JULY 18, 2008 • Activision Blizzard is now a reality having passed muster with both shareholders and regulators. The merger creates the largest video game publisher in the business, at least for the near future. That kind of clout is one of the reason why the company felt secure in withdrawing from the Entertainment Software Association, and why DFC wanted to speak with Activision Blizzard chief financial officer Thomas Tippl.
Thanks to solid choices in product development, Activision has seen robust balance sheets during the last several years. And it is no secret that Blizzard had been carrying the rest of Vivendi Games on its shoulders for some time. The combination of both operations presents opportunities for successful expansion into Asian and European territories – something clearly on the mind of shareholders who saw the value of their holdings rise in the months leading up to the mid-July closing of the deal.
In these pages back in February, we ran a chart indicating the valuation of Activision Blizzard with and without the tender offer. That chart showed the valuation at $18.9 billion without the tender offer, and $15.5 billion with the tender offer. That analysis caused a stir in some circles, but time and confirmation by Mr. Tippl, proved us right – the value of a combined Activision Blizzard negated the need for a tender offer.
DFC: Activision was clearly on a roll with record performance for the first half of fiscal 2008. Why was this the right time to sell now?
Thomas: It’s very rare for the best two performing companies in an industry to get together. We’ve been performing very well the last couple of years, and our strategies are working. Yet, as a strategic planning exercise, when we look at what can we do to further accelerate our revenue growth and margin expansion objectives, one of the areas we were looking at getting into was the fast-growing and highly profitable field of online subscription-based games. Blizzard is, by far, the most successful company in this attractive segment.
When we analyzed what was the best way for us to participate in this segment we decided it would be through a partnership with Blizzard, rather than spend hundreds of millions of dollars to attempt to go in green with a very low likelihood of success. Following the close of the merger we are by far the largest player in the segment. It was a great way for us to complement our portfolio from a platform perspective, yet also from a geographic perspective. Blizzard is the only western publisher to have any success in Asia, and Asia is a market we were heavily under-represented in.
The merger was also a transaction that paid off for our shareholders. Before we announced the deal our stock was trading around $21, and now we’re trading in the $30s. Our shareholders have seen tremendous stock price appreciation.
DFC: There are a lot of comparisons being made that show how Activision Blizzard has now passed up Electronic Arts in terms of overall revenue. EA grew very rapidly to the $3 billion revenue range in the 2001 to 2003 time frame. But then their revenue growth stagnated and they have had trouble growing beyond that. Activison Blizzard has these monster franchises like Call of Duty, Guitar Hero, and World of Warcraft that should push you to the $4 billion revenue mark. How much revenue growth do you see in these core franchises, and where do you see the outside growth opportunities?
Thomas: Our strategy all along has been to focus on our proven intellectual properties. We’ve done that consistently with Call of Duty. Last year in its fourth iteration we doubled that franchise. Obviously, Guitar Hero III was another sequel that has been a hallmark for that franchise. World of Warcraft has grown another 20% since we signed the deal – from 9 million to 10.7 million subscribers. So the strategy to concentrate on the proven franchises has been working for us. This is not all that surprising. When you think about it, if you have mega franchises, you have a completely different amount of resources available to put against innovation, marketing, and execution at retail. It should be easier for us then to grow larger franchises rather than the smaller franchises that can’t afford anywhere near the resources.
Looking forward, our pipeline for new product is very strong. We have our first band product coming out on Guitar Hero in the fall, we just launched Guitar Hero on the DS platform which has been performing very well, and we have James Bond coming out for the first time this fall concurrent with the next Bond movie. Next year we will enter the $1.5 billion racing game segment with a game Bizarre Creations is working on. Bizarre Creations is one of the best, if not the best, racing developer.
