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Executives

Julie MacMedan – VP, IR & Corporate Communications

Brian Farrell – President and CEO

Paul Pucino – EVP & CFO

Analysts

Colin Sebastian – Lazard Capital Markets

Edward Williams – BMO Capital Markets

Heath Terry – FBR Capital Markets

Arvind Bhatia – Sterne, Agee & Leach

Edward Tenthoff – Piper Jaffray

John Taylor – Arcadia

Ben Schachter – Broadpoint AmTech

Herman Leung – Deutsche Bank

Eric Handler – MKM Partners

THQ Inc. (THQI) F3Q10 (Qtr End 12/31/09) Earnings Call Transcript February 3, 2010 5:00 PM ET

Operator

Good afternoon. My name is Michelle and I will be your conference operator today. At this time, I would like to welcome everyone to the THQ Inc. fiscal 2010 third quarter results conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator instructions)

Thank you. I would now like to turn the call over Julie MacMedan, Vice President of Investor Relations and Corporate Communications. You may begin your conference.

Julie MacMedan

Thank you and good afternoon, everyone. On today's call, management will make forward-looking statements and projections regarding our expectations, estimates and predictions 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, 2009 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 these statements are made.

In describing THQ's financial performance, we will discuss non-GAAP measures including net sales and EPS. These non-GAAP measures exclude the following; stock based compensation expense, the impact of certain deferred revenue and related costs, business realignment expense, the other-than-temporary write-down of investments and mark-to-market adjustments on auction rate securities, other material litigation settlements and non-recurring charges and benefits, and the related income tax effects for each of these items. Please refer to the reconciliation of these measures to 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 our third quarter achievements and will then turn the call over to Paul Pucino, our Executive Vice President and Chief Financial Officer to discuss THQ's financial results for our fiscal 2010 third quarter and our outlook for the year. 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. A year ago on this call, we laid out a focused strategic plan and some challenging, but clear financial targets. We have made significant progress on this plan and have accomplished a great deal in a short time. While there is still a lot of work to be done, we are pleased with our progress to date and we intend to carry this momentum forward.

Specifically, we set out the following six operating goals for THQ. One, focus on delivering one to two quality titles for the core gamer each year; two, extend our leadership in fighting games; three, reinvigorate our kids portfolio and improve its profitability; four, build our portfolio of casual games; five, increase digital revenues and extend our brands to online platforms; and six, reduce our cost structure significantly.

We also set specific financial targets for fiscal 2010 as follows. One, generate higher net sales year-over-year; two, deliver profitability; three, deliver a cash balance at least $50 million higher than at the end of the prior year.

Today, I'm pleased to report crisp execution on each of our operating strategies and financial targets. Let's review our progress in more detail. We reported third quarter fiscal 2010 net sales in line with our guidance. While we did not provide third quarter earnings guidance, we generated $27 million of net income during the quarter and reaffirmed our full-year outlook.

Although our third quarter net sales were down slightly from the same period a year ago, operating efficiencies enabled us to deliver solid profitability this holiday quarter versus last year. The holiday quarter played out as we expected. As we discussed in our previous conference call in November, we experienced a cautious retail and – consumer and retail environment this holiday.

As we expected, Christmas came late again this year with very strong sell-through and reorders in the U.S. during the last two weeks of the quarter, partially offsetting weakness in Europe. We executed in this competitive marketplace with high-quality games, well-known brands, and targeted marketing campaigns.

For the first nine months of fiscal 2009, net sales are up and we are generating net income versus a net loss for the same period last year. We are on track to achieve our stated financial goals of higher net sales, profitability, and significant cash generation this fiscal year and as importantly, through our business unit restructuring and significant cost reductions we have positioned the company for continued earnings growth. In calendar 2009, THQ gained market share. We were the number four independent publisher in the U.S. with a 4.7% share, up from 3.8% a year ago.

Turning to execution on our specific operating strategies, our stated strategy for core games is to develop one to two new, high-quality games each year and to build franchises through sequels. This year, we shipped core games Red Faction Guerrilla with an 85 Metacritic rating and Darksiders with an 83 Metacritic rating. We intend to build upon the outstanding technology in game design of each of these franchises with sequels in the future.

We also achieved our goal of extending THQ's leadership in the fighting game category. In May of last year, we successfully launched a UFC franchise with an 84 Metacritic rating and shipments of more than 3.5 million units to date. We look forward to launching an exciting new high-quality UFC game this coming May.

We also recently signed a new direct eight-year agreement with WWE to publish games based on this tremendous fighting brand. We believe this deal will generate better profitability for THQ in future years. This holiday, we shipped more than 3.5 million units of WWE SmackDown vs. Raw 2010, which achieved a Metacritic rating of 81. It is a significant competitive advantage to have two multi-million unit fighting franchises in our annual release plan.

Turning now to our kids, family, and casual business, our stated strategy is to reinvigorate our portfolio and to improve profitability in our kids license business. To that end, we recently announced a multi-year, multi-property agreement with DreamWorks Animation to publish games based on Kung-Fu Panda 2, Puss in Boots, and Penguins of Madagascar. With the previously announced MegaMind, this deal adds two Tentpole franchises in each of fiscal 2011 and 2012.

