Activision Blizzard, Inc.
Activision Blizzard, Inc. (Form: 10-Q, Received: 05/06/2015 16:22:23)

Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark one)

 

x       QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the Quarterly Period Ended March 31, 2015

 

OR

 

o          TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                      to                     

 

Commission File Number 1-15839

 

 

ACTIVISION BLIZZARD, INC.

(Exact name of registrant as specified in its charter)

 

Delaware

 

95-4803544

(State or other jurisdiction of
incorporation or organization)

 

(I.R.S. Employer Identification No.)

 

 

 

3100 Ocean Park Boulevard, Santa Monica, CA

 

90405

(Address of principal executive offices)

 

(Zip Code)

 

(310) 255-2000

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant:  (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  x   No  o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes  x   No  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large Accelerated Filer  x

 

Accelerated Filer  o

 

 

 

Non-accelerated filer  o

 

Smaller reporting company  o

(Do not check if a smaller reporting company)

 

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  o  No  x

 

The number of shares of the registrant’s Common Stock outstanding at April 29, 2015 was 726,186,329.

 

 

 



Table of Contents

 

ACTIVISION BLIZZARD, INC. AND SUBSIDIARIES

 

Table of Contents

 

 

Cautionary Statement

3

 

 

 

PART I.

FINANCIAL INFORMATION

 

 

 

 

Item 1.

Financial Statements (Unaudited)

 

 

 

 

 

Condensed Consolidated Balance Sheets at March 31, 2015 and December 31, 2014

4

 

 

 

 

Condensed Consolidated Statements of Operations for the three months ended March 31, 2015 and March 31, 2014

5

 

 

 

 

Condensed Consolidated Statements of Comprehensive Income for the three months ended March 31, 2015 and March 31, 2014

6

 

 

 

 

Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2015 and March 31, 2014

7

 

 

 

 

Condensed Consolidated Statement of Changes in Shareholders’ Equity for the three months ended March 31, 2015

8

 

 

 

 

Notes to Condensed Consolidated Financial Statements

9

 

 

 

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

28

 

 

 

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

45

 

 

 

Item 4.

Controls and Procedures

47

 

 

 

PART II.

OTHER INFORMATION

48

 

 

 

Item 1.

Legal Proceedings

48

 

 

 

Item 1A.

Risk Factors

51

 

 

 

Item 6.

Exhibits

51

 

 

 

SIGNATURE

52

 

 

EXHIBIT INDEX

53

 

 

CERTIFICATIONS

 

 

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CAUTIONARY STATEMENT

 

This Quarterly Report on Form 10-Q contains, or incorporates by reference, certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements consist of any statement other than a recitation of historical facts and include, but are not limited to: (1) projections of revenues, expenses, income or loss, earnings or loss per share, cash flow or other financial items; (2) statements of our plans and objectives, including those relating to product releases; (3) statements of future financial or operating performance; (4) statements relating to the outcome or impact of pending or threatened litigation; and (5) statements of assumptions underlying such statements. Activision Blizzard, Inc. (“Activision Blizzard”) generally uses words such as “outlook,” “forecast,” “will,” “could,” “should,” “would,” “to be,” “plan,” “plans,” “believes,” “may,” “might,” “expects,” “intends,” “intends as,” “anticipates,” “estimate,” “future,” “positioned,” “potential,” “project,” “remain,” “scheduled,” “set to,” “subject to,” “upcoming” and other similar expressions to help identify forward-looking statements. Forward-looking statements are subject to business and economic risk, reflect management’s current expectations, estimates and projections about our business, and are inherently uncertain and difficult to predict. Our actual results could differ materially. Risks and uncertainties that may affect our future results include, but are not limited to: sales levels of our titles; increasing concentration of revenue among a small number of titles; our ability to predict consumer preferences, including interest in specific genres, such as first-person action, massively multiplayer online, “toys to life” and music-based games, and preferences among hardware platforms; the amount of our debt and the limitations imposed by the covenants in the agreements governing our debt; the adoption rate and availability of new hardware (including peripherals) and related software, particularly during console transitions; counterparty risks relating to customers, licensees, licensors and manufacturers; maintenance of relationships with key personnel, customers, financing providers, licensees, licensors, manufacturers, vendors, and third-party developers, including the ability to attract, retain and develop key personnel and developers that can create high quality titles; changing business models, including digital delivery of content and the increased prevalence of free-to-play games; product delays or defects; competition including from used games and other forms of entertainment; rapid changes in technology and industry standards; possible declines in software pricing; product returns and price protection; the identification of suitable future acquisition opportunities and potential challenges associated with geographic expansion; the seasonal and cyclical nature of the interactive game market; litigation risks and associated costs; protection of proprietary rights; shifts in consumer spending trends; capital market risks; applicable regulations; domestic and international economic, financial and political conditions and policies; tax rates and foreign exchange rates; the impact of the current macroeconomic environment; and the other factors identified in “Risk Factors” included in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2014. The forward-looking statements contained herein are based upon information available to us as of the date of this Quarterly Report on Form 10-Q and we assume no obligation to update any such forward-looking statements. Although these forward-looking statements are believed to be true when made, they may ultimately prove to be incorrect. These statements are not guarantees of our future performance and are subject to risks, uncertainties and other factors, some of which are beyond our control and may cause actual results to differ materially from current expectations.

 

Activision Blizzard Inc.’s names, abbreviations thereof, logos, and product and service designators are all either the registered or unregistered trademarks or trade names of Activision Blizzard. All other product or service names are the property of their respective owners.

 

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ACTIVISION BLIZZARD, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

(Amounts in millions, except share data)

 

 

 

At March 31,

 

At December 31,

 

 

 

2015

 

2014

 

Assets

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

4,465

 

$

4,848

 

Short-term investments

 

5

 

10

 

Accounts receivable, net of allowances of $234 and $383 at March 31, 2015 and December 31, 2014, respectively

 

208

 

659

 

Inventories, net

 

102

 

123

 

Software development

 

358

 

452

 

Intellectual property licenses

 

5

 

5

 

Deferred income taxes, net

 

365

 

368

 

Other current assets

 

355

 

444

 

Total current assets

 

5,863

 

6,909

 

 

 

 

 

 

 

Long-term investments

 

9

 

9

 

Software development

 

46

 

20

 

Intellectual property licenses

 

18

 

18

 

Property and equipment, net

 

158

 

157

 

Other assets

 

138

 

85

 

Intangible assets, net

 

28

 

29

 

Trademark and trade names

 

433

 

433

 

Goodwill

 

7,084

 

7,086

 

Total assets

 

$

13,777

 

$

14,746

 

Liabilities and Shareholders’ Equity

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

123

 

$

325

 

Deferred revenues

 

1,161

 

1,797

 

Accrued expenses and other liabilities

 

615

 

592

 

Total current liabilities

 

1,899

 

2,714

 

Long-term debt, net

 

4,075

 

4,324

 

Deferred income taxes, net

 

124

 

114

 

Other liabilities

 

441

 

361

 

Total liabilities

 

6,539

 

7,513

 

Commitments and contingencies (Note 12)

 

 

 

 

 

Shareholders’ equity:

 

 

 

 

 

Common stock, $0.000001 par value, 2,400,000,000 shares authorized, 1,154,580,858 and 1,150,605,926 shares issued at March 31, 2015 and December 31, 2014, respectively

 

 

 

Additional paid-in capital

 

9,968

 

9,924

 

Less: Treasury stock, at cost, 428,676,471 shares at March 31, 2015 and December 31, 2014

 

(5,709

)

(5,762

)

Retained earnings

 

3,598

 

3,374

 

Accumulated other comprehensive income (loss)

 

(619

)

(303

)

Total shareholders’ equity

 

7,238

 

7,233

 

Total liabilities and shareholders’ equity

 

$

13,777

 

$

14,746

 

 

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

 

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ACTIVISION BLIZZARD, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(Amounts in millions, except per share data)

 

 

 

For the Three Months Ended March 31,

 

 

 

2015

 

2014

 

 

 

 

 

 

 

Net revenues

 

 

 

 

 

Product sales

 

$

784

 

$

769

 

Subscription, licensing, and other revenues

 

494

 

342

 

Total net revenues

 

1,278

 

1,111

 

 

 

 

 

 

 

Costs and expenses

 

 

 

 

 

Cost of sales — product costs

 

209

 

225

 

Cost of sales — online

 

53

 

58

 

Cost of sales — software royalties and amortization

 

148

 

57

 

Cost of sales — intellectual property licenses

 

3

 

2

 

Product development

 

145

 

143

 

Sales and marketing

 

92

 

104

 

General and administrative

 

86

 

95

 

Total costs and expenses

 

736

 

684

 

 

 

 

 

 

 

Operating income

 

542

 

427

 

 

 

 

 

 

 

Interest and other expense, net

 

50

 

51

 

 

 

 

 

 

 

Income before income tax expense

 

492

 

376

 

 

 

 

 

 

 

Income tax expense

 

98

 

83

 

 

 

 

 

 

 

Net income

 

$

394

 

$

293

 

 

 

 

 

 

 

Earnings per common share

 

 

 

 

 

Basic

 

$

0.54

 

$

0.40

 

Diluted

 

$

0.53

 

$

0.40

 

 

 

 

 

 

 

Weighted-average number of shares outstanding

 

 

 

 

 

Basic

 

723

 

709

 

Diluted

 

731

 

720

 

 

 

 

 

 

 

Dividends per common share

 

$

0.23

 

$

0.20

 

 

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

 

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ACTIVISION BLIZZARD, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)

(Amounts in millions)

 

 

 

For the Three Months Ended March 31,

 

 

 

2015

 

2014

 

 

 

 

 

 

 

Net income

 

$

394

 

$

293

 

 

 

 

 

 

 

Other comprehensive income (loss):

 

 

 

 

 

Foreign currency translation adjustment

 

(330

)

(5

)

Unrealized gains on forward contracts designated as hedges, net of deferred income taxes of $0 million for the three months ended March 31, 2015 and 2014

 

14

 

 

Other comprehensive income (loss)

 

$

(316

)

$

(5

)

 

 

 

 

 

 

Comprehensive income

 

$

78

 

$

288

 

 

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

 

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ACTIVISION BLIZZARD, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(Amounts in millions)

 

 

 

For the Three Months Ended March 31,

 

 

 

2015

 

2014

 

Cash flows from operating activities:

 

 

 

 

 

Net income

 

$

394

 

$

293

 

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

 

Deferred income taxes

 

(3

)

6

 

Provision for inventories

 

6

 

9

 

Depreciation and amortization

 

20

 

19

 

Amortization   of   capitalized   software   development   costs   and   intellectual   property   licenses   (1)

 

142

 

51

 

Amortization of debt discount and debt financing costs

 

2

 

2

 

Stock-based compensation expense (2)

 

23

 

29

 

Excess tax benefits from stock awards

 

(14

)

(17

)

Changes in operating assets and liabilities:

 

 

 

 

 

Accounts receivable, net

 

438

 

290

 

Inventories

 

10

 

5

 

Software development and intellectual property licenses

 

(77

)

(71

)

Other assets

 

108

 

111

 

Deferred revenues

 

(567

)

(298

)

Accounts payable

 

(208

)

(189

)

Accrued expenses and other liabilities

 

(65

)

(104

)

Net cash provided by operating activities

 

209

 

136

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Proceeds from maturities of available-for-sale investments

 

 

21

 

Capital expenditures

 

(21

)

(37

)

Decrease in restricted cash

 

5

 

4

 

Net cash used in investing activities

 

(16

)

(12

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Proceeds from issuance of common stock to employees

 

27

 

119

 

Tax payment related to net share settlements on restricted stock rights

 

(3

)

(13

)

Excess tax benefits from stock awards

 

14

 

17

 

Repayment of long-term debt

 

(250

)

(375

)

Net cash used in financing activities

 

(212

)

(252

)

 

 

 

 

 

 

Effect of foreign exchange rate changes on cash and cash equivalents

 

(364

)

(3

)

 

 

 

 

 

 

Net decrease in cash and cash equivalents

 

(383

)

(131

)

 

 

 

 

 

 

Cash and cash equivalents at beginning of period

 

4,848

 

4,410

 

 

 

 

 

 

 

Cash and cash equivalents at end of period

 

$

4,465

 

$

4,279

 

 


(1)   Excludes deferral and amortization of stock-based compensation expense.

