Pachter: IW Firings May Impact Call Of Duty's Future Success

Wedbush Morgan analyst Michael Pachter predicts that Activision's recent firings of Infinity Ward heads Jason West and Vince Zampella could impact the future success of the developer's Call of Duty and Modern Warfare series. Zampella and West, formerly CEO and studio president of Infinity Ward respectively, were fired by parent company Activision last week after the publisher conducted an internal investigation. The company accused the two executives of insubordination and breaches of contract, and revealed a reorganization of its Call Of Duty franchise that has Sledgehammer Games working on its 2011 Call of Duty game. "West’s and Zampella’s departures may impact future success of Call of Duty games," says Pachter. "It is difficult to assess the contribution of the two men, but their track record suggests that their oversight of the creative process has contributed greatly to the brand’s success." The two senior employees helped create the Call of Duty and Modern Warfare franchises and develop them into two of the most successful video games in history. West and Zampella responded to their abrupt removals by filing a suit against Activision for breach of contract, breach of the implied covenant of good faith and fair dealing, and wrong termination in violation of public policy. Their lawsuit seeks $36 million in compensation, plus royalties, as well the contractual rights that "Activision granted to" the studio heads to control the Modern Warfare brand. The duo also accused the publisher of strong-arm tactics and an alleged unwillingness to honor previous agreements, claims that Activision later described as "meritless". Pachter says that it's impossible to conclude which side will prevail in the suit for damages without first reviewing the contracts involved and understanding Activision's investigation, but he comments, "We think that it is likely that West’s and Zampella’s damage claims have some merit, and expect to see the lawsuit progress to trial or settlement, with some compensation likely awarded." "Separately, we think that West’s and Zampella’s claim for creative control over the Call of Duty and Modern Warfare brands has little merit, and we expect Activision to retain control over the brands," the analyst adds. "If the pair are unable to demonstrate that their firing was discriminatory (by proving membership in some kind of protected class), we think it is likely that their recourse for wrongful termination will be limited to a damage claim, and think that their claims in equity will likely be dismissed." Pachter's full comments on West and Zampella's firings, their lawsuit against Activision, and the future of the Call of Duty and Modern Warfare franchises are as follows: "The chain of events leading up to the lawsuit filed last week appears to be especially nasty, and the public nature of the squabble is unusual. We do not have access to the MOU, nor do we have access to the conclusions Activision reached following its internal investigation into West’s and Zampella’s alleged insubordination and breach of contract. It is possible that Activision discovered West’s and Zampella’s plans to leave Activision in order to create a new studio or work for a competitor (purely conjecture on our part, but the type of event that the company would term a “breach of contract”). We are at a loss to venture a guess as to the type of behavior that may have constituted “insubordination”. The tone of the dispute is quite nasty. In the lawsuit, West’s and Zampella’s outside counsel, O’Melveny & Myers, used inflammatory language that we have seldom seen from white shoe firms. Among the many statements we found amusing, O’Melveny used terms such as “astonishing arrogance and unbridled greed” when referring to Activision. O’Melveny also called Activision’s investigation “pretextual”; said that West and Zampella were invited to a “sham meeting”; said that Activision “took advantage” of West and Zampella when it purchased IW; said that Activision provided West and Zampella a list of “trumped up” charges; and stated that Activision “had already made up its mind” when it offered West and Zampella the opportunity to respond to their impending termination. It is also quite unusual to see internal disputes between a publisher and its employees play out in the press, as we have seen over the past week with this dispute. In our view, Activision’s decision to terminate West and Zampella was not made lightly, and the move to lock the pair out of their offices and confiscate their computers and cell phones suggests that the company fears that the pair will somehow use company information in order to compete with Activision going forward. We can only speculate as to what happened, and offer our best guesses about the past, and our views about what will likely happen going forward. It seems to us that the most likely explanation for the dispute is that Activision discovered that West and Zampella intended to leave the company and set up a competitive enterprise elsewhere (either with another publisher or as an independent studio). Such a scenario provides some justification for Activision’s pre-emptive decision to lock West and Zampella out of their IW offices, and to withhold any potential royalty payments. The allegations in the lawsuit are clearly intended to place West and Zampella in the most favorable light, and to place Activision in the least favorable light. For example, the lawsuit comments on the purchase price for IW, saying that the total price of $5 million was “an unusually good deal for Activision”. The suit did not mention how the first Call of Duty game was financed, nor did it mention whether IW received royalties from sales of the first game. It is our understanding that Activision fully financed the development of the first game, and paid IW substantial royalties as a result of that game’s success, so the one-sided comments in the lawsuit do not fully reflect the total compensation paid to a start-up studio with 24 employees that created one game. The suit also suggests that West and Zampella were somehow taken advantage of when the MOU was signed in early 2008. It appears to us that the MOU provided West and Zampella with significant powers at a high rate of compensation, and in exchange, the two agreed to remain employees of Activision through October 2011. There is no allegation that the two were under duress when the MOU was signed. We can only conclude that the MOU was an arm’s length agreement under which Activision agreed to employ West and Zampella for a