We also shipped our first games based on Marvel Super Hero Squad in fiscal 2010 and we expect to continue to publish games on this great brand for the next two years. We've been taking aggressive actions to reduce the cost structure for our kids games and we are well on our way to returning our kids portfolio to a steady, predictable revenue and profit driver for THQ.

We also set a goal to build strong mass appeal in family gaming franchises. The Biggest Loser game has been a great success for us this year. It was the number one fitness game from an independent publisher in the U.S. during the December quarter. We continue to build our Drawn to Life brand with our latest title approaching 1 million units shipped and total lifetime franchise shipments in excess of 3 million units.

We also established new original game World of Zoo at more than 700,000 units shipped. Earlier this week, we announced a new agreement with Sony to develop games based on Wheel of Fortune and JEOPARDY! In short, we have made great progress toward achieving our goal of building strong casual and family gaming franchises.

Finally, we see digital gaming as a huge market opportunity. As a result, we are increasing our investments in this area. This year, we continue to execute on our strategy to extend our brands to online markets and distribution models. We have cultivated strategic partnerships to develop and operate games based on our IP in key markets such as China, Korea, and other Asian territories. And we have been steadily building our internal game development and online publishing capabilities. As a result, we have a robust pipeline of digital games scheduled to launch based on our core brands.

As we announced earlier today, we have two more studios with teams dedicated to online game development. These studios will extend our core game brands online, develop new digital-only IPs and provide community technology that connects each of our core brands to gamers.

We are currently investing in the following digital gaming platforms; Facebook, iPhone and iPad, Xbox LIVE and PlayStation Network, Casual MMOs and Core MMOs. Several of these games are scheduled to launch starting in fiscal 2011. Our strategy is to connect every game possible through digital distribution and community features.

In summary, year-to-date, we have established two new highly rated core game franchises, UFC and Darksiders and successfully launched Red Faction on current-gen consoles. We have secured multi-year agreements to make games based on WWE, DreamWorks, JEOPARDY! and Wheel of Fortune. We have added new kids, family, and casual franchises such as The Biggest Loser and we positioned THQ's online business to grow in fiscal 2011 and beyond.

Also, we are on track to achieve our stated goals of revenue growth, profitability, and significant cash generation this fiscal year and we have built a foundation for our long-term success with our focused business units and lower cost structure.

Now, let's turn to the broader market picture. Industry software sales declined in calendar 2009, but were still the second highest on record. Much of this decline is explained by the fall in the music category and a challenging economy. Looking into calendar 2010, we believe industry software dollar sales will be flat-to-up single-digits in North America and Europe, driven primarily by growth in PS3 and Xbox 360 software sales. We like our position to capitalize on these platforms with a strong core game and fighting lineup.

With that, I'd like to turn the call over to Paul.

Paul Pucino

Thank you, Brian, and good afternoon. Today, I'll recap our fiscal 2010 third quarter results and discuss our future business outlook. As I discuss our financial performance in more detail, I will use non-GAAP results, which are comparative to the prior period's non-GAAP.

As Julie mentioned, there were several adjustments to GAAP reporting. Please refer to our press release issued earlier today for a reconciliation of our GAAP and non-GAAP results.

For the fiscal third quarter, we reported net sales of $357 million, which was in line with our guidance of down 5% to 10% from $386 million a year ago. As a reminder, last year's revenue benefited from the strong performance of Saints Row 2 in the quarter. Our top title for the third quarter was WWE SmackDown vs. Raw 2010, which shipped more than 3.5 million units. While its units were down 13% year-over-year, net sales were only down 7% due to an overall higher average selling price, reflecting growth on the Xbox 360 platform.

We also shipped nearly 700,000 units of the highly rated MX vs. ATV Reflex in the U.S. and Asia-Pacific during the holiday quarter. We are launching this game in European territories this week and it is on track to surpass 1 million units this fiscal year.

In addition, at shipments of more than 700,000 units, The Biggest Loser game is posting great numbers. According to NPD, it was the number one fitness game from an independent publisher in the December quarter and we continue to see strong sell-through of this game.

Our product cost, as percentage of net sales, decreased 1.3 percentage points to 35.8% versus the same quarter last year, primarily due to a higher mix of net sales from games with higher average selling prices relative to product cost as compared to the same period last fiscal year.

Software amortization, as a percent of net sales, decreased 7.6 percentage points to 20.1%. Excluding prior-year accelerated amortization, software amortization, as a percent of sales, stayed relatively flat. License and royalties, as a percent of net sales, increased slightly to 9.7% from 9.3%, due primarily to a higher mix of sales from licensed products in fiscal 2010.

Venture partner expense decreased 1.4 percentage points, due primarily to a lower preferred payment rate to JAKKS. As a reminder, effective January 1st, 2010, JAKKS will no longer earn a preferred return rate on WWE sales. Included in venture partner expense in our GAAP results only, but worth explaining is our settlement with WWE and JAKKS. In December, we reached settlement agreements with WWE and JAKKS with respect to the WWE video game license and the termination of the joint venture. As a result, we reported a one-time settlement charge of $29.5 million, which is included in the venture partner expense line in our GAAP financial results.

Also, as we reported last quarter, we recorded a one-time benefit of $24.2 million from the settlement of the preferred return arbitration with JAKKS. As a result, under the new direct arrangement with WWE, we will pay a lower effective royalty rate than under the previous agreements.