The same is true if you look at Blizzard. They have The Wrath of the Lich King expected for this fall, StarCraft II is announced and expected to release next year, and they just announced Diablo III – the last iteration of which sold more than 18 million units. So both companies come together with a very strong pipeline. That’s why we are optimistic for our growth opportunities. Combined with a market that has been growing rapidly – 30% market growth last year – and we have a track record to outpace market growth. We have all of the ingredients. We have the intellectual property, we have a great stable of developers, we have strategies that are working, and we have the discipline to maximize results against those assets. So we don’t have to change anything, only stay focused on execution, make sure we don’t get complacent, and hold the pedal to the floor.
DFC: The creation of Activision Blizzard makes obvious sense for the parties, and for Vivendi, which retains control of the new company and can benefit from better management of its non-Blizzard properties. But in terms of strategic positioning as a publisher, what net benefits does Activision receive from non-Blizzard properties as a result of the merger?
Thomas: Sierra has not been as successful as Blizzard or Activision has been with their portfolios. Having said that, from our analysis, there are a few proven properties in Sierra’s portfolio. They have some good development talent for which we’ll find a complementary use. But we are going to apply the same success factors to Sierra’s products as we apply to our own to decide what makes sense for the long term and what doesn’t. There will be projects that make it, and some that don’t.
We believe, excluding Blizzard, that we can probably augment our portfolio of owned intellectual properties as a result of the merger. We can add some good development talent in places like Canada where there’s a really good studio, and where we don’t have a really strong presence in, yet is a great market for development talent.
The other opportunity we haven’t talked about are the synergies we are going to generate by simply eliminating the overlap that exists between the Sierra business and the Activision business. That includes the back office, as well as going to market with one sales force. We expect to generate synergies between $50 million and $100 million just from that.
DFC: On the tender offer following the merger. When you announced the deal the offer was $27.50. What’s the current status?
Thomas: The tender took effect 5 days after the close and runs for 20 days. Given where the stock is trading, this will be a fast way to lose five bucks. Therefore, I think it is unlikely that we will see a lot of subscription. Then again, if the DOW dips another 28%, that picture may change. After the tender offer, we will be sitting on about $3 billion in cash, as opposed to $1 billion in debt.
DFC: The tender offer being fully subscribed is not crucial to the merger?
Thomas: No, not at all. Vivendi holds 52% of the combined company. If the tender offer is not subscribed fully, Vivendi will continue to hold 52% of the company. The reason we put the tender offer in place was for the protection of our own shareholders. The way we structured the deal, we gave our own shareholders the best of all worlds. If the investment community viewed the transaction in the way we thought it would be viewed – as making a lot of sense – then no one is forced to sell. Our existing shareholders could all hold onto to shares and participate in the appreciation from the merger with Blizzard. But for whatever reason the market came to a different conclusion, through the tender offer we put a mechanism in place that guaranteed our shareholders a liquidity event with more than a 30% premium at that time.
As we indicated in our February profile, by not having to pay cash for buying shares in a tender offer, Activision Blizzard will have a higher market value. $27.50 is stock price for merger/tender offer and $33.11 is stock price as of July 14, 2008.
DFC: Blizzard’s revenue, which comes primarily from the World of Warcraft franchise, increased significantly in both revenue and income for 2007. With over $1 billion in annual revenue and a vast chunk of operating income coming from one product, how much of Activision Blizzard’s future is dependent on the continued success of World of Warcraft?
Thomas: Obviously, World of Warcraft will continue to play an important role. But don’t forget that Blizzard has created the four of the top five PC titles of all time, and has sold more than 55 million units. There’s a lot more in the pipeline than World of Warcraft. StarCraft II alone is going to be huge, and Diablo III is another huge title in their pipeline. Currently, most of their revenue is being generated by World of Warcraft. This may also be true in the future. But Blizzard is not a one-product company. They have a proven track record across multiple franchises.
When you step back and look at what it takes to be successful in this industry, the larger brands are becoming more successful. We did analysis looking at the market share of the top 10 titles in calendar 2007 versus calendar 2006. The market share of the top 10 titles doubled. You need more resources these days, you need better retail execution, etc., in order to be successful. When you think of World of Warcraft, Blizzard has already invested hundreds of millions of dollars into that franchise. They have trained more than 1,700 game masters that provide customer service to the user community. That’s extremely difficult to match. That’s why we determined there was no way we were going to be successful going in green to compete with Blizzard. They have such a huge advantage and such a successful product that it would take hundred of millions of dollars to compete and still lose.
