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Executives

Julie MacMedan - Vice President of Investor Relations and Corporate Communications

Brian Farrell - President and Chief Executive Officer

Colin Slade - Executive Vice President and Chief Financial Officer

Rasmus van der Colff - Vice President and Controller and Chief Accounting Officer

THQ Inc. (THQI) F2Q09 Earnings Call November 5, 2008 5:00 PM ET

Operator

Good afternoon. My name is [Don] and I will be your conference operator today. At this time I would like to welcome everyone to the THQ Inc. fiscal 2009 second quarter results conference call. (Operator Instructions)

I would not like to turn the call over to Julie MacMedan, Vice President of Investor Relations and Corporate Communications. You may begin your conference.

Julie MacMedan

Thank you. Good afternoon, everyone.

On today's call management will make forward-looking statements and projections regarding our expectations, estimates and projections of the future. These statements are based in part on management's beliefs and certain assumptions made by management and are not guarantees of future performance. Therefore, actual results may differ materially from today's forward-looking statements due to the risk factors and cautionary statements that are described in our March 31, 2008 Form 10-K and subsequent filings with the SEC. A copy of these filings may be obtained from our website.

THQ disclaims any obligation to update its view on any such risks or uncertainties after the date they are made.

In describing THQ's financial performance, we will discuss non-GAAP measures, including net sales and earnings per share. These non-GAAP measures include the following: share-based compensation expense, the impact of deferred revenue and related costs, business realignment expense, the other than temporary write-down of investments, the non-cash valuation allowance for deferred tax assets, and the related income tax effects for each of these items. Please refer to the reconciliation of these measure to our GAAP results in the tables provided in today's results release.

On today's call Brian Farrell, THQ's President and Chief Executive Officer, will review trends in our business and our new strategic plan and will then turn the call over to Colin Slade, our Executive Vice President and Chief Financial Officer, as well as Rasmus van der Colff, our Chief Accounting Officer, to discuss THQ's results for our fiscal 2009 second quarter and our guidance for fiscal 2009. Brian will then provide closing remarks before we conduct a question-and-answer session.

I would now like to introduce Brian Farrell, our President and Chief Executive Officer. Brian?

Brian Farrell

Thank you, Julie, and good afternoon, everyone.

Earlier today we announced second quarter results below plan and significantly reduced our outlook for fiscal 2009. On today's call I will discuss the trends affecting our business and our new strategic plan to address those trends. I will also share with you our perspective on the macroeconomic environment. Following today's financial review, I will close the call with an overview of our upcoming product slate.

We have just completed a new strategic plan. There are five key elements: One, we will publish fewer, bigger core gamer titles; two, we will dominate the fighting category; three, we will make our kids business more profitable; four, we will capitalize on the emerging family gaming segment; and five, we will migrate our key brands to the online gaming market. Our goal is to improve performance and deliver profitable growth in fiscal 2010. I'll drill down on each of these priorities and the business trends they address.

First, the quality bar for core gamers continued to be set higher and the cost to deliver this quality has increased significantly. As a result, we have reduced the number of core gamer games in our pipeline, but will increase our development budgets where appropriate to compete at the highest levels.

Saints Row 2 reflects this approach. The game achieved critical acclaim and early commercial success, with more than 2 million units shipped worldwide. Our commitment to compete at the highest level also influenced our decision to move Red Faction Guerrilla and Darksiders into fiscal '10.

Second, we see an opportunity to grow the fighting category beginning in fiscal 2010. We are the clear global market leader in the fighting segment with our WWE SmackDown! vs. RAW games. We plan to launch select product extensions to this franchise, such as WWE Legends and WWE Online. We also plan to build on our leadership with the release of a high-quality UFC game next spring and to grow UFC into a global videogame brand.

Third, growth in the kids license business has slowed considerably, and the business has become less profitable. We will rationalize our product line in the kids business and improve profitability by publishing on the most relevant platforms and by reducing development costs through more outsourcing. We are also reinvigorating our licensed franchise portfolio with the recent additions of Marvel's SuperHero Squad and DreamWorks Animation's Master Mind.

