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Executives

Julie MacMedan - Vice President, Investor Relations

Brian J. Farrell - Chairman, President and Chief Executive Officer

Rasmus Van Der Colff - Interim Chief Financial Officer, Vice President, Corporate Controller

Analysts

Edward Williams - BMO Capital Markets

Colin Sebastian – Lazard Capital

Ben Schachter - UBS Securities

Heath Terry - Credit Suisse

John Taylor - Arcadia

Tony Gikas - Piper Jaffray

Michael Savner - Banc of America Securities

Doug Creutz - Cowen and Company

Brent Thill - Citi

Edward Urban - Bear Stearns

Justin Post - Merrill Lynch

Eric Handler - Lehman Brothers

Jeetil Patel - Deutsche Bank

THQ Inc. (THQI) F3Q08 Earnings Call February 5, 2008 5:00 PM ET

Operator

I would like to welcome everyone to the THQ Inc. Fiscal 2008 third quarter results conference call. (Operator Instructions) I would now like to turn the call over to Julie MacMedan, Vice President of Investor Relations.

Julie MacMedan

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 about our business are based, in part, on 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 that are described in our March 31, 2007 Form 10-K. A copy of this filing may be obtained from our website.

In describing THQ’s financial performance, we will discuss non-GAAP measures including net income. 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 recent accomplishments and challenges and will then turn the call over to Rasmus Van Der Colff, our Corporate Controller and Interim Chief Financial Officer who will discuss THQ’s results for our fiscal 2008 third quarter and our guidance for the remainder of fiscal 2008. Rasmus will also provide our calendar 2008 market growth assumptions. Brian will then close with a discussion of our plans for fiscal 2009 and long-term growth. We will then conduct a question-and-answer session following prepared remarks.

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

Brian J. Farrell

Thank you, Julie and good afternoon, everyone. On today’s call, we will review the key successes and challenges that THQ faced during the quarter and what we have done to address our challenges. I will also discuss our long-term strategy as well as our robust product pipeline for fiscal 2009 and the next several years.

During the fiscal 2008 third quarter, we posted record net sales of $510 million. We executed on our strategy to grow revenue through a combination of licensed and owned properties. We shipped a record 5 million units of WWE SmackDown vs. Raw 2008, and we have successfully grown the WWE franchise in each of the past four years.

During the quarter, MX versus ATV: Untamed, one of our proven internally developed and owned franchises, got off to a strong start. We plan to launch the title in Europe and on the Wii platform during the March quarter.

From a platform standpoint during the quarter, our sales from current gen consoles more than doubled versus last holiday with the most significant growth on the PS3 and Wii platforms. We doubled our Nintendo Wii and DS revenue from the same period a year ago. We were particularly pleased that we established a new owned franchise, Drawn to Life, which is currently exclusive to the DS platform and we intend to extend this brand to the Wii in the future.

Geographically, we continue to execute on our strategy to increase sales from international markets. During the quarter, international sales represented 45% of net sales, up from 38% a year ago driven by a more global portfolio and our expanded direct sales locations overseas. Year-to-date, international revenues are 50% of our total revenue.

We also had significant challenges during the quarter. Several properties under-performed versus our expectations and required us to accelerate amortization expense. In a very competitive year for kids titles, Ratatouille and our Nickelodeon titles did not perform to forecast. In addition, we did not achieve our expectations for Stuntman despite a price reduction on the product.

Our third quarter bottom line was also negatively affected by decisions we made with respect to our product pipeline. In October we announced certain product quality initiatives including personnel and structural changes in product development and a more rigorous internal and external product evaluation and feedback process.

Consistent with these initiatives, we recently took aggressive actions including discontinuing certain projects and closing one studio. While these decisions affected our near-term results, they were the right decisions for our business over the long term.

As we had previously stated, we are committed to continuing to improve our pipeline and developing products of the highest caliber. To that end, we’ve enhanced our significant resources in product development with the newly created positions of Vice President of Creative Development and Vice President of Production. These positions are charged with increasing visibility and execution related to product processes, scheduling and overall content and quality. We believe these additions and the process changes we’ve implemented have significantly strengthened our already capable studio system.

We are obviously not satisfied with our loss of market share in calendar 2007. THQ has a tremendous track record of growing revenue and gaining share over the long term and we believe we have taken steps necessary to put the company on track to regain our momentum in calendar 2008 and beyond.

