beloved franchises to new heights, including, as I'd mentioned, some of the best contents we've ever created for World of Warcraft, Skylanders and Call of Duty.

In short, we're well-positioned to build on our past successes and emerging industry trends to continue to deliver great games for our fans and superior returns for our shareholders as we have for almost 1/4 of a century. Now Dennis will discuss our performance and our outlook for the future.

Dennis Durkin

Thanks, Bobby. Good afternoon, everyone. Today I will review our better-than-expected Q1 financial results and then our outlook for Q2 and our increased outlook for 2014.

Starting with our financial results. Please refer to our earnings release for a full non-GAAP to GAAP reconciliations. Also the numbers I'll be quoting are compared to the prior year, unless otherwise noted.

For the quarter, on a GAAP basis, we generated revenues of $1.1 billion and operating margin of 38% and EPS of $0.40. On a non-GAAP basis for the quarter, we generated revenues of $772 million, including a record high 68% from digital channels which drove a record Q1 operating margin of 31% and record Q1 EPS of $0.19. Our strong performance was driven by 5 distinct franchises, highlighting the increasing breadth and depth of our portfolio.

Blizzard Entertainment produced record results, including strong sales of the Diablo III: Reaper of Souls expansion, better-than-expected Hearthstone card sales and World of Warcraft subscriptions. Additionally in Q1, we recognized revenues from portion of the price paid for the pre-purchase of World of Warcraft: Warlords of Draenor expansion, which included a character boost that is immediately playable upon purchase. During the quarter, we also recognized revenues for standalone character boost, which were sold separately.

In addition, on the Activision Publishing side of the house, Call of Duty: Ghosts and Skylanders SWAP Force were the 2 top games in North America and Europe combined. Finally, we also saw some strength in our low-margin European distribution business due to better-than-expected next-gen console sales.

Turning to the specific P&L line items, please note all percentages are based on revenues except for the tax rate. For Q1, GAAP product costs were 25%, operating expenses were 36%, and operating margin was 38%. GAAP and non-GAAP interest expense was $53 million and our GAAP tax rate was 22%. Our GAAP and non-GAAP weighted average share count was 720 million. And for EPS purposes, we also include 17 million of participating securities for a fully diluted total of 737 million.

On a non-GAAP basis for the quarter, product costs were 24%, operating expenses were 45% and operating margin was a Q1 record, 31%. Our adjusted EBITDA margin was 33% and our non-GAAP tax rate was 25%. Our Q1 results were higher-than-anticipated due to better-than-expected operating performance in an amount about equal to our non-GAAP over-performance and our recently identified forecast miscalculation with regard to deferred revenue recognition in our previous GAAP outlook, which accounted for the balance of the GAAP over-delivery.

In terms of cash flow, in Q1, we generated strong cash flow with non-GAAP adjusted EBITDA of $257 million, operating cash flow of $136 million and free cash flow of $99 million. We also repaid $375 million of our term loan in February. And next week, on May 14, we plan to pay a $0.20 per share cash dividend or approximately $143 million to shareholders of record on March 19.

Turning to the balance sheet. As of March 31, we had approximately $4.3 billion in cash and investments, of which over $800 million was held domestically, with total debt of $4.37 billion and net debt of only $73 million. Our net debt to trailing 12-month non-GAAP adjusted EBITDA ratio is nearly 0.

In summary, Q1 was a solid start to the year for Activision Blizzard, but please note that of the $0.10 of the first quarter non-GAAP EPS over-performance against our February outlook, approximately $0.06 was due to timing as we pulled forward some revenues from future quarters from revenue recognition from character boost included in the Warlords of Draenor pre-purchase program and also from delayed OpEx spending that will hit future quarters.

Now let's turn to our slate and our outlook for Q2 and for 2014. For Q2, we have no major product releases planned. In addition, as we have seen historically, we would expect to see declines in World of Warcraft worldwide subscribers in the quarters leading up to the launch of the expansion, when players then typically return to the game. In Q2, we also expect to begin to ramp in sales and marketing spending for our 4 major releases in the back half beginning with the September 9 launch of Bungie's Destiny. For Q2 on a GAAP basis, we expect net revenues of $910 million, product cost of 26% and operating expenses of 45%. We expect GAAP and non-GAAP interest expense of $52 million, a GAAP tax rate of 22%, GAAP and non-GAAP share count of 745 million and EPS of $0.22.