Fourth, the family gaming segment is large and growing, particularly among females and casual gamers. We will capitalize on the emerging family gaming segment by building on current franchises such as de Blob, Big Beach and Drawn to Life, which appeal to the broadening gamer demographic. In addition, we have other projects in development for this category that we will announce at a later date.

Fifth, more gamers are buying and playing games online. Our strategy is to make targeted investments in extending key brands, including Company of Heroes Online, WWE Online, and our Warhammer 40000 MMO. We also plan to exploit growing consumer segments such as the casual MMO market with the release of Dragonica working with our partner, ICE Entertainment.

These actions will result in a smaller, more focused and profitable product portfolio that is aligned with the key consumer trends in the videogame business that we have identified.

We are making a number of changes to our organization to support our new strategy. As we announced earlier this month, we have restructured our product development organization. This week we discontinued a number of titles in our product pipeline that did not fit our strategic objectives. As a result, we have closed five of our studios and reduced staff at two others. These actions resulted in a headcount reduction of approximately 350 people, which is approximately 17% of our studio staff.

We are also realigning our organizational structure to support this more-focused product strategy. Over the next several weeks we plan to reduce both costs and headcount in our corporate and global publishing organizations.

As a result of these actions we have reduced our forecasted product development spending for fiscal 2010 by approximately $100 million, which is about $30 million below the spending level in the current fiscal year. We will further reduce costs and streamline operations and expect to reduce selling, marketing, and general and administrative expenses on an annual basis by approximately $20 million.

We also expect to incur significant charges as part of our business realignment which will be excluded from the company's non-GAAP results. Most of these charges will be recognized in the remainder of fiscal 2009.

The combination of a much more focused and competitive product line and a more efficient cost structure will put THQ back on the path to growth and profitability in fiscal 2010. We intend to execute on our new strategic plan with a strong studio system that is comprised of some of the best creative talent in the industry and a streamlined corporate and publishing organization.

Now just a few comments on the broader economy. The weakening macroeconomic environment began to impact our sales in certain international territories at the end of September. Clearly, we have seen consumer confidence further deteriorate during the month of October on a global basis. While videogames provide great entertainment value and have proven to be resilient in weak economic times, we are seeing a cautious retail environment overall. In addition, we are seeing lower initial launch order quantities and softness in sales of catalog titles. We also expect consumers to delay purchases until late in the holiday season.

Also the strengthening of the U.S. dollar relative to the British pound and euro has had a particularly negative effect on THQ since we generate about 50% of our sales outside of the U.S. This alone resulted in a reduction in our sales forecast for the remainder of the year of about $80 million.

As Colin will review in more detail, the combination of the changing trends in our business, the weak macroeconomic environment, unfavorable currency exchange rates, and the move of two titles into the next fiscal year have significantly reduced our outlook for fiscal 2009. In light of these conditions, we are accelerating the actions under the strategic plan I just outlined. Our goal is to deliver profitable growth in fiscal 2010.

With that, I will turn the call over to Colin Slade, our CFO. As you saw earlier today, we announced that Colin is going out on a temporary medical leave of absence and we are looking forward to his return as soon as possible. In the meantime, I look forward to working with Rasmus van der Colff and our strong financial and accounting staff in the interim.

Colin?

Colin Slade

Thank you, Brian. Good afternoon to everyone. Today I'll provide an overview of our financial results and outlook before turning the call over to Rasmus van der Colff, who'll review our financials in more detail.

As you saw in our news release earlier today, I'll be taking a medical leave of absence. In the interim Rasmus, our Vice President, Controller, and Chief Accounting Officer, will be interim CFO. I'm confident that Rasmus and the rest of THQ's experienced financial and accounting organization will continue to do a great job and meet the financial, accounting and reporting needs of the company.

Before I turn the call over to Rasmus, I'd like to summarize our Q2 financial results and discuss our reduced financial outlook for the second half of the fiscal year.

We reported Q2 net sales a little below the lower end of our guidance, mostly due to softer than expected sales of kids titles, particularly WALL-E, across international territories, higher than anticipated sales returns and allowances due to softer sell through in Europe, a greater mix of lower margin titles, unfavorable foreign currency exchange rates, and early signs of softer consumer spending in certain regions of Europe, but we partially offset the impact of softer sales with operating cost control efforts and a favorable non-GAAP tax rate. Our EPS came in below our guidance.

