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ACTIVISION BLIZZARD, INC. - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) Business Overview The Company's Formation and Business Combination Activision, Inc. was originally incorporated in California in 1979 and was reincorporated in Delaware in December 1992. On July 9, 2008, a business combination (the "Business Combination") by and among 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, was consummated. As a result of the consummation of the Business Combination, Activision, Inc. was renamed Activision Blizzard, Inc. Activision Blizzard is a public company traded on the NASDAQ under the ticker symbol "ATVI." Activision Blizzard, Inc. is a worldwide online, personal computer ("PC"), video game console, tablet, handheld, and mobile game publisher. The terms "Activision Blizzard," the "Company," "we," "us," and "our" are used to refer collectively to Activision Blizzard, Inc. and its subsidiaries. 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 international developer and publisher of interactive software products and content. Activision develops games based on both internally-developed and licensed intellectual property. Activision markets and sells games we develop and, through our affiliate label program, games developed by certain third-party publishers. We sell games both through retail channels and by digital download. Activision currently offers games that operate on the Sony Computer Entertainment, Inc. ("Sony") PlayStation 3 ("PS3"), Nintendo Co. Ltd. ("Nintendo") Wii ("Wii") and Nintendo Wii U ("Wii U"), and Microsoft Corporation ("Microsoft") Xbox 360 ("Xbox 360") console systems; the Nintendo Dual Screen ("DS") and Nintendo 3DS ("3DS") handheld game systems; the PC; and other handheld and mobile devices. Blizzard Entertainment, Inc. Blizzard Entertainment, Inc. ("Blizzard") is a leader in the subscription-based massively multi-player online role-playing game ("MMORPG") 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 PC-based computer games, including games in the multiple-award winning Diablo® and StarCraft® 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 (which consist of fees from individuals playing World of Warcraft®, sales of prepaid subscription cards, and revenue from value-added services such as realm transfers, faction changes and other character customizations within the World of Warcraft gameplay); retail sales of physical "boxed" products; online download sales of PC products; and licensing of software to third-party or related party companies that distribute World of Warcraft, Diablo® III and StarCraft® II products. 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. 41-------------------------------------------------------------------------------- Table of Contents Business Results and Highlights In 2012, Activision Blizzard's consolidated net revenues were $4.9 billion and consolidated net income was $1.1 billion, resulting in diluted earnings per common share of $1.01. The Company grew net revenues, operating income, and earnings per share as compared to 2011. We also generated $1.3 billion in cash from operating activities in 2012. Also, according to The NPD Group with respect to North America, GfK Chart-Track with respect to Europe, and Activision Blizzard internal estimates, during 2012: º • º In North America and Europe combined, including toys and accessories, Activision Publishing was the #1 console and handheld publisher for the calendar year with the #1 and #3 best-selling franchises-Call of Duty® and Skylanders. º • º Activision Blizzard reported record digital revenues for the calendar year and was the #1 third-party interactive entertainment Western digital publisher. º • º For the calendar year, in aggregate across all platforms in the U.S. and Europe, Activision Publishing's Call of Duty: Black Ops II was the #1 best-selling title in dollars and Call of Duty: Modern Warfare® 3 was the #9 best-selling title in dollars. º • º In both North America and Europe, including toys and accessories, Skylanders Giants™ was the #1 best-selling kids' title in dollars for the fourth quarter. Additionally, for the calendar year, in North America and Europe combined, including toys and accessories, Skylanders Giants was the #5 best-selling game in dollars, and Skylanders Spyro's Adventure® was the #4 best-selling game in dollars. º • º For the calendar year, Blizzard Entertainment had two top-10 PC games in North America and Europe. Diablo III was the #1 best-selling PC game at retail, breaking PC-game sales records with more than 12 million copies sold worldwide through December 31, 2012, and World of Warcraft: Mists of Pandaria® was the #3 best-selling PC game at retail. Product Release Highlights The following games and content packs, among other titles, were released during the year ended December 31, 2012: • • 007™ Legends Family Guy: Back to the Multiverse • • Angry Birds™ Trilogy Ice Age™ Continental Drift Arctic Games • • Battleship® Men In Black: Alien Crisis™ • • Cabela's® Dangerous Hunts 2013 Prototype® 2 • • Cabela's Hunting Expeditions Skylanders Giants • • Call of Duty: Black Ops II The Amazing Spider-Man™ • • Call of Duty Modern Warfare 3 Transformers™: Fall of Cybertron™ Content Collection #1 • • Call of Duty: Modern Warfare 3 Transformers Prime™ Content Collection #2 • • Call of Duty: Modern Warfare 3 Wipeout 3 Content Collection #3 • • Call of Duty: Modern Warfare 3 World of Warcraft: Mists of Pandaria Content Collection #4 • Diablo III On January 29, 2013, Activision released Revolution, the first downloadable map pack for Call of Duty: Black Ops II, ("Revolution") on the Xbox 360. Revolution is expected to be available on other platforms during the first quarter of 2013. 42-------------------------------------------------------------------------------- Table of Contents StarCraft II: Heart of the Swarm™, the first expansion to Blizzard's real-time strategy game StarCraft II: Wings of Liberty®, is expected to be available in stores and online beginning March 12, 2013. International Operations International sales are a fundamental part of our business. Net revenues from international sales accounted for approximately 50%, 50%, and 46% of our total consolidated net revenues for the years ended December 31, 2012, 2011 and 2010, respectively. 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. An important element of our international strategy is to develop content that is specifically directed toward local cultures and customs. Our international business is subject to risks typical of an international business, including, but not limited to, foreign currency exchange rate volatility and changes in local economies. Accordingly, our future results could be materially and adversely affected by changes in foreign currency exchange rates and changes in local economies. Management's Overview of Business Trends Online Content and Digital Downloads We provide our products through both retail channels and digital online delivery methods. Many of our video games that are available through retailers as physical "boxed" software products, such as DVDs, are also available by direct digital download over the Internet (both from websites that we own and from others owned by third parties). In addition, we offer players 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 for World of Warcraft, which are digitally delivered and hosted by Blizzard's proprietary online-game related service, Battle.net. In 2011, Activision launched Call of Duty Elite, a digital service that provides both free and paid subscription-based content and features for Call of Duty: Modern Warfare 3. In conjunction with the release of Call of Duty: Black Ops II, all of the Call of Duty Elite service features for that game were made available for free. This free service does not include downloadable map packs, which are sold separately, either a la carte as individual map packs or as part of a discounted season pass bundle. Existing Call of Duty Elite premium members will continue to enjoy the Call of Duty Elite premium membership features for Call of Duty: Modern Warfare 3 through the end of their subscription period. Digital revenues remain an important part of our business, and we continue to focus on and develop products 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. We currently define digital online channel-related sales as revenues from subscriptions and memberships, licensing royalties, value-added services, downloadable content, and digitally distributed products. This definition may differ from that used by our competitors or other companies. For the year ended December 31, 2012, our sales through the digital online channels decreased by approximately $100 million, as compared to 2011, and our net revenues from digital online channels represented 32% of our total consolidated net revenues in 2012 as compared to 34% in 2011. These decreases were mainly attributable to the deferral of revenues due to the timing of the releases of Diablo III and World of Warcraft: Mists of Pandaria. On a non-GAAP basis, our sales through the digital online channels increased by $40 million, as compared to 2011, and our net revenues from digital online channels represented 32% of our total consolidated net revenues in 2012 as compared to 35% in 2011. This increase in sales from the digital online channels was primarily due to the releases of Diablo III and World of Warcraft: Mists of Pandaria. 43-------------------------------------------------------------------------------- Table of Contents Please refer to the reconciliation between GAAP and non-GAAP financial measures later in this document for further discussions of retail and digital online channels. Current Generation of Game Consoles The current generation of game consoles began with Microsoft's launch of the Xbox 360 in November 2005, and continued in 2006 when Sony and Nintendo launched the PS3 and the Wii, respectively. The installed base of current generation hardware (i.e. Xbox 360, PS3 and Wii) in the U.S. and Europe was approximately 183 million units as of December 31, 2012, as compared to 166 million units at December 31, 2011, according to The NPD Group, with respect to North America, and GfK Chart-Track, with respect to Europe, representing an increase of 11% in units year-over-year. The installed base of PS3 and Xbox 360 hardware units increased 15% year-over-year, while the installed base of Wii hardware units increased 5% year-over-year. During the 2012 year-end holiday season, Nintendo released a new "next-generation" high-definition version console, the Wii U. On February 20, 2013, Sony announced that it intends to launch PlayStation 4, its next-generation computer entertainment system, by the 2013 year-end holiday buying season. We continually monitor console hardware sales, as well as the development of "next-generation" consoles. We manage our product delivery on each current and future platform 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. Conditions in the Retail Distribution Channels Conditions in the retail channels of the interactive entertainment industry remained challenging through 2012. In North America and Europe, retail sales within the industry experienced a combined overall decrease of approximately 21% in 2012, as compared to 2011, according to The NPD Group and GfK Chart-Track. The declines in the North America and European retail channels were impacted by fewer releases and catalog sales in 2012 as compared to 2011, as well as price declines over the prior year. In addition, the decline in sales to the retail channels continue to be more pronounced for casual titles on the Nintendo Wii and handheld platforms (down over 35% year-over-year), than titles on high-definition platforms (i.e., Xbox 360 and PS3). Despite the 21% decrease in retail sales for the overall industry, according to The NPD Group, GfK Chart-Track and the Company's internal estimates, the sales of the industry's top five titles (including accessory packs and figures) grew 1% in 2012, as compared to 2011. This has resulted in the further concentration of revenues in the top titles, particularly for high-definition platforms, which experienced year-over-year growth, while non-premier titles experienced declines. The Company's results have been less impacted by the general declining trends in retail compared to our competitors because of our greater focus on premier top titles and a more focused overall slate of titles. Concentration of Top Titles The concentration of retail revenues among key core titles has continued as a trend in the overall interactive software industry. According to The NPD Group, the top 10 titles accounted for 30% of the sales in the U.S. video game industry in 2012 as compared to 26% in 2011. Similarly, a significant portion of our revenues has historically been derived from video games based on a few popular franchises and these video games are responsible for a disproportionately high percentage of our profits. For example, our four largest franchises in 2012-Call of Duty, Diablo, Skylanders and World of Warcraft-accounted for approximately 83% of our net revenues, and a significantly higher percentage of our operating income, for the year. We expect that a limited number of popular franchises will continue to produce a disproportionately high percentage of the industry and our revenues and profits. 44 -------------------------------------------------------------------------------- Table of Contents Seasonality The interactive entertainment industry is highly seasonal. We have historically experienced our highest sales volume in the year-end holiday buying season, which occurs in the fourth quarter. We defer the recognition of a significant amount of net revenue related to our software titles containing online functionality that constitutes a more-than-inconsequential separate service deliverable over an extended period of time (i.e., typically five months to less than a year). As a result, the quarter in which we generate the highest sales volume may be different than the quarter in which we recognize the highest amount of net revenue. Our results can also vary based on a number of factors including, but not limited to, title release date, consumer demand, market conditions and shipment schedule. Outlook Looking forward, the above discussed factors, such as the ongoing console transition, increasing concentration of top titles in the interactive entertainment industry, and a continuingly challenged global economy, might negatively impact our short-term results. In addition, 2013 compared to 2012 will be a difficult year-over-year comparison due to the highly successful launch of Diablo III in May 2012. We will continue to invest in our established franchises, as well as new titles we think have the potential to drive our growth over the long-term. 