For Q2 on a non-GAAP basis, we expect revenues of $600 million, product costs of 26% and operating expenses of 63%. We expect a non-GAAP tax rate of approximately 37% and non-GAAP EPS of $0.01.

In Q3, we expect the release Destiny, which we think will be the biggest new video-game IP launch in history. However, we expect limited operating income in the quarter from Destiny as we will incur significant marketing and development expenses consistent with launching the property of this scale. We will also be ramping our spending ahead of our other large Q4 launches.

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

In 2014, we also plan to continue investing in new properties with long-term potential in the fast-growing free-to-play segment, including Activision Publishing's Call of Duty Online for China and Blizzard's Heroes of the Storm. But as we said on our last call, revenues from these games are not factored into our 2014 outlook.

Now to our 2014 numbers. For 2014, on a GAAP basis we, expect increased revenues of $4.22 billion, product costs of 23% and operating expenses of 52%. For both GAAP and non-GAAP, we expect interest expense of $210 million. Our GAAP tax rate is expected to be 22%. We expect 750 million fully diluted shares, both for GAAP and non-GAAP, and GAAP EPS is expected to be $0.89. The increase in our GAAP outlook for 2014 is the result of our actual Q1 GAAP performance, which was higher than our prior Q1 GAAP outlook for the reasons I've previously cited, as well as our current expectations for the remainder of the year.

For 2014, on a non-GAAP basis, we expect increased revenues of $4.675 billion, product cost of 25% and operating expenses of 43% and an operating margin of 32%. Our non-GAAP tax rate is expected to be 25%. For the year, we are raising our full year outlook by $0.01, and we expect record non-GAAP EPS of $1.27.

As I mentioned earlier, we had Q1 non-GAAP EPS upside of $0.10, of which $0.06 was due to timing. And although we're excited about the next-gen console ramp, we are taking a more prudent approach to the balance of the year due to continued pressure on current-gen software demand, and given that about 3/4 of our full year non-GAAP EPS outlook is expected to be generated in the holiday quarter.

In summary, Activision Blizzard's expanding portfolio of industry-leading franchises delivered better-than-expected financial results and record non-GAAP EPS during Q1. Looking to the back half the year, we expect to launch the strongest line up in our history. In all, during 2014, we plan to deliver 6 major properties across our Call of Duty, Skylanders, Destiny, World of Warcraft, Hearthstone and Diablo franchises. We expect each will set new benchmarks for online playing innovation, while also further broadening and diversifying Activision Blizzard's portfolio across platforms and geographies. We expect that each will contribute non-GAAP revenues in excess of $100 million, which should drive non-GAAP digital revenues, record full year non-GAAP earnings per share and strong cash flows.

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

Eric Hirshberg

Thanks, Dennis. I'm going to start my remarks by talking about the console industry overall. The next-gen console transition continues at a record pace, with Sony recently announcing over 7 million units sold through worldwide for the PS4, and Microsoft announcing 5 million units sold in for the Xbox One. Both of these milestones were achieved faster in this cycle than in comparable points for the PS3 and the Xbox 360 in the last console cycle. This is, of course, good news for our business. Both platforms offer faster computing power, richer graphics and more compelling online social experiences, which play directly into our strengths as the industry's biggest creator and publisher of AAA games.

Second, both platforms improve the consumer experience of buying digitally, which we believe, over time, will increase our high-margin digital business. However, this transition to the next-gen platforms will take time.

In the interim, we've seen industry software sales decline year-over-year, particularly on current-gen hardware, and the current-gen versions of our own games have not been immune. In spite of that, Activision Publishing has delivered another quarter of industry-leading performance and is set up for success throughout the rest of this year.

In Q1, in particular, including toys and accessories, Activision Publishing had the top 2 titles in North America and Europe combined. Skylanders SWAP Force is #1 and Call of Duty: Ghosts was #2. Call of Duty, of course, remains the #1 selling franchise life-to-date on the current-gen PS3 and Xbox 360 consoles. Importantly, though, Call of Duty: Ghosts also continues to be the #1 selling title on both next-gen consoles life-to-date, an important achievement as we establish Call of Duty as the first person action game of choice for the next-gen.