That summarizes the changes in our third quarter cost of sales line items compared to the prior-year period. As a result, our gross profit improved to 32.3% of net sales from 22.4% a year ago.

Now, turning to operating expenses, our product development expense decreased to $21 million from $24 million in the prior-year period, consistent with our guidance. Selling and marketing expenses, as a percent of net sales, decreased by 3.8 percentage points versus the prior-year period, primarily due to our more focused product strategy and cost reductions from our business realignment. G&A expense decreased to $13 million from $20 million a year ago, due primarily to the fact that last year's G&A included $6 million of bad debt expense.

Although third quarter net sales were slightly lower this year, our improved gross margins and lower expense structure resulted in an operating income of $33 million compared to an operating loss of $25 million in the prior-year period. We reported income tax expense of $5 million compared with the $13 million benefit a year ago. This reflects our long-term 15% tax rate applied to this fiscal year.

In summary, we reported net income of $27 million or $0.35 per share compared with a net loss of $10 million or $0.14 per share last year, as a result of improved gross profit and reduced operating expenses. It is important to note that our EPS would have been $0.39 per share if we were not required to use the if-converted method to calculate EPS.

To review, let me spend a few moments talking about the mechanics of the if-converted method. As you know, we issued $100 million of convertible senior notes this past August. As a result, we are required to use the if-converted method when calculating EPS. If-converted method – the if-converted calculation backs out interest and debt issuance expense net of taxes related to the convertible notes and increases the number of common shares outstanding as if the notes were converted to equity.

If-converted method is used for financial reporting purposes if it results in a lower EPS than if it were not used. For THQ, the if-converted method will be used if quarterly non-GAAP net income exceeds approximately $8 million and if annual non-GAAP net income exceeds approximately $32 million. If this happens, we back out quarterly after-tax interest and debt issuance expense of about $1.2 million and increase shares outstanding by $11.7 million.

Given that fiscal 2010 third quarter non-GAAP net income exceeded $8 million, the if-converted method was applied. This had the impact of reducing non-GAAP EPS by $0.04 for the quarter. However, we do not anticipate the if-converted method to be required to be used for the full-year fiscal 2010 results. Therefore, the $0.04 reduction from applying the if-converted method in Q3 is not expected to impact full-year results.

Accordingly, our full-year non-GAAP EPS will be $0.04 higher and if our quarterly results for the year are added together as reported. I know this accounting is somewhat confusing, but I hope this was helpful in describing the methodology that we are required to use.

Now, let's turn to the balance sheet. As of December 31st, 2009, we had $234 million in cash and short-term investments. This compares with $141 million at March 31st, 2009. Our cash balance positions us well to invest in new intellectual properties, both owned and licensed, other growth opportunities such as digital platforms and core games with multi-year development cycles.

Net accounts receivable were $115 million, a decrease from $146 million last December. This decrease reflects lower revenues in the quarter and the improved timing of cash collections. Accounts receivable allowances of $85 million decreased from $125 million last December, primarily due to lower in-channel inventory. The coverage ratio on a trialing nine months of net sales basis was 10% compared with 13% in the prior-year period, primarily due to stronger performing products released this year.

Inventory was $25 million compared with $40 million last December, reflecting our tighter inventory management. Our investment in licenses increased by $61 million from March 31st, 2009, due primarily to the addition of the new eight-year license with WWE. This agreement resulted in a similar amount being reflected in our current and long-term liabilities.

Capitalized software development was $161 million compared with $162 million at March 31st, 2009. The December 2009 balance includes investments in key titles such as Darksiders, UFC 2010, and Homefront. Our total THQ Inc. stockholders' equity was $337 million.

And that concludes the financial results for the third quarter of fiscal 2010. Now, I’d like to share with your our outlook and perspective on our business for the fiscal 2010 fourth quarter and full year. To reiterate, our net sales and profitability guidance is based on non-GAAP numbers.

We continue to expect to report fiscal 2010 second half net sales similar to last year's second half based on a stronger Q4 in the current year. We expect to report fiscal fourth quarter net sales in the range of $175 million to $185 million. We also expect to report EPS of approximately breakeven in Q4.

I'll briefly review our key titles for our fiscal 2010 fourth quarter. In January, we successfully launched our new owned core game Darksiders. Darksiders achieved a Metacritic rating of 83 and has sold through well in a competitive core game launch window, which is a testament to the quality of the game and a strong marketing campaign.

At about 1.2 million units shipped to date, we believe Darksiders is on track to meet our Q4 forecast. The other two key new releases for our March quarter are Metro 2033 and an expansion to our multi-million unit Warhammer 40000 Dawn of War PC franchise. In addition to these new releases, our Q4 results will be driven by the European launch of MX vs. ATV Reflex and continued sales of Q3 releases.

As we discussed earlier today, we realigned our Juice Games and Rainbow Studios to become focused on the creation of digital content. As a result, we expect to incur business realignment charges of approximately $10 million in our March 31st, 2010 results, most of which is non-cash. These charges will be excluded from our non-GAAP results.