Looking ahead to the rest of fiscal 2009, we've lowered our sales and earnings outlook. We expect earnings for the second half of the year to be at approximately breakeven on a nonGAAP basis, excluding business realignment charges. The primary drivers of the lower outlook are:

One, our decision to release Red Faction Guerrilla and Darksiders Wrath of War in fiscal 2010 instead of the fourth quarter of fiscal 2009, and this has accounted for approximately $125 million in lower forecasted net sales;

Two, the significant appreciation of the U.S. dollar, which accounted for approximately $80 million in lower forecasted net revenue;

And three, our expectations for a more cautious retail environment and continued softness in sales of kids games, which accounted for approximately $70 million in lower forecasted net sales.

As Brian discussed, in response to these challenges we've announced significant business realignment action. This is a significant right-sizing of our company to position us to get back on the path of long-term profitable growth. Like Brian, I'm encouraged about our new products and continued progress in our product development efforts, and I'm looking forward to returning to THQ as soon as possible.

With that, I'll now turn the call over to Rasmus to review our financials in more detail. Rasmus?

Rasmus van der Colff

Thank you, Colin. Good afternoon to everyone.

Colin just reviewed the overall trends that impacted Q2 results and our fiscal 2009 outlook. I'll now review our Q2 financial results in more detail and focus my remarks primarily on the year-over-year quarterly comparison. In addition, I'll provide guidance for the December quarter and updated guidance for fiscal 2009.

As I discuss our financial performance in more detail, I'll use non-GAAP results which are comparative to prior quarters' non-GAAP results. There were several adjustments to GAAP reporting to get to non-GAAP reporting, and two of the adjustments are new.

First, non-GAAP results excluded the impact of share-based compensation expense and this was consistent with the prior quarter and prior year treatment.

Second, we deferred a portion of revenue and related costs from GAAP reporting. For purposes of non-GAAP reporting, we'll treat this revenue in the same way we have historically, and we will not defer any portion of the revenue or related cost of sales.

Third, excluded from non-GAAP reporting is the impact of business realignment charges.

Fourth, non-GAAP results excluded the impact of other than temporary writedowns on investments.

And last, non-GAAP results excluded the impact of non-cash charges to record a valuation allowance and related tax effect on deferred tax [inaudible].

As Colin mentioned, our second quarter results were below our expectations. Net sales for the second quarter of fiscal 2009 were $151.6 million, excluding the net impact of deferred revenue. This represented a 34% decline versus the prior year quarter and was slightly below the low end of our expectations of $160 million.

The decrease in our net sales versus the prior year quarter was primarily due to fewer new releases in the current quarter and lower sales of WALL-E compared with Ratatouille in the prior year's quarter.

Key titles during the second quarter were WALL-E, which was released in Europe and Asia-Pacific, as well as new releases, including our new, original title de Blob. Catalog was 33% of net sales.

Within cost of sales, product costs at 48% of net sales were up 10 points versus the prior year quarter. This increase is primarily the result of lower average net selling prices during the current quarter due to fewer new releases in the current quarter.

[Software] amortization and royalties at 21% of net sales was 5 points above the prior year's second quarter. This increase was primarily the result of accelerated amortization recorded due to lower forecasted sales of WALL-E and other kids titles.

License amortization and royalty costs of 13% of net sales increased by approximately 3 points compared to the second quarter of the last fiscal year, due primarily to higher effective royalty rates.

Venture partner expense was roughly flat, at about 0.6% of net sales compared to the prior year quarter.

As a result of higher product costs, higher software development amortization and higher license amortization as a percentage of net sales, the gross margin was 17% versus 36% in the prior year quarter. Product development expenses of $21.8 million were down $5.7 million compared to the prior year quarter. This decrease is the result of cost control efforts and the timing of capitalization of development costs.

Selling and marketing expenses were $42.2 million or 28% of net sales, up from 20% of net sales in the prior year quarter. The increase as a percentage of net sales is primarily due to lower net sales, partially offset by cost control efforts.