Skylanders SWAP Force also had a strong quarter, remaining the industry's largest toys-to-life title. The franchise overall have now had sales over $2 billion with over 175 million toys sold through and has more new characters and toys rolling out this quarter than ever before.

These are great accomplishments, but we are taking nothing for granted. We continue to see new competition entering the toys-to-life genre that we created and we remain committed to continuing to lead the category with even more breakthrough innovations to captivate our young fans. To that end, we recently revealed our next installment of Skylanders franchise, Skylanders: Trap Team, developed by Toys for Bob, the originators of both the franchise and the genre. It would have been easy to make Skylanders 2.0 simply by adding more characters, but instead we chose to keep innovating because we believe success in this genre is built on making kids say wow. With Skylanders: Trap Team, we're no longer just letting kids bring their toys to life inside the game, now we're letting them pull their toys out of the game as well. The game's core innovation allows players to battle villains on screen and then pull them into the physical world by capturing them in magical crystal traps. Once trapped, a player can release the villain back into the game to fight on their side so you can capture evil and unleash good. As one reviewer said, "It's a simple yet genius idea combining traditional play with clever tech to accomplish what every child has dreamt of doing with their favorite toy." Consumers seem to agree as our reveal zone for Trap Team is off to a faster start with millions more views than any reveal trailer in the franchise's history. We're confident that this installment of Skylanders, which is to launch October 5, will, once again, redefine what's possible at the intersection of physical and digital play and expect it to, once again, be the must-have gift of the holiday season.

Looking ahead to the end of the second quarter, we're excited for E3, where we will showcase 3 AAA tentpole franchises: Destiny, Skylanders and Call of Duty. As mentioned in previous calls, Destiny has been in development for over 4 years, the next Skylanders game has the most of a significant innovation since the franchise's inception, and this year's Call of Duty game benefits from our first-ever 3-year development cycle on the franchise. As a result, 3 of the most anticipated, most innovative and highly polished games in the industry will be on display in the Activision Publishing booth. We plan to launch Destiny in the third quarter and we expect it to be the biggest new IP launch in video-game history and over time, to become Activision's third $1-billion franchise. Our partner, Bungie, is creating a truly epic game that combines the speed and digital thrill of a great first-person multi-player action game, with the depth and character development of an MMO and RPG, culminating what we believe would be a new industry-leading genre, the shared-world shooter.

I'm excited to share that we believe preorders for the game remain on a record pace for new IP. We look forward to showing you more at E3 with our great partner, Sony, to our public beta later the summer and to having you join the Destiny universe for yourself on September 9.

In Q4, on November 4, we also plan to launch our next entry into the Call of Duty series, Call of Duty: Advanced Warfare. As many of you know, the reveal trailer we released last Friday used footage captured from the Xbox One. I'm pleased to share the reveal was so popular that it made the top slot on YouTube's U.S. homepage and has already received more views on the first 3 days of its reveal than Ghost did in its first week. As Bob and I both said, Advanced Warfare is the first Call of Duty game to benefit from a 3-year development cycle, allowing us to introduce both more innovation and more polished content at this point, pre-launch than any previous Call of Duty game. With a great new AAA studios, Sledgehammer Games at the helm, our first 3-year development cycle, a truly next-gen graphic experience, new core mechanics and a little help from Academy Award winner, Kevin Spacey. We're optimistic this could be one of, if not the best, Call of Duty game yet.

Over the long term, Activision continues to work to expand our portfolio with carefully selected list of growth initiatives. Call of Duty Online for China is one of our most important. And I'm proud to say that the game play looks great and that our development is going well. With our strong partnership with Tencent, we're more excited than ever at the prospects of this project. We look forward to sharing more with you on this and our other initiatives in the near future.

So in closing, Q1 was another industry-leading quarter for Activision Publishing. We're excited about our ability to continue to lead the industry through the console transition and by our incredible 2014 slate led by Destiny in September, Skylanders in October and Call of Duty in November.

Thanks, and I'll now turn the call over to Mike to talk about Blizzard.