(2)   Includes the net effects of capitalization, deferral, and amortization of stock-based compensation expense.

 

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

 

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ACTIVISION BLIZZARD, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

For the Three Months Ended March 31, 2015

(Unaudited)

(Amounts and shares in millions)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Accumulated

 

 

 

 

 

 

 

 

 

 

 

 

 

Additional

 

 

 

Other

 

Total

 

 

 

Common Stock

 

Treasury Stock

 

Paid-In

 

Retained

 

Comprehensive

 

Shareholders’

 

 

 

Shares

 

Amount

 

Shares

 

Amount

 

Capital

 

Earnings

 

Income (Loss)

 

Equity

 

Balance at December 31, 2014

 

1,151

 

$

 

(429

)

$

(5,762

)

$

9,924

 

$

3,374

 

$

(303

)

$

7,233

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Components of comprehensive income:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

 

 

 

394

 

 

394

 

Other comprehensive income (loss)

 

 

 

 

 

 

 

(316

)

(316

)

Issuance of common stock pursuant to employee stock options

 

2

 

 

 

 

27

 

 

 

27

 

Issuance of common stock pursuant to restricted stock rights

 

3

 

 

 

 

 

 

 

 

Restricted stock surrendered for employees’ tax liability

 

(1

)

 

 

 

(18

)

 

 

(18

)

Tax benefit associated with employee stock awards

 

 

 

 

 

13

 

 

 

13

 

Stock-based compensation expense related to employee stock options and restricted stock rights

 

 

 

 

 

22

 

 

 

22

 

Dividends ($0.23 per common share)

 

 

 

 

 

 

(170

)

 

(170

)

Indemnity on tax attributes assumed in connection with the Purchase Transaction (see Note 9)

 

 

 

 

53

 

 

 

 

53

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance at March 31, 2015

 

1,155

 

$

 

(429

)

$

(5,709

)

$

9,968

 

$

3,598

 

$

(619

)

$

7,238

 

 

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

 

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ACTIVISION BLIZZARD, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

 

1.               Description of Business and Basis of Consolidation and Presentation

 

Activision Blizzard, Inc. (“Activision Blizzard”) is a leading global developer and publisher of interactive entertainment.  The terms “Activision Blizzard,” the “Company,” “we,” “us,” and “our” are used to refer collectively to Activision Blizzard, Inc. and its subsidiaries.  We currently offer games for video game consoles, personal computers (“PC”), and handheld, mobile and tablet devices.  We maintain significant operations in the United States (“U.S.”), Canada, the United Kingdom (“U.K.”), France, Germany, Ireland, Italy, Sweden, Spain, the Netherlands, Australia, South Korea and China.

 

The Business Combination and Share Repurchase

 

Activision Blizzard is the result of the 2008 business combination (“Business Combination”) by and among the Company (then known as Activision, Inc.), Sego Merger Corporation, a wholly-owned subsidiary of Activision, Inc., Vivendi S.A. (“Vivendi”), VGAC LLC, a wholly-owned subsidiary of Vivendi, and Vivendi Games, Inc. (“Vivendi Games”), a wholly-owned subsidiary of VGAC LLC.  As a result of the consummation of the Business Combination, Activision, Inc. was renamed Activision Blizzard, Inc. and Vivendi became a majority shareholder of Activision.

 

On October 11, 2013, we repurchased approximately 429 million shares of our common stock, pursuant to a stock purchase agreement (the “Stock Purchase Agreement”) we entered into with Vivendi and ASAC II LP (“ASAC”), an exempted limited partnership established under the laws of the Cayman Islands, acting by its general partner, ASAC II LLC (together with ASAC, the “ASAC Entities”). Pursuant to the terms of the Stock Purchase Agreement, we acquired all of the capital stock of Amber Holding Subsidiary Co., a Delaware corporation and wholly-owned subsidiary of Vivendi (“New VH”), which was the direct owner of approximately 429 million shares of our common stock, for a cash payment of $5.83 billion, or $13.60 per share, before taking into account the benefit to the Company of certain tax attributes of New VH assumed in the transaction (collectively, the “Purchase Transaction”). Immediately following the completion of the Purchase Transaction, ASAC purchased from Vivendi 172 million shares of our common stock, pursuant to the Stock Purchase Agreement, for a cash payment of $2.34 billion, or $13.60 per share (the “Private Sale”). Robert A. Kotick, our Chief Executive Officer, and Brian G. Kelly, Chairman of our Board of Directors, are affiliates of ASAC II LLC. Refer to Note 6 of the Notes to Condensed Consolidated Financial Statements for further information regarding the financing of the Purchase Transaction.

 

On May 28, 2014, Vivendi sold approximately 41 million shares, or approximately 50% of its then-current holdings, of our common stock in a registered public offering.  Vivendi received proceeds of approximately $850 million from that sale; we did not receive any proceeds.

 

As of March 31, 2015, we had approximately 726 million shares of common stock issued and outstanding.  At that date: (i) Vivendi held 41 million shares, or approximately 6% of the outstanding shares of our common stock; (ii) ASAC held 172 million shares, or approximately 24% of the outstanding shares of our common stock; and (iii) our other stockholders held approximately 70% of the outstanding shares of our common stock. The common stock of Activision Blizzard is traded on The NASDAQ Stock Market under the ticker symbol “ATVI.”

 

Operating Segments

 

Based upon our organizational structure, we conduct our business through three operating segments as follows:

 

(i) Activision Publishing, Inc.

 

Activision Publishing, Inc. (“Activision”) is a leading global developer and publisher of interactive software products and content. Activision delivers content to a broad range of gamers, ranging from children to adults, and from core gamers to mass-market consumers to “value” buyers seeking budget-priced software, in a variety of geographies. Activision develops games based on internally-developed properties, including games in the Call of Duty® and Skylanders® franchises, and to a lesser extent, based on licensed intellectual properties. Additionally, we have established a long-term alliance with Bungie to publish its game universe, Destiny .   Activision sells games through both retail and digital online channels.  Activision currently offers games that operate on the Microsoft Corporation (“Microsoft”) Xbox One (“Xbox One”) and Xbox 360 (“Xbox 360”), Nintendo Co. Ltd. (“Nintendo”) Wii U (“Wii U”) and Wii (“Wii”), and Sony Computer Entertainment, Inc. (“Sony”) PlayStation 4 (“PS4”) and PlayStation 3 (“PS3”) console systems (Xbox One, Wii U, and PS4 are collectively referred to as “next-generation”; Xbox 360, Wii, and PS3 are collectively referred to as “prior-generation”); the PC; the Nintendo 3DS, Nintendo Dual Screen, and Sony PlayStation Vita handheld game systems; and mobile and tablet devices.

 

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(ii) Blizzard Entertainment, Inc.

 

Blizzard Entertainment, Inc. (“Blizzard”) is a leader in the subscription-based massively multi-player online role-playing game category in terms of both subscriber base and revenues generated through its World of Warcraft ® franchise, which it develops, hosts and supports. Blizzard also develops, markets, and sells role-playing action and strategy games for the PC, console, mobile and tablet platforms, including games in the multiple-award winning Diablo®, StarCraft®, and Hearthstone®: Heroes of Warcraft™ franchises.  In addition, Blizzard maintains a proprietary online game-related service, Battle.net ® .  Blizzard distributes its products and generates revenues worldwide through various means, including: subscriptions; sales of prepaid subscription cards; value-added services, such as in-game purchases and services; retail sales of physical “boxed” products; online download sales of PC products; purchases and downloads via third-party console, mobile and tablet platforms; and licensing of software to third-party or related-party companies that distribute World of Warcraft, Diablo, StarCraft and Hearthstone: Heroes of Warcraft products.  In addition, Blizzard is the creator of Heroes of the Storm™ , a new free-to-play online hero brawler that is currently in closed beta testing.

 

(iii) Activision Blizzard Distribution

 

Activision Blizzard Distribution (“Distribution”) consists of operations in Europe that provide warehousing, logistical and sales distribution services to third-party publishers of interactive entertainment software, our own publishing operations, and manufacturers of interactive entertainment hardware.

 

Basis of Consolidation and Presentation

 

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission (the “SEC”) and accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim reporting. Accordingly, certain notes or other information that are normally required by U.S. GAAP have been condensed or omitted if they substantially duplicate the disclosures contained in the annual audited consolidated financial statements. The year-end condensed balance sheet data was derived from audited financial statements but does not include all disclosures required by U.S. GAAP. The unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2014.

 

The preparation of the condensed consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for the fair statement of our financial position and results of operations in accordance with U.S. GAAP have been included in the accompanying unaudited condensed consolidated financial statements. Actual results could differ from these estimates and assumptions.

 

The accompanying condensed consolidated financial statements include the accounts and operations of the Company. All intercompany accounts and transactions have been eliminated.

 

The Company considers events or transactions that occur after the balance sheet date, but before the financial statements are issued, to provide additional evidence relative to certain estimates or to identify matters that require additional disclosures .

 

2.               Inventories, Net

 

Our inventories, net consist of the following (amounts in millions):

 

 

 

At March 31,

 

At December 31,

 

 

 

2015

 

2014

 

Finished goods

 

$

90

 

$

112

 

Purchased parts and components

 

12

 

11

 

 

 

 

 

 

 

Inventories, net

 

$

102

 

$

123

 

 

Inventory reserves were $50 million and $52 million at March 31, 2015 and December 31, 2014, respectively.

 

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3.               Software Development and Intellectual Property Licenses

 

The following table summarizes the components of our capitalized software development costs and intellectual property licenses (amounts in millions):

 

 

 

At

 

At

 

 

 

March 31,

 

December 31,

 

 

 

2015

 

2014

 

Internally developed software costs

 

$

247

 

$

262

 

Payments made to third-party software developers

 

157

 

210

 

Total software development costs

 

$

404

 

$

472

 

 

 

 

 

 

 

Intellectual property licenses

 

$

23

 

$

23

 

 

Amortization of capitalized software development costs and intellectual property licenses was the following (amounts in millions):

 

 

 

For the Three Months Ended March 31,

 

 

 

2015

 

2014

 

Amortization of capitalized software development costs and intellectual property licenses

 

$

147

 

$

58

 

 

4.               Intangible Assets, Net

 

Intangible assets, net consist of the following (amounts in millions):

 

 

 

At March 31, 2015

 

 

 

Estimated

 

Gross

 

 

 

 

 

 

 

useful

 

carrying

 

Accumulated

 

Net carrying

 

 

 

lives

 

amount

 

amortization

 

amount

 

Acquired definite-lived intangible assets:

 

 

 

 

 

 

 

 

 

License agreements and other

 

3 - 10 years

 

$

98

 

$

(92

)

$

6

 

Internally-developed franchises

 

11 - 12 years

 

309

 

(287

)

22

 

Total definite-lived intangible assets

 

 

 

$

407

 

$

(379

)

$

28

 

 

 

 

 

 

 

 

 

 

 

Acquired indefinite-lived intangible assets:

 

 

 

 

 

 

 

 

 

Activision trademark

 

Indefinite

 

 

 

 

 

386

 

Acquired trade names

 

Indefinite

 

 

 

 

 

47

 

Total indefinite-lived intangible assets

 

 

 

 

 

 

 

$

433

 

 

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At December 31, 2014

 

 

 

Estimated

 

Gross

 

 

 

 

 

 

 

useful

 

carrying

 

Accumulated

 

Net carrying

 

 

 

lives

 

amount

 

amortization

 

amount

 

Acquired definite-lived intangible assets:

 

 

 

 

 

 

 

 

 

License agreements and other

 

3 - 10 years

 

$

98

 

$

(92

)

$

6

 

Internally-developed franchises

 

11 - 12 years

 

309

 

(286

)

23

 

Total definite-lived intangible assets

 

 

 

$

407

 

$

(378

)

$

29

 

 

 

 

 

 

 

 

 

 

 

Acquired indefinite-lived intangible assets:

 

 

 

 

 

 

 

 

 

Activision trademark

 

Indefinite

 

 

 

 

 

386

 

Acquired trade names

 

Indefinite

 

 

 

 

 

47

 

Total indefinite-lived intangible assets

 

 

 

 

 

 

 

$

433

 

 

Amortization expense of intangible assets was $1 million and $2 million for the three months ended March 31, 2015 and 2014, respectively.