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): For the Years Ended December 31, 2012 2011 2010 Net revenues: Product sales $ 3,620 75 % $ 3,257 68 % $ 3,087 69 % Subscription, licensing, and other revenues 1,236 25 1,498 32 1,360 31 Total net revenues 4,856 100 4,755 100 4,447 100 Costs and expenses: Cost of sales-product costs 1,116 23 1,134 24 1,350 31 Cost of sales-online subscriptions 263 5 255 5 250 5 Cost of sales-software royalties and amortization 194 4 218 5 338 8 Cost of sales-intellectual property licenses 89 2 165 3 197 4 Product development 604 12 629 14 626 14 Sales and marketing 578 12 545 11 516 12 General and administrative 561 12 456 10 375 8 Impairment of intangible assets - - - - 326 7 Restructuring - - 25 - - - Total costs and expenses 3,405 70 3,427 72 3,978 89 Operating income 1,451 30 1,328 28 469 11 Investment and other income (expense), net 7 - 3 - 23 1 Income before income tax expense 1,458 30 1,331 28 492 12 Income tax expense 309 6 246 5 74 2 Net income $ 1,149 24 % $ 1,085 23 % $ 418 10 % 45 -------------------------------------------------------------------------------- Table of Contents Operating Segment Results 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. We do not aggregate operating segments. The CODM reviews segment performance exclusive of the impact of the change in deferred net revenues and related cost of sales with respect to certain of our online-enabled games, stock-based compensation expense, restructuring expense, amortization of intangible assets, and impairment of intangible assets and goodwill. 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 segment net revenues and total segment operating income to consolidated net revenues and income before income tax expense from external customers and consolidated income before income tax expense for the years ended December 31, 2012, 2011, and 2010 are presented in the table below (amounts in millions): For the Years Ended December 31, Increase/ Increase/ (decrease) (decrease) 2012 2011 2010 2012 v 2011 2011 v 2010 Segment net revenues: Activision $ 3,072 $ 2,828 $ 2,769 $ 244 $ 59 Blizzard 1,609 1,243 1,656 366 (413 ) Distribution 306 418 378 (112 ) 40 Operating segment net revenue total 4,987 4,489 4,803 498 (314 ) Reconciliation to consolidated net revenues: Net effect from changes in the deferral of net revenues (131 ) 266 (356 ) (397 ) 622 Consolidated net revenues $ 4,856 $ 4,755 $ 4,447 $ 101 $ 308 Segment income from operations: Activision $ 970 $ 851 $ 511 $ 119 $ 340 Blizzard 717 496 850 221 (354 ) Distribution 11 11 10 - 1 Operating segment income from operations total 1,698 1,358 1,371 340 (13 ) Reconciliation to consolidated operating income and consolidated income before income tax expense: Net effect from changes in the deferral of net revenues and related cost of sales (91 ) 183 (319 ) (274 ) 502 Stock-based compensation expense (126 ) (103 ) (131 ) (23 ) 28 Restructuring - (26 ) (3 ) 26 (23 ) Amortization of intangible assets (30 ) (72 ) (123 ) 42 51 Impairment of goodwill/intangible assets - (12 ) (326 ) 12 314 Consolidated operating income 1,451 1,328 469 123 859 Investment and other income (expense), net 7 3 23 4 (20 ) Consolidated income before income tax expense $ 1,458 $ 1,331 $ 492 $ 127 $ 839 46 -------------------------------------------------------------------------------- Table of Contents For better understanding of the differences in presentation between our segment results and the consolidated results, the following explains the nature of each reconciling item. Net Effect from Deferral of Net Revenues and Related Cost of Sales We have determined that some of our game's online functionality represents an essential component of gameplay and as a result a more-than-inconsequential separate deliverable. As such, we are required to recognize the revenues of these game titles over the estimated service periods, which may range from a minimum of five months to a maximum of less than a year. The related cost of sales is deferred and recognized as the related revenues are recognized. In the table on the previous page, we present the amount of net revenues and related cost of sales separately for each period as a result of this accounting treatment. Stock-Based Compensation Expense We expense our stock-based awards using the grant date fair value over the vesting periods of the stock awards. In the case of liability awards, the liability is subject to revaluation based on the stock price at the end of the relevant period. Included within stock-based compensation are the net effects of capitalization, deferral, and amortization. Restructuring On February 3, 2011, the Company's Board of Directors authorized a restructuring plan (the "2011 Restructuring") involving a focus on the development and publication of a reduced slate of titles on a going-forward basis. The 2011 Restructuring included the discontinuation of the development of music-based games, the closure of the related business unit and the cancellation of other titles then in production, along with a related reduction in studio headcount and corporate overhead. The costs related to the 2011 Restructuring activities included severance costs, facility exit costs, and exit costs from the cancellation of projects. The 2011 Restructuring charges for the year ended December 31, 2011 were $25 million, which is reflected in a separate caption "Restructuring expenses" on our consolidated statement of operations. The 2011 Restructuring was completed as of December 31, 2011 and we do not expect to incur significant additional restructuring expenses relating thereto. In 2008, we implemented an organizational restructuring plan as a result of the Business Combination. This organizational restructuring was to integrate different operations and to streamline the combined Activision Blizzard organization. The costs related to the restructuring activities included severance costs, facility exit costs, write-offs of assets and liabilities and exit costs from the cancellation of projects. For the year ended December 31, 2011, expense related to the organizational restructuring was $1 million and has been reflected in the "General and administrative expense" in the consolidated statement of operations. The organizational restructuring activities as a result of the Business Combination were completed as of December 31, 2011 and we do not expect to incur additional restructuring expenses relating thereto. Amortization of Intangible Assets All of our intangible assets are the result of the Business Combination and other acquisitions. We amortize the intangible assets over their estimated useful lives based on the pattern of consumption of the underlying economic benefits. The amount presented in the table represents the effect of the amortization of intangible assets as well as other purchase price accounting adjustments, where applicable, in our consolidated statements of operations. 47-------------------------------------------------------------------------------- Table of Contents Impairment of Goodwill/Intangible Assets We recorded a non-cash charge of $12 million related to the impairment of goodwill of our Distribution reporting unit for the year ended December 31, 2011, reflecting a continuing shift in the distribution of interactive entertainment software from retail distribution channels to digital distribution channels. Furthermore, we recorded a non-cash impairment charge on definite-lived intangible assets of $326 million for the year ended December 31, 2010, reflecting a continuing weaker environment for the casual game and music genres. Segment Net Revenues Activision Activision's net revenues increased for 2012 as compared to 2011, primarily due to revenues from the Skylanders franchise (both from the launch of Skylanders Giants in the fourth quarter of 2012 and the full-year revenues from Skylanders Spyro's Adventure, which was launched in the fourth quarter of 2011). The increase was partially offset by lower revenues from the Call of Duty franchise primarily from lower catalog sales and lower revenues from downloadable content packs for Call of Duty: Modern Warfare 3, though these decreases were partially mitigated by the strong performance from Call of Duty: Black Ops II which launched in the fourth quarter of 2012. For 2011, net revenues from the Activision segment increased as compared to 2010 primarily due to: the strong performance of Call of Duty: Modern Warfare 3 and the strong digital revenue performance from the franchise; revenues from Skylanders Spyro's Adventure which successfully launched as a new intellectual property in the fourth quarter of 2011; the release of Lego Star Wars III, which we published on behalf of Lucas Arts in Europe and certain countries in Asia Pacific; and benefits from foreign exchange as compared to the prior year. The increase was partially offset by a more focused release schedule in 2011 than in 2010, and lower catalog sales of games in the music and casual games genre. Blizzard Blizzard's net revenues increased for 2012 as compared to 2011, primarily due to the release of Diablo III in May 2012 and World of Warcraft: Mists of Pandaria in September 2012. The increase in net revenues was partially offset by lower subscription revenues from World of Warcraft due to a lower subscriber base. At December 31, 2012, the worldwide subscriber* base for World of Warcraft was approximately 9.6 million, down from a base of more than 10 million subscribers at September 30, 2012, and approximately 10.2 million subscribers at December 31, 2011, with the majority of the decline from the East (where the "East" includes China, Taiwan, and Korea, and the "West" includes North America, Europe and Latin America). With the launch of World of Warcraft: Cataclysm®, in the fourth quarter of 2010, the subscriber base reached a new peak at more than 12 million subscribers at December 31, 2010. Since that time, the subscriber base has trended downward. Looking forward, Blizzard Entertainment expects to continue to deliver new game content in all regions that is intended to further appeal to the gaming community. -------------------------------------------------------------------------------- º * º World of Warcraft subscribers include individuals who have paid a subscription fee or have an active prepaid card to play World of Warcraft, as well as those who have purchased the game and are within their free month of access. Internet Game Room players who have accessed the game over the last thirty days are also counted as subscribers. The above definition excludes all players under free promotional subscriptions, expired or cancelled subscriptions, and expired prepaid cards. Subscribers in licensees' territories are defined along the same rules. 48 -------------------------------------------------------------------------------- Table of Contents Blizzard's net revenues decreased for 2011 as compared to 2010 primarily as a result of no new titles released in 2011 as compared to 2010, when StarCraft II: Wings of Liberty was released in the third quarter and World of Warcraft: Cataclysm was released in the fourth quarter; and as a result of a decline in World of Warcraft's subscriber base during 2011. These decreases were partially offset by benefits from foreign exchange as compared to the prior year. Distribution Distribution's net revenues decreased in 2012 as compared to 2011, primarily due to a weaker U.K. market. Distribution's net revenues increased in 2011 as compared to 2010, primarily due to additional customer sales opportunities in the U.K. and benefits from foreign exchange as compared to prior year. Segment Income from Operations Activision Activision's operating income increased in 2012 as compared to 2011, primarily due to higher net revenues as described above, and lower sales and marketing costs. The increase was partially offset by higher cost of sales as a result of higher net revenues, higher product development costs, and higher general and administrative costs, primarily resulting from legal-related expenses (including legal-related accruals, settlements and fees) and additional accrued bonuses reflecting our strong 2012 financial performance. Activision's operating income increased in 2011 as compared to 2010, primarily due to a more focused release of products that delivered higher operating margins; increased digital sales of Call of Duty's digital content, resulting in high operating margins; and reduction of operating expenses resulting from the 2011 Restructuring. These positive impacts on operating income were partially offset by an increase in sales and marketing expenses to support the launch of Skylanders Spyro's Adventure, Call of Duty: Modern Warfare 3 and Call of Duty Elite and additional litigation activities and settlement of lawsuits. Blizzard Blizzard's operating income increased in 2012 as compared to 2011, primarily due to higher revenues as described above. The increase was partially offset by higher cost of sales as a result of higher net revenues, higher sales and marketing costs to support the launch of Diablo III and World of Warcraft: Mists of Pandaria, and higher general and administrative costs from additional accrued bonuses reflecting our strong 2012 financial performance. Blizzard's operating income decreased in 2011 as compared to 2010, primarily due to lower revenues as discussed above. These negative impacts on operating income were partially offset by a decrease in sales and marketing expenses, as higher sales and marketing expenses were incurred in 2010 to support the release of StarCraft II: Wings of Liberty in the third quarter and World of Warcraft: Cataclysm in the fourth quarter; and lower customer support costs incurred. Non-GAAP Financial Measures The analysis of revenues by distribution channel is presented both on a GAAP (including the impact from change in deferred revenues) and non-GAAP (excluding the impact from change in deferred revenues) basis. We use this non-GAAP measure internally when evaluating our operating performance, when planning, forecasting and analyzing future periods, and when assessing the performance of our management