Tuesday, May 10, 2016

Review of Activision-Blizzard's First Quarter Form 10-Q

So for those of you that aren't dedicated public reporting and accounting geeks and were wondering about my title, a Form 10-Q is the quarterly document that public companies registered in the U.S. file with the Securities and Exchange Commission.  The document itself contains some of the same information that companies typically include in the press releases but can often have other valuable information worth reviewing.  For large public companies, the document is due 40 days after the end of the quarter (so for a calendar year-end company, that would be today for Q1)

The first section of the document is the financial statements and footnotes themselves.  The second section is called "Management's Discussion and Analysis of Financial Condition and Results of Operations", which you'll sometimes see referred to as MD&A.  This is where the company explains all the things that caused changes in their financial results for the quarter.  There's also a portion of this section that is dedicated to discussions of liquidity - how much cash the company has, how much debt and what the terms of that debt is and how they plan to manage all of that.

The final few sections are more specific and technical and may include information on significant legal cases as well as a discussion of any changes or issues with the company's internal controls.

So that's the background.  There are a couple of places you can usually find this document.  Most companies will have a copy of it on the Investor Relations section of their website (usually under SEC Filings).  You can also get it directly off the SEC's website at www.sec.gov, and click the button on the top right that says "Company Filings".

So, couple of things from the Activision-Blizzard (ATVI) 10-Q that I wanted to go through today:  Segment Reporting, the Candy Crush Transaction, Monthly Active User disclosures and nuggets from MD&A.

Segment Reporting

The way the accounting disclosure rules work, a company determines their segments based on the way they provide information to top management for decision making and based on how they think about resource allocation.  Traditionally, ATVI has disclosed two segments - Activision and Blizzard.  Typically, when you do a major acquisition like the King deal, it gives you the chance to reevaluate whether that continues to be how you'd like to look at things.  In this case, it looks like the company decided to continue with business as usual, but of course with adding King as a third segment.  They also report a fourth category of "Other" which are things that aren't yet large enough to merit reporting as a separate segment.  Those include things like eSports, the studio and their distribution business.

The Candy Crush Transaction

So when you acquire a company like King, you're required to record all of the assets and liabilities of that company at their current fair value, including intangible assets that might not have been on the books of that company when you acquired it.  Then, to the extent that the amount that you paid is more than the value of those net assets, the difference gets recorded as goodwill.  Because technology companies and gaming companies don't typically have a lot of hard identifiable assets, this goodwill number can end up being quite large.

So the purchase price for King was approximately $5.8 billion.  And here is how they allocated that:

So you see a few interesting things here under intangible assets - a value for King's internally-developed franchises at $845 million, a separate value for the software itself at $580 million and then a value for their existing customer base at $609 million.  These things will all be amortized to expense over the periods in the right hand column, reducing King's profitability for those periods.

They also added $2.7 billion of goodwill related to King bringing the total goodwill on the books of ATVI as a whole to $9.8 billion.

Monthly Active User Disclosures

So in their MD&A, we got a little bit more detail on their monthly active users by segment than what they had put in the earnings call information.  Below is their disclosure by quarter, for the past year.

So looking at the Blizzard line, there is a pretty significant spike in Q2 of 2015, which likely relates to the Hearthstone expansion and the full release of Heroes of the Storm during that period.

The decline in MAU's for King is also pretty interesting.

MD&A Nuggets

So reading through their MD&A, you see some pretty interesting detail.  For the quarter, they disclose that revenue for Blizzard as a whole was down because of declines in Warcraft, related to lower subscriber numbers, and also because of declines in Heroes of the Storm, because the comparable period in 2015 contained a one-time revenue boost from the sales of Founders' Packs.  However, this was offset by increases in revenue for Hearthstone, which was released on iPhone and Android smartphones beginning in Q2 of 2015.

Finally, they disclose for Blizzard that their profitability as a whole as impacted by the same factors, and also by increased sales and marketing costs being incurred to support future releases.

The other comment that I found interesting in MD&A was under Product Development expense where they disclosed that development costs actually decreased for Blizzard because of the timing of cost capitalizations.***

One additional item that I wanted to highlight from the 10-Q is from the cash flow statement, where they showed operating cash flow of $309 million, up from $209 million for the same quarter in the prior year, so they are continuing to show strong cash flow generation.

Last item that was a little bit interesting was in Part II, Item 1 of the 10-Q which is the section related to legal proceedings where they disclose that there is a class action lawsuit out there against King arising from their IPO.   They include the fairly standard language around believing the claims are without merit and intending to defend it vigorously, but it may merit monitoring in case they end up incurring lots of costs from a defense standpoint.


***  I was asked a follow up question on Twitter about what this means exactly.  Unfortunately, it's probably too detailed to fit into a 140 character response, so I'm updating it here instead.  The accounting policy note in their 10-K explains their accounting for software development costs as follows:

 Software development costs include payments made to independent software developers under development agreements, as well as direct costs incurred for internally developed products. Software development costs are capitalized once technological feasibility of a product is established and such costs are determined to be recoverable. Technological feasibility of a product encompasses both technical design documentation and game design documentation, or the completed and tested product design and working model. Significant management judgments and estimates are utilized in the assessment of when technological feasibility is established. For products where proven technology exists, this may occur early in the development cycle. Technological feasibility is evaluated on a product-by-product basis. 

So prior to establishing "technological feasibility", the costs related to that particular game or piece of software are expensed under Product Development expense.  So what that means in general is the timing of a game getting to the point that they can call in technologically feasible so they can start capitalizing costs instead of expensing them can have a significant impact on the expense recognized for the period in this particular category.  What that would seem to imply is that something just hit that technological feasibility threshold recently, so costs are now being capitalized instead of expensed (or possibly they had a few things that were just short of that point last year).

1 comment:

  1. Good post, I love it when you do these economic analyses. Makes it more digestible for those of us too lazy/dense to read the fine print for ourselves. I find myself searching out your blog after every ATVI quarterly report. Thanks!


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