 

At March 31, 2015, future amortization of definite-lived intangible assets is estimated as follows (amounts in millions):

 

2015 (remaining nine months)

 

$

10

 

2016

 

8

 

2017

 

5

 

2018

 

3

 

2019

 

2

 

Total

 

$

28

 

 

5.                  Fair Value Measurements

 

Financial Accounting Standards Board (“FASB”) literature regarding fair value measurements for financial and non-financial assets and liabilities establishes a three-level fair value hierarchy that prioritizes the inputs used to measure fair value. This hierarchy requires entities to maximize the use of “observable inputs” and minimize the use of “unobservable inputs.” The three levels of inputs used to measure fair value are as follows:

 

·                   Level 1—Quoted prices in active markets for identical assets or liabilities;

 

·                   Level 2—Observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets or liabilities in active markets or other inputs that are observable or can be corroborated by observable market data; and

 

·                   Level 3—Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities, including certain pricing models, discounted cash flow methodologies and similar techniques that use significant unobservable inputs.

 

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Fair Value Measurements on a Recurring Basis

 

The table below segregates all financial assets that are measured at fair value on a recurring basis into the most appropriate level within the fair value hierarchy based on the inputs used to determine the fair value at the measurement date (amounts in millions):

 

 

 

 

 

Fair Value Measurements at

 

 

 

 

 

 

 

March 31,2015 Using

 

 

 

 

 

 

 

Quoted

 

 

 

 

 

 

 

 

 

 

 

Prices in

 

 

 

 

 

 

 

 

 

 

 

Active

 

Significant

 

 

 

 

 

 

 

 

 

Markets for

 

Other

 

Significant

 

 

 

 

 

As of

 

Identical

 

Observable

 

Unobservable

 

 

 

 

 

March 31,

 

Assets

 

Inputs

 

Inputs

 

Balance Sheet

 

 

 

2015

 

(Level 1)

 

(Level 2)

 

(Level 3)

 

Classification

 

Financial Assets:

 

 

 

 

 

 

 

 

 

 

 

Recurring fair value measurements:

 

 

 

 

 

 

 

 

 

 

 

Money market funds

 

$

4,271

 

$

4,271

 

$

 

$

 

Cash and cash equivalents

 

Foreign government treasury bills

 

34

 

34

 

 

 

Cash and cash equivalents

 

Foreign currency forward contracts designated as hedges

 

14

 

 

14

 

 

Other current assets

 

Auction rate securities (“ARS”)

 

9

 

 

 

9

 

Long-term investments

 

Total recurring fair value measurements

 

$

4,328

 

$

4,305

 

$

14

 

$

9

 

 

 

 

 

 

 

 

Fair Value Measurements at

 

 

 

 

 

 

 

December 31, 2014 Using

 

 

 

 

 

 

 

Quoted

 

 

 

 

 

 

 

 

 

 

 

Prices in

 

 

 

 

 

 

 

 

 

 

 

Active

 

Significant

 

 

 

 

 

 

 

 

 

Markets for

 

Other

 

Significant

 

 

 

 

 

As of

 

Identical

 

Observable

 

Unobservable

 

 

 

 

 

December 31,

 

Assets

 

Inputs

 

Inputs

 

Balance Sheet

 

 

 

2014

 

(Level 1)

 

(Level 2)

 

(Level 3)

 

Classification

 

Recurring fair value measurements:

 

 

 

 

 

 

 

 

 

 

 

Money market funds

 

$

4,475

 

$

4,475

 

$

 

$

 

Cash and cash equivalents

 

Foreign government treasury bills

 

40

 

40

 

 

 

Cash and cash equivalents

 

ARS

 

9

 

 

 

9

 

Long-term investments

 

Total recurring fair value measurements

 

$

4,524

 

$

4,515

 

$

 

$

9

 

 

 

 

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The following tables provide a reconciliation of the beginning and ending balances of our financial assets classified as Level 3 by major categories (amounts in millions) at March 31, 2015 and 2014, respectively:

 

 

 

Level 3

 

 

 

 

 

Total

 

 

 

 

 

financial

 

 

 

 

 

assets at

 

 

 

ARS

 

fair

 

 

 

(a)

 

value

 

Balance at December 31, 2014

 

$

9

 

$

9

 

Total unrealized gains included in other comprehensive income

 

 

 

Balance at March 31, 2015

 

$

9

 

$

9

 

 

 

 

Level 3

 

 

 

 

 

Total

 

 

 

 

 

financial

 

 

 

 

 

assets at

 

 

 

ARS

 

fair

 

 

 

(a)

 

value

 

Balance at December 31, 2013

 

$

9

 

$

9

 

Total unrealized gains included in other comprehensive income

 

 

 

Balance at March 31, 2014

 

$

9

 

$

9

 

 


(a)          Fair value measurements have been estimated using an income-approach model. When estimating the fair value, we consider both observable market data and non-observable factors, including credit quality, duration, insurance wraps, collateral composition, maximum rate formulas, comparable trading instruments, and the likelihood of redemption. Significant assumptions used in the analysis include estimates for interest rates, spreads, cash flow timing and amounts, and holding periods of the securities. At March 31, 2015, assets measured at fair value using significant unobservable inputs (Level 3), all of which were ARS, represent less than 1% of our financial assets measured at fair value on a recurring basis.

 

Foreign Currency Forward Contracts

 

The Company transacts business in various foreign currencies and has significant international sales and expenses denominated in foreign currencies, subjecting us to foreign currency risk. In addition, the Company transacts intercompany business in various foreign currencies other than its functional currency, subjecting us to variability in the functional currency-equivalent cash flows. To mitigate our foreign currency risk resulting from our foreign currency-denominated monetary assets, liabilities and earnings and our foreign currency risk related to functional currency-equivalent cash flows resulting from our intercompany transactions, we periodically enter into currency derivative contracts, principally forward contracts with maturities of generally less than one year. We report the fair value of these contracts within “Other current assets” or “Other current liabilities” in our condensed consolidated balance sheets based on the prevailing exchange rates of the various hedged currencies as of the end of the relevant period.

 

We do not hold or purchase any foreign currency forward contracts for trading or speculative purposes.

 

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Foreign Currency Forward Contracts Not Designated as Hedges

 

For foreign currency forward contracts entered into to mitigate risk from foreign currency-denominated monetary assets, liabilities, and earnings that are not designated as hedging instruments in accordance with FASB Accounting Standards Codification (“ASC”) Topic 815, changes in the estimated fair value of these derivatives are recorded within “General and administrative expenses” and “Interest and other investment income (expense), net” in our condensed consolidated statements of operations, depending on the nature of the underlying transactions.

 

At March 31, 2015 there were no outstanding foreign currency forward contracts not designated as hedges.  At December 31, 2014, there was one outstanding foreign currency forward contract not designated as a hedge; the notional amount of that foreign currency forward contract was $11 million and the fair value was not material.  For the three months ended March 31, 2015 and 2014, pre-tax net losses related to these forward contracts were not material.

 

Foreign Currency Forward Contracts Designated as Hedges

 

For foreign currency forward contracts entered into to hedge forecasted intercompany cash flows that are subject to foreign currency risk and which we designated as cash flow hedges in accordance with ASC Topic 815, we assess the effectiveness of these cash flow hedges at inception and on an ongoing basis to determine if the hedges are effective at providing offsetting changes in cash flows of the hedged items. We record the effective portion of changes in the estimated fair value of these derivatives in “Accumulated other comprehensive income (loss)” and subsequently reclassify the related amount of accumulated other comprehensive income (loss) to earnings within “General and administrative expense” when the hedged item impacts earnings. We measure hedge ineffectiveness, if any, and if it is determined that a derivative has ceased to be a highly effective hedge, we will discontinue hedge accounting for the derivative.

 

The gross notional amount of all outstanding foreign currency forward contracts designated as cash flow hedges was approximately $213 million at March 31, 2015. During the three months ended March 31, 2015, there was no ineffectiveness relating to these hedges. The net unrealized gains of approximately $14 million related to these contracts at March 31, 2015 are expected to be reclassified into earnings within the next twelve months. We did not have any outstanding foreign currency forward contracts designated as cash flow hedges at December 31, 2014, or for the three months ended March 31, 2014.

 

Fair Value Measurements on a Non-Recurring Basis

 

We measure the fair value of certain assets on a non-recurring basis, generally annually or when events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable.

 

For the three months ended March 31, 2015 and 2014, there were no impairment charges related to assets that are measured on a non-recurring basis.

 

6.               Debt

 

The proceeds from the credit facilities and the unsecured senior notes, as described below, were used to fund the Purchase Transaction disclosed in Note 1 of the Notes to Condensed Consolidated Financial Statements.

 

Credit Facilities

 

On October 11, 2013, in connection and simultaneously with the Purchase Transaction, we entered into a credit agreement (the “Credit Agreement”) for a $2.5 billion secured term loan facility maturing in October 2020 (the “Term Loan”), and a $250 million secured revolving credit facility maturing in October 2018 (the “Revolver” and, together with the Term Loan, the “Credit Facilities”). A portion of the Revolver can be used to issue letters of credit of up to $50 million, subject to the availability of the Revolver.   To date, we have not drawn on the Revolver and there are no letters of credit issued and outstanding as of March 31, 2015 and December 31, 2014.

 

Borrowings under the Term Loan and the Revolver bear interest, payable on a quarterly basis, at an annual rate equal to an applicable margin plus, at our option, (A) a base rate determined by reference to the highest of (a) the interest rate in effect determined by the administrative agent as its “prime rate,” (b) the federal funds rate plus 0.5%, and (c) the London InterBank Offered Rate (“LIBOR”) rate for an interest period of one month plus 1.00%, or (B) LIBOR. LIBOR borrowings under the Term Loan will be subject to a LIBOR floor of 0.75%.  At March 31, 2015, the Credit Facilities bore interest at 3.25%. In certain circumstances, our applicable interest rate under the Credit Facilities will increase.

 

In addition to paying interest on outstanding principal balances under the Credit Facilities, we are required to pay the lenders a commitment fee on unused commitments under the Revolver. Commitment fees are recorded within “Interest and other investment income (expense), net” on the condensed consolidated statement of operations. We are also required to pay customary letter of credit fees, if any, and agency fees.