For the fiscal 2010 full year, we still expect net sales to be higher than those reported in fiscal 2009 and we also expect to achieve profitability. We are reaffirming our expectation to report a cash balance that will be at least $50 million higher at the end of fiscal 2010 from fiscal 2009, excluding the settlements with JAKKS and WWE and the net proceeds of our convertible senior note offering.

As a reminder, the reduction of Q3 EPS by $0.04 due to the if-converted method should be added back for full-year EPS and you should use an estimated share count of 68 million.

In closing, we reported fiscal 2010 third quarter net sales in line with guidance and delivered strong profitability. We remain focused on executing on our product slate and continuing to manage cost in order to grow net sales, achieve profitability, and generate positive cash flow in fiscal 2010 and beyond.

With that, I'll turn the call back to Brian.

Brian Farrell

Thank you, Paul. Now, I'd like to review THQ's product pipeline and how we position the company for success.

As I mentioned in my opening remarks, we have accomplished a tremendous amount in the last year. We have built a creative development engine that has a proven track record of creating core games with high-quality scores and long-term franchise potential. This was a key aspect to the realignment we began one year ago and I believe it will yield significant benefits and shareholder value as we move forward.

Let's drill down on our fiscal 2011 lineup, which demonstrates continued execution on our key operating strategies. First, core games. In fiscal 2011, we plan to ship two major core games, Homefront and a sequel to our Red Faction franchise. Homefront, a first-person shooter, made a strong debut at E3 last spring. The game's compelling storyline coupled with its groundbreaking multiplayer capabilities are two reasons we believe this game will become a new hit franchise for THQ.

We also plan to launch a high-quality sequel to Red Faction in fiscal 2011. Building on their innovative destruction engine, our team at Volition is delivering a quality sequel in the Red Faction universe that will include robust online gameplay. We look forward to showing you why we are excited about these games at E3 this June.

Second, fighting games. For fiscal 2011, we have announced UFC in May and we plan to launch WWE SmackDown vs. Raw at holiday. In fiscal 2011, we plan to increase sales of UFC as the brand continues to grow in popularity both in North America and internationally and by launching brand extensions.

Building on the quality game we introduced last year, UFC 2010 Undisputed will have a dynamic multiplayer component and will feature new gameplay modes, as well as an even wider array of fighting styles.

Our new direct relationship with WWE should help drive growth for this franchise. For fiscal 2011, we plan to deliver another high-quality game that captures the excitement of WWE. We also plan to go live with WWE online in Korea this fall. We will be discussing other WWE brand extensions on future calls.

Turning to kids, family, and casual, we are focused on our continued leadership in this category, taking advantage of the lower hardware price points that we expect will attract new mass market gamers and new family-friendly platforms such as Microsoft's Natal and Sony's Arc motion controller.

This holiday, we plan to release games based on DreamWorks Animation's MegaMind in conjunction with its theatrical release. This superhero theme will be – will also have broad consumer product support at retail, which helps drive video game sales. In addition, we will publish our first games based on the popular CG animated television show Penguins of Madagascar.

We also plan to release games based on Paramount's Tentpole production, The Last Airbender in conjunction with the live action movie directed by M. Night Shyamalan, which is scheduled to the 4th of July weekend. We also intend to launch new games based on Marvel Super Hero Squad.

In the growing lifestyle and fitness category, we plan to release a sequel to The Biggest Loser on Wii. And as we announced on Monday, we have also planned to publish our first games based on popular television game shows Wheel of Fortune and JEOPARDY! in fiscal 2011. Finally, our de Blob franchise will be back again in fiscal 2011. We successfully launched this highly rated owned franchise in fiscal 2009 to broad critical acclaim.

Turning to our digital gaming initiatives, we continue to build our pipeline of online games including the launch of Company of Heroes online in Korea and North America and our WWE online game, which is scheduled for its initial release in Korea later this year. We plan to launch our first digital core games this fiscal year including Facebook games based on three of our major brands and four games in development at our THQ Digital Studios.

In summary, we expect to demonstrate continued improvement in fiscal 2011 after the significant turnaround in fiscal 2010. We believe this momentum will carry us into fiscal 2011 when we expect to see accelerated growth with three major core games titles scheduled, Warhammer 40000 Space Marine, a sequel to Darksiders, and the third generation of our popular Saints Row franchise. We also expect continued growth in our fighting, kids, family and casual businesses, as well as a significant growth in our digital business in fiscal 2012.

In closing, THQ delivered third quarter results in line with our expectations and we are reaffirming our full-year financial goals. We have gained market share. We continue to build and expand our portfolio of both owned and licensed franchises. We are ramping up our digital gaming initiatives. We successfully executed on our plan and we look forward to continued solid execution. We are confident that our focused product strategy and lower cost structure will generate increased value for shareholders. And finally, I'd like to thank our dedicated employees for their diligent efforts in all we've achieved over the last year.

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

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from the line of Colin Sebastian with Lazard Capital Markets.

Colin Sebastian – Lazard Capital Markets

Thanks very much for taking my questions. First, Brian, in terms of building up the digital initiative, should we assume that the revenues you are expecting from the three different business units are basically balanced with the cost or is digital more of an investment mode for now?

Brian Farrell

Well, initially digital is an investment mode, particularly with things like Company of Heroes online and the new WWE game coming this year. And the other game, we did not name in our prepared remarks, but obviously the Warhammer 40k MMO that we have developed at our Austin Studio, the studio that built Darksiders, that is in investment mode, but obviously that's where we think the best return will be over the next several years. So yes, we are investing in that business now.