G&A expenses were $15.2 million, up from $13.8 million in the prior year quarter.

Interest and other income for the quarter were $2.1 million, down $0.5 million from the prior year quarter primarily as a result of lower average yields on lower average investment balances.

Including a non-GAAP net tax benefit of $20.9 million, the net loss for the second quarter was $30.4 million or $0.46 per share. This compares with a net loss in last year's second quarter of $2.2 million or $0.03 per share.

In summary, sales at $151.6 million were slightly below the low end of our guidance. A lower gross margin partially offset by cost control efforts and a favorable tax benefit resulted in a loss of $0.46 per share, which was below our guided range.

Now let's turn to the balance sheet.

THQ ended the quarter with $200 million or $3 per share in cash and investments, including $38 million in long-term investments. This balance was down sequentially by $131 million from the prior quarter and primarily reflects the net use of cash to fund product development and inventories in advance of the important holiday season.

Net accounts receivable of $63.3 million decreased from $112.8 million at the prior fiscal year end. The decrease is primarily due to lower net sales for the first half of fiscal '09.

DSO of 38 days improved by 27 days versus the prior year's Q2, primarily due to the timing of sales and collections.

Accounts receivable reserves were $94 million at quarter end. The coverage ratio on a trailing nine months of net sales basis was 15%, up from 14% in the prior year quarter.

Inventory was $64 million, an increase from the $38 million at the prior fiscal year end, primarily related to inventory for Saints Row 2, which was released in October. Inventory turns were 8, down 2 from 10 in the prior year quarter.

Our investment in licenses was $118 million, up from $87 million at the prior fiscal year end. This primarily reflects the timing of payments for existing and new licenses entered into during the current fiscal year.

Capitalized software development increased to $275 million at the end of the current quarter, up from $181 million at the prior fiscal year end. This growth reflects the investment in key titles, including WWE SmackDown! vs. RAW 2009, Saints Row 2, UFC, Red Faction Guerrilla, Darksiders, and Dawn of War II.

I'd like to spend a few moments on taxes. In accordance with FAS 109, Accounting for Income Taxes, the company evaluates its deferred tax asset to determine if a valuation allowance is required. Although THQ reported net income in two of the last three fiscal years, we've had three years of cumulative U.S. tax losses. Therefore, during the second quarter of 2009 on a GAAP basis the company reported a non-cash charge of $80.5 million to report a valuation allowance and related tax effect against its U.S. deferred tax asset.

It is important to note that if we generate sufficient taxable income in the U.S. in future years, we will realize the benefits of the reversal of the valuation allowance to offset the tax expense in future years. THQ will explore alternative strategies to increase U.S. taxable income in future years.

Long-term marketable securities were down $14.8 million from the end of the prior fiscal year. This includes the $6.9 million of auction rate securities that were re-classed as short-term investment, $4.4 million that were called at par value, $2.6 million of permanent impairment, and $1 million of additional temporary impairment.

Total current liabilities were $295 million, down a little from $300 million at the end of the prior fiscal year. The change is primarily due to the [signing] of trade accounts payable and other accruals as well as an increase for accrued royalties associated with new licenses entered into during the quarter.

Other long-term liabilities were down $5 million from the prior fiscal year end to $39 million, primarily reflecting payments to [inaudible].

We had no borrowings at quarter end and total stockholders equity was $603 million.

That concludes the financial results for the current quarter. Turning now to our guidance for the second half of the year, Colin provided an overview of the key drivers in our revised forecast. As a result of these factors, our new guidance on a non-GAAP basis is as follows:

For our fiscal third quarter we expect net sales in the range of approximately $400 million to $420 million. Sales are low relative to our [inaudible] expectations given the factors Colin mentioned.

In October, Congress renewed the R&D tax credit on a retroactive basis. As a result, we expect a lower-than-usual non-GAAP tax rate in Q3 of approximately 24%.

Based on these assumptions, we expect to produce net income of about $0.05 to $0.15 per share, again, on a non-GAAP basis, excluding business realignment charges.