 

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The terms of the Credit Agreement required quarterly principal repayments of 0.25% of the Term Loan’s original principal amount, with the balance due on the maturity date.  On February 11, 2014, we made a voluntary repayment of $375 million on our Term Loan.   This repayment satisfied the required quarterly principal repayments for the entire term of the Credit Agreement.  On February 11, 2015, we made an additional voluntary repayment of $250 million on our Term Loan.

 

The Credit Facilities are guaranteed by certain of the Company’s U.S. subsidiaries, whose assets represent approximately 70% of our consolidated assets.  The Credit Agreement contains customary covenants that place restrictions in certain circumstances on, among other things, the incurrence of debt, granting of liens, payment of dividends, sales of assets and mergers and acquisitions.  If our obligations under the Revolver exceed 15% of the total facility amount as of the end of any fiscal quarter (subject to certain exclusions for letters of credit), we are also subject to certain financial covenants. A violation of any of these covenants could result in an event of default under the Credit Agreement.  Upon the occurrence of such event of default or certain other customary events of default, payment of any outstanding amounts under the Credit Agreement may be accelerated, and the lenders’ commitments to extend credit under the Credit Agreement may be terminated.  In addition, an event of default under the Credit Agreement could, under certain circumstances, permit the holders of other outstanding unsecured debt, including the debt holders described below, to accelerate the repayment of such obligations. The Company was in compliance with the terms of the Credit Facilities as of March 31, 2015.

 

Unsecured Senior Notes

 

On September 19, 2013, we issued, at par, $1.5 billion of 5.625% unsecured senior notes due September 2021 (the “2021 Notes”) and $750 million of 6.125% unsecured senior notes due September 2023 (the “2023 Notes” and, together with the 2021 Notes, the “Notes”) in a private offering to qualified institutional buyers made in accordance with Rule 144A under the Securities Act of 1933, as amended.

 

The Notes are general senior obligations of the Company and rank pari passu in right of payment to all of the Company’s existing and future senior indebtedness, including the Credit Facilities described above. The Notes are guaranteed on a senior basis by certain of our U.S. subsidiaries . The Notes and related guarantees are not secured and are effectively subordinated to any of the Company’s existing and future indebtedness that is secured, including the Credit Facilities. The Notes contain customary covenants that place restrictions in certain circumstances on, among other things, the incurrence of debt, granting of liens, payment of dividends, sales of assets and mergers and acquisitions.  The Company was in compliance with the terms of the Notes as of March 31, 2015.

 

Interest on the Notes is payable semi-annually in arrears on March 15 and September 15 of each year.  As of March 31, 2015 and December 31, 2014, we had interest payable of $5 million and $38 million, respectively, related to the Notes, recorded within “Accrued expenses and other liabilities” in our condensed consolidated balance sheet.

 

We may redeem the 2021 Notes on or after September 15, 2016 and the 2023 Notes on or after September 15, 2018, in whole or in part on any one or more occasions, at specified redemption prices, plus accrued and unpaid interest. At any time prior to September 15, 2016, with respect to the 2021 Notes, and at any time prior to September 15, 2018, with respect to the 2023 Notes, we may also redeem some or all of the Notes by paying a “make-whole premium”, plus accrued and unpaid interest.  Upon the occurrence of one or more qualified equity offerings, we may also redeem up to 35% of the aggregate principal amount of each of the 2021 Notes and 2023 Notes outstanding with the net cash proceeds from such offerings. The Notes are repayable, in whole or in part and at the option of the holders, upon the occurrence of a change in control and a ratings downgrade, at a purchase price equal to 101% of principal, plus accrued and unpaid interest.    These redemption options are considered clearly and closely related to the Notes and are not accounted for separately upon issuance.

 

Fees associated with the closing of the Term Loan and the Notes are recorded as debt discount, which reduce the carrying value of the Term Loan and the Notes. The debt discount is amortized over the respective terms of the Term Loan and the Notes. Amortization expense related to the debt discount is recorded within “Interest and other investment income (expense), net” in our condensed consolidated statement of operations.

 

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A summary of our debt is as follows (amounts in millions):

 

 

 

March 31, 2015

 

 

 

Gross Carrying

 

Unamortized

 

Net Carrying

 

 

 

Amount

 

Discount

 

Amount

 

Term Loan

 

$

1,869

 

$

(10

)

$

1,859

 

2021 Notes

 

1,500

 

(22

)

1,478

 

2023 Notes

 

750

 

(12

)

738

 

Total long-term debt

 

$

4,119

 

$

(44

)

$

4,075

 

 

 

 

December 31, 2014

 

 

 

Gross Carrying

 

Unamortized

 

Net Carrying

 

 

 

Amount

 

Discount

 

Amount

 

Term Loan

 

$

2,119

 

$

(10

)

$

2,109

 

2021 Notes

 

1,500

 

(23

)

1,477

 

2023 Notes

 

750

 

(12

)

738

 

Total long-term debt

 

$

4,369

 

$

(45

)

$

4,324

 

 

For the three months ended March 31, 2015 and March 31, 2014, interest expense was $49 million and $51 million, respectively, amortization of the debt discount for the Credit Facilities and Notes was $1 million and $2 million, respectively, and commitment fees for the Revolver were not material.

 

As of March 31, 2015, the scheduled maturities and contractual principal repayments of our debt for each of the five succeeding years are as follows (amounts in millions):

 

For the year ending December 31,

 

 

 

2015 (remaining nine months)

 

$

 

2016

 

 

2017

 

 

2018

 

 

2019

 

 

Thereafter

 

4,119

 

Total

 

$

4,119

 

 

As of March 31, 2015 and December 31, 2014, the carrying value of the Term Loan approximates the fair value, based on Level 2 inputs (observable market prices in less than active markets), as the interest rate is variable over the selected interest period and is similar to current rates at which we can borrow funds.  Based on Level 2 inputs, the fair values of the 2021 Notes and 2023 Notes were $1,599 million and $819 million, respectively, as of March 31, 2015 and $1,586 million and $810 million, respectively, as of December 31, 2014.

 

Deferred Financing Costs

 

Costs incurred to obtain our long-term debt are recorded as deferred financing costs within “Other assets — non-current” in our condensed consolidated balance sheets and are amortized over the terms of the respective debt agreements using a straight-line basis for costs related to the Revolver and the interest earned method for costs related to the Term Loan and Notes.  Amortization expense related to the deferred financing costs is recorded within “Interest and other investment income (expense), net” in our condensed consolidated statements of operations.  For the three months ended March 31, 2015 and 2014, this amount was not material .

 

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Table of Contents

 

7.               Accumulated Other Comprehensive Income (Loss)

 

The components of accumulated other comprehensive income (loss) at March 31, 2015 and 2014, were as follows (amounts in millions):

 

 

 

For the Three Months Ended March 31, 2015

 

 

 

Foreign currency

 

Unrealized gain

 

Unrealized gain

 

 

 

 

 

translation

 

on available-for-

 

on forward

 

 

 

 

 

adjustments

 

sale securities

 

contracts

 

Total

 

Balance at December 31, 2014

 

$

(304

)

$

1

 

$

 

$

(303

)

Other comprehensive income (loss) before reclassifications

 

(330

)

 

14

 

(316

)

Balance at March 31, 2015

 

$

(634

)

$

1

 

$

14

 

$

(619

)

 

 

 

For the Three Months Ended March 31, 2014

 

 

 

Foreign currency

 

Unrealized gain

 

Unrealized gain

 

 

 

 

 

translation

 

on available-for-

 

on forward

 

 

 

 

 

adjustments

 

sale securities

 

contracts

 

Total

 

Balance at December 31, 2013

 

$

67

 

$

1

 

$

 

$

68

 

Other comprehensive income (loss) before reclassifications

 

(5

)

 

 

(5

)

Balance at March 31, 2014

 

$

62

 

$

1

 

$

 

$

63

 

 

Income taxes were not provided for foreign currency translation items as these are considered indefinite investments in non-U.S. subsidiaries.

 

8.               Operating Segments and Geographic Region

 

Our operating segments are consistent with our internal organizational structure, the manner in which our operations are reviewed and managed by our Chief Executive Officer, who is our Chief Operating Decision Maker (“CODM”), the manner in which we assess operating performance and allocate resources, and the availability of separate financial information. Currently, we conduct our business through three operating segments: Activision, Blizzard and Distribution (see Note 1 of the Notes to Condensed Consolidated Financial Statements). We do not aggregate operating segments.

 

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The CODM reviews segment performance exclusive of the impact of the change in deferred revenues and related cost of sales with respect to certain of our online-enabled games, stock-based compensation expense, amortization of intangible assets as a result of purchase price accounting, and fees and other expenses (including legal fees, costs, expenses and accruals) related to the Purchase Transaction and related debt financings. The CODM does not review any information regarding total assets on an operating segment basis, and accordingly, no disclosure is made with respect thereto. Information on the operating segments and reconciliations of total net revenues and total segment operating income to consolidated net revenues from external customers and consolidated income before income tax expense for the three months ended March 31, 2015 and 2014 are presented below (amounts in millions):

 

 

 

Three Months Ended March 31,

 

 

 

2015

 

2014

 

2015

 

2014

 

 

 

 

 

 

 

Income (loss) from operations

 

 

 

Net revenues

 

before income tax expense

 

Activision

 

$

303

 

$

237

 

$

66

 

$

2

 

Blizzard

 

352

 

462

 

139

 

239

 

Distribution

 

48

 

73

 

(1

)

(1

)

Operating segments total

 

703

 

772

 

204

 

240

 

 

 

 

 

 

 

 

 

 

 

Reconciliation to consolidated net revenues / consolidated income before income tax expense:

 

 

 

 

 

 

 

 

 

Net effect from deferral of net revenues and related cost of sales

 

575

 

339

 

362

 

219

 

Stock-based compensation expense

 

 

 

(23

)

(30

)

Amortization of intangible assets

 

 

 

(1

)

(2

)

Consolidated net revenues / operating income

 

$

1,278

 

$

1,111

 

$

542

 

$

427

 

Interest and other expense, net

 

 

 

 

 

50

 

51

 

Consolidated income before income tax expense

 

 

 

 

 

$

492

 

$

376

 

 

Geographic information presented below for the three months ended March 31, 2015 and 2014 is based on the location of the selling entity. Net revenues from external customers by geographic region were as follows (amounts in millions):

 

 

 

Three months ended March 31,

 

 

 

2015

 

2014

 

Net revenues by geographic region:

 

 

 

 

 

North America

 

$

704

 

$

563

 

Europe

 

464

 

462

 

Asia Pacific

 

110

 

86

 

Total consolidated net revenues

 

$

1,278

 

$

1,111

 

 

The Company’s net revenues in the U.S. were 53%, and 48% of consolidated net revenues for the three months ended March 31, 2015 and 2014, respectively.  The Company’s net revenues in the U.K. were 12% and 15% of consolidated net revenues for the three months ended March 31, 2015 and 2014, respectively. The Company’s net revenues in France were 8% and 13% of consolidated net revenues for the three months ended March 31, 2015 and 2014, respectively.  No other country’s net revenues exceeded 10% of consolidated net revenues.

 

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Net revenues by platform were as follows (amounts in millions):

 

 

 

Three Months Ended March 31,

 

 

 

2015

 

2014

 

Net revenues by platform:

 

 

 

 

 

Console

 

$

758

 

$

654

 

Online (1)

 

272

 

201

 

PC

 

114

 

100

 

Mobile and other(2)

 

86

 

83

 

Total Activision Blizzard net revenues

 

1,230

 

1,038

 

Distribution

 

48

 

73

 

Total consolidated net revenues

 

$

1,278

 

$

1,111

 

 


(1)                                  Revenues from online consist of revenues from all World of Warcraft products, including subscriptions, boxed products, expansion packs, licensing royalties, and value-added services.