Colin Sebastian – Lazard Capital Markets

Okay. If I can follow up on the studio conversion then with, I guess Rainbow specifically, are they still developing an MX vs. ATV franchise going forward or are you shifting that somewhere else?

Brian Farrell

Yes. No, the team at Rainbow has done a great job, always delivering high-quality MX vs. ATV games. As the press release stated, that team will continue to do the MX vs. ATV game. And stay tuned for more details, but our view on that is in the future, we will have a lot more robust digital strategy around that brand going forward.

Colin Sebastian – Lazard Capital Markets

Okay. And then just lastly, obviously Darksiders is off to a very good start at launch. I'm just curious how you are seeing sell-through trends in the last couple of weeks, if the game has shown some legs.

Brian Farrell

Yes, we've been very pleased with the sell-through of that game. We believe strongly that the NPD data and Chart Track data that come out at the end of the month will show solid sell-through of the title. As we said in our prepared remarks, quality game, good marketing campaign, we picked a launch window that turned out to be a little more crowded than we would have liked, but to have succeeded in that environment, we are really pleased to be able to build this franchise.

Colin Sebastian – Lazard Capital Markets

Okay. Great, thanks very much.

Operator

Your next question comes from the line of Edward Williams with BMO Capital Markets.

Edward Williams – BMO Capital Markets

Good afternoon. A couple of quick questions for you. Just following up on Colin's questioning on digital, can you give us an idea as to what we should look for out of that as far as your P&L is concerned, I guess more on the revenue side, how significant can that be in kind of a calendar 2010 or an FY 2011 angle and what's your growth rates are looking like going forward?

Also, if you can give us an idea as to what the cost structure is like as we look into this calendar year and how much you've been able to pull out and how much you are pulling out with the 60 heads that you are cutting out of those two studios?

And then also just some thoughts on kind of if we were to desegregate the industry growth rate that you are talking about, are you – just to be clear, are you talking about packaged good sales being kind of flat to up or is there – and what sort of an impact do you see digital having on that growth rate?

Brian Farrell

Okay. I think I got them all. With respect to online revenues, like all the major publishers that have significant revenues in the traditional packaged goods, what we will all experience is high growth rate off of relatively small bases.

So the way we are looking at that, fiscal '10 obviously will have a small amount of digital revenues like most of our competitors. We see it ramping in fiscal 2011 with the product line that we outlined. Fiscal '12, we think will be even better given the pipeline we've put in – into place. And then obviously, the biggest pop for us is when we release the MMO that – again, stay tuned for E3 because we will be unveiling it there and I think you'll like what you see.

With respect to the 60 heads, as Paul said in his prepared remarks, the total charge there is about $10 million, most of it non-cash. And – but that is a reduction in net headcount. As you know, we are also – we have also opened a Montreal studio where we will be building a lot of our development capabilities in a lower-cost environment. We are – as you might imagine, right now we are right in the midst of putting together our fiscal '11 plan. So the exact impact of these cost reductions and our investments in things like online, it's just hard to put a number at this time. We'll give you a lot more color on the next call.

Obviously, on the subject of cost reductions, I mean, we are very pleased given all the actions we've taken in this fiscal year, we think we are well ahead of our competitors and very well positioned with our very lean cost structure and very nimble business unit managers.

Edward Williams – BMO Capital Markets

Okay, great. Thank you.

Operator

Your next question comes from the line of Heath Terry with FBR Capital Markets.

Heath Terry – FBR Capital Markets

Great. Brian, can you give us a sense of what you are seeing at retail broadly in January? Has the spike in hardware sales in December carried over into the New Year and is it really having much of an impact on software beyond new releases?

Brian Farrell

Good question. I mean, we've been pleased with the action at retail both here and in Europe. As we said on our call in November, watch 360 and PS3 hardware sales, because they will be a good harbinger of what will happen in calendar 2010. And in our view, new releases are performing well. And particularly, I'll remind you, most retailers have their year-end in January, so it's hard to get a lot of inventory in. That said, Darksiders has performed very well as you. We understand Mass Effect is off to a good start. There have been a couple of other releases that have performed well.

So – I mean, what I would say is January was a good start to the year, not just for THQ, but for the industry.

Heath Terry – FBR Capital Markets

Great. And then you talked about the lineup that you've got in fiscal 2011, named a lot of your biggest franchises that you will have coming out this year. Looking at the competitive environment, do you get a sense of just how significant it's really going to be for titles like Saints Row and Red Faction to kind of get traction in what looks like a really crowded calendar?

Brian Farrell

Well, again, competitively, we love our position in fiscal '11. It – we've got, as we pointed out, the core titles coming in fiscal '11 with Homefront and Red Faction Guerrilla, both iterating on existing technology. You saw Homefront at E3 last year, there is some buzz building on that. Look at – it's always a competitive environment. One of the things we are very pleased about over the last 12 months is improving our ability to generate high-quality core games and get some traction around them.

You still got to pick your window, you've got to it right, but we've made tremendous strides in this area and we are very pleased with that. The other thing is – particularly in the kids, family and casual area, we've really right at the ship in that category, more robust product line and we see competition softening in that environment. So we are very pleased with our positioning there.

