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Activision Blizzard Inc. (ATVI - Snapshot Report) reported dismal second-quarter 2013 non-GAAP earnings of 8 cents, which declined from 20 cents reported in the year-ago quarter. Including stock-based compensation of a penny, earnings came in at 6 cents per share, which were in line with the Zacks Consensus Estimate.

Revenues 

Although, revenues on a non-GAAP basis plummeted 42.5% from the year-ago quarter to $608.0 million, it marginally beat the Zacks Consensus Estimate of $606.0 million. Reported revenues were also ahead of management’s guidance of $590 million.

Tough year-over-year comparable sales, primarily driven by robust sales of Diablo III in the year-ago period, were the reason for the company’s lackluster performance.

However, the better-than-expected revenue performance was primarily attributed to solid sales from the Call of Duty, Skylanders and World of Warcraft franchises.

World of Warcraft continued to lose subscribers. During the quarter, the game lost approximately 0.6 million subscribers. World of Warcraft had 7.7 million subscribers at the end of the second quarter.

Segment wise, revenues from Activision Publishing were down 7.0% from the year-ago quarter to $347.0 million. Despite the year-over-year declines, the company recorded robust sales from Skylanders Giants and Call of Duty: Black Ops II.

Blizzard Entertainment and its subsidiaries’ revenues slumped 64.7% from the prior-year quarter to $224.0 million primarily due to tough year-over-year comparisons (Diablo III). Revenues from Activision’s Distribution segment were also down 21.3% from the year-ago quarter to $37.0 million.

Activision reported retail sales of $188.0 million (down 63.1% year over year) and digital online revenues of $383.0, which comprised 63.0% of the non-GAAP revenues (down 22.9% year over year).

On a geographical basis, revenues from North America, Europe and Asia-Pacific declined 35.0%, 39.0% and 70.0%, respectively, year over year.

Operating Results

Total costs and expenses on a non-GAAP basis (excluding stock-based compensation and amortization and net effect of deferrals) decreased 35.1% year over year to $489.0 million, primarily due to prudent product mix and timing of the expenses. However, operating expenses, as a percentage of revenues, increased from 71.5% to 80.4% during the same period of time.

Including stock-based compensation, total costs and expenses came in at $513.0 million, down 34.6% year over year.

Lower revenues and percentage increase of total costs led to a year-over-year decrease in the operating income. For the quarter, non-GAAP operating income (excluding stock-based compensation and amortization and net effect of deferrals) slumped 60.3% to $119.0 million from the year-ago quarter while operating margin contracted from 28.5% to 19.6% during the same period.

Including stock-based compensation, operating income came in at $95.0 million while operating margin was 15.6%.

Net income on a non-GAAP basis (excluding stock-based compensation and amortization and net effect of deferrals) was $90.0 million in the quarter compared with $203.0 million in the year-ago quarter. Including stock-based compensation, net income stood at $75.0 million.

Balance Sheet

Activision exited the second quarter with $4.55 billion in cash and short-term investments versus $4.62 billion in the previous quarter. The company did not have any long-term debt in its balance sheet. Activision Blizzard is expected to pay $5.83 billion to purchase its 429 million shares from Vivendi.

Outlook

For the third quarter of 2013 (without the effect to proposed transactions with Vivendi), Activision expects non-GAAP earnings of 3 cents per share and revenues of $585.0 million. The company expects product costs of 25.0% and operating expenses of 66.0%.

The company expects to launch Diablo III’s PS3 and Xbox 360 version in Sep 2013. The company also announced a new free-to-play game, Hearthstone, for Microsoft’s (MSFT - Analyst Report) Windows and Apple’s (AAPL - Analyst Report) Mac and iPad.

The company also provided outlook for the fourth quarter (without the effect to proposed transactions with Vivendi). Activision expects earnings per share of 54 cents with revenues of $2.25 billion.

Activision Blizzard reiterated its fiscal 2013 earnings outlook (without the effect to proposed transactions with Vivendi) of 82 cents and revenues of $4.25 billion. The company expects product costs of 26% and operating expenses of 44%.

Including the proposed transaction with Vivendi, Activision expects fourth-quarter non-GAAP earnings per share in the range of 76 cents to 79 cents and fiscal 2013 earnings per share in the range of 85 cents to 87 cents.

Recommendation

We believe that Activision’s product portfolio will boost top-line growth over the long term. The company’s partnership with Tencent is expected to help it to gain traction in China. Moreover, Activision’s solid performances from its Call of Duty, Skylanders and World of Warcraft franchises are expected to boost the near-term results. Going forward, the higher mix of digital revenues is expected to help margins as well.

However, continued softness in the video game industry, limited presence in the mobile gaming segment, higher adoption of free-to-play games and significant competition from Electronic Arts (EA - Analyst Report) could act as the headwinds going forward.

Currently, Activision Blizzard has a Zacks Rank #1 (Strong Buy).

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