team. We believe this is appropriate because this non-GAAP measure enables an analysis of performance based on the timing of actual transactions with our customers, 49 -------------------------------------------------------------------------------- Table of Contents which is consistent with the way the Company is measured by investment analysts and industry data sources, and facilitates comparison of operating performance between periods. In addition, excluding the impact from change in deferred net revenue provides a much more timely indication of trends in our sales and other operating results. While we believe that this non-GAAP measure is useful in evaluating our business, this information should be considered as supplemental in nature and is not meant to be considered in isolation from, as a substitute for, or as more important than, the related financial information prepared in accordance with GAAP. In addition, this non-GAAP financial measure may not be the same as any non-GAAP measure presented by another company. This non-GAAP financial measure has limitations in that it does not reflect all of the items associated with our GAAP revenues. We compensate for the limitations resulting from the exclusion of the change in deferred revenues by considering the impact of that item separately and by considering our GAAP, as well as non-GAAP, revenues. Results of Operations-Years Ended December 31, 2012, 2011, and 2010 Non-GAAP Financial Measures The following table provides reconciliation between GAAP and non-GAAP net revenues by distribution channel for the years ended December 31, 2012, 2011, and 2010 (amounts in millions): For the Years Ended December 31, Increase/ Increase/ (decrease) (decrease) % Change % Change 2012 2011 2010 2012 v 2011 2011 v 2010 2012 v 2011 2011 v 2010 GAAP net revenues by distribution channel Retail channels $ 3,013 $ 2,697 $ 2,629 $ 316 $ 68 12 % 3 % Digital online channels(1) 1,537 1,640 1,440 (103 ) 200 (6 ) 14 Total Activision and Blizzard 4,550 4,337 4,069 213 268 5 7 Distribution 306 418 378 (112 ) 40 (27 ) 11 Total consolidated GAAP net revenues 4,856 4,755 4,447 101 308 2 7 Change in deferred net revenues(2) Retail channels 69 (185 ) 251 254 (436 ) (137 ) (174 ) Digital online channels(1) 62 (81 ) 105 143 (186 ) (177 ) (177 ) Total changes in deferred net revenues 131 (266 ) 356 397 (622 ) (149 ) (175 ) Non-GAAP net revenues by distribution channel Retail channels 3,082 2,512 2,880 570 (368 ) 23 (13 ) Digital online channels(1) 1,599 1,559 1,545 40 14 3 1 Total Activision and Blizzard 4,681 4,071 4,425 610 (354 ) 15 (8 ) Distribution 306 418 378 (112 ) 40 (27 ) 11 Totalnon-GAAP net revenues(3) $ 4,987 $ 4,489 $ 4,803 $ 498 $ (314 ) 11 % (7 )% -------------------------------------------------------------------------------- º (1) º We currently define revenues from digital online channels as revenues from subscriptions and memberships, licensing royalties, value-added services, downloadable content, and digitally distributed products. º (2) º We have determined that some of our game's online functionality represents an essential component of gameplay and as a result a more-than-inconsequential separate deliverable. As such, we are required to recognize the revenues of these game titles over the estimated service periods, which may range from a minimum of five months to a maximum of less than a year. In the table above, we present the amount of net revenues for each period as a result of this accounting treatment. º (3) º Total non-GAAP net revenues presented also represents our total operating segment net revenues. 50 -------------------------------------------------------------------------------- Table of Contents The increase in GAAP net revenues from retail channels for 2012 as compared to 2011 was the result of sales from the Skylanders franchise (both from the launch of Skylanders Giants in the fourth quarter of 2012 and the full-year revenues from Skylanders Spyro's Adventure, which was launched in the fourth quarter of 2011) and revenues from Diablo III and World of Warcraft: Mists of Pandaria. The increase was partially offset by lower catalog sales of Call of Duty and other titles, and lower catalog revenues generated from World of Warcraft: Cataclysm and Starcraft II: Wings of Liberty, which were released in 2010. The increase in GAAP net revenues from retail channels for 2011 as compared to 2010 was the result of the strong performance of the Call of Duty franchise, recognition of deferred revenues from the 2010 launches of StarCraft II: Wings of Liberty and World of Warcraft: Cataclysm, and revenues generated from the launch of Skylanders Spyro's Adventure, partially offset by the release of fewer key titles. The decrease in GAAP net revenues from digital online channels for 2012 as compared to 2011 was primarily due to lower revenues from World of Warcraft subscriptions and lower net revenues from Call of Duty downloadable content packs released in 2012 for Call of Duty: Modern Warfare 3, in comparison to downloadable content packs released in 2011 for Call of Duty®: Black Ops. The decrease was partially offset by the full game download sales of Diablo III and World of Warcraft: Mists of Pandaria, and revenues from Call of Duty Elite memberships. The increase in GAAP net revenues from digital online channels for 2011 as compared to 2010 was primarily due to the stronger performance and greater number of downloadable content packs for Call of Duty: Black Ops, which was released in 2011, as compared to the downloadable content packs for Call of Duty: Modern Warfare® 2 released in the prior year, and a higher number of full game downloads from the Call of Duty catalog titles. In addition, revenues generated from the World of Warcraft franchise, particularly from the digital release of World of Warcraft: Cataclysm in December 2010, as well as the digital release of StarCraft II: Wings of Liberty in July 2010, resulted in more deferred revenues recognized in 2011 as compared to 2010. The increase in non-GAAP net revenues from retail channels for 2012 as compared to 2011 was the result of sales from the Skylanders franchise (both from the launch of Skylanders Giants in the fourth quarter of 2012 and the full-year revenues from Skylanders Spyro's Adventure, which was launched in the fourth quarter of 2011), Diablo III and World of Warcraft: Mists of Pandaria. The increase was partially offset by lower catalog sales of Call of Duty titles as well as other titles, and lower catalog revenues generated from World of Warcraft: Cataclysm and Starcraft II: Wings of Liberty, which were released in 2010. The decrease in non-GAAP net revenues from retail channels for 2011 as compared to 2010 was the result of our more focused slate, with the release of fewer key titles, and lower revenues generated from the casual "value" titles. The decrease was partially offset by the strong performance of the Call of Duty franchise and revenues generated from Skylanders Spyro's Adventure. The increase in non-GAAP net revenues from digital online channels for 2012 as compared to 2011 was attributable to sales of full game digital downloads from the launches of World of Warcraft: Mists of Pandaria and Diablo III (which were launched in 2012) and memberships revenues from Call of Duty Elite (which was launched in late November 2011). The increase was partially offset by lower revenues from World of Warcraft subscriptions and lower net revenues from Call of Duty downloadable content packs. The increase in non-GAAP net revenues from digital online channels for 2011 as compared to 2010 was attributable to the stronger performance and greater number of downloadable content packs released in 2011 for Call of Duty: Black Ops, versus downloadable map packs released in the prior year for Call of Duty: Modern Warfare 2, and a higher number of full game downloads from the Call of Duty 51 -------------------------------------------------------------------------------- Table of Contents catalog titles. This increase was partially offset by the unfavorable impact of the decrease in World of Warcraft's subscriber base, the decrease of full game downloads of World of Warcraft: Cataclysm, which was released in December 2010, and StarCraft II: Wings of Liberty, which was released in July 2010. Consolidated Results Net Revenues by Geographic Region The following table details our consolidated net revenues by geographic region for the years ended December 31, 2012, 2011, and 2010 (amounts in millions): For the Years ended December 31, Increase/ Increase/ (decrease) (decrease) % Change % Change 2012 2011 2010 2012 v 2011 2011 v 2010 2012 v 2011 2011 v 2010 Geographic region net revenues: North America $ 2,436 $ 2,405 $ 2,409 $ 31 $ (4 ) 1 % - % Europe 1,968 1,990 1,743 (22 ) 247 (1 ) 14 Asia Pacific 452 360 295 92 65 26 22 Consolidated net revenues $ 4,856 $ 4,755 $ 4,447 $ 101 $ 308 2 7 The increase/(decrease) in deferred revenues recognized by geographic region for the years ended December 31, 2012, 2011, and 2010 was as follows (amounts in millions): For the Years Ended December 31, Increase/ Increase/ (Decrease) (Decrease) 2012 2011 2010 2012 v 2011 2011 v 2010 Deferred revenues recognized by geographic region: North America $ (78 ) $ 154 $ (166 ) $ (232 ) $ 320 Europe (28 ) 104 (159 ) (132 ) 263 Asia Pacific (25 ) 8 (31 ) (33 ) 39 Total impact on consolidated net revenues (131 ) 266 (356 ) (397 ) 622 Consolidated net revenues from North America and Asia Pacific increased in 2012 as compared to 2011, primarily due to sales from the Skylanders franchise (both from the launch of Skylanders Giants in the fourth quarter of 2012, and the full-year revenues from Skylanders Spyro's Adventure, which was launched in the fourth quarter of 2011), Diablo III and World of Warcraft: Mists of Pandaria. Sales of Diablo III accounted for the majority of the year-over-year increase in net revenues for the Asia Pacific region. The increase in consolidated net revenues from North America and Asia Pacific was partially offset by lower subscriptions revenues from World of Warcraft, lower catalog sales of Call of Duty titles as well as other titles, and lower catalog revenues generated from World of Warcraft: Cataclysm and Starcraft II: Wings of Liberty, which were released in 2010. Consolidated net revenues from Europe decreased slightly in 2012 as compared to 2011, primarily due to lower subscriptions revenues from World of Warcraft, lower catalog sales of Call of Duty titles as well as other titles, and lower catalog revenues generated from World of Warcraft: Cataclysm and from Starcraft II: Wings of Liberty, which were released in 2010, and lower revenues from our Distribution segment. The decrease was partially offset by sales from the Skylanders franchise (both from the launch of Skylanders Giants in the fourth quarter of 2012 and the full-year revenues from Skylanders Spyro's Adventure, which was launched in the fourth quarter of 2011), Diablo III and World of Warcraft: Mists of Pandaria. 52-------------------------------------------------------------------------------- Table of Contents Further, in Europe and certain countries in Asia Pacific, net revenues were also negatively impacted due to the fact that we published titles for Lucas Arts in 2011, such as Lego Star Wars III, while no comparable title was published in 2012. The decrease in deferred revenues recognized in all regions for the year ended December 31, 2012 as compared to 2011 was primarily attributable to lower World of Warcraft subscription revenues, lower sales of Call of Duty digital downloadable content packs and catalogs titles, and lower catalog sales of World of Warcraft: Cataclysm and Starcraft II: Wings of Liberty, as well as an increase in revenues deferred due to the launch of both Diablo III and World of Warcraft: Mists of Pandaria. The decrease was partially offset by the recognition of the deferred revenues from Call of Duty: Modern Warfare 3. Consolidated net revenues from Europe and Asia Pacific increased in 2011 as compared to 2010, primarily due to the success of Call of Duty catalog titles, stronger performance of downloadable content packs for Call of Duty: Black Ops and the release of World of Warcraft: Cataclysm and StarCraft II: Wings of Liberty in 2010, all of which resulted in increased revenues recognized in 2011 as compared to 2010. Further, the launch of Skylanders Spyro's Adventure and the increase in Distribution segment revenues in Europe contributed to the increase in consolidated net revenues. These increases were partially offset by the additional deferral of revenues as a result of greater sales from the launch of Call of Duty: Modern Warfare 3 in November 2011. Consolidated net revenues from North America decreased slightly in 2011 as compared to 2010, primarily due to the decrease in net revenues from music and casual titles and the greater sales from the launch of Call of Duty: Modern Warfare 3 which resulted in additional deferral of revenues. These decreases were almost entirely offset by the success of Call of Duty catalog titles, stronger performance of downloadable content packs for Call of Duty: Black Ops, the releases of World of Warcraft: Cataclysm and StarCraft II: Wings of Liberty in 2010, and the launch of Skylanders Spyro's Adventure, all of which resulted in increased revenues recognized in 2011 as compared to 2010. The releases of Call of Duty: Black Ops, World of Warcraft: Cataclysm and StarCraft II: Wings of Liberty in 2010 were the primary reason why more deferred revenues were recognized during 2011 as compared to 2010 across all regions. This increase in the recognition of deferred revenues was partially offset by greater revenues deferred in 2011 as a result of the higher sales from the initial launch of Call of Duty: Modern Warfare 3 as compared to Call of Duty: Black Ops. Foreign Exchange Impact Changes in foreign exchange rates had a negative impact of approximately $114 million and a positive impact of approximately $100 million on Activision Blizzard's net revenues in 2012 and 2011, respectively. The change is primarily due to the year-over-year movements of the British pound, Euro and Australian dollar average rates relative to the U.S. dollar. 