Michael Morhaime

Thank you, Eric. Blizzard Entertainment kicked off 2014, with a busy and record-setting quarter. We closed out March with record revenues and operating income for any Q1 in Blizzard history. Our success was fueled by the launch of Diablo III: Reaper of Souls, presales from World of Warcraft: Warlords of Draenor and the official launch of Hearthstone: Heroes of Warcraft on Mac -- on Windows and in Mac. In addition, we also kicked off initial alpha testing for Heroes of the Storm, our upcoming free-to-play Hero products. The Reaper of Souls launch was the definite highlight of Q1. The game sold through 2.7 million copies as of the first week alone making it the top-selling PC game of 2014 so far, based on the internal estimates and reports from key distribution partners. The press reaction has been extremely positive and players are really enjoying the new contents and features, such as Adventure Mode, that enhance replayability. We attribute a lot of the game's access to a focused effort, by listening to player feedback and making improvements to the game based on that feedback. The result was a smooth global launch, as well as strong sales and ongoing engagement.

Looking ahead, we're already working on a content update that will add new features, like [indiscernible], where players can unlock increasingly more difficult dungeons for greater rewards. We also expect to launch the Diablo III: Ultimate Evil Edition, which will bring the Reaper of Souls content to console later this year.

On the World of Warcraft front, we ended Q1 at approximately 7.6 million subscribers, slightly below the prior quarter. We also began taking pre-sales for the next expansion, Warlords of Draenor. We've seen strong interest in the pre-sale offer with more than 1 million sold so far, and believe that the included character boost played a role in motivating players to make an early commitment to Warlords of Draenor. Players who participated in the pre-sale were granted immediate access to a character boost to level 90, which is part of the Warlords of Draenor package. Character boosts are also available under separate service. The boost make it easier for players to return to the game and rejoin their friends or to just try out a new class. We believe that Warlords of Draenor offers a compelling package for players. The story takes Warcraft back to the setting of some of the original games, reintroduces classic heroes and villains. Warlords of Draenor also includes the innovative new garrisons feature, which allows players to further customize their experience in the game. Each player's garrison acts as a home base. It allows players to leave a personal footprint in the world, tailored to their taste and gameplay preferences. Overall, we're pleased with the ongoing stability in the player base, but look ahead cautiously given the seasonality and a late-expansion cycle dynamics. We expect to launch Warlords of Draenor in the back half of the year.

Moving on to Hearthstone. The game officially launched on Windows and Mac on March 11 and it's currently one of the top-rated iPad and PC games of 2014 on Metacritic.

At the time we launched on PC, more than 10 million players had already tried Hearthstone. More have joined since we launched the iPad version a few weeks later, and the game quickly climbed to the top of the free app chart in dozens of countries. While it is still too early to talk specifics about the impact of the iPad release, we're very pleased with the response we received and are excited to expand Blizzard's reach to the iPad. We were also proud of the fact that Hearthstone offers a seamless cross-platform experience. The progress, collection and friend list remain the same across all platforms, allowing players to enjoy the game easily on both PC and iPad. Hearthstone's pace and design make it ideally suited for the tablet format. Matches are quick, generally around 10 minutes, and concepts are easy to grasp for newcomers, while maintaining enough depth for long-term competitive play.

Looking ahead for Hearthstone, we plan to release a new single-player adventure called The Curse of NaxxramaS this summer. This content is based on a popular raid dungeons in World of Warcraft. Players will be able to face off against card versions of classic boxes from the dungeon and unlock new cards. The Naxxramas content will be released over several weeks. To celebrate the launch, the first set of content will be free for a limited time, while the subsequent ones will be unlockable through in-game gold or real money. We're thrilled to bring the first new piece of new content out for Hearthstone this summer and look forward to creating more content for this growing community.

Rounding out a busy quarter for us, we began a technical alpha test for our upcoming team brawler, Heroes of the Storm. Heroes will be our second free-to-play game, giving our spin on a very popular game genre. Players can choose from dozens of iconic Blizzard characters, team up with friends and take on other teams in competitive online matches. The technical alpha currently includes U.S. players and select global press and community influencers. Early feedback has been very positive, with many media talking about Heroes' unique gameplay design, which is tailored to be more welcoming for newcomers to the genre. That fresh game -- that fresh take on gameplay, combined with the appeal of Blizzard's popular characters has generated a lot of interest in the game. At a recent showing at PAX East, players waited up to 2 hours to try the game and came away with very good impressions. We're steadily adding more content and features over the course of testing and we look forward to expanding the test audience globally in the coming months. In addition, our partners at NetEase and Asiasoft have announced that they're working with us to bring the game to China and Southeast Asia, respectively.