 

(2)                                  Revenues from mobile and other include revenues from handheld, mobile and tablet devices, as well as non-platform specific game related revenues such as standalone sales of toys and accessories products from the Skylanders franchise and other physical merchandise and accessories.

 

Long-lived assets by geographic region at March 31, 2015 and December 31, 2014 were as follows (amounts in millions):

 

 

 

At March 31,

 

At December 31,

 

 

 

2015

 

2014

 

Long-lived assets* by geographic region:

 

 

 

 

 

North America

 

$

129

 

$

122

 

Europe

 

24

 

29

 

Asia Pacific

 

5

 

6

 

Total long-lived assets by geographic region

 

$

158

 

$

157

 

 

*The only long-lived assets that we classify by region are our long-term tangible fixed assets, which only include property, plant and equipment assets; all other long-term assets are not allocated by location.

 

We did not have any single external customers that accounted for 10% or more of consolidated net revenues for the three months ended March 31, 2015 and 2014.

 

9.               Income Taxes

 

The Company accounts for its provision for income taxes in accordance with ASC 740, Income Taxes , which requires an estimate of the annual effective tax rate for the full year to be applied to the interim period, taking into account year-to-date amounts and projected results for the full year.  The provision for income taxes represents federal, foreign, state and local income taxes.  Our effective tax rate differs from the statutory U.S. income tax rate due to the effect of state and local income taxes, tax rates in foreign jurisdictions and certain nondeductible expenses. Our effective tax rate could fluctuate significantly from quarter to quarter based on recurring and nonrecurring factors including, but not limited to: variations in the estimated and actual level of pre-tax income or loss by jurisdiction; changes in the mix of income by tax jurisdiction (as taxes are levied at relatively lower statutory rates in foreign regions and relatively higher statutory rates in the U.S.); changes in enacted tax laws and regulations, rulings and interpretations thereof, including with respect to tax credits, state and local income taxes; developments in tax audits and other matters;  and certain nondeductible expenses. Changes in judgment from the evaluation of new information resulting in the recognition, derecognition or remeasurement of a tax position taken in a prior annual period are recognized separately in the quarter of the change.

 

The income tax expense of $98 million for the three months ended March 31, 2015 reflects an effective tax rate of 19.9%, which is lower than the effective tax rate of 22.1% for the three months ended March 31, 2014.  This decrease is primarily due to an increase in the amount of foreign earnings, which are taxed at relatively lower statutory rates, as compared to domestic earnings, which are taxed at relatively higher statutory rates, in the estimated effective annual tax rate.

 

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The effective tax rate of 19.9% for the three months ended March 31, 2015 differed from the U.S. statutory rate of 35.0%, primarily due to the tax benefit from foreign earnings taxed at relatively lower statutory rates, recognition of California research and development credits, and the federal domestic production deductions, offset by increases to the Company’s reserve for uncertain tax positions.

 

The overall effective income tax rate for the year could be different from the effective tax rate for the three months ended March 31, 2015 and will be dependent, in part, on our profitability for the remainder of the year, as well as the other factors described above.

 

The Internal Revenue Service (“IRS”) is currently examining Activision Blizzard’s federal tax returns for the 2008 through 2011 tax years.  Additionally, the IRS is currently reviewing our application for an advanced pricing agreement (“APA”) with respect to the transfer pricing methodology that would be used by the Company for tax years 2010 through 2024.   If ongoing discussions with the IRS result in an APA, this could result in a different allocation of profits and losses under the Company’s transfer pricing agreements.  Such allocation could have a positive or negative impact on our provision for uncertain tax positions for the period in which such an agreement is reached and the relevant periods thereafter.

 

In addition, Vivendi Games’ tax return for the 2008 tax year is under examination by the Internal Revenue Service and several state taxing authorities. While Vivendi Games’ results for the period January 1, 2008 through July 9, 2008 are included in the consolidated federal and certain foreign, state and local income tax returns filed by Vivendi or its affiliates, Vivendi Games’ results for the period July 10, 2008 through December 31, 2008 are included in the consolidated federal and certain foreign, state and local income tax returns filed by Activision Blizzard. Additionally, the Company has several state and non-U.S. audits pending. Although the final resolution of the Company’s global tax disputes is uncertain, based on current information, in the opinion of the Company’s management, the ultimate resolution of these matters are not expected to have a material adverse effect on the Company’s consolidated financial position, liquidity or results of operations. However, an unfavorable resolution of the Company’s global tax disputes could have a material adverse effect on our business and results of operations in the period in which the matters are ultimately resolved.

 

In connection with the Purchase Transaction, we assumed certain tax attributes of New VH, generally consisting of New VH’s net operating loss (“NOL”) carryforwards of approximately $760 million, which represent a potential future tax benefit of approximately $266 million. The utilization of such NOL carryforwards will be subject to certain annual limitations and will begin to expire in 2021. The Company also obtained indemnification from Vivendi against losses attributable to the disallowance of claimed utilization of such NOL carryforwards of up to $200 million in unrealized tax benefits in the aggregate, limited to taxable years ending on or prior to December 31, 2016. No benefit for these tax attributes or indemnification was recorded upon the close of the Purchase Transaction, as the benefit from these tax attributes did not meet the “more-likely-than-not” standard.  For the three months ended March 31, 2015, we utilized $152 million of the NOL, which resulted in a tax benefit of $53 million, and a corresponding reserve was established as the position did not meet the “more-likely-than-not” standard.  As of March 31, 2015, an indemnification asset of $121 million has been recorded in “Other Assets”, and, correspondingly, the same amount has been recorded as a reduction to the consideration paid for the shares repurchased in “Treasury Stock” (see Note 1 of the Notes to Condensed Consolidated Financial Statements for details about the share repurchase).

 

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10.        Computation of Basic/Diluted Earnings Per Common Share

 

The following table sets forth the computation of basic and diluted earnings per common share (amounts in millions, except per share data):

 

 

 

For the Three Months Ended March 31,

 

 

 

2015

 

2014

 

 

 

 

 

 

 

Numerator:

 

 

 

 

 

Consolidated net income

 

$

394

 

$

293

 

Less: Distributed earnings to unvested stock-based awards that participate in earnings

 

(4

)

(5

)

Less: Undistributed earnings allocated to unvested stock-based awards that participate in earnings

 

(3

)

(3

)

Numerator for basic and diluted earnings per common share — income available to common shareholders

 

$

387

 

$

285

 

 

 

 

 

 

 

Denominator:

 

 

 

 

 

Denominator for basic earnings per common share - weighted-average common shares outstanding

 

723

 

709

 

 

 

 

 

 

 

Effect of potential dilutive common shares under the treasury stock method:

 

8

 

11

 

Denominator for diluted earnings per common share - weighted-average common shares outstanding plus dilutive common shares under the treasury stock method

 

731

 

720

 

 

 

 

 

 

 

Basic earnings per common share

 

$

0.54

 

$

0.40

 

 

 

 

 

 

 

Diluted earnings per common share

 

$

0.53

 

$

0.40

 

 

Certain of our unvested restricted stock rights (including certain restricted stock units, restricted stock awards, and performance shares) met the definition of participating securities based on their rights to dividends or dividend equivalents.  Therefore, we are required to use the two-class method in our computation of basic and diluted earnings per common share. For the three months ended March 31, 2015 and 2014, on a weighted-average basis, we had outstanding unvested restricted stock rights with respect to 10 million and 17 million shares of common stock, respectively, that are participating in earnings.

 

Certain of our employee-related restricted stock rights are contingently issuable upon the satisfaction of pre-defined performance measures.  These shares are included in the weighted-average dilutive common shares only if the performance measures are met as of the end of the reporting period.   Approximately 4 million and 3 million shares are not included in the computation of diluted earnings per share for the three months ended March 31, 2015 and 2014, respectively, as their respective performance measures had not yet been met.

 

Potential common shares are not included in the denominator of the diluted earnings per common share calculation when the inclusion of such shares would be anti-dilutive, such as in a period in which a net loss is recorded. Therefore, options to acquire 6 million and 3 million shares of common stock were not included in the calculation of diluted earnings per common share for the three months ended March 31, 2015 and 2014, respectively, as the effect of their inclusion would be anti-dilutive.

 

11.    Capital Transactions

 

Repurchase Programs

 

On February 3, 2015, our Board of Directors authorized a stock repurchase program under which we may repurchase up to $750 million of our common stock during the two-year period from February 9, 2015 through February 8, 2017.  As of March 31, 2015, we have not repurchased any shares under this program.

 

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Dividend

 

On February 3, 2015, our Board of Directors declared a cash dividend of $0.23 per common share, payable on May 13, 2015, to shareholders of record at the close of business on March 30, 2015.  As such, we have included $170 million of dividends payable in “Accrued expense and other liabilities” and “Other liabilities” on our condensed consolidated balance sheet as of March 31, 2015.

 

On February 6, 2014, our Board of Directors declared a cash dividend of $0.20 per common share, payable on May 14, 2014, to shareholders of record at the close of business on March 19, 2014. On May 14, 2014, we made an aggregate cash dividend payment of $143 million to such shareholders, and on May 30, 2014, we made related dividend equivalent payments of $4 million to holders of restricted stock rights.

 

12.        Commitments and Contingencies

 

Legal Proceedings

 

We are subject to various legal proceedings and claims. SEC regulations govern disclosure of legal proceedings in periodic reports and ASC Topic 450 governs the disclosure of loss contingencies and accrual of loss contingencies in respect of litigation and other claims. We record an accrual for a potential loss when it is probable that a loss will occur and the amount of the loss can be reasonably estimated. When the reasonable estimate of the potential loss is within a range of amounts, the minimum of the range of potential loss is accrued, unless a higher amount within the range is a better estimate than any other amount within the range. Moreover, even if an accrual is not required, we provide additional disclosure related to litigation and other claims when it is reasonably possible ( i.e. , more than remote) that the outcomes of such litigation and other claims include potential material adverse impacts on us.

 

The outcomes of legal proceedings and other claims are subject to significant uncertainties, many of which are outside of our control. There is significant judgment required in the analysis of these matters, including the probability determination and whether a potential exposure can be reasonably estimated. In making these determinations, we, in consultation with outside counsel, examine the relevant facts and circumstances on a quarterly basis assuming, as applicable, a combination of settlement and litigated outcomes and strategies. Moreover, legal matters are inherently unpredictable and the timing of development of factors on which reasonable judgments and estimates can be based can be slow. As such, there can be no assurance that the final outcome of any legal matter will not materially and adversely affect our business, financial condition, results of operations, profitability, cash flows or liquidity.

 

Purchase Transaction Matters

 

On August 1, 2013, a purported shareholder of the Company filed a shareholder derivative action in the Superior Court of the State of California, County of Los Angeles, captioned Miller v. Kotick, et al. , No. BC517086. The complaint names our Board of Directors and Vivendi as defendants, and the Company as a nominal defendant. The complaint alleges that our Board of Directors committed breaches of fiduciary duties, waste of corporate assets and unjust enrichment in connection with Vivendi’s sale of its stake in the Company and that Vivendi also breached its fiduciary duties. The plaintiff further alleges that demand by it on our Board of Directors to institute action would be futile because a majority of our Board of Directors is not independent and a majority of the individual defendants face a substantial likelihood of liability for approving the transactions contemplated by the Stock Purchase Agreement. The complaint seeks, among other things, damages sustained by the Company, rescission of the transactions contemplated by the Stock Purchase Agreement, an order restricting our Chief Executive Officer and our Chairman from purchasing additional shares of our common stock and an order directing us to take necessary actions to improve and reform our corporate governance and internal procedures to comply with applicable law, including ordering a shareholder vote on certain amendments to our by-laws or charter that would require half of our Board of Directors to be independent of Messrs. Kotick and Kelly and Vivendi and a proposal to appoint a new independent Chairman of the Board of Directors. On January 28, 2014, the parties filed a stipulation and proposed order temporarily staying the California action. On February 6, 2014, the court entered the order granting a stay of the California action.