53-------------------------------------------------------------------------------- Table of Contents Net Revenues by Platform The following table details our net revenues by platform and as a percentage of total consolidated net revenues for the years ended December 31, 2012, 2011, and 2010 (amounts in millions): Year % of Year % of Year % of Increase/ Increase/ Ended total Ended total Ended total (decrease) (decrease) December 31, consolidated December 31, consolidated December 31, consolidated 2012 v 2011 v 2012 net revs. 2011 net revs. 2010 net revs. 2011 2010 Platform net revenues: Online subscriptions(1) $ 986 20 % $ 1,357 29 % $ 1,230 28 % $ (371 ) $ 127 PC and other(2) 1,214 25 374 8 325 7 840 49 Console Sony PlayStation 3 876 18 948 20 889 20 (72 ) 59 Microsoft Xbox 360 1,019 21 1,140 24 1,033 23 (121 ) 107 Nintendo Wii and Wii U 291 6 351 7 408 9 (60 ) (57 ) Total console 2,186 45 2,439 51 2,330 52 (253 ) 109 Handheld 164 4 167 3 184 4 (3 ) (17 ) Total platform net revenues 4,550 94 4,337 91 4,069 91 213 268 Distribution 306 6 418 9 378 9 (112 ) 40 Total consolidated net revenues $ 4,856 100 % $ 4,755 100 % $ 4,447 100 % $ 101 $ 308 The increase/(decrease) in deferred revenues recognized by platform for the years ended December 31, 2012, 2011, and 2010 was as follows (amounts in millions): Years Ended December 31, Increase/ Increase/ (Decrease) (Decrease) 2012 2011 2010 2012 v 2011 2011 v 2010 Increase/(decrease) in deferred revenues recognized by platform: Online subscriptions(1) $ (85 ) $ 202 $ (191 ) $ (287 ) $ 393 PC and other(2) (36 ) 75 (81 ) (111 ) 156 Console Sony PlayStation 3 (30 ) (36 ) (77 ) 6 41 Microsoft Xbox 360 3 (43 ) (15 ) 46 (28 ) Nintendo Wii and Wii U 12 66 16 (54 ) 50 Total console (15 ) (13 ) (76 ) (2 ) 63 Nintendo 3DS and DS 5 2 (8 ) 3 10 Total impact on consolidated net revenues $ (131 ) $ 266 $ (356 ) $ (397 ) $ 622 -------------------------------------------------------------------------------- º (1) º Revenues from online subscriptions consists of revenue from all World of Warcraft products, including subscriptions, boxed products, expansion packs, licensing royalties, value-added services, and revenues from Call of Duty Elite memberships. º (2) º Revenues from PC and other consists of net revenues from the sale of PC boxed products, Skylanders franchise standalone toys products, mobile sales and other physical merchandise and accessories. 54-------------------------------------------------------------------------------- Table of Contents Net revenues from online subscriptions decreased in 2012 as compared to 2011, primarily as a result of lower World of Warcraft subscription revenues, and lower Blizzard catalog sales from World of Warcraft: Cataclysm, which was released in December 2010. The decrease was partially offset by revenues from Call of Duty Elite memberships and World of Warcraft: Mists of Pandaria. Net revenues from online subscriptions increased in 2011 as compared to 2010, primarily driven by the recognition of deferred revenues from the release of World of Warcraft: Cataclysm in December 2010 and from the sales of World of Warcraft's value-added services, partially offset by the unfavorable impact of World of Warcraft's declining subscriber base. Net revenues from PC and other significantly increased in 2012 as compared to 2011, primarily as a result of the sale of standalone toys and accessories from the Skylanders franchise (both from the launch of Skylanders Giants in the fourth quarter of 2012 and Skylanders Spyro's Adventure, which was launched in the fourth quarter of 2011), and from sales of Diablo III. The increase was partially offset by the decrease in revenues from Starcraft II: Wings of Liberty, which was released in July 2010. Net revenues from PC and other increased in 2011 as compared to 2010, primarily due to the sale of standalone toys and accessories for Skylanders Spyro's Adventure, and the success of the Call of Duty franchise titles. The increase was partially offset by lower revenues from music and causal titles and no major release for PC and other in 2011 as compared to 2010, when StarCraft II: Wings of Liberty was released. Net revenues from PS3 and Xbox 360 decreased in 2012 as compared to 2011, primarily due to lower revenues from Call of Duty downloadable content packs and catalog sales, partially offset by sales from the Skylanders franchise. Net revenues from PS3 and Xbox 360 increased in 2011 as compared to 2010, primarily due to the launch of Skylanders Spyro's Adventure, the success of the Call of Duty franchise, and downloadable content packs for Call of Duty: Black Ops as compared to the downloadable content packs for Call of Duty: Modern Warfare 2. The increase was partially offset by the strong consumer demand at launch in November 2011 for Call of Duty: Modern Warfare 3, which resulted in additional deferral of revenues. Net revenues from Nintendo Wii and Wii U decreased in 2012 as compared to 2011, primarily due to overall weaker catalog sales and fewer comparable releases, partially offset by additional revenues from titles associated with the launch of the Wii U. Net revenues from the Nintendo Wii and handheld systems decreased in 2011 as compared to 2010 due to the release of fewer key titles than in 2010, and lower catalog sales of games in the music and casual games genres. The deferred revenues recognized for online subscriptions decreased in 2012 as compared to 2011, primarily due to revenues deferred from World of Warcraft: Mists of Pandaria, which launched on September 25, 2012, and lower revenues recognized from World of Warcraft: Cataclysm, which was released in December 2010, and was partially offset by additional revenues recognized from Call of Duty Elite memberships in 2012. The deferred revenues recognized for online subscriptions increased in 2011 as compared to 2010, primarily driven by the recognition of deferred revenues from the release of World of Warcraft: Cataclysm in December 2010 and from the sales of World of Warcraft's value-added services, partially offset by the unfavorable impact of World of Warcraft's declining subscriber base. The decrease in deferred revenues recognized for PC and other in 2012 as compared to 2011 was primarily related to revenues deferred from the successful launch of Diablo III on May 15, 2012 and a decrease in revenues recognized from catalog sales of StarCraft II: Wings of Liberty, which was released in July 2010. The deferred revenues recognized for PC and other increased in 2011 as compared to 2010, primarily related to the recognition of revenues of StarCraft II: Wings of Liberty, which was released in July 2010. The increase in deferred revenue recognized for Xbox 360 in 2012 as compared to 2011 was primarily due to less revenue deferred from Call of Duty: Black Ops II. The decrease in deferred revenue recognized for Xbox 360 in 2011 as compared to 2010, was primarily due to the revenues 55-------------------------------------------------------------------------------- Table of Contents deferral from Call of Duty: Modern Warfare 3. The decreases in deferred revenues recognized for Nintendo Wii in 2012 as compared to 2011, primarily relate to overall weaker catalog sales and fewer comparable releases, and were partially offset by additional Wii U deferred revenues recognized. The increases in deferred revenues recognized for Nintendo Wii in 2011 as compared to 2010, primarily relate to recognition of revenues of our catalog sales of games in the music and casual games genres. Costs and Expenses Cost of Sales (amounts in millions) The following table details the components of cost of sales in dollars and as a percentage of total consolidated net revenues for the years ended December 31, 2012, 2011, and 2010 (amounts in millions): Increase Increase Year Ended % of Year Ended % of Year Ended % of (Decrease) (Decrease) December 31, consolidated December 31, consolidated December 31, consolidated 2012 v 2011 v 2012 net revs. 2011 net revs. 2010 net revs. 2011 2010 Product costs $ 1,116 23 % $ 1,134 24 % $ 1,350 31 % $ (18 ) $ (216 ) Online subscriptions 263 5 255 5 250 5 8 5 Software royalties and amortization 194 4 218 5 338 8 (24 ) (120 ) Intellectual property licenses 89 2 165 3 197 4 (76 ) (32 ) Total cost of sales decreased in 2012 as compared to 2011, primarily due to a decrease in amortization of capitalized software development and intellectual property license costs as we had fewer titles released during 2012; a decrease in amortization of intangible assets due to decreasing intangible assets balances year-over-year; and lower product costs from our Distribution segment due to lower revenues. These decreases in cost of sales were partially offset by higher product costs from our Publishing and Blizzard segments due to higher revenues. Total cost of sales decreased in 2011 as compared to 2010, primarily due to the continued change in mix for products with fewer hardware peripherals, and accordingly lower product costs; an increasing number of products distributed through digital online channels; a decrease in inventory obsolescence charges, as the prior year included higher inventory obsolescence charges relating to peripherals; a decrease in amortization of capitalized software development and intellectual property license costs as we had fewer titles released during 2011; and a decrease in amortization of intangible assets. These decreases in cost of sales were partially offset by more deferred costs recognized, consistent with more deferred revenues recognized, during 2011 as compared to 2010; and higher product costs from our Distribution segment revenues associated with higher revenues. Product Development (amounts in millions) Increase Increase Year Ended % of Year Ended % of Year Ended % of (Decrease) (Decrease) December 31, consolidated December 31, consolidated December 31, consolidated 2012 v 2011 v 2012 net revs. 2011 net revs. 2010 net revs. 2011 2010 Product development $ 604 12 % $ 629 14 % $ 626 14 % $ (25 ) $ 3 For 2012, product development costs decreased as compared to 2011, principally due to higher capitalization in 2012 of our overall product development costs related to future titles and the timing at which these titles reached technical feasibility and lower stock option expenses. Additionally, product development costs in 2011 included larger amounts written off, due to the cancellation of games under development, than in 2012. The decrease was partially offset by higher studio-related bonuses reflecting our strong 2012 financial performance. 56 -------------------------------------------------------------------------------- Table of Contents For 2011, product development costs increased slightly as compared to 2010, principally due to lower capitalization of our overall product development costs related to future titles and higher accrued studio-related bonuses. This increase in product development expense was partially offset by the benefits realized from our 2011 Restructuring, which involved a focus on reducing the number of titles in development and publication, including the discontinuation of the development of music-based games. Additionally, product development costs in 2011 included amounts written off due to the cancellation of a future game under development; however, the write-off of capitalized software development was slightly less than in 2010. Sales and Marketing (amounts in millions) Increase Increase Year Ended % of Year Ended % of Year Ended % of (Decrease) (Decrease) December 31, consolidated December 31, consolidated December 31, consolidated net 2012 v 2011 v 2012 net revs. 2011 net revs. 2010 revs. 2011 2010 Sales and marketing $ 578 12 % $ 545 11 % $ 516 12 % $ 33 $ 29 Sales and marketing expenses increased in 2012 as compared to 2011, primarily due to increased spending on sales and marketing activities to support the launches of Diablo III and World of Warcraft: Mists of Pandaria, as well as continued investments in our Skylanders franchise. Sales and marketing expenses increased in 2011 as compared to 2010, primarily due to increased spending on sales and marketing activities to support the launch of Skylanders Spyro's Adventure, Call of Duty: Modern Warfare 3 and Call of Duty Elite in the fourth quarter of 2011. General and Administrative (amounts in millions) Increase Increase Year Ended % of Year Ended % of Year Ended % of (Decrease) (Decrease) December 31, consolidated December 31, consolidated December 31, consolidated 2012 v 2011 v 2012 net revs. 2011 netrevs. 2010 net revs. 2011 2010 General and administrative $ 561 12 % $ 456 10 % $ 375 8 % $ 105 $ 81 General and administrative expenses increased in 2012 as compared to 2011, primarily due to higher legal-related expenses (including legal-related accruals, settlements and fees), stock-based compensation expenses and additional accrued bonuses reflecting our strong 2012 financial performance. General and administrative expenses increased in 2011 as compared to 2010, primarily due to higher legal expenses incurred from additional litigation activities and settlement of lawsuits, the impairment of our Distribution segment's goodwill and higher depreciation expense and facilities costs. Impairment of Intangible Assets (amounts in millions) Increase Increase Year Ended % of Year Ended % of Year Ended % of (Decrease) (Decrease) December 31, consolidated December 31, consolidated December 31, consolidated 2012 v 2011 v 2012 net revs. 2011 net revs. 2010 net revs. 2011 2010 Impairment of intangible assets $ - - % $ - - % $ 326 7 % $ - $ (326 ) There was no impairment of intangible assets for the years ended December 31, 2012 and 2011. In the fourth quarter of 2010, as a result of the franchise and industry results of the holiday season, we significantly revised our outlook for the retail sales of software. Further, with the impact of the continued economic downturn on our industry in 2010 and the change in the buying habits of casual consumers, we reassessed our overall expectations with respect to our future sales of certain 57 -------------------------------------------------------------------------------- Table of Contents games titles. We considered these economic changes during our planning process for 2011 that we conducted during the months of November and December, 2010, which resulted in a strategy change to, among other things, focus on fewer title releases in the casual and music genres. As a result, we updated our future projected revenue streams for our franchises in the casual and music genres. We performed recoverability and, where applicable, impairment tests on the related intangible assets in accordance with ASC Subtopic 360-10. Based on the analysis performed, we recorded impairment charges of $67 million, $9 million and $250 million to license agreements, game engines and internally developed