Charges related to the cancellation of the unannounced titles and long-life assets associated with the studio closures are currently expected to be $30 million to $35 million, which we will incur in fiscal 2009. We also expect to incur significant additional charges as part of our business realignment, most of which will be recognized in the remainder of fiscal 2009; however, we have not yet fully quantified these charges. We expect these charges to consist primarily of severance and other employee-related costs and lease and other contract termination costs.

Switching now THQ's full fiscal year, we now expect net revenue in the range of $875 million to $900 million for the fiscal year. We estimate approximately 67 million average outstanding shares for the fiscal year. We expect earnings for the second half of the year to be approximately breakeven on a non-GAAP basis, excluding business realignment charges.

That concludes our guidance for fiscal 2009. I'd now like to turn the call back to Brian. Brian?

Brian Farrell

Thank you, Rasmus.

Earlier on the call I reviewed our strategic plan with you. Now I'd like to discuss the progress we are making in our product development organization and our strong product pipeline.

We have made significant strides in our product development organization, specifically our improved product quality and the changes we have made to our creative development process. Last month we restructured our product development organization in order to increase efficiency, predictability and quality. As a result, I'm now working directly with our product development leadership team to ensure a disciplined adherence to our Green Light and project management processes, the implementation of a more efficient product development cost structure, and the establishment of higher creative standards, including game play, story, and production values.

In mid-October we launched Saints Row 2 to strong critical acclaim and commercial success. Saints Row 2 has been broadly recognized as the most fun, biggest and over-the-top open world action game on the market. As I discussed, our strategic plan calls for a focus on fewer, bigger titles. When we focus our efforts on big opportunities such as Saints Row 2, we win.

We are looking forward to the launch of several strong titles over the next four quarters. WWE SmackDown! vs. RAW ships next week, and WWE Legends and Warhammer 40000: Dawn of War 2 are scheduled in Q4.

Looking into fiscal 2010, we have a strong first quarter, anchored by UFC and Red Faction Guerrilla. We have decided to spend an additional eight to 10 weeks to polish Red Faction Guerrilla and have moved this game into our fiscal Q1. We have moved Darksiders, an ambitious and promising franchise for THQ, to the second quarter of fiscal 2010 in order to deliver the highly competitive product that the marketplace demands. Obviously, with these strong releases in the first two fiscal quarters, we have much more visibility in the first half of fiscal 2010.

With respect to our kids lineup in fiscal 2010, we'll have our first games based on Marvel Entertainments SuperHero Squad, Disney Pixar's Up, and SpongeBob's Tenth Anniversary Event. As I mentioned earlier, our goal is to enhance profitability in this segment of our business.

We intend to capitalize on emerging online opportunities. We view the online gaming market as an attractive long-term growth opportunity for THQ, and we currently have four key online initiatives.

First, we are pleased with the adaptation of Company of Heroes Online to the free-to-play microtransaction model for the Chinese market. We look forward to launching this title with leading Chinese game operator Shanda in our fiscal fourth quarter, and we plan to roll the game out to other Asian territories starting in fiscal 2010.

Second, we recently announced our plans to launch WWE Online first in Korea in fiscal 2011, followed by other Asian markets.

We also plan to exploit the growing casual MMO market in North America with the launch of Dragonica to our joint venture with ICE Entertainment in fiscal 2010.

Most importantly, we are very pleased with the progress to date on our massively multi-player game, Warhammer 40000.

In summary, we are taking aggressive and immediate actions to implement the strategic plan I outlined for you today. Our goal is to publish a tighter product line of fewer, better games and to return THQ to profitability in fiscal 2010. We are taking the necessary steps that we believe will bring long-term value to our stockholders.

With that, I'd like to ask the operator to open the call up to questions.

Question-and-Answer Session

Operator

(Operator Instructions)

Julie MacMedan

Okay, Operator, I believe there are no questions at this time. Thank you for listening to the call and please follow up directly with me and the Investor Relations Department if you have follow-up questions. Thank you.

Operator

And this concludes today's conference call. You may now disconnect.

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Source: THQ Inc. F2Q09 (Qtr End 9/30/08) Earnings Call Transcript
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