 

In addition, on August 14, 2013, we received a letter dated August 9, 2013, from a shareholder seeking, pursuant to Section 220 of the Delaware General Corporation Law, to inspect the books and records of the Company to ascertain whether the Purchase Transaction and Private Sale were in the best interests of the Company. In response to that request, we provided the stockholder with certain materials under a confidentiality agreement. On September 11, 2013, a complaint was filed under seal by the same stockholder in the Court of Chancery of the State of Delaware in an action captioned Pacchia v. Kotick et al. , C.A. No. 8884-VCL. A public version of that complaint was filed on September 16, 2013. The allegations in the complaint were substantially similar to the allegations in the above referenced matter filed on August 1, 2013. On October 25, 2013, Pacchia filed an amended complaint under seal. The amended complaint added claims on behalf of an alleged class of Activision stockholders other than the Company’s Chief Executive Officer and Chairman, Vivendi, ASAC, investors in ASAC and other stockholders affiliated with the investors of ASAC. The added class claims are against the Company’s Chief Executive Officer and Chairman, the Vivendi affiliated directors, the members of the special committee of the Board of Directors formed in connection with the Company’s consideration of the transactions with Vivendi and ASAC, and Vivendi for breach of fiduciary duty, as well as aiding and abetting a

 

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breach of fiduciary duty against ASAC. The amended complaint removed the derivative claims for waste of corporate assets and disgorgement but continued to allege derivative claims for breach of fiduciary duties. The amended complaint seeks, among other things, certification of a class, damages, reformation of the Private Sale, and disgorgement of any alleged profits received by the Company’s Chief Executive Officer, Chairman and ASAC. On October 29, 2013, Pacchia filed a motion to consolidate the Pacchia case with the Hayes case described below. On November 2, 2013, the Court of Chancery consolidated the Pacchia and Hayes cases and ordered the plaintiffs to file supplemental papers related to determining lead plaintiff and lead counsel no later than November 8, 2013. On December 3, 2013, the court selected Pacchia as lead plaintiff. Pacchia filed a second amended complaint on December 11, 2013, and Activision filed an answer on January 31, 2014. Also on January 31, 2014, the special committee, ASAC, Messrs. Kotick and Kelly, Vivendi and the Vivendi-affiliated directors each filed motions to dismiss certain claims in the second amended complaint. On February 21, 2014, Pacchia filed a third amended complaint under seal. In response to Pacchia’s filing of a third amended complaint, the special committee, ASAC, Messrs. Kotick and Kelly, Vivendi and the Vivendi-affiliated directors each filed motions to dismiss certain claims in the third amended complaint. On June 6, 2014, the Court of Chancery denied the defendants’ motions to dismiss such claims, with the exception of a breach of contract claim. Subsequently, Pacchia filed a fourth amended complaint containing substantially all of his prior claims, but with the addition of new allegations gleaned from discovery in the matter. ASAC filed a motion to dismiss the re-pleaded breach of contract claim and the other defendants filed answers in response to the fourth amended complaint.

 

On September 11, 2013, another stockholder of the Company filed a putative class action and stockholder derivative action in the Court of Chancery of the State of Delaware, captioned Hayes v. Activision Blizzard, Inc., et al. , No. 8885-VCL. The complaint names our Board of Directors, Vivendi, New VH, the ASAC Entities, Davis Selected Advisers, L.P. (“Davis”) and Fidelity Management & Research Co. (“FMR”) as defendants, and the Company as a nominal defendant. The complaint alleges that the defendants violated certain provisions of our Amended and Restated Certificate of Incorporation by failing to submit the matters contemplated by the Stock Purchase Agreement for approval by a majority of our stockholders (other than Vivendi and its controlled affiliates); that our Board of Directors committed breaches of their fiduciary duties in approving the Stock Purchase Agreement; that Vivendi violated fiduciary duties owed to other stockholders of the Company in entering into the Stock Purchase Agreement; that our Chief Executive Officer and our Chairman usurped a corporate opportunity from the Company; that our Board of Directors and Vivendi have engaged in actions to entrench our Board of Directors and officers in their offices; that the ASAC Entities, Davis and FMR aided and abetted breaches of fiduciary duties by the Board of Directors and Vivendi; and that our Chief Executive Officer and our Chairman, the ASAC Entities, Davis and FMR will be unjustly enriched through the Private Sale. The complaint seeks, among other things, the rescission of the Private Sale; an order requiring the transfer to the Company of all or part of the shares that are the subject of the Private Sale; an order implementing measures to eliminate or mitigate the alleged entrenching effects of the Private Sale; an order requiring our Chief Executive Officer and our Chairman, the ASAC Entities, Davis and FMR to disgorge to the Company the amounts by which they have allegedly been unjustly enriched; and alleged damages sustained by the class and the Company. In addition, the stockholder sought a temporary restraining order preventing the defendants from consummating the transactions contemplated by the Stock Purchase Agreement without stockholder approval. Following a hearing on the motion for a temporary restraining order, on September 18, 2013, the Court of Chancery issued a preliminary injunction order, enjoining the consummation of the transactions contemplated by the Stock Purchase Agreement pending (a) the issuance of a final decision after a trial on the merits; (b) receipt of a favorable Activision Blizzard stockholder vote on the transactions contemplated by the Stock Purchase Agreement under Section 9.1(b) of our Amended and Restated Certificate of Incorporation or (c) modification of such preliminary injunction order by the Court of Chancery or the Delaware Supreme Court. On September 20, 2013, the Court of Chancery certified its order issuing the preliminary injunction for interlocutory appeal to the Delaware Supreme Court. The defendants moved the Delaware Supreme Court to accept and hear the appeal on an expedited basis. On September 23, 2013, the Delaware Supreme Court accepted the appeal of the Court of Chancery’s decision and granted the defendant’s motion to hear the appeal on an expedited basis.

 

Following a hearing on October 10, 2013, the Delaware Supreme Court reversed the Court of Chancery’s order issuing a preliminary injunction, and determined that the Stock Purchase Agreement was not a merger, business combination or similar transaction that would require a vote of Activision’s unaffiliated stockholders under the charter.

 

On October 29, 2013, an amended complaint was filed. It added factual allegations but no new claims or relief. Also on October 29, 2013, Hayes filed a motion to consolidate the Hayes case with the Pacchia case. As noted above, on November 2, 2013, the Court of Chancery consolidated the Pacchia and Hayes cases and ordered the plaintiffs to file supplemental papers related to determining lead plaintiff and lead counsel no later than November 8, 2013. See the discussion above related to the Pacchia matter (now the consolidated matter) for any further updates to the status of the litigation.

 

Further, on September 18, 2013, the Company received a letter from another purported stockholder of the Company, Milton Pfeiffer, seeking, pursuant to Section 220 of the Delaware General Corporation Law, to inspect the books and records of the Company to investigate potential wrongdoing or mismanagement in connection with the approval of the Stock Purchase Agreement. On November 11, 2013, Pfeiffer filed a lawsuit in the Court of Chancery of the State of Delaware pursuant to Delaware Section 220 containing claims similar to Hayes , Pacchia and Miller . The Company answered on November 27, 2013. On January 21, 2014, the Court of Chancery entered the parties’ stipulation and order of dismissal.

 

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On December 17, 2013, the Company received a letter from Mark Benston requesting certain books and records of the Company pursuant to Section 220 of the Delaware General Corporation Law. Benston is represented by the same law firm as Pfeiffer. On January 2, 2014, Benston filed a lawsuit in the Court of Chancery of the State of Delaware pursuant to Delaware Section 220 containing claims similar to Hayes , Pacchia , Pfeiffer and Miller . The Company answered on January 17, 2014. On February 14, 2014, the Court of Chancery entered the parties’ stipulation and order of dismissal.

 

On March 14, 2014, Benston filed a putative class action and derivative complaint in the Court of Chancery, captioned Benston v. Vivendi S.A. et al. , No. 9447-VCL. The complaint makes claims similar to Hayes, Pacchia, Pfeiffer and Miller , but also adds J.P. Morgan Chase & Co. and J.P. Morgan Securities LLC as defendants and a so-called Brophy claim for insider trading against certain of the defendants. Benston and his attorneys petitioned the Court of Chancery to appoint them as co-lead plaintiff and co-lead counsel, respectively, for purposes of pursuing the Brophy claim as part of the consolidated Pacchia litigation. On June 6, 2014, the Court of Chancery denied Benston’s motion for a leadership role in the consolidated Pacchia litigation. As a result, Pacchia continues to serve as the lead plaintiff in the consolidated cases.

 

Certain of defendants filed a motion to dismiss the breach of contract claim set forth in the Fourth Amended Complaint. Pacchia obtained leave to file a Fifth Amended Complaint, which adds additional color to his allegations of wrongdoing based on information learned in discovery, including with respect to the appointment and subsequent election of several of the directors to our Board of Directors. For the most part, fact and expert discovery was completed in the Pacchia matter, including the exchange of expert damage and other reports. Pacchia’s expert’s reports allege damages to the Company in excess of $540 million and to the purported class in excess of $640 million, in addition to disgorgement claims, which could, in theory, exceed $1 billion. Defendants’ experts’ reports maintain there are no damages to the Company or to the purported class because the Purchase Transaction and the Private Sale were the best transactions available to the parties and the alternate transactions hypothesized by the plaintiff were inferior.

 

For the quarter ended September 30, 2014, we accrued a loss contingency in our consolidated financial statements in connection with this matter. The accrual related to potential liabilities associated with legal fees, costs and expenses for services already received prior to the quarter’s end, where such fees, costs and expenses had not yet been paid at the quarter’s end, and the Company’s potential contribution toward the potential settlement of the matter. Although the Company has D&O insurance in connection with the consolidated litigation in a total amount up to $200 million, various insurers have raised arguments that they believe give them the right to deny coverage for a portion of these fees, costs and expenses, as well as for all or a portion of the ultimate liability which may occur in settlement or at trial. Under our Amended and Restated Certificate of Incorporation and certain agreements with members of our Board of Directors, the Company has indemnification obligations to the director defendants to advance fees, costs and expenses and to pay liabilities which arise in connection with their service to the Company, in each case, to the maximum extent permitted by Delaware law. In light of these indemnification obligations and the positions taken by the parties and the various insurers, we determined that a liability was probable and estimable, and accordingly, an accrual was required, as of the quarter ended September 30, 2014.

 

On November 19, 2014, the Company announced that an agreement had been reached to settle the Pacchia matter. The Company believes the settlement agreement, which acknowledges no wrongdoing on the part of any party, is in the best interest of the Company and all of its shareholders. Pursuant to the settlement agreement, multiple insurance companies, along with various defendants, will pay $275 million to a settlement fund (“Settlement Fund”). Payment of reasonable and customary fees and costs of plaintiff’s attorney, likely not to exceed $72.5 million, will be made from the Settlement Fund. The remaining balance of the Settlement Fund, likely to be at least $202.5 million, will be paid to the Company and will be recorded within “Shareholders’ equity” in our consolidated balance sheet. Other terms of the settlement agreement include the addition of two unaffiliated persons to the Company’s Board of Directors, an adjustment of certain voting rights and a global release of claims against the defendants. On December 29, 2014, the Company filed a Current Report on Form 8-K, describing and attaching the Stipulation of Compromise and Settlement, which was filed with the Delaware Chancery Court with respect to the settlement of the Pacchia matter (the “Stipulation”). Pursuant to the Stipulation, the Company has notified the applicable shareholders of the settlement agreement. Applicable shareholders were provided an opportunity to object to the settlement, which is subject to approval by the Delaware Chancery Court.