franchises intangible assets, respectively, for 2010 within our Activision segment. See Note 11 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for additional information regarding the determination of the impairment charges recorded for the year ended December 31, 2010. Restructuring (amounts in millions) Increase Increase Year Ended % of Year Ended % of Year Ended % of (Decrease) (Decrease) December 31, consolidated December 31, consolidated December 31, consolidated 2012 v 2011 v 2012 net revs. 2011 net revs. 2010 net revs. 2011 2010 Restructuring $ - - % $ 25 - % $ - - % $ (25 ) $ 25 There were no material restructuring expenses for the year ended December 31, 2012. On February 3, 2011, the Company's Board of Directors authorized the 2011 Restructuring. The 2011 Restructuring focused on the development and publication of a reduced slate of titles on a going-forward basis, including the discontinuation of the development of music-based games, the closure of the related business unit and the cancellation of other titles then in production, along with a related reduction in studio headcount and corporate overhead. The costs related to the 2011 Restructuring activities included severance costs, facility exit costs, and exit costs from the cancellation of projects. The 2011 Restructuring was completed as of December 31, 2011 and we do not expect to incur additional restructuring expenses relating thereto. See Note 7 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for more detail and a roll forward of the restructuring liability that includes the beginning and ending liability, costs incurred, cash payments and non-cash write downs. In 2008, we implemented an organizational restructuring plan as a result of the Business Combination. This organizational restructuring was to integrate different operations and to streamline the combined Activision Blizzard organization. The restructuring activities included severance costs, facility exit costs, write offs of assets and liabilities and exit costs from the cancellation of projects. At December 31, 2010, we had completed our organizational restructuring activities as a result of the Business Combination. Restructuring expenses during year ended December 31, 2011 and 2010 associated to this plan were immaterial and were recorded within the "General and administrative expense" in our consolidated statements of operations. Investment and Other Income (Expense), Net (amounts in millions) Increase Increase Year Ended % of Year Ended % of Year Ended % of (Decrease) (Decrease) December 31, consolidated December 31, consolidated December 31, consolidated 2012 v 2011 v 2012 net revs. 2011 net revs. 2010 net revs. 2011 2010 Investment and other income (expense), net $ 7 - % $ 3 - % $ 23 1 % $ 4 $ (20 ) Investment and other income (expense), net, increased in 2012 as compared to 2011. The increase is primarily due to the net realized gain on our foreign exchange contracts of $2 million in 2012 as 58-------------------------------------------------------------------------------- Table of Contents compared to a $7 million loss in 2011. However, during 2012, we experienced lower yields on our investments, which partially offset the increase. Investment and other income (expense), net, decreased in 2011 as compared to 2010. During 2011, we recorded higher yields generated from our cash and investment balances, which was partially offset by a higher realized loss from foreign exchange contracts, as compared to 2010. Further, the majority of Investment and other income (expense), net, in 2010 related to the reduction in fair value of a financial liability relating to a contingent earn-out liability from a previous acquisition and there was no such item during 2011. Income Tax Expense (Benefit) (amounts in millions) Increase Increase Year Ended % of Year Ended % of Year Ended % of (Decrease) (Decrease) December 31, Pretax December 31, Pretax December 31, Pretax 2012 v 2011 v 2012 income 2011 income 2010 income 2011 2010 Income tax expense $ 309 21.2 % $ 246 18.5 % $ 74 15.0 % $ 63 $ 172 For 2012, the Company's income before income tax expense was $1.46 billion. Our income tax expense of $309 million resulted in an effective tax rate of 21.2%. The difference between our effective tax rate and the U.S. statutory tax rate of 35% is due to earnings taxed at relatively lower rates in foreign jurisdictions, recognition of California research and development credits, the federal domestic production deduction, and a tax benefit resulting from a federal income tax audit settlement allocated to us by a subsidiary of Vivendi S.A. ("Vivendi"), as further discussed below. For 2011, the Company's income before income tax expense was $1.3 billion. Our income tax expense of $246 million resulted in an effective tax rate of 18.5%. The difference between our effective tax rate and the U.S. statutory tax rate of 35% is due to earnings taxed at relatively lower rates in foreign jurisdictions, recognition of federal and California research and development credits, the federal domestic production deduction and a favorable impact from discrete items recognized in connection with the filing of our 2010 tax returns. In 2012 and 2011, our U.S. income before income tax expense was $668 million and $623 million, respectively, and comprised 46% and 47%, respectively, of our consolidated income before income tax expense. In 2012 and 2011, the foreign income before income tax expense was $790 million and $708 million, respectively, and comprised 54% and 53%, respectively, of our consolidated income before income tax expense. In 2012 and 2011, the impact of earnings taxed at lower rates in foreign jurisdictions versus our U.S. federal statutory tax rate was 17% and 15%, respectively. As previously disclosed, on July 9, 2008, the Business Combination occurred among Vivendi, the Company and certain of their respective subsidiaries pursuant to which Vivendi Games, then a member of the consolidated U.S. tax group of Vivendi's subsidiary, Vivendi Holdings I Corp. ("VHI"), became a subsidiary of the Company. As a result of the business combination, the favorable tax attributes of Vivendi Games carried forward to the Company. In late August 2012, VHI settled a federal income tax audit with the Internal Revenue Service ("IRS") for the tax years ended December 31, 2002, 2003, and 2004. In connection with the settlement agreement, VHI's consolidated federal net operating loss carryovers were adjusted and allocated to various companies that were part of its consolidated group during the relevant periods. This allocation resulted in a $132 million federal net operating loss allocation to Vivendi Games. In September 2012, the Company filed an amended tax return for its December 31, 2008 tax year to utilize these additional federal net operating losses allocated as a result of the aforementioned settlement, resulting in the recording of a one-time tax benefit of $46 million. Prior to the settlement, and given the uncertainty of the VHI audit, the Company had insufficient information to allow it to record or disclose any information related to the audit until the quarter ended September 30, 2012, as disclosed in the Company's Form 10-Q for that period. 59-------------------------------------------------------------------------------- Table of Contents Vivendi Games results for the period January 1, 2008 through July 2009 are included in the consolidated federal and certain foreign state and local income tax returns files by Vivendi or its affiliates while 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. Vivendi Games tax years 2005 through 2008 remain open to examination by the major taxing authorities. The IRS is currently examining Vivendi Games tax returns for the 2005 through 2008 tax years. Activision Blizzard's tax years 2008 through 2011 remain open to examination by the major taxing jurisdictions to which we are subject. The IRS is currently examining the Company's federal tax returns for the 2008 and 2009 tax years. The Company also 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 our management, the ultimate resolution of these matters will not 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. On January 2, 2013, the American Taxpayer Relief Act of 2012 was signed into law by the President of the United States. Under the provisions of the American Taxpayer Relief Act of 2012, the research and development ("R&D") tax credit that had expired December 31, 2011, was reinstated retroactively to January 1, 2012, and is now scheduled to expire on December 31, 2013. The Company will record the impact of the extension of the R&D tax credit related to the tax year ended December 31, 2012, as a discrete item the first quarter of 2013. The impact of the extension of the R&D tax credit is expected to result in a tax benefit of approximately $11 million related to the tax year ended December 31, 2012. The overall effective income tax rate in future periods will depend on a variety of factors, such as changes in the mix of income by tax jurisdiction, applicable accounting rules, applicable tax laws and regulations, and rulings and interpretations thereof, developments in tax audits and other matters, and variations in the estimated and actual level of annual pretax income or loss. Further, the effective tax rate could fluctuate significantly on a quarterly basis and could be adversely affected by the extent that income (loss) before income tax expenses (benefit) is lower than anticipated in foreign regions where taxes are levied at relatively lower statutory rates and/or higher than anticipated in the United States where taxes are levied at relatively higher statutory rates. A more detailed analysis of the differences between the U.S. federal statutory rate and the consolidated effective tax rate, as well as other information about our income taxes, is provided in Note 15 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Foreign Exchange Impact Changes in foreign exchange rates had a negative impact of $67 million and a positive impact of $49 million on Activision Blizzard's consolidated operating income in 2012 and 2011, respectively. The change is primarily due to the strengthening of the British pound, Euro and Australian dollar average rates relative to the U.S. dollar. 60 -------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources Sources of Liquidity (amounts in millions) For the Years Ended December 31, Increase (Decrease) 2012 2011 2012 v 2011 Cash and cash equivalents $ 3,959 $ 3,165 $ 794 Short-term investments 416 360 56 $ 4,375 $ 3,525 $ 850 Percentage of total assets 31 % 27 % For the Years Ended December 31, Increase Increase (Decrease) (Decrease) 2012 2011 2010 2012 v 2011 2011 v 2010 Cash flows provided by operating activities $ 1,345 $ 952 $ 1,376 $ 393 $ (424 ) Cash flows provided by (used in) investing activities (124 ) 266 (312 ) (390 ) 578 Cash flows used in financing activities (497 ) (808 ) (1,053 ) 311 245 Effect of foreign exchange rate changes 70 (57 ) 33 127 (90 ) Net increase in cash and cash equivalents $ 794 $ 353 $ 44 $ 441 $ 309 Cash Flows Provided by Operating Activities The primary drivers of cash flows provided by operating activities included the collection of customer receivables generated by the sale of our products and digital and subscription revenues, partially offset by payments to vendors for the manufacturing, distribution and marketing of our products, payments to third-party developers and intellectual property holders, tax liabilities, and payments to our workforce. A significant operating use of our cash relates to our continued focus on customer service for our subscribers and investment in software development and intellectual property licenses. Cash flows provided by operating activities were higher for 2012 as compared to 2011, and were lower for 2011 as compared to 2010. Our source of cash inflow varies with our release schedule. For example, Blizzard's major releases of StarCraft II and World of Warcraft: Cataclysm during 2010, and Blizzard's major releases of Diablo III and World of Warcraft: Mist of Pandaria during 2012 contributed to the higher cash inflows for 2010 and 2012 as compared to 2011, when there were no major releases from Blizzard. Additionally, the strong performance of Activision's Skylanders franchise and Call of Duty: Black Ops II contributed to strong operating cash flows in 2012. Cash Flows Provided by (Used in) Investing Activities The primary drivers of cash flows used in investing activities have typically included capital expenditures, acquisitions and the net effect of purchases and sales/maturities of short-term investments. Cash flows provided by investing activities were lower for 2012 as compared to 2011, primarily due to decreased proceeds from the maturity of investments, partially offset by higher purchases of short-term investments. In 2012, proceeds from the maturity of investments were $444 million, the majority of which consisted of U.S. treasury and other government agency securities, while the purchase of short-term investments totaled $503 million. Further, capital expenditures, primarily related to property and equipment, were $73 million. 