Summing up, we had a great start to 2014, with major achievements across a range of different franchises. Now that Hearthstone is officially released, we have active communities across 4 different games, including World of Warcraft. Diablo III and StarCraft II. Heroes of the Storm is in testing and will become Blizzard's 5th active game, all tied together on And we just recently updated the app with chat functionality making it easier than ever for Blizzard gamers to stay in touch no matter which game they're playing. We're working very hard to carry the momentum from Q1 throughout the year, and cap off with our biggest BlizzCon yet in November. Tickets go on sale tomorrow and this Saturday, so don't miss out. We're working on more games and game contents than ever before, and the future is really bright for all Blizzard gamers.

Thanks, and I'll turn the call back over to Kristin.

Kristin Mulvihill Southey

Thanks, Mike. Operator, we're ready to take some questions.

Question-and-Answer Session


[Operator Instructions] We'll take our first question from Colin Sebastian with Robert W. Baird.

Colin A. Sebastian - Robert W. Baird & Co. Incorporated, Research Division

Eric, I was wondering if you could provide, first off, some perspective on what aspects of the next-gen version of Call of Duty will particularly be unique and stand out this year, just given the 3-year development cycle, as well as the focus on the next-gen platforms? And then secondly, just curious if the performance of recent other next-gen releases gives you any hesitation with respect to the lack of a single-player mode for Destiny?

Eric Hirshberg

Okay. I'll take your questions in order. First of all, the answer on Call of Duty is really a fairly long list. I think the answer is honestly several things. I'll just focus on a few of the most prominent. I think, first and foremost, is visual and graphic fidelity and polish. I hope you'd agree that you're seeing, even in the reveal trailer, a different level of graphic fidelity than we've had in the past. And it's our true -- first true next-gen -- pure next-gen development where we have access to the new hardware throughout the development process, unlike Ghost which was cross-gen.

Second, it's allowed us more time for experimentation, creativity and iteration in the development process. So that led to things like us adding some of the first new mechanics in core gameplay in the franchise in a long time, things like boost jump and exo strength and new mechanics, which we have also had time to test with our players to make sure that they resonate and will create a compelling and balanced gameplay. IGN, I think, just ran an article talking about 11 game changers they were perceiving just from picking apart the reveal trailer frame-by-frame. So there's a lot of new ideas in it.

And then third, it allowed us more time to put more emphasis on story and character. And you could see that in the trailer, too. We hope that the villain character being played by Kevin Spacey soon to become iconic. And also, you're seeing really state-of-the-art facial capture and animation. That's a full performance capture technology that we revealed last year at GEC. We've got some great acclaim from the 3-year cycle. It allowed us the time to move that from an R&D effort into real gameplay.

As far as your question on Destiny, I think that the framing of your question actually plays to one of Destiny's strengths, which is that it does have a single-player experience, and it has multiple different ways to play the game. So we're not putting all our chips on multi-player the way some others have been offering a wide variety of content and game modes. So no matter what way you like to play, Destiny has a great experience for you.


And our next question comes from Justin Post with Merrill Lynch.

A. Justin Post - BofA Merrill Lynch, Research Division

As we enter year 2 of the cycle, some of other companies in the space are seeing some operating leverage. And I -- we just wonder if you could talk about your operating leverage this year and going forward, how you see that? And are there some expense savings going forward?

Dennis Durkin

Sure. Thanks, Justin. It's Dennis here. What you generally see in the console transition is that margins compress modestly at the beginning of the cycle. You're building software for multiple platforms, installed bases are not fully grown out yet, development tools and engines are not fully mature. So there's inefficiency that comes with the early years of the console transition cycle and your investments are spread across multiple generations. As you more fully transition in the later years of this cycle and focus on the next-gen, margins expand, obviously, as the installed base grows and you get more scale out of your development and marketing efficiency. You've seen this in our financials when you look in the past couple of years, in 2012, we had peak operating margins late in the last cycle, about 34%. And then last year, you saw a little bit of compression on that when we compressed down to 31%. This year, it's rebuilding up a little bit to 32%. So we expect, over the course of this generation, for those margins to continue to expand, and particularly on next-gen with all the new business models. And then digital, you heard about the record performance in Q1. We do expect digital to continue to drive that expansion.