specified term, agreed to provide them with broad control over the IW operations and the Call of Duty and Modern Warfare brands, and agreed to compensate them accordingly. At the heart of the dispute is whether West and Zampella were wrongfully terminated, and whether their rights under the employment contract should be restored. Again, we do not have sufficient facts to conclude who will prevail. It is clear that West and Zampella performed valuable services for a considerable period prior to their termination, culminating in the November 10, 2009 launch of the best-selling game of 2009. It is equally clear that Activision believes that the pair breached their contracts with the company, and believes that it was justified in terminating their employment. Because a substantial amount of work was performed prior to the termination, we think that it is likely that West and Zampella have the better case in the damages claim, and we think that a substantial portion of the royalties and bonuses expected on March 31, 2010 will ultimately be paid to them. It is not clear whether these royalties add up to the $36 million claimed as damages, but we suspect that they do not. However, we think that West and Zampella are likely to ultimately prevail in their damages claim, and expect that Activision will ultimately pay the pair a substantial sum. Even if the entire $36 million is paid, with interest and attorney’s fees, the total would impact Activision earnings by around $0.02 per share. The greater issue is the injunction sought. According to the allegations in the lawsuit, the MOU granted West and Zampella, as employees of Activision, control over the IW studio and creative control over the Modern Warfare brand and any Call of Duty game set in the post-Vietnam era. Given that West and Zampella are no longer Activision employees, we think it is unlikely that they will be awarded the continuing control provided by the MOU. Should Activision agree to re-hire them as employees (a scenario that we think is incredibly unlikely, given the hostile tone taken by the pair), the terms of the MOU would likely be restored, and West and Zampella would again have creative control. Should West and Zampella remain independent contractors or become employees of an Activision competitor, we think it is highly unlikely that they will be awarded continuing control over the Modern Warfare brand and any Call of Duty game set in the post-Vietnam era. We reach this conclusion after thinking about the arm’s length negotiations in arriving at the MOU, and admit that we have not seen the MOU itself, but base our opinion solely on the allegations contained in the lawsuit. It is clear from the language in the lawsuit that the MOU involved West’s and Zampella’s status as Activision employees, and that the creative control offered was extended only while their status remained as Activision employees. We think that the MOU is analogous to a contract with a sports team manager, who may be given control over the drafting of amateur athletes and the ability to decide who plays in a given game; when the sports team manager’s employment terminates, there is typically not an expectation that the unemployed manager will have further control over roster decisions. Similarly, once West’s and Zampella’s employment was terminated, we believe that Activision has a legitimate expectation that their control over the Modern Warfare brand and any Call of Duty game set in the post-Vietnam era terminated, as well. In our view, West and Zampella can only legitimately claim future control in the event that they restore their employment status, which, as we said earlier, is exceedingly unlikely to happen. Should we be wrong about the control issue, Activision has significant exposure. While Treyarch’s Call of Duty iterations have been successful, they have not reached the heights of Infinity Ward’s Modern Warfare games. It is difficult to assess the contribution of West and Zampella to the IW bi-annual Call of Duty installments, but should the pair retain creative control as non-employees, it is unlikely that there will be any future installments of the game from IW. Again, we do not expect this to happen, but if it does, the results would be leveraging to Activision’s bottom line. More likely, we think that Activision will prevail, and will be able to make future versions of the Modern Warfare brand and any Call of Duty game set in the post-Vietnam era with impunity. Again, the contributions of West and Zampella are difficult to assess, but the pair has had incredible success with each version of the game created under their supervision. The “secret sauce” of their involvement is analogous to the direction of a movie; some directors work with certain types of material in a unique way, and repeatedly achieve commercial success with that material. In the same way, we think that West and Zampella provide something unique to the creation of games at Infinity Ward, and think it’s likely that their contribution will be missed in future installments. Last week, Activision announced a new Call of Duty business unit, as well as three new Call of Duty titles (first person shooters in 2010 and 2011, and an action-adventure game), and two downloadable map packs in 2010. So far, Infinity Ward seems to be involved in only one of these items (the two map packs), while Treyarch will complete the 2010 first-person shooter and Sledgehammer Games will create the action-adventure game (the 2011 first-person shooter’s developer has not yet been announced). The company appears intent upon exploiting its Call of Duty brand, and, other than the map packs, no mention was made of the Modern Warfare brand. We think that West’s and Zampella’s departure could be a serious negative for Activision should the pair choose to work for Electronic Arts. EA has recently revived the Medal of Honor series, placing this year’s installment in the modern warfare realm, and the addition of the former Infinity Ward heads could help EA sell a greater number of copies of this and future installments of Medal of Honor. Perhaps more importantly, we understand that West and Zampella were popular among IW employees, and should they work for an Activision competitor (or even set up shop independently), it is likely that they will aggressively recruit former co-workers to join them. Because of their senior roles at IW, they presumably know which employees are the most talented, and are in a position to compete with Activision going forward. We will monitor their employment status and will update investors as these events unfold in the future."