 

Objections to the Stipulation have been filed by several shareholders. The plaintiff in the Hayes matter has objected to the settlement on the grounds that a portion of the $275 million Settlement Fund should be reallocated to the members of the class, that the amount of any attorney’s fee award should be reduced and that the court should deny any “special award” to the plaintiff in the Pacchia matter. In the absence of such a reallocation, Hayes argues the court should deny approval of the settlement and appoint Hayes and his counsel to lead the class-based claims. Hayes also contends the notice of settlement provided by the Company is inadequate. The Company disputes this allegation. The plaintiffs in the Benston and Pfeiffer matters have also filed applications to the court requesting that their counsel receive an attorney’s fee award of $7.25 million to be paid out of the attorneys’ fees contemplated by the proposed Settlement. Certain defendants have also filed objections to the $50,000 “special award” requested by the Pacchia plaintiff. The Delaware Court of Chancery held a hearing on March 4, 2015, to consider the approval of the Stipulation, and a decision by the court is expected on or before June 2, 2015.

 

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Since the Stipulation does not require the Company to pay any liability on behalf of its defendant directors, the Company reversed the accrual described above as of December 31, 2014. The reversal of the accrual was partially offset by a new accrual for liabilities associated with legal fees, costs and expenses for services already received prior to the year’s end, where such fees, costs and expenses had not yet been paid at the year’s end.

 

Due to the inherent uncertainties of litigation, including the possibility that the Delaware Chancery Court does not approve the Stipulation, other potential outcomes are reasonably possible, including outcomes which could include an increase in the Company’s liability. The Company believes the possibility that this lawsuit will have a material impact on the Company’s business, financial condition, results of operation or liquidity is remote. However, if this assessment is incorrect, then an unfavorable resolution of this lawsuit could have a material adverse effect on the Company’s business, financial condition, results of operation or liquidity, particularly in the period in which any potential liabilities may be recognized.

 

We believe that the defendants have meritorious defenses. If the Delaware Chancery Court does not approve the Stipulation and the parties are not otherwise able to settle the matter subsequently, then we believe the defendants intend to defend the lawsuit and other related cases vigorously at trial. However, these lawsuits and any other lawsuits are subject to inherent uncertainties and the actual outcome and costs will depend upon many unknown factors. The outcome of litigation is necessarily uncertain, and the Company could be forced to expend significant resources in the defense of these lawsuits and the Company and the defendants may not prevail. The Company also may be subject to additional claims in connection with the Purchase Transaction and Private Sale. Monitoring and defending against legal actions is time consuming for our management and detracts from our ability to fully focus our internal resources on our business.

 

Other Matters

 

In addition, we are party to routine claims, suits, investigations, audits and other proceedings arising from the ordinary course of business, including with respect to intellectual property rights, contractual claims, labor and employment matters, regulatory matters, tax matters, unclaimed property matters, compliance matters, and collection matters. In the opinion of management, after consultation with legal counsel, such routine claims and lawsuits are not significant and we do not expect them to have a material adverse effect on our business, financial condition, results of operations, or liquidity.

 

13.  Related Party Transactions

 

Transactions with Vivendi and Its Affiliates

 

As part of the Business Combination in 2008, we entered into various transactions and agreements, including cash management services agreements, a tax sharing agreement and an investor agreement, with Vivendi and its subsidiaries. In connection with the consummation of the Purchase Transaction, we terminated the cash management arrangements with Vivendi and amended our investor agreement with Vivendi. We are also party to a number of agreements with subsidiaries and other affiliates of Vivendi, including music licensing and distribution arrangements and promotional arrangements, none of which were impacted by the Purchase Transaction.  None of these services, transactions and agreements with Vivendi and its affiliates were material, either individually or in the aggregate, to the consolidated financial statements as a whole.  As discussed in Note 1 of the Notes to Condensed Consolidated Financial Statements, on May 28, 2014 Vivendi sold 41 million shares, reducing its ownership interest below 10%, and is no longer considered a related party.

 

Transactions with ASAC’s Affiliates

 

Pursuant to the Stock Purchase Agreement, the Company and each of Mr. Kotick, the Company’s Chief Executive Officer, and Mr. Kelly, the Company’s Chairman of the board of directors, entered into a waiver and acknowledgement letters (together, the “Waivers”), which provide, among other things, (i) that the Purchase Transaction, Private Sale, any public offerings by Vivendi and restructurings by Vivendi and its subsidiaries contemplated by the Stock Purchase Agreement and other transaction documents, shall not (or shall be deemed not to) constitute a “change in control” (or similar term) under their respective employment arrangements, including their employment agreements with the Company, the Company’s 2008 Incentive Plan or any award agreements in respect of awards granted thereunder, or any Other Benefit Plans and Arrangements (as defined in the Waivers), (ii) (A) that the shares of our common stock acquired by ASAC and held or controlled by the ASAC Investors (as defined in the Waivers) in connection with the Transactions (as defined in the Waivers) will not be included in or count toward, (B) that the ASAC Investors will not be deemed to be a group for purposes of, and (C) any changes in the composition in the Board of Directors of the Company, in connection with or during the one-year period following the consummation of the Transactions will not contribute towards, a determination that a “change in control” or similar term has occurred with respect to Messrs. Kotick and Kelly’s employment arrangements with the Company, and (iii) for the waiver by Messrs. Kotick and Kelly of their rights to change in control payments or benefits under their employment agreements with the Company, the Company’s 2008 Incentive Plan or any award agreements in respect of awards granted thereunder, and any Other Benefit Plans and Arrangements (in each case, with respect to all current and future grants, awards, benefits or entitlements) in connection with or as a consequence of the Transactions.

 

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Also pursuant to the Stock Purchase Agreement, on October 11, 2013, we, ASAC and, for the limited purposes set forth therein, Messrs. Kotick and Kelly entered into the Stockholders Agreement. The Stockholders Agreement contains various agreements among the parties regarding voting rights, transfer rights, and a standstill agreement, among other things.

 

14.        Recently issued accounting pronouncements

 

Revenue recognition

 

In May 2014, the FASB issued new accounting guidance related to revenue recognition. The new standard will replace all current U.S. GAAP guidance on this topic and eliminate all industry-specific guidance. The new revenue recognition standard provides a unified model to determine when and how revenue is recognized. The core principle is that a company should recognize revenue upon the transfer of promised goods or services to customers in an amount that reflects the consideration for which the entity expects to be entitled in exchange for those goods or services. This guidance will be effective beginning January 1, 2017 and can be applied either retrospectively to each period presented or as a cumulative-effect adjustment as of the date of adoption. We are evaluating the adoption method as well as the impact of this new accounting guidance on our financial statements.

 

Stock-based compensation

 

In June 2014, the FASB issued new guidance related to stock compensation. The new standard requires that a performance target that affects vesting, and that could be achieved after the requisite service period, be treated as a performance condition. As such, the performance target should not be reflected in estimating the grant date fair value of the award. This update further clarifies that compensation cost should be recognized in the period in which it becomes probable that the performance target will be achieved and should represent the compensation cost attributable to the periods for which the requisite service has already been rendered. The new standard is effective for fiscal years beginning after December 15, 2015 and can be applied either prospectively or retrospectively to all awards outstanding as of the beginning of the earliest annual period presented as an adjustment to opening retained earnings. Early adoption is permitted. The adoption of this guidance will not have a material impact on the Company’s consolidated financial statements.

 

Consolidations

 

In February 2015, the FASB issued new guidance related to consolidations. The new standard amends certain requirements for determining whether a variable interest entity must be consolidated. The new standard is effective for fiscal years beginning after December 15, 2015. Early adoption is permitted. We are evaluating the impact, if any, of adopting this new accounting guidance on our financial statements.

 

Debt Issuance Costs

 

In April 2015, the FASB issued new guidance related to the presentation of debt issuance costs in financial statements. The new standard requires an entity to present such costs in the balance sheet as a direct deduction from the related debt liability rather than as an asset. Amortization of the costs will continue to be reported as interest expense. It is effective for annual reporting periods beginning after December 15, 2015. The new guidance will be applied retrospectively to each prior period presented. The adoption of this guidance will not have a material impact on our financial statements.

 

Internal-Use Software

 

In April 2015, the FASB issued new guidance related to internal-use software. The new standard relates to a customer’s accounting for fees paid in cloud computing arrangements. The amendment provides guidance for customers to determine whether such arrangements include software licenses. If a cloud arrangement includes a software license, then the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If a cloud computing arrangement does not include a software license, the customer should account for the arrangement as a service contract.  The new standard is effective for fiscal years beginning after December 15, 2015. Early adoption is permitted. We are evaluating the impact, if any, of adopting this new accounting guidance on our financial statements.

 

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Item 2.          Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Business Overview

 

Activision Blizzard, Inc. is a leading global developer and publisher of interactive entertainment. The terms “Activision Blizzard,” the “Company,” “we,” “us,” and “our” are used to refer collectively to Activision Blizzard, Inc. and its subsidiaries.

 

Operating Segments

 

Based upon our organizational structure, we conduct our business through three operating segments as follows:

 

Activision Publishing, Inc.

 

Activision Publishing, Inc. (“Activision”) is a leading global developer and publisher of interactive software products and content. Activision delivers content to a broad range of gamers, ranging from children to adults, and from core gamers to mass-market consumers to “value” buyers seeking budget-priced software, in a variety of geographies. Activision develops games based on internally-developed properties, including games in the Call of Duty® and Skylanders® franchises, and to a lesser extent, based on licensed intellectual properties. Additionally, we have established a long-term alliance with Bungie to publish its game universe, Destiny .   Activision sells games through both retail and digital online channels.  Activision currently offers games that operate on the Microsoft Corporation (“Microsoft”) Xbox One (“Xbox One”) and Xbox 360 (“Xbox 360”), Nintendo Co. Ltd. (“Nintendo”) Wii U (“Wii U”) and Wii (“Wii”), and Sony Computer Entertainment, Inc. (“Sony”) PlayStation 4 (“PS4”) and PlayStation 3 (“PS3”) console systems (Xbox One, Wii U, and PS4 are collectively referred to as “next-generation”; Xbox 360, Wii, and PS3 are collectively referred to as “prior-generation”); the personal computer (“PC”); the Nintendo 3DS, Nintendo Dual Screen, and Sony PlayStation Vita handheld game systems; and mobile and tablet devices.

 

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Blizzard Entertainment, Inc.

 

Blizzard Entertainment, Inc. (“Blizzard”) is a leader in the subscription-based massively multi-player online role-playing game category in terms of both subscriber base and revenues generated through its World of Warcraft ® franchise, which it develops, hosts and supports. Blizzard also develops, markets, and sells role-playing action and strategy games for the PC, console, mobile and tablet platforms, including games in the multiple-award winning Diablo®, StarCraft®, and Hearthstone®: Heroes of Warcraft™ franchises.  In addition, Blizzard maintains a proprietary online game-related service, Battle.net ® .  Blizzard distributes its products and generates revenues worldwide through various means, including: subscriptions; sales of prepaid subscription cards; value-added services, such as in-game purchases and services; retail sales of physical “boxed” products; online download sales of PC products; purchases and downloads via third-party console, mobile and tablet platforms; and licensing of software to third-party or related-party companies that distribute World of Warcraft, Diablo and StarCraft products.  In addition, Blizzard is the creator of Heroes of the Storm™ , a new free-to-play online hero brawler that is currently in closed beta testing.