The next question comes from Daniel Ernst with Hudson Square Research.

Daniel Ernst - Hudson Square Research, Inc.

As we look at your R&D expense, and if I include -- if I would include the capitalized portion of that expense, now you have Call of Duty on a 3-year cycle, you've got a multi-year plan, I believe, for Destiny, could you give us a sense of how much of that R&D budget is geared for things that will see the next year, next 2 years, next 3 years with things that we see today and things that were -- that we don't yet get to see? How much spending is going towards those things in the future? And then a related question to that, how much of that investment will be on for IP that we know in the current portfolio versus new things that you have in the development?

Dennis Durkin

Yes, no worries. Thanks, Dan. Good question. I guess I'll just start by highlighting the fact that -- you alluded to this, but we have -- our whole investment model is anchored on building franchise value over time. And so we plan our businesses and our franchises with multiple-year planning horizons, constantly evaluating what we're going to build, who's building it, what the innovation is, when it will come to market, and we're really trying to build a consistent flow of content for our communities and growing franchise value over time. So with that in mind, we're always trying to managing the short, medium and longer term to make sure we're investing in innovation across each franchises, while also selectively layering in new franchises when we see big market opportunities and capabilities that we can exploit. Specifically to your question, it'll vary in any year, but generally speaking and directional for 2014, probably about 1/3 of our total cash spend is for future games that we'll release beyond 2014. And then relative to new IP, probably about 1/4 of our spend is on new IP on franchises like Bungie, Heroes, Hearthstone, Call of Duty Online, et cetera. So that gives you directional mix in terms of how our cash spend in 2014 lays out against sort of near term and long term, as well as existing and future IP. So appreciate the question.


Our next question comes from Chris Merwin with Barclays.

Christopher Merwin - Barclays Capital, Research Division

So it looks like you've had a lot of early success with Hearthstone. I think you reported about 10 million users. And now that, that game has been launched on iPad, can you quantify at all for us what type of uptick you've seen in users so far and how those iPad users been converting any better than the desktop ones? And then lastly, just in terms of monetization for the games, is it possible to share what type of payer rates you're seeing for Hearthstone as compared to the typical mid-core mobile game?

Michael Morhaime

We'll we're not ready to discuss specific impact on the total player base or specifics around monetization yet. I can say that it's monetizing very well compared to other free-to-play games, at least from what I've seen. One thing to point out, since it is a cross-platform game and we have users that joined us on multiple platforms, you are seeing players that joined on the PC purchasing both on the PC and the iPad and vice versa. And so the way that we look at the ecosystem there is as really one-player base that has the ability to play on multiple platforms. And we think that judging by the rapid rise of the download popularity on the iPad charts and the positive reviews that we've been getting, we're very pleased.


The next question comes from Ben Schachter with Macquarie.

Benjamin A. Schachter - Macquarie Research

Do you think that some of the large-platform companies like Apple, Amazon and Google are going to pursue exclusive content as they try to basically build their app store market share? And how is this going to be different than what we've seen over many years for Microsoft and Sony in how they use exclusive content?

Robert A. Kotick

Yes, and they already are pursuing exclusive content. And I just think it'll add more opportunities for companies like ours that has the kind of content that they would like to have exclusively. And you're going to start to see more of that as there become more platforms available to create content for.


And our next question comes from Arvind Bhatia with Sterne Agee.

Arvind Bhatia - Sterne Agee & Leach Inc., Research Division

Maybe just a couple of questions. First, I was wondering if you guys could share some thoughts on capital allocation? And then I know a bunch of questions on Hearthstone have been asked, but could you help us maybe size the market and the audience size from your perspective?