So it's always competitive, but we've doing this a while and we think we can come up with the right product quality and also the right product launch schedule to compete aggressively.

Heath Terry – FBR Capital Markets

Okay. And last question, I promise. You mentioned the restructuring that you've done in your – with your kids products. Kids and wrestling have always been strong, late-cycle franchises for you. Is there any reason to think that things are different this cycle in terms of seeing those two segments of your business outperform once we get to the – once we get to these lower hardware prices?

Brian Farrell

Well, that's a really good question because what we really like about this cycle, as you know – I mean, we are at price points where still a lot of hardware is yet to be sold. So as – particularly, Microsoft and Sony move down the price curve on hardware. That should open up the markets for all of our traditional winning titles in the kids and family, as well as wrestling categories.

It's very interesting to know Microsoft and Sony's strategy this year, with both the Natal and the Arc motion controller. Our view of those is those expand what – really core gamer platforms now more into the mass market. So we believe this plays to our advantage and if we continue to excel on those categories and continue to build our core game franchises, that's the formula for our success.

Heath Terry – FBR Capital Markets

Great. Thanks a lot.

Operator

Your next question comes from the line of Arvind Bhatia with Sterne, Agee & Leach.

Arvind Bhatia – Sterne, Agee & Leach

Thank you and congratulations on a good quarter.

Brian Farrell

Thank you, Arvind.

Arvind Bhatia – Sterne, Agee & Leach

Brian, I wanted to ask you a little bit more on Saints Row. I think I heard you say that's a fiscal '12 title, which would make it a three-year – make it a three-year gap versus the last one. And previously you were on a two-year cycle. So just wondering if I heard you right. This is – is this to time it competitively, make a better window or this is more development time, just kind of give us some color on the thinking there.

And then also, you mentioned Natal and Sony's controller. What kind of incremental costs should we be building in our models? I mean, how many games are you planning this year and next year, fiscal '11 and fiscal '12 to take advantage of that technology?

Brian Farrell

Well, starting with Saints Row. Yes, it will be in fiscal '12. Our hope is it will be on slightly under a three-year cycle. As you know, those open-world games are the most complex games to build. The team at Volition has done a great job competing in that genre. As you know, we are the clear number two in that genre and hope to do even better with the next one.

So it's coming out very much as we anticipated. The – what I would say is, when we look at all of our titles, which we review all the time, it's – what does it need to do, what's the competitive set, all the things you suggest. So we think it’s the right spot and we really like our lineup for fiscal '11.

For – with respect to Natal and Sony, like most new platforms, we want to be there at launch. We want to support the platforms with the right brands, we are not over-investing in those because we do like – like we always have, like to see a ramp in installed base before we aggressively go after it. But I think the big win here for us is the expansion of 360 and PS3 to the mass markets, which is a huge win for us.

Arvind Bhatia – Sterne, Agee & Leach

And then couple of other questions. On hardware, you mentioned you are pleased with PS3, 360. We were hearing some shortages on Nintendo Wii. One, I'm wondering if you heard any – anything like that. And then, Juice Games, you mentioned some of the things that they are doing, but are they also working on a racing game or that's not in the pipeline right now?

Brian Farrell

With respect to Nintendo Wii, look at the – I saw a great chart on sell-through of the Wii by month and we had a huge spike in December. There was a lot of negative press around the Wii that – about the weakness in the Wii sales in the middle to later part of the year and then in December, the Wii came roaring back in terms of hardware sales. And again, the more installed base is the better for us. And we congratulate Nintendo on that.

With respect to your used game questions, Arvind –

Arvind Bhatia – Sterne, Agee & Leach

Juice Games.

Brian Farrell

Oh, Juice Games? I'm sorry. Juice Games, I don't want to speak in too much detail about the exact products they are working on. They do have an expertise in racing, they have shown some great products to us in this digital space and we'll lay out their exact product strategy in future calls.

Arvind Bhatia – Sterne, Agee & Leach

Great. Thank you.

Operator

Your next question comes from the line of Tony Gikas with Piper Jaffray.

Edward Tenthoff – Piper Jaffray

Yes. Hi, guys. This is Edward Tenthoff stepping in for Tony. I have two questions. The first relates to hardware. As you guys look out planning through the next year, what are you thinking in terms of timing and magnitude of potential price cuts? And then also, do you think that Natal and Arc are Sony and Microsoft's way of sort of prolonging the current run at the current price points?

And then my second question relates to retailer commitment to the category here as we move through the later innings of the cycle. Do you see them being in support of in terms of shelf space and promotion and then maybe some comments on their willingness to take inventory?

Brian Farrell

With respect to hardware price cuts, obviously we are going to let Microsoft, Sony, and Nintendo announce the depth and timing of their price cuts, but we all know in the industry that they will cut price of hardware over time and usually they do that in response to decline in demand. So it's going to be – it's going to happen and we'll let them answer the questions as to the timing and the depth.

Natal and Arc are clearly cycle-extending strategies in our view. But I wouldn't necessarily – we do not know their thinking around this, but we don't see it as a way to extend the cycle at the current price points.

With respect to retail, I think it's business as usual. I think everyone is breathing a sigh of relief. As we said in our prepared remarks, Christmas did come, but it came late. Speaking for THQ, we exited the year very well in terms of inventory at retail. And what we are seeing is good commitment to shelf space, good inventory management.

You mentioned the word promotions. Promotions are always going to be part of the category, they always have. We see a lot of notes now kind of doing some arm-waving around that, but with retailers, we use both advertising and price promotions selectively to drive products at certain points in time. But we are not seeing, to your question, any major sea changes in what's happening at retail today.

Edward Tenthoff – Piper Jaffray

Okay. Thanks, guys.

Operator

Your next question comes from the line of John Taylor with Arcadia.

John Taylor – Arcadia

Hi. I've got three questions, if I can. If you look at the actions you have taken to pull cost out of development and lower breakeven, I wonder if there is anyway – and I kind of ask this every quarter, but I'm going to try again, kind of what your breakeven numbers might look like or ranges or deltas from what it was before in the core game category and in the kids category? I'm most interested in that I guess.

The second question is, let me take a shot at the direct digital revenue piece. As you think about games that will have a DLC component, I wonder if you could talk about how much of ARPU contribution you might get on top of the disc revenue on a per unit basis kind of thing. So maybe give us a sense of how much upside there might be from that.

And then, just to clarify, the $10 million non-cash charge for the realignment and so on, is that likely to come out of capitalized software development? And if so, were there some things cancelled or where is – where is that going to show up in the P&L? Thanks.

Brian Farrell

Okay. I'll take the first couple. In terms of cost of development, as you know – let's take core. There is such a wide range of games, for example, on UFC and WWE, we are iterating on existing technology and so the costs there are well under control. Something like a Saints Row 3, where we are competing with the biggest and best in a very difficult and complicated genre, those are higher costs and obviously, a higher breakeven.

And one of the things we like about what we see in the modeling around our Montreal studio is if we can get that quality up for a significantly lower cost, that's really a huge win as move forward. And that should lower breakevens down, well below I would think the million unit mark in the core gamer category, which is why we are investing up there.

Kids is an area where all – hats off to the people at our kids, family and casual units. They did exactly what they said they were going to do in the last 12 months, continue to lower the development costs there. We are seeing much lower breakevens on those titles, again, building on existing technology, delivering the right product to the consumer for the price point. So we are getting those breakeven units well, well below the million unit level, well below.

With respect to digital downloads, as you know, DLC has an attached rate to the original property and then depending on how many downloads we do, we've done and we were between two and five and the price points are different, anywhere from a couple of bucks up to $14.99. But to your point, yes, if we can get somewhere between another $5 and $8 of ARPU, that's really a great place to be because that's pretty high-margin business.

As you also know, the DLC – robust DLC and robust online play also combat both piracy and used games. So yes, as I said in my prepared remarks, we are connecting every game just for those reasons, higher revenues, hopefully better margins, and combating piracy and used games.

Paul Pucino

This is Paul. In terms of the $10 million of charges that we mentioned in the prepared remarks, first of all, we will be taking out for non-GAAP purposes, so it will only hit the GAAP P&L. Of that $10 million, the large, large majority is going to be non-cash as we mentioned as well. And again, we are working through some of the details at this point, but of the $10 million, the largest portion of that would be software amortization, it would come through the software amortization line. And we would anticipate all those charges coming through in Q4.

John Taylor – Arcadia

So does that represent cancellation or something, games that were underway that you are getting rid of and you are going to reposition those guys?

Paul Pucino

Yes, it certainly does.

John Taylor – Arcadia

Yes, okay. Thank you.

Operator

Your next question comes from the line of Ben Schachter with Broadpoint AmTech.

Ben Schachter – Broadpoint AmTech

Guys, I just wanted to ask a few questions. First one, on WWE. It declined again this year, certainly better than last year. I was wondering what does the profitability of that product looks like next year and do you think that you can get the sales sort of flat line here? That's the first question.

Second question, if you can talk about just profitability levels on some of these newer platforms like iPhone or Facebook versus say an Xbox LIVE or some of the other category [ph] of things that you've done in the past and how do you kind of define a hit there?

And then, the final question, we've seen this tremendous success from Nintendo and able to have these sort of evergreen titles of the Wii fit that just continues to sell all the time, how do you – why is Nintendo doing that and others don't seem to be as successful and can a game like The Biggest Loser do that? Thanks.

Brian Farrell

Well, okay. Let me see if I can get them all, Ben. With respect to WWE, first of all, as you know, at 3.5 million units just in the quarter, right? So we are not done with WWE SmackDown vs. Raw. It will certainly trend over the 4 million unit mark and who knows how high it could go. And you've been around a while, a perennial 4 million unit plus seller is a huge hit in the industry.

And just by way of a correction, just – we don't like to sound like sour grapes, but the NPD, as you know, doesn't capture Wal-Mart and Toys"R"Us and did under-report WWE pretty significantly in December. I mean, that said, as Paul said in his remarks, units were down 13%, but dollars were down only 6% and what we are doing is migrating consumers to the higher-price, higher-margins 360 and PS3. So it's a terrific brand, it's an evergreen brand. I mean, we've been doing games for 10 years. It's been a terrific, one of the leading game franchises for almost 20 years. So – it will ebb and flow as it has over the last 20 years, but we are delighted with the new deal.