 

Activision Blizzard Distribution

 

Our distribution segment (“Distribution”) consists of operations in Europe that provide warehousing, logistical and sales distribution services to third-party publishers of interactive entertainment software, our own publishing operations, and manufacturers of interactive entertainment hardware.

 

Business Highlights

 

For the three months ended March 31, 2015, Activision Blizzard had net revenues of $1.3 billion, as compared to net revenues of $1.1 billion for the same period in 2014.  For the three months ended March 31, 2015, Activision Blizzard had earnings per diluted share of $0.53, as compared to earnings per diluted share of $0.40 for the same period in 2014.

 

On February 3, 2015, our Board of Directors declared a cash dividend of $0.23 per common share, payable on May 13, 2015, to shareholders of record at the close of business on March 30, 2015.  As such, we have included $170 million of dividends payable in “Accrued expense and other liabilities” and “Other liabilities” on our condensed consolidated balance sheet as of March 31, 2015.

 

According to The NPD Group with respect to North America, GfK Chart-Track with respect to Europe, and Activision Blizzard internal estimates, including toys and accessories, during the first quarter of 2015:

 

·                   Activision had two of the top five videogame franchises in North America and Europe.

 

·                   Skylanders Trap Team was the #1 console title globally.

 

Activision Blizzard Recent and Upcoming Product Releases

 

We have recently released the following titles and games, among other titles:

 

·                   On January 11, 2015, Activision entered open beta for Call of Duty Online , a free-to-play game available in China.

 

·                   On January 13, 2015, Blizzard began closed beta for Heroes of the Storm, its upcoming free-to-play online team brawler featuring iconic heroes from Blizzard games.

 

·                   Activision released Call of Duty: Advanced Warfare Havoc (“ Havoc ”), the first downloadable content pack for Call of Duty: Advanced Warfare on the Xbox One and Xbox 360 on January 27, 2015 and on other platforms on February 26, 2015.

 

·                   Activision released Call of Duty: Advanced Warfare Ascendance (“ Ascendance ”), the second downloadable content pack for Call of Duty: Advanced Warfare on the Xbox One and Xbox 360 platforms on March 31, 2015.  Ascendance is expected to be released on other platforms in the second quarter of 2015.

 

·                   On April 2, 2015, Blizzard released Blackrock Mountain TM , the latest addition to Hearthstone : Heroes of Warcraft content.

 

·                   On April 7, 2015, Blizzard launched the WoW Token System, which enables World of Warcraft players to exchange game-time Tokens, purchased at $20, to other players for in-game gold, which provides players with a secure method for purchasing gold in-game.

 

·                   On April 23, 2015, Blizzard began open beta for the action role-playing game Diablo III: Reaper of Souls in China.

 

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Management’s Overview of Business Trends

 

Console Platform Transition

 

In November 2013, Sony released the PS4 and Microsoft released the Xbox One, their respective next-generation game consoles and entertainment systems. According to The NPD Group and GfK Chart-Track in North America and Europe, as of March 31, 2015, the combined installed base of PS4 and Xbox One hardware was approximately 26 million units, as compared to the combined installed base of PS3 and Xbox 360 hardware of approximately 123 million units.

 

When new console platforms are announced or introduced into the market, consumers may reduce their purchases of game console software products for prior-generation console platforms in anticipation of new platforms becoming available. During these periods, sales of the game console software products we publish may slow or even decline until new platforms are introduced and achieve wide consumer acceptance. In prior cycles, as the next-generation installed base grew, software sales declines abated and software sales grew.

 

During platform transitions, we simultaneously incur costs to develop and market new titles for prior-generation video game platforms, which may not sell at premium prices, and to develop and market products for next-generation platforms, which may have a smaller installed base until the next-generation platforms achieve wide consumer acceptance.  We continually monitor console hardware sales and manage our product delivery on each of the prior- and next-generation platforms in a manner we believe to be most effective to maximize our revenue opportunities and achieve the desired return on our investments in product development. In the long term, we expect the next-generation consoles to drive industry growth and expand our opportunities.

 

Digital Online Channel Revenues

 

We provide our products through both retail and digital distribution channels. Many of our video games that are available through retailers as physical “boxed” software products are also available digitally (from our websites and from websites and digital distribution channels owned by third parties).  In addition, we offer players digital downloadable content as add-ons to our products ( e.g. , new multi-player content packs), generally for a one-time fee. We also offer subscription-based services and other value-added services for World of Warcraft and microtransactions for Hearthstone : Heroes of Warcraft , all of which are digitally delivered and hosted by Battle.net.  We have further plans to introduce games based on some of our most successful franchises which operate online on a free-to-play model with microtransactions, including Blizzard’s Heroes of the Storm and Activision’s Call of Duty Online, which both entered beta during the three months ended March 31, 2015.

 

We currently define sales via digital online channels as revenues from subscriptions, licensing royalties, value-added services, downloadable content, and digitally distributed products. This definition may differ from that used by our competitors or other companies.

 

According to Activision Blizzard internal estimates, overall market digital gaming revenues for the three months ended March 31, 2015 increased by approximately 19% as compared to the same period in 2014.   The primary drivers of the increase in digital gaming revenues were increases in consumer purchases of full games via digital channels and an increase in mobile gaming revenues.   Digital revenues are an important part of our business, and we continue to focus on and develop products, such as downloadable content, that can be delivered via digital online channels.  The amount of our digital revenues in any period may fluctuate depending, in part, on the timing and nature of our specific product releases.  Our sales of digital downloadable content are driven in part by sales of, and engagement by players in, our retail products.  As such, lower revenues in our retail distribution channels in the current year may impact our digital online channels revenues in the subsequent year.

 

For the three months ended March 31, 2015, revenues through digital online channels increased by $202 million, as compared to the same period in 2014, and represented 45% of our total consolidated net revenues, as compared to 34% for the same period in 2014. On a non-GAAP basis (which excludes the impact of deferred revenues), revenues through digital online channels for the three months ended March 31, 2015 increased by $11 million, as compared to the same period in 2014, and represented 76% of our total non-GAAP net revenues, as compared to 68% for the same period in 2014.

 

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Conditions in the Retail Distribution Channels

 

Conditions in the retail distribution channels of the interactive entertainment industry continued to be challenging during the first three months of 2015.  In North America and Europe, retail sales of video games declined by 3%, as compared to the same period in 2014, according to The NPD Group and GfK Chart-Track.  The continued shift of video game purchases to digital distribution channels has impacted the ongoing decline in retail console software sales.

 

Further, while the new console cycle has started strongly and demand for next-generation games was higher than expected, the demand for prior-generation games declined at a faster pace than the growth of sales for next-generation titles, resulting in the overall decline in sales in the retail distribution channels. According to The NPD Group and GfK Chart-Track, retail sales from prior-generation platform games declined by 51% for the three months ended March 31, 2015, as compared to the same period in 2014. However, the increase in digitally distributed games, including full-game downloads, add-on content, and free-to-play games, has partially offset the negative trends in the retail distribution channels.

 

Please refer to the reconciliation between GAAP and non-GAAP financial measures later in this document for further discussions of digital and retail online channels.

 

The Business Combination and Share Repurchase

 

Activision Blizzard is the result of the 2008 business combination (“Business Combination”) by and among the Company (then known as Activision, Inc.), Sego Merger Corporation, a wholly-owned subsidiary of Activision, Inc., Vivendi S.A. (“Vivendi”), VGAC LLC, a wholly-owned subsidiary of Vivendi, and Vivendi Games, Inc. (“Vivendi Games”), a wholly-owned subsidiary of VGAC LLC.  As a result of the consummation of the Business Combination, Activision, Inc. was renamed Activision Blizzard, Inc. and Vivendi became a majority shareholder of Activision.

 

On October 11, 2013, we repurchased approximately 429 million shares of our common stock, pursuant to a stock purchase agreement (the “Stock Purchase Agreement”) we entered into with Vivendi and ASAC II LP (“ASAC”), an exempted limited partnership established under the laws of the Cayman Islands, acting by its general partner, ASAC II LLC (together with ASAC, the “ASAC Entities”). Pursuant to the terms of the Stock Purchase Agreement, we acquired all of the capital stock of Amber Holding Subsidiary Co., a Delaware corporation and wholly-owned subsidiary of Vivendi (“New VH”), which was the direct owner of approximately 429 million shares of our common stock, for a cash payment of $5.83 billion, or $13.60 per share, before taking into account the benefit to the Company of certain tax attributes of New VH assumed in the transaction (collectively, the “Purchase Transaction”). Immediately following the completion of the Purchase Transaction, ASAC purchased from Vivendi 172 million shares of our common stock, pursuant to the Stock Purchase Agreement, for a cash payment of $2.34 billion, or $13.60 per share (the “Private Sale”). Robert A. Kotick, our Chief Executive Officer, and Brian G. Kelly, Chairman of our Board of Directors, are affiliates of ASAC II LLC. Refer to Note 6 of the Notes to Condensed Consolidated Financial Statements for further information regarding the financing of the Purchase Transaction.

 

On May 28, 2014, Vivendi sold approximately 41 million shares, or approximately 50% of its then-current holdings, of our common stock in a registered public offering.  Vivendi received proceeds of approximately $850 million from that sale; we did not receive any proceeds.

 

As of March 31, 2015, we had approximately 726 million shares of common stock issued and outstanding.  At that date: (i) Vivendi held 41 million shares, or approximately 6% of the outstanding shares of our common stock; (ii) ASAC held 172 million shares, or approximately 24% of the outstanding shares of our common stock; and (iii) our other stockholders held approximately 70% of the outstanding shares of our common stock. The common stock of Activision Blizzard is traded on The NASDAQ Stock Market under the ticker symbol “ATVI.”

 

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Consolidated Statements of Operations Data

 

The following table sets forth consolidated statements of operations data for the periods indicated in dollars and as a percentage of total net revenues (amounts in millions):

 

 

 

Three months ended March 31,

 

 

 

2015

 

2014

 

 

 

 

 

 

 

 

 

 

 

Net revenues:

 

 

 

 

 

 

 

 

 

Product sales

 

$

784

 

61

%

$

769

 

69

%

Subscription, licensing, and other revenues

 

494

 

39

 

342

 

31

 

Total net revenues

 

1,278

 

100

 

1,111

 

100

 

 

 

 

 

 

 

 

 

 

 

Costs and expenses:

 

 

 

 

 

 

 

 

 

Cost of sales — product costs

 

209

 

16

 

225

 

20

 

Cost of sales — online

 

53

 

4

 

58

 

5

 

Cost of sales — software royalties and amortization

 

148

 

12

 

57

 

5

 

Cost of sales — intellectual property licenses

 

3

 

 

2

 

 

Product development

 

145

 

11

 

143

 

13

 

Sales and marketing

 

92

 

7

 

104

 

9

 

General and administrative

 

86

 

7

 

95

 

9

 

Total costs and expenses

 

736

 

57

 

684

 

61

 

 

 

 

 

 

 

 

 

 

 

Operating income

 

542

 

43

 

427

 

39

 

 

 

 

 

 

 

 

 

 

 

Interest and other expense, net

 

50

 

4

 

51

 

5

 

 

 

 

 

 

 

 

 

 

 

Income before income tax expense

 

492

 

39

 

376

 

34

 

 

 

 

 

 

 

 

 

 

 

Income tax expense