61-------------------------------------------------------------------------------- Table of Contents Cash flows provided by investing activities were higher for 2011 as compared to 2010, primarily due to increased proceeds from the maturity of investments, decreased purchases of short-term investments and lower capital expenditures. Proceeds from the maturity of investments were $740 million, the majority of which consisted of U.S. treasury and other government agency securities, while the purchase of short-term investments totaled $417 million and capital expenditures, primarily related to property and equipment, were $72 million. Cash Flows Used in Financing Activities The primary drivers of cash flows used in financing activities have historically related to transactions involving our common stock, including the issuance of shares of common stock to employees, payment of dividends and the repurchase of our common stock. We have not historically utilized debt financing as a source of cash flows although we may do so in the future. Cash flows used in financing activities were lower for 2012 as compared to 2011, primarily due to decreased share repurchase activities. Cash flows used in financing activities for the year ended December 31, 2012 primarily reflected an aggregate cash payment of $204 million to holders of our common stock and restricted stock units in connection with our annual dividend. In addition, cash flows used in financing activities for the year ended December 31, 2012 reflect the repurchase of $315 million of our common stock and the payment of $16 million in taxes relating to the vesting of employees' restricted stock rights. The repurchases and dividend payments were partially offset by $33 million of proceeds from the issuance of shares of our common stock to employees in connection with stock option exercises. Cash flows used in financing activities were lower for 2011 as compared to 2010, primarily due to decreased share repurchase activities. Cash flows used in financing activities for the year ended December 31, 2011 primarily reflected an aggregate cash payment of $194 million to holders of our common stock and restricted stock units in connection with our annual dividend. In addition, cash flows used in financing activities for the year ended December 31, 2011 reflect the repurchase of $692 million of our common stock, as compared to the repurchase of $959 million for the year ended December 31, 2010. Other Liquidity and Capital Resources Our primary sources of liquidity are cash and cash equivalents and investments and cash flows provided by operating activities. With our cash and cash equivalents and investments of $4.4 billion and expected cash flows provided by operating activities, we believe that we have sufficient liquidity to meet daily operations for the foreseeable future. We also believe that we have sufficient working capital ($3.6 billion at December 31, 2012) to finance our operational requirements for at least the next twelve months, including purchases of inventory and equipment, the development, production, marketing and sale of new products, the provision of customer service for our subscribers, the acquisition of intellectual property rights for future products from third parties, and to fund our stock repurchase program and dividends. As of December 31, 2012, the amount of cash and cash equivalents held outside of the U.S. by our foreign subsidiaries was $2.6 billion, compared with $1.6 billion as of December 31, 2011. If these funds are needed in the future for our operations in the U.S., we would accrue and pay the required U.S. taxes to repatriate these funds. However, our intent is to permanently reinvest these funds outside of the U.S. and our current plans do not demonstrate a need to repatriate them to fund our U.S. operations. We are considering, or may consider during 2013, substantial stock repurchases, dividends, acquisitions, licensing or other non-ordinary course transactions, and significant debt financings relating thereto. 62-------------------------------------------------------------------------------- Table of Contents Capital Expenditures We made capital expenditures of $73 million in 2012, as compared to $72 million in 2011. In 2013, we anticipate total capital expenditures of approximately $85 million. Capital expenditures are expected to be primarily for computer hardware and software purchases. Commitments In the normal course of business, we enter into contractual arrangements with third-parties for non-cancelable operating lease agreements for our offices, for the development of products, and for the rights to intellectual property. Under these agreements, we commit to provide specified payments to a lessor, developer or intellectual property holder, as the case may be, based upon contractual arrangements. The payments to third-party developers are generally conditioned upon the achievement by the developers of contractually specified development milestones. Further, these payments to third-party developers and intellectual property holders typically are deemed to be advances and are recoupable against future royalties earned by the developer or intellectual property holder based on the sale of the related game. Additionally, in connection with certain intellectual property rights acquisitions and development agreements, we commit to spend specified amounts for marketing support for the related game(s) which is to be developed or in which the intellectual property will be utilized. Assuming all contractual provisions are met, the total future minimum commitments for these and other contractual arrangements in place at December 31, 2012 are scheduled to be paid as follows (amounts in millions): Contractual Obligations(1) Facility and Developer equipment leases and IP Marketing Total For the year ending December 31, 2013 33 119 58 210 2014 31 5 51 87 2015 22 1 - 23 2016 18 - 6 24 2017 17 - 6 23 Thereafter 52 3 - 55 Total 173 128 121 422 -------------------------------------------------------------------------------- º (1) º We have omitted uncertain income tax liabilities from this table due to the inherent uncertainty regarding the timing of potential issue resolution. Specifically, either the underlying positions have not been fully developed enough under audit to quantify at this time or the years relating to the issues for certain jurisdictions are not currently under audit. At December 31, 2012, we had $207 million of unrecognized tax benefits, of which $197 million was included in "Other Liabilities" and $10 million was included in "Accrued Expenses and Other Liabilities" in the consolidated balance sheets. Off-balance Sheet Arrangements At December 31, 2012 and 2011, Activision Blizzard had no significant relationships with unconsolidated entities or financial parties, often referred to as "structured finance" or "special purpose" entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes, that have or are reasonably likely to have a material future effect on our financial condition, changes in financial condition, revenues or expenses, results of operation, liquidity, capital expenditures, or capital resources. 63-------------------------------------------------------------------------------- Table of Contents Financial Disclosure We maintain internal control over financial reporting, which generally includes those controls relating to the preparation of our financial statements in conformity with accounting principles generally accepted in the United States of America ("U.S. GAAP"). We also are focused on our "disclosure controls and procedures," which as defined by the Securities and Exchange Commission (the "SEC"), are generally those controls and procedures designed to ensure that financial and non-financial information required to be disclosed in our reports filed with the SEC is reported within the time periods specified in the SEC's rules and forms, and that such information is communicated to management, including our principal executive and financial officers, as appropriate, to allow timely decisions regarding required disclosure. Our Disclosure Committee, which operates under the Board-approved Disclosure Committee Charter and Disclosure Controls & Procedures Policy, includes senior management representatives and assists executive management in its oversight of the accuracy and timeliness of our disclosures, as well as in implementing and evaluating our overall disclosure process. As part of our disclosure process, senior finance and operational representatives from all of our corporate divisions and business units prepare quarterly reports regarding their current quarter operational performance, future trends, subsequent events, internal controls, changes in internal controls and other accounting and disclosure relevant information. These quarterly reports are reviewed by certain key corporate finance executives. These corporate finance representatives also conduct quarterly interviews on a rotating basis with the preparers of selected quarterly reports. The results of the quarterly reports and related interviews are reviewed by the Disclosure Committee. Finance representatives also conduct reviews with our senior management team, our legal counsel and other appropriate personnel involved in the disclosure process, as appropriate. Additionally, senior finance and operational representatives provide internal certifications regarding the accuracy of information they provide that is utilized in the preparation of our periodic public reports filed with the SEC. Financial results and other financial information also are reviewed with the Audit Committee of the Board of Directors on a quarterly basis. As required by applicable regulatory requirements, the principal executive and financial officers review and make various certifications regarding the accuracy of our periodic public reports filed with the SEC, our disclosure controls and procedures, and our internal control over financial reporting. With the assistance of the Disclosure Committee, we will continue to assess and monitor, and make refinements to, our disclosure controls and procedures, and our internal control over financial reporting. Critical Accounting Policies and Estimates The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates and assumptions. The impact and any associated risks related to these policies on our business operations are discussed throughout Management's Discussion and Analysis of Financial Condition and Results of Operations where such policies affect our reported and expected financial results. The estimates and assumptions discussed below are considered by management to be critical because they are both important to the portrayal of our financial condition and results of operations and because their application places the most significant demands on management's judgment, with financial reporting results relying on estimates and assumptions about the effect of matters that are inherently uncertain. Specific risks for these critical accounting estimates and assumptions are described in the following paragraphs. Revenue Recognition including Revenue Arrangements with Multiple Deliverables On January 1, 2011, we adopted amendments to an accounting standard related to revenue recognition for arrangements with multiple deliverables (which standard, as amended, is referred to 64-------------------------------------------------------------------------------- Table of Contents herein as the "new accounting principles"). The new accounting principles establish a selling price hierarchy for determining the selling price of a deliverable and require the application of the relative selling price method to allocate the consideration received for an arrangement to each deliverable in a multiple deliverables revenue arrangement. Certain of our revenue arrangements have multiple deliverables and, as such, are accounted for under the new accounting principles. These revenue arrangements include product sales consisting of both software and hardware deliverables (such as peripherals or other ancillary collectors' items sold together with physical "boxed" software) and our sales of World of Warcraft boxed products, expansion packs and value-added services, each of which is considered with the related subscription services for these purposes. Our assessment of deliverables and units of accounting does not change under the new accounting principles. Pursuant to the guidance of ASU 2009-13, when a revenue arrangement contains multiple elements, such as hardware and software products, licenses and/or services, we allocate revenue to each element based on a selling price hierarchy. The selling price for a deliverable is based on its vendor-specific-objective-evidence ("VSOE") if it is available, third-party evidence ("TPE") if VSOE is not available, or best estimated selling price ("BESP") if neither VSOE nor TPE is available. In multiple element arrangements where more-than-incidental software deliverables are included, revenue is allocated to each separate unit of accounting for each of the non-software deliverables and to the software deliverables as a group using the relative selling prices of each of the deliverables in the arrangement based on the aforementioned selling price hierarchy. If the arrangement contains more than one software deliverable, the arrangement consideration allocated to the software deliverables as a group is then allocated to each software deliverable using the guidance for recognizing software revenue. As noted above, when neither VSOE nor TPE is available for a deliverable, we use BESP. We do not have significant revenue arrangements that require BESP for the years ended December 31, 2012 and 2011. The inputs we use to determine the selling price of our significant deliverables include the actual price charged by the Company for a deliverable that the Company sells separately, which represents the VSOE, and the wholesale prices of the same or similar products, which represents TPE. The pattern and timing of revenue recognition for deliverables and allocation of the arrangement consideration did not change upon the adoption of the new accounting principles. Also, the adoption of the new accounting standard has not had a material impact on our financial statements. Overall, we recognize revenue from the sale of our products upon the transfer of title and risk of loss to our customers and once any performance obligations have been completed. Certain products are sold to customers with a "street date" (i.e., the earliest date these products may be sold by retailers). For these products we recognize revenue on the later of the street date or the date the product is sold to our customer. Revenue from product sales is recognized after deducting the estimated allowance for returns and price protection. For our software products with online functionality, we evaluate whether those features or functionality are more than an inconsequential separate deliverable in addition to the software product. This evaluation is performed for each software product and any online transaction, such as a digital download of a title with product add-ons, when it is released. When we determine that a software title contains online functionality that constitutes a more-than-inconsequential separate service deliverable in addition to the product, which, when we do, is principally because of its importance to gameplay, we consider our performance obligations for this title to extend beyond the sale of the game. VSOE of fair value does not exist for the online functionality of some products, as we do not separately charge for this component of every title. As a result, we recognize all of the software-related revenue from the sale of any such title ratably over the estimated service period of such title. In addition, we