At some point conventional wisdom says the World of Warcraft user community can’t grow any more. But that’s what Blizzard thought when they crossed 1 million subscribers. That’s what they thought when they crossed 5 million subscribers. That’s what they thought when they crossed 10 million subscribers. If you wonder how do you get into emerging markets with video games these days, it’s the only business model that works. There is no console installed base, there is a huge piracy problem on PCs, so the only way you are going to win in markets like China, Russian and India in the foreseeable future is through a server-based business model. There’s nobody that has that figured out better than Blizzard.
DFC: You’ve mentioned how Blizzard is the only company that had build a subscription-based model on a global basis. When we look at the release StarCraft II, DFC is forecasting a big bump in South Korea based on that one product. How does that Blizzard experience in the global market mean for opportunities for the traditional Activision brand in emerging markets?
Thomas: It has been and will be difficult for us to break into the Asian market. If you think about how we are going to establish a franchise like Guitar Hero in places like Korea, a market that really goes for internet cafes, we will benefit from the experience and relationships Blizzard has built. We will be avoiding a lot of the mistakes other publishers will be making trying to get into that market. It’s difficult to put an EPS number on that, but it certainly is a qualitative benefit. For some of our franchises like Guitar Hero there are some big opportunities out there. Having Blizzard’s team on board, we’ll be able to realize and monetize sooner and to a greater extent than we otherwise could.
DFC: From an investment standpoint, what level of capital resources will the merged Activision Blizzard be able to devote to new IP? What opportunities can you entertain now that you may not have entertained before?
Thomas: The controlling constraint on new intellectual property has not necessarily been the ability to finance it. We’ve always had a very healthy balance sheet with $1.5 billion in cash at the end of the last fiscal year. The constraint on getting a concept developed is whether it has global appeal, can it be exploited across multiple platforms, and most importantly, does it have a proven development team behind it. The risk in creating intellectual property is disproportionate. As a result, the returns have to be disproportionate as well, or else it doesn’t make sense to green light new properties. If you can’t at least generate $100 million in revenue from a new IP, it is unlikely you will be able to earn a disproportionate return, in which case it’s not a smart move to make for your shareholders.
We looked back at the last five years through the end of 2006, and there were only four new IPs that generated more than $100 million in revenue. They were Call of Duty, True Crime, Guitar Hero and Gears of War. Three out of those four came from Activision. Nevertheless, we are the most selective about green lighting new properties because we know how difficult it is to achieve success.
We have a couple of new IPs in our development pipeline, but we’re not making any commitments on timing, or whether they will make it through at all. We want to make sure we have the flexibility to cancel them if we don’t have the confidence those new properties can live up to those thresholds.
DFC: We’ve talked about how Blizzard’s experience can benefit Activision’s franchises, but how can Activision’s experience benefit Blizzard’s properties?
Thomas: There is some mutual benefit in exchanging our thinking on the online business model since we have started to build a significant user community around brands like Call of Duty and Guitar Hero. But more importantly we can bring the best retail execution for any new product that Blizzard is going to bring to the marketplace. Our teams have developed a real competitive advantage in our retail relationships, and maximizing impact in-store. That will come into play when Wrath of the Lich King or StarCraft II launch. We believe our ability to execute across markets is going to be superior to what Blizzard has received so far. Blizzard will also benefit from the additional scale we’re generating. The overhead cost that they had to carry generating 90% of revenue at Vivendi Games will decrease to generating around one-third of the revenue. And we’re going to deliver a much leaner overhead structure. So Blizzard will have the advantage of carrying much less of the cost overhead. We have some of the best development talent around, and they can benefit from exchanging ideas with studios like Neversoft or Infinity Ward.