Dennis Durkin

Sure, I'll take the first one on capital allocation and then Mike and I can probably pair up on the Hearthstone market size. On capital allocation, obviously, it's been a question that's been asked with our new capital structure and our first priority is around debt service. And you can see from our recent paydown and current net debt situation being almost 0 that we're in a very comfortable position with a lot of flexibility. So we have a lot of opportunities to use that excess cash in various ways. And we've historically paid a dividend, which, as we've mentioned -- as I mentioned in my prepared remarks, we'll pay next week a $0.20 dividend. It's up on a per-share basis versus last year, but down in aggregate versus last year due to our lower share count. So that stays on the list of our annual priorities. And then, we'll -- as we look across other uses of capital, whether it be investing in our businesses we're doing across the multiple new IPs that you see coming out in both content and infrastructure, M&A or other inorganic activities, we look at all of these with the focus of driving and increasing shareholder value as our top priority. So overall, I think those are generally the priorities that we have across the business and we'll be prudent and disciplined at how we look at capital allocation and continue to do that in the way that we think maximizes shareholder return for the long term.

Michael Morhaime

Okay, and the sort of the sizing the Hearthstone opportunity -- market size opportunity for Hearthstone. I think it's very difficult to project something like that. Certainly giving the -- given the accessibility and depth of the game, we certainly believe that there's a lot of potential. Also when you consider that we still have the Android platforms and the iPhone to expand to, we see that as a big opportunity as well. And also we're continuing to build on the game experience, listening to player feedback and adding new content. So we're really excited about the upcoming release of Naxxramas.


Our next question comes from Stephen Ju with Credit Suisse.

Stephen Ju - Crédit Suisse AG, Research Division

So, Bobby or Eric, Destiny is being released at a the time of the year where we'll be competing with -- for consumer wallet share with annual iterations of franchises from your competitors, as well as perhaps new releases from others. So do you foresee this as being a headwind to initial sales, or is this apples and oranges in terms of the target customer? And from what you can tell, is the September release window more or less crowded versus years past?

Eric Hirshberg

This is Eric, I'll take that. We think we have a great window to release Destiny. More importantly, we think we have a great game. As far as the window goes, I would just remind everyone, this is the same window essentially that Grand Theft Auto had last year. So I think that fairly decisively proves that a great action game can find a huge audience during that time period and they had all the same annual competitors to contend with as we will. But more importantly, we found that whenever your launch is, if you have a breakthrough game and you have a great experience, which is sticky and novel and deep for the variety of game players, we think we have all of that and then some with Destiny that we can find a meaningful audience. So we've got a breakthrough game. We think we've got a great window and we would have competition no matter when we launch it.


The last question comes from Mike Hickey with The Benchmark Co.

Michael Hickey - The Benchmark Company, LLC, Research Division

Mike, just give us some details on Heroes of the Storm. And I know it's early days here, I'm not sure how much more you can share, but I was hoping you could just, if possible, kind of size maybe the market opportunity as it relates to the game category? Or maybe the Blizzard audience. I mean, you've got 10 million, looks like, PC players almost immediately for Hearthstone. Is that kind of an initial reasonable range you think for Heroes of the Storm, or is it unique that maybe it doesn't appeal to the same player base? And then maybe this is way too early, but maybe monetization of the game and also as it relates or I guess compares to what you saw from Hearthstone?

Michael Morhaime

Thanks for the question. So currently, we're in a very limited technical alpha testing, really, to test the infrastructure around the game and all the technical issues surrounding the game. It's also giving us the opportunity to test some of the game design innovations that we have been creating. And the response has been very positive. The game is already very fun. We're getting really good feedback from the people that are currently helping us test it. We're looking forward to expanding the number of -- the size of our test audience in the future. In terms of the opportunity, it is a proven genre. I mean, you can see that some of the existing games in the genre have achieved a very high level of success. We think that there's an opportunity to make the genre even more approachable for new players. I think that it can skew very hardcore, and there's definitely room for improvement in that area while still maintaining the depth and replayability that exist there. So let's see, in terms of monetization, we are still experimenting with monetization, but it will be free-to-play, we will have micro-transactions and we'll have more information about the offerings that we'll provide in the future.

Kristin Mulvihill Southey

Okay. Well, carry on, and thanks, everyone. On behalf of everyone at Activision Blizzard, we thank you for your time and consideration, and we look forward to seeing some of you at E3. Thank you.


Thank you for your participation. That does conclude today's call.

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