initially defer the costs of sales for the title (excluding intangible asset amortization), and recognize the costs of sales as the related revenues are 65-------------------------------------------------------------------------------- Table of Contents recognized. Cost of sales includes manufacturing costs, software royalties and amortization, and intellectual property licenses. Determining whether the online functionality for a particular game constitutes more than an inconsequential deliverable, as well as the estimated service periods and product life over which to recognize the revenue and related costs of sales, is subjective and require management's judgment. We recognize revenues from World of Warcraft boxed product, expansion packs and value-added services, in each case with the related subscription service revenue, ratably over the estimated service period beginning upon activation of the software and delivery of the related services. Revenues attributed to the sale of World of Warcraft boxed software and related expansion packs are classified as "Product sales," whereas revenues attributable to subscriptions and other value-added services are classified as "Subscription, licensing, and other revenues." Revenue for software products with more than inconsequential separate service deliverables and World of Warcraft products are recognized over the estimated service periods, which range from a minimum of five months to a maximum of less than a year. For our software products with features we consider to be incidental to the overall product offering and an inconsequential deliverable, such as products which provide limited online features at no additional cost to the consumer, we recognize the related revenue from them upon the transfer of title and risk of loss of the product to our customer. Allowances for Returns, Price Protection, Doubtful Accounts and Inventory Obsolescence We closely monitor and analyze the historical performance of our various titles, the performance of products released by other publishers, market conditions, and the anticipated timing of other releases to assess future demand of current and upcoming titles. Initial volumes shipped upon title launch and subsequent reorders are evaluated with the goal of ensuring that quantities are sufficient to meet the demand from the retail markets, but at the same time are controlled to prevent excess inventory in the channel. We benchmark units to be shipped to our customers using historical and industry data. We may permit product returns from, or grant price protection to, our customers under certain conditions. In general, price protection refers to the circumstances in which we elect to decrease, on a short or longer term basis, the wholesale price of a product by a certain amount and, when granted and applicable, allow customers a credit against amounts owed by such customers to us with respect to open and/or future invoices. The conditions our customers must meet to be granted the right to return products or price protection include, among other things, compliance with applicable trading and payment terms, and consistent return of inventory and delivery of sell-through reports to us. We may also consider other factors, including the facilitation of slow-moving inventory and other market factors. Significant management judgments and estimates must be made and used in connection with establishing the allowance for returns and price protection in any accounting period based on estimates of potential future product returns and price protection related to current period product revenue. We estimate the amount of future returns and price protection for current period product revenue utilizing historical experience and information regarding inventory levels and the demand and acceptance of our products by the end consumer. The following factors are used to estimate the amount of future returns and price protection for a particular title: historical performance of titles in similar genres; historical performance of the hardware platform; historical performance of the franchise; console hardware life cycle; sales force and retail customer feedback; industry pricing; future pricing assumptions; weeks of on-hand retail channel inventory; absolute quantity of on-hand retail channel inventory; our warehouse on-hand inventory levels; the title's recent sell-through history (if available); marketing trade programs; 66-------------------------------------------------------------------------------- Table of Contents and performance of competing titles. The relative importance of these factors varies among titles depending upon, among other items, genre, platform, seasonality, and sales strategy. Based upon historical experience, we believe that our estimates are reasonable. However, actual returns and price protection could vary materially from our allowance estimates due to a number of reasons including, among others, a lack of consumer acceptance of a title, the release in the same period of a similarly themed title by a competitor, or technological obsolescence due to the emergence of new hardware platforms. Material differences may result in the amount and timing of our revenue for any period if factors or market conditions change or if management makes different judgments or utilizes different estimates in determining the allowances for returns and price protection. For example, a 1% change in our December 31, 2012 allowance for sales returns, price protection and other allowances would have impacted net revenues by approximately $3 million. Similarly, management must make estimates as to the collectability of our accounts receivable. In estimating the allowance for doubtful accounts, we analyze the age of current outstanding account balances, historical bad debts, customer concentrations, customer creditworthiness, current economic trends, and changes in our customers' payment terms and their economic condition, as well as whether we can obtain sufficient credit insurance. Any significant changes in any of these criteria would affect management's estimates in establishing our allowance for doubtful accounts. We regularly review inventory quantities on-hand and in the retail channels. We write down inventory based on excess or obsolete inventories determined primarily by future anticipated demand for our products. Inventory write-downs are measured as the difference between the cost of the inventory and net realizable value, based upon assumptions about future demand, which are inherently difficult to assess and dependent on market conditions. At the point of loss recognition, a new, lower cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established basis. Software Development Costs and Intellectual Property Licenses Software development costs include payments made to independent software developers under development agreements, as well as direct costs incurred for internally developed products. We account for software development costs in accordance with the Financial Accounting Standards Board ("FASB") guidance for the costs of computer software to be sold, leased, or otherwise marketed ("Accounting Standards Codification ("ASC") Subtopic 985-20"). 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. Prior to a product's release, we expense, as part of "Cost of sales-software royalties and amortization," capitalized costs if and when we believe such amounts are not recoverable. Capitalized costs for those products that are cancelled or expected to be abandoned are charged to "Product development expense" in the period of cancellation. Amounts related to software development which are not capitalized are charged immediately to "Product development expense." Commencing upon product release, capitalized software development costs are amortized to "Cost of sales-software royalties and amortization" based on the ratio of current revenues to total projected revenues for the specific product, generally resulting in an amortization period of six months or less. Intellectual property license costs represent license fees paid to intellectual property rights holders for use of their trademarks, copyrights, software, technology, music or other intellectual property or 67-------------------------------------------------------------------------------- Table of Contents proprietary rights in the development of our products. Depending upon the agreement with the rights holder, we may obtain the right to use the intellectual property in multiple products over a number of years, or alternatively, for a single product. Prior to the related product's release, we expense, as part of "Cost of sales-intellectual property licenses," capitalized intellectual property costs when we believe such amounts are not recoverable. Capitalized intellectual property costs for those products that are cancelled or expected to be abandoned are charged to "Product development expense" in the period of cancellation. Commencing upon the related product's release, capitalized intellectual property license costs are amortized to "Cost of sales-intellectual property licenses" based on the ratio of current revenues for the specific product to total projected revenues for all products in which the licensed property will be utilized. As intellectual property license contracts may extend for multiple years, the amortization of capitalized intellectual property license costs relating to such contracts may extend beyond one year. We evaluate the future recoverability of capitalized software development costs and intellectual property licenses on a quarterly basis. For products that have been released in prior periods, the primary evaluation criterion is actual title performance. For products that are scheduled to be released in future periods, recoverability is evaluated based on the expected performance of the specific products to which the costs relate or in which the licensed trademark or copyright is to be used. Criteria used to evaluate expected product performance include: historical performance of comparable products developed with comparable technology; market performance of comparable titles; orders for the product prior to its release; general market conditions; and, for any sequel product, estimated performance based on the performance of the product on which the sequel is based. Further, as many of our capitalized intellectual property licenses extend for multiple products over multiple years, we also assess the recoverability of capitalized intellectual property license costs based on certain qualitative factors, such as the success of other products and/or entertainment vehicles utilizing the intellectual property, whether there are any future planned theatrical releases or television series based on the intellectual property, and the rights holder's continued promotion and exploitation of the intellectual property. Significant management judgments and estimates are utilized in assessing the recoverability of capitalized costs. In evaluating the recoverability of capitalized costs, the assessment of expected product performance utilizes forecasted sales amounts and estimates of additional costs to be incurred. If revised forecasted or actual product sales are less than the originally forecasted amounts utilized in the initial recoverability analysis, the net realizable value may be lower than originally estimated in any given quarter, which could result in an impairment charge. Material differences may result in the amount and timing of expense for any period if management makes different judgments or utilizes different estimates in evaluating these qualitative factors. Income Taxes We record a tax provision for the anticipated tax consequences of the reported results of operations. In accordance with FASB income tax guidance ("ASC Topic 740"), the provision for income taxes is computed using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities due to a change in tax rates is recognized in income in the period that includes the enactment date. We evaluate deferred tax assets each period for recoverability. For those assets that do not meet the threshold of "more likely than not" that they will be realized in the future, a valuation allowance is recorded. 68-------------------------------------------------------------------------------- Table of Contents Management believes it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with the tax effects of the deferred tax liabilities, will be sufficient to fully recover the remaining deferred tax assets. In the event that all or part of the net deferred tax assets are determined not to be realizable in the future, an adjustment to the valuation allowance would be charged to tax expenses in the period such determination is made. The calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of ASC Topic 740 and other complex tax laws. Resolution of these uncertainties in a manner inconsistent with management's expectations could have a material impact on our business and results of operations in an interim period in which the uncertainties are ultimately resolved. Significant judgment is required in evaluating our uncertain tax positions and determining our provision for income taxes. Although we believe our reserves are reasonable, no assurance can be given that the final tax outcome of these matters will not be different from that which is reflected in our historical income tax provisions and accruals. We adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit or the refinement of an estimate. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will impact the provision for income taxes in the period in which such determination is made. The provision for income taxes includes the impact of reserve provisions and changes to reserves that are considered appropriate, as well as the related net interest and penalties. Our provision for income taxes is subject to volatility and could be adversely impacted by earnings being lower than anticipated in foreign regions where taxes are levied at relatively lower statutory rates and/or higher than anticipated in the United States where taxes are levied at relatively higher statutory rates; by changes in the valuation of our deferred tax assets and liabilities; by expiration of or lapses in the R&D tax credit laws; by tax effects of nondeductible compensation; by tax costs related to intercompany realignments; by differences between amounts included in our tax filings and the estimate of such amounts included in our tax expenses; by changes in accounting principles; or by changes in tax laws and regulations including possible U.S. changes to the taxation of earnings of our foreign subsidiaries, the deductibility of expenses attributable to foreign income, or the foreign tax credit rules. Significant judgment is required to determine the recognition and measurement attributes prescribed in the accounting guidance for uncertainty in income taxes. The accounting guidance for uncertainty in income taxes applies to all income tax positions, including the potential recovery of previously paid taxes, which if settled unfavorably could adversely impact our provision for income taxes or additional paid-in capital. In addition, we are subject to the continuous examination of our income tax returns by the Internal Revenue Service ("IRS") and other tax authorities. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes. There can be no assurance that the outcomes from these continuous examinations will not have an adverse impact on our operating results and financial condition. Fair Value Estimates The preparation of financial statements in conformity with U.S. GAAP often requires us to determine the fair value of a particular item to fairly present our Consolidated Financial Statements. Without an independent market or another representative transaction, determining the fair value of a particular item requires us to make several assumptions that are inherently difficult to predict and can have a material impact on the conclusion of the appropriate accounting. There are various valuation techniques used to estimate fair value. These include (1) the market approach where market transactions for identical or comparable assets or liabilities are used to determine the fair value, (2) the income approach, which uses valuation techniques to convert future amounts (for example, future cash flows or future earnings) to a single present amount, and (3) the cost approach, which is based on the amount that would be required to replace an asset. For many of our fair value estimates, including our estimates of the fair value of acquired intangible assets, we use 69-------------------------------------------------------------------------------- Table of Contents the income approach. Using the income approach requires the use of financial models, which require us to make various estimates including, but not limited to (1) the potential future cash flows for the asset, liability or equity instrument being measured, (2) the timing of receipt or payment of those future cash flows, (3) the time value of money associated with the delayed receipt or payment of such cash flows, and (4) the inherent risk associated with the cash flows (that is, the risk premium). Determining these cash flow estimates is inherently difficult and subjective, and, if any of the estimates used to determine the fair value using the income approach turns out to be inaccurate, our financial results may be negatively impacted. Furthermore, relatively small changes in many of these estimates can have a significant impact on the estimated fair value resulting from the financial models or the related accounting conclusion reached. For example, a relatively small change in the estimated fair value of an asset may change a conclusion as to whether an asset is impaired. While we are required to make certain fair value assessments associated with the accounting for several types of transactions, the following areas are the most sensitive to the assessments: Business Combinations. We must estimate the fair value of assets acquired and liabilities assumed in a business combination. Our assessment of the estimated fair value of each of these can have a material effect on our reported results as intangible assets are amortized over various lives. Furthermore, a change in the estimated fair value of an asset or liability often has a direct impact on the amount to recognize as goodwill, which is an asset that is not amortized. Often determining the fair value of these assets and liabilities assumed requires an assessment of expected use of the asset, the expected cost to extinguish the liability or our expectations related to the timing and the successful completion of development of an acquired in-process technology. Such estimates are inherently difficult and subjective and can have a material impact on our financial statements. Assessment of Impairment of Assets. Management evaluates the recoverability of our identifiable intangible assets and other long-lived assets in accordance with FASB literature related to accounting for the impairment or disposal of long-lived assets within ASC Subtopic 360-10, which generally requires the assessment of these assets for recoverability when events or circumstances indicate a potential impairment exists. We considered certain events and circumstances in determining whether the carrying value of identifiable intangible assets and other long-lived assets, other than indefinite-lived intangible assets, may not be recoverable including, but not limited to: significant changes in performance relative to expected operating results; significant changes in the use of the assets; significant negative industry or economic trends; a significant decline in our stock price for a sustained period of time; and changes in our business strategy. In determining whether an impairment exists, we estimate the undiscounted cash flows to be generated from the use and ultimate disposition of these assets. If an impairment is indicated based on a comparison of the assets' carrying values and the undiscounted cash flows, the impairment loss is measured as the amount by which the carrying amount of the assets exceeds the fair value of the assets. During 2010, we recorded an impairment charge of $326 million to our definite-lived intangible assets. See Note 11 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for additional information regarding the determination of the impairment charges recorded for the year ended December 31, 2010. We did not record an impairment charge to our definite-lived intangible assets as of December 31, 2012 and 2011. FASB literature related to the accounting for goodwill and other intangibles within ASC Topic 350 provides companies an option to first perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value before performing a two-step approach to testing goodwill for impairment for each reporting unit. Our reporting units are determined by the components of our operating segments that constitute a business for which both (1) discrete financial information is available and (2) segment management regularly reviews the operating results of that component. ASC Topic 350 requires that the impairment test be performed at least annually by applying a fair-value-based test. The qualitative assessment is optional. The first step 70 -------------------------------------------------------------------------------- Table of Contents measures for impairment by applying fair-value-based tests at the reporting unit level. The second step (if necessary) measures the amount of impairment by applying fair-value-based tests to the individual assets and liabilities within each reporting unit. To determine the fair values of the reporting units used in the first step, we use a discounted cash flow approach. Each step requires us to make judgments and involves the use of significant estimates and assumptions. These estimates and assumptions include long-term growth rates and operating margins used to calculate projected future cash flows, risk-adjusted discount rates based on our weighted average cost of capital, and future economic and market conditions. These estimates and assumptions have to be made for each reporting unit evaluated for impairment. Our estimates for market growth, our market share and costs are based on historical data, various internal estimates and certain external sources, and are based on assumptions that are consistent with the plans and estimates we are using to manage the underlying business. If future forecasts are revised, they may indicate or require future impairment charges. We base our fair value estimates on assumptions we believe to be reasonable but that are unpredictable and inherently uncertain. Actual future results may differ from those estimates. Fair value of our reporting units is determined using an income approach based on discounted cash flow models. In determining the fair value of our reporting units, we assumed a discount rate of approximately 10.5%. The estimated fair value of the Activision Publishing reporting unit exceeded its carrying value by approximately $3 billion or at least 25% as of December 31, 2012. The estimated fair value of the Blizzard reporting unit substantially exceeded its carrying value as of December 31, 2012. However, changes in our assumptions underlying our estimates of fair value, which will be a function of our future financial performance, and changes in economic conditions could result in future impairment charges. We test acquired trade names for possible impairment by using a discounted cash flow model to estimate fair value. We have determined that no impairment has occurred at December 31, 2012 and 2011 based upon a set of assumptions regarding discounted future cash flows, which represent our best estimate of future performance at this time. In determining the fair value of our trade names, we assumed a discount rate of 10.5%, and royalty saving rates of approximately 1.5%. A one percentage point increase in the discount rate would not yield an impairment charge to our trade names. Changes in our assumptions underlying our estimates of fair value, which will be a function of our future financial performance and changes in economic conditions, could result in future impairment charges. Stock-Based Compensation Stock-based compensation expense is recognized during the requisite service periods (that is, the period for which the employee is being compensated) and is based on the value of stock-based payment awards after a reduction for estimated forfeitures. Forfeitures are estimated at the time of grant and are revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. We estimate the value of stock-based payment awards on the measurement date using a binomial-lattice model. Our determination of fair value of stock-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, our expected stock price volatility over the term of the awards, and actual and projected employee stock option exercise behaviors. 71-------------------------------------------------------------------------------- Table of Contents We generally determine the fair value of restricted stock rights (including restricted stock units, restricted stock awards and performance shares) based on the closing market price of the Company's common stock on the date of grant. Certain restricted stock rights granted to our employees and senior management vest based on the achievement of pre-established performance or market goals. We estimate the fair value of performance-based restricted stock rights at the closing market price of the Company's common stock on the date of grant. Each quarter, we update our assessment of the probability that the specified performance criteria will be achieved. We amortize the fair values of performance-based restricted stock rights over the requisite service period adjusted for estimated forfeitures for each separately vesting tranche of the award. We estimate the fair value of market-based restricted stock rights at the date of grant using a Monte Carlo valuation methodology and amortize those fair values over the requisite service period adjusted for estimated forfeitures for each separately vesting tranche of the award. The Monte Carlo methodology that we use to estimate the fair value of market-based restricted stock rights at the date of grant incorporates into the valuation the possibility that the market condition may not be satisfied. Provided that the requisite service is rendered, the total fair value of the market-based restricted stock rights at the date of grant must be recognized as compensation expense even if the market condition is not achieved. However, the number of shares that ultimately vest can vary significantly with the performance of the specified market criteria. For a detailed discussion of the application of these and other accounting policies see Note 2 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Recently Issued Accounting Pronouncements Indefinite-lived intangible assets impairment In July 2012, the FASB issued an update to the authoritative guidance related to testing indefinite-lived intangible assets for impairment. This update gives an entity the option to first consider certain qualitative factors to determine whether the existence of events and circumstances indicates that it is more likely than not that the fair value of an indefinite-lived intangible asset is less than its carrying amount as a basis for determining whether it is necessary to perform the quantitative impairment test. This update is effective for the indefinite-lived intangible asset impairment test performed for fiscal years beginning after September 15, 2012. Early adoption is permitted. The adoption of this guidance does not have a material impact on our consolidated financial statements. Balance sheet offsetting disclosures In December 2011, the FASB issued authoritative guidance on the disclosure of financial instruments and derivative instruments that are either offset or subject to an enforceable master netting arrangement or similar agreement and should be applied retrospectively for all comparative periods presented for annual periods beginning on or after January 1, 2013 and interim periods within those annual periods. The adoption of this guidance does not have a material impact on our consolidated financial statements. Reclassification of accumulated other comprehensive loss In February 2013, the FASB issued an accounting standards update requiring new disclosures about reclassifications from accumulated other comprehensive loss to net income. These disclosures may be presented on the face of the statements or in the notes to the consolidated financial statements. The standards update is effective for fiscal years beginning after December 15, 2012. The adoption of this guidance does not have a material impact on our consolidated financial statements. 72-------------------------------------------------------------------------------- Table of Contents |