DFC: Back to emerging markets. Beyond China and Korea we’re seeing a lot more growth in India, Latin America, Eastern Europe and the Middle East. That means issues of localization are starting to crop up. Even Blizzard only recently put a Spanish language group in place for World of Warcraft. How actively are you considering localizing your products in the future throughout these emerging markets?
Thomas: This is a true priority for us since we are massively underdeveloped outside of the U.S. If you look at the split of the game market between Europe and the U.S., it is split about 50-50, yet we only generate about one-third of our revenues in Europe. So we have a big opportunity to catch up in the international market. That requires us to establish intellectual properties that are more suited for those consumers. That’s one of the reasons why we expanded our portfolio with the Bond license. James Bond is one of the few franchises that actually sells more internationally than in the U.S. This is also the reason why we were keen on entering the racing genre. Racing is a genre that is very well developed in Europe, and should help us accelerate our progress internationally. That’s why we are quadrupling the amount of local song content in Guitar Hero to better appeal to the European community with European bands.
But you also have to make sure you don’t go overboard and lose the scale benefits of running a global business. It’s a constant balancing act. If you talk about Blizzard, they have been very successful localizing their product in China and Korea. if you look at the content they are localizing in Korea, it is different. They cater to whatever events are happening in Korea. If they are having a cherry blossom season there, then something happens in World of Warcraft in Korea that doesn’t happen in the U.S. Now Blizzard is now coming out with a localized product for Russia.
DFC: Vivendi had begun a pretty significant venture into the casual game market with a separate label. Since the casual segment has been a hot topic lately, where does that fit into the Activision Blizzard strategy? Will you continue the venture or reassess it?
Thomas: We are not dogmatic about what the genres are called. We are only dogmatic about the financial returns. So if there are no returns to be had, we will not be there. We are in the video game business. This model applies to every part of our business, as well as any business we might enter.
DFC: You’ve already stated that your are in a cross-platform business. Looking at sales increases for the PS3 in Japan, and Europe, how do you view the different international markets from a console basis, and how will you maximize your sales in those markets?
Thomas: All three platforms – Xbox 360, PlayStation 3 and the Wii – have critical mass. It makes sense for us to make our games for each of these platforms. This is not a very difficult decision for us. All of our titles go on each platform.
DFC: But you have launched some initiatives just on the Wii.
Thomas: This is what we call Wii First. Some of our games are designed for the Wii first, but this doesn’t mean they won’t appear on other platforms. It’s just a clear focus on the Wii audience for some titles. Developing on the Xbox 360 and porting over to the Wii is a process that just doesn’t work for the Wii. It’s a different consumer and they expect a different style of gameplay. You have to be creative about the use of the interface. If you don’t put the Wii consumer in mind first for those games, you’re not going to be successful. That doesn’t mean we’ll make those games only for the Wii. Rapala Tournament Fishing is designed to work best with the Wii, but you can still play the game on the Xbox 360 and PS3. The same is true with Dancing With the Stars and Little League Baseball World Series 2008.
DFC: What about handhelds in your platform mix? Do you feel you’ve embraced handhelds as much as you need to?
Thomas: I think more support for handhelds is necessary. We are handheld underdeveloped. The DS has been on fire, and arguably we have a great DS developer in Vicarious Visions, but we have not yet gotten our fair share of the DS market. Now we have launched Guitar Hero with a very creative DS product. We figured out the DS has the old GBA cartridge slot that we utilized for a Fret Button extension like on a guitar. This has been by far our best DS launch so far, and we only launched during the third week of June. We also have some other innovation in the works to better meet the needs of that audience.
DFC: And the PSP? It’s having a renaissance in Japan.
Thomas: Thomas: PSP development is more difficult to justify because the installed base is more limited. There’s also the extra requirements put on developers by the first-party to make so many things special for the PSP, which increases the cost. So we have a more selective approach to the PSP, which doesn’t mean we make no games for the PSP. Only that we are more selective than we are for the DS.