As we also pointed out, given the settlement of the litigation and the new direct relationship, our effective royalty rate going forward will be lower. So that should improve our margins there. So we are very pleased with that deal and that – it's a terrific brand and we really look forward to the next eight years.

With Facebook, iPhone and just opposing those to Xbox LIVE Arcade and PSN, there is really two purposes. One is there is a revenue and profit opportunity, the price points are certainly lower in those areas, but they are also great areas to extend our brands and as we roll out this strategy, I think you will understand what we mean, but it’s a great way to keep consumer engagement with our core properties in between these launches every two or three years. So we look at those markets as both revenue and profit drivers, but more importantly, they are great brand extensions for our key brands.

I agree with you, Nintendo does build terrific evergreen brands and that's certainly part of our strategy as well. The Biggest Loser has been a great television show. As far as I know, it will continue to air on NBC as long as it garners these high ratings. We have tremendous relationship with them. We love what they've done with the product placement on air, have been very supportive of driving this brand. And again, yes, our strategy there is to continue to move forward this brand as long as it's a profitable endeavor for us.

Ben Schachter – Broadpoint AmTech

Thanks and good luck.

Operator

Your next question is from the line of Jeetil Patel with Deutsche Bank.

Herman Leung – Deutsche Bank

This is actually Herman in for Jeetil. Two quick ones. I guess the first one is when – a follow-up on earlier question, but if you look at pricing in the marketplace due to the software, I think it's been sort of holding up pretty well, but there has been a lot of promotion activity. Could you talk about what you are seeing in the U.S. relative to the European marketplace? I think you noted a little bit of weakness in Europe earlier in the year.

And then second, the new releases are obviously selling pretty well from a selling standpoint, with UFC 3.5 million, WWE 3.5 million, but could you talk about your catalog performance for this quarter, as well as your expectations going forward? Thanks.

Brian Farrell

Yes. On pricing, I mean, again, premier content will command the premier price points for an extended period of time. I mean, that's been true in the past, it's true now, and I suspect it will be true in the future.

And as I mentioned a moment ago, promotion has always been part of this business and again, it's just a matter of how we allocate dollars and how we – and how we bring our games to market. We can do it with consumer advertising, we can use those dollars for advertising with retailers and we can also use them for pricing promotions from time to time. Again, we've always done that, we'll always do it, and I don't see any real sea change in that pattern, at least from my perspective.

In Europe, I wouldn't attribute the weakness in Europe to price promotion. The economies there, particularly the U.K. and Spain have been very, very weak and I wouldn't attribute the weakness in video game performance there to pricing erosion. It's just the markets there just seem to be weaker at the current time and we look forward to those economies recovering.

Paul Pucino

Our catalog sales for the quarter were about 16% of revenues, 16% of net sales for the quarter. For full year of fiscal 2009, last year was 30% and what we had said coming into this year and we are still holding to it, it will be lower than that this year. So 30% last year, some – probably in the area of about low-20s this year portfolio.

Herman Leung – Deutsche Bank

Okay, thanks.

Julie MacMedan

It looks like we have time for one more question, operator.

Operator

And that question comes from the line of Eric Handler with MKM Partners.

Eric Handler – MKM Partners

Hi, thanks for taking my question. I'm just wondering with all your digital initiatives that you mentioned, DLC, Asia, the MMOs, Facebook, iPhone [ph] and so forth, can you sort of rank them how you see those revenue opportunities developing over the next couple of years for – just for THQ specific?

Brian Farrell

Yes, I mean the highest ranking revenue opportunity for us clearly is the Warhammer 40k MMO. Again, I encourage you to come by and see what we are seeing at E3 with that when we fully unveil it, but we think we are going to have a very competitive MMO and as you know, one of the big wins there is when you are successful with those properties, you have a long life on both revenues and cash flow, that's not just one year or two years it can go, five, six, seven years. So that's probably the biggest opportunity.

We also like the free-to-play market. And as you know, we've been experimenting with that market, leading with Company of Heroes, but we think there is opportunity not just for that product as we migrate it from Korea into North America and eventually into Europe, we think that model has a future, not just in Asia, but also here in Western markets. So it’s a matter of finding which brands work in that marketplace and how you most successfully monetize those.

SmackDown vs. Raw online, great brand, hasn't currently been exploited much outside of the U.S. and Europe. We look forward to one of the great wins with the WWE relationship, is now working directly to drive that new game, WWE online, first in Korea, but also in other Asian markets where we think there is a tremendous opportunity going forward.

So free-to-play is where I'd rank -- free-to-play/micro transactions to be clear, is an area where we think there is significant growth opportunity. There is also opportunity in the Facebook and more casual gaming spaces. Again, for us, it's natural to extend our key brands into those areas. And as I said a moment ago, both as revenue and profit opportunities, but more importantly as brand extension opportunities. The revenue potential in those markets is obviously not quite as high because of the price points, but we think they are still viable markets to be attacked.

Eric Handler – MKM Partners

Okay, great. Thank you.

Julie MacMedan

Great. Well, thank you. So that concludes our third quarter results call. We appreciate you joining us today.

Operator

And this does conclude today's conference. You may now disconnect.

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Source: THQ Inc. F3Q10 (Qtr End 12/31/09) Earnings Call Transcript
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