In summary, for the third quarter we were pleased with our execution on our WWE business, the successful launch of owned IP MX versus ATV:Untamed and Drawn to Life; the growth in our current gen platform mix; and the growth in our international business. We made tough decisions to strengthen our product portfolio and we will continue to diligently review all products to ensure the highest level of quality in order to achieve our goals of long-term revenue and margin growth.

Before I turn the call over to Rasmus Van Der Colff, our Corporate Controller and Interim Chief Financial Officer, I’d like to thank him for his service in this capacity over the last few months. As you may have seen, yesterday we announced that our new Chief Financial Officer, Colin Slade, will join THQ at the end of this month. Colin demonstrated strong operational leadership as Chief Financial Officer of Tektronix, Inc. a billion-dollar revenue technology company. We are pleased to add him to the THQ team as we continue to execute on our plans for growth and profitability.

Now Rasmus will review over third quarter financial results and forecast in more detail.

Rasmus Van Der Colff

Thank you, Brian. Good afternoon. Today I will review our Q3 financial results and reaffirm guidance for the fourth quarter and for the full fiscal year ending March 31, 2008. THQ’s financial results include stock-based compensation expense and FAS 123 R. As I discussed our financial performance in more detail, I’ll review the non-GAAP numbers which excluded this expense.

For the third quarter of fiscal 2008 we reported net sales of $510 million and net income of $0.24 per diluted share above our November 1st net sales guidance of $490 million, but short of our earnings per diluted share guidance of $0.67. Our bottom line miss to the November 1 guidance was due to approximately $27 million in non-cash charges related to our decision to cancel certain project and development and the write off of two intellectual properties; as well as approximately $20 million in accelerated amortization expense related to the underperformance of certain previously released games, including Stuntman, Ratatouille and Konan.

Our fiscal 2008 third quarter net sales were driven primarily by WWE SmackDown vs. Raw 2008, Cars: MaterNational and MX vs. ATV: Untamed. In the prior year quarter we reported $476 million in net sales and earnings per diluted share of $1.

Moving on to cost of sales, product cost of 34% of net sales where the same at the prior year quarter. Software amortization and royalties increased 9 points to 24% of net sales versus the prior year quarter due to accelerated amortization expense related to the underperformance of certain previously released games that I just discussed. In addition, approximately $18 million of the previously announced $27 million in non-cash charges is reflected in the software amortization and royalties line. Excluding these charges, software amortization would have increased only 2 points as a percent of net sales.

License amortization and royalty costs of 10% net sales were flat quarter over quarter. Included in this amount is approximately $5 million for the previously announced write-off of our Juiced and Stuntman intellectual properties. The venture partner expense increased slightly as a percent of net sales due to WWE gains being a greater percentage of our product mix in the current quarter. As a result, the gross margin after these costs was 28%, down from 38% in the prior year quarter.

Product development expense increased to $40 million from $20 million in the prior year quarter due to increased product development efforts to support future growth, additional quality assurance efforts, increased wireless development as well as less capitalization of certain titles. Additionally approximately $5 million of the $27 million of non-cash charges recorded in the quarter were charged to product development expense. While we expect to increase product development expense in future periods to support our focus on higher product quality, we do not believe it will continue at the level experienced in the current quarter.

Selling and marketing expenses were 13% of net sales, up from 11% in the prior year quarter reflecting increased support as a percentage of their net sales for Ratatouille versus Cars in the prior year quarter.

G&A expenses were $15 million, down nearly $6 million from the prior year quarter due primarily to lower performance-based compensation and lower legal and professional fees. During the quarter we received $1.5 million of additional proceeds from the sale of Minick AG, which constitute the current quarter’s gain on sale of discontinued operations. Minick AG was sold in the third quarter of our fiscal year 2007. As a result, our net income for the third quarter was $16.4 million or $0.24 per diluted share compared to net income of $68.1 million or $1 per diluted share in the prior year quarter.

In summary, while we successfully drove an increase in revenues in the third quarter, the previously announced accelerated amortization on underperforming titles, along with the non-cash charge associated with the cancellation of certain future titles and our increased investment in product development and marketing significantly reduced our operating leverage in the quarter.

Now let’s turn to the balance sheet. THQ ended the quarter with $325 million or $4.80 per diluted share in cash and short-term investments. This balance decreased from the $407 million balance at December 31, 2006 reflecting the repurchase of $42 million of stock during the current fiscal year and the timing of the collection of accounts receivable.

As of mid-January, the company had over $400 million in cash. The company still has $42 million available on our stock repurchase program and we are committed to returning value to stockholders.

Net accounts receivable of $271 million increased from $181 million at December 31, 2006 due to higher sales related to the launch of MX versus ATV: Untamed late in the quarter and the higher international sales mixed in the prior year quarter.

Our day sales outstanding on the rolling 12-month basis was 97 days versus 66 days in the prior quarter due to the same factors. This increase is reflective of the timing of cash receipts and other substantive change in our business and corporate practices.

Accounts receivable allowances were $134 million at quarter end, up from $112 million at December 31, 2006. The coverage on a trailing nine months of net sales basis were 12%, up from 10% in the prior year quarter. Inventory was $44 million, up from $27 million at March 31, 2007, slightly down from the prior year balance. On a rolling 12-month basis, inventory turns were 10, up slightly from nine in the prior year quarter.

Our investment in license of $89 million was down slightly from $91 million at March 31, 2007. Capitalized software development decreased to $175 million at quarter end from $241 million at September 30, 2007, which reflect the impact of the previously discussed accelerated amortization of different titles and less capitalization on other titles in development.

Property and equipment of $49 million was up slightly from the March 31, 2007 balance due primarily to the purchase of development kits and computer hardware and software. Goodwill was $99 million, up from $89 million at March 31, 2007 due primarily to the acquisition of Universomo, our wireless developer in May 2007.

Total current liabilities were $303 million, up $106 million from the March 31, 2007 balance of $197 million. The quarter end balance includes $36 million due to Jakks Pacific that has been accrued at a payment rate that expired over a year-and-a-half ago. Until the new rate is determined through arbitration, which we have filed a court action to expedite, this accrued balance will continue to grow. It will remain unpaid until the new rate is established. In addition, current liabilities increased due to higher product purchase accruals and VAT.

The company’s current ratio of 3:1 with working capital of $533 million compared with $575 million a year ago. On a rolling 12-month basis, cash used in operations was $53 million compared with cash provided by operations of $112 million for the prior year of 12 months, due primarily to lower results from operations and higher accounts receivable.

Return on invested capital on a rolling 12-month basis was 6% versus 20% for the prior year because of lower results from operations in the most recent 12 months. We had no borrowing at quarter end and total stockholders equity was $775 million.

That concludes the financial results for the third quarter of fiscal 2008.

For the 2008 fiscal fourth quarter, we expect net sales of approximately $200 million and a net loss of approximately $0.06 per share. Net sales in the March quarter will be driven by Frontlines: Fuel of War on Xbox 360 and PC; Destroy All Humans!, Big Willy Unleashed on the Wii and the continued sales of WWE and MX vs. ATV: Untamed on multiple platforms.

Our Q4 guidance includes a deferral of approximately $10 million of net sales due to the significant online game play component of Frontlines: Fuel of War on PCs. For the full fiscal year 2008 we plan to generate approximately $1.04 billion in net sales and earnings per share of approximately $0.05 per diluted share. Based on the robust sales of Wii, PlayStation 3, Xbox 360 and DS hardware in calendar year 2007 and our expectations that strong sales of these platforms will continue in 2008, we are currently expecting approximately 10% to 12% growth in software dollars across our relevant markets in calendar 2008.

I would now like to turn the call back to Brian.

Brian J. Farrell

Thank you, Rasmus. Looking ahead, we are confident in our near-term product slate and long-term product pipeline. Frontlines: Fuel of War, our next new internally developed title, is scheduled for launch on February 25th. We believe Frontlines is a uniquely positioned shooter distinguished by large-scale multiplayer action and open world game play.

In fiscal 2009, we plan to release sequels to two of THQ’s most successful owned franchises, Saints Row and Red Faction. Both games are in development at our award-winning for Volition Studio.

Saints Row II is planned for Xbox 360 and PlayStation 3. Building on the success of the original Saints Row, Saints Row II is differentiated by its quality game play, deep customization and multi-player online capability.

We established our Red Faction franchise early in the last console cycle. The game distinguished itself with ground-breaking game play focused on destruction technology. We plan to bring the Red Faction franchise to Xbox 360, PlayStation 3 and PC in fiscal 2009 showcasing even more exciting destruction technology only possible on today’s consoles. In the coming weeks, we will begin to more broadly unveil these titles to the game press and expect a very positive response.

We are also focused on continuing to increase our revenue on Nintendo platforms. Although we increased our revenue significantly on Nintendo platforms last calendar year, we believe there is room for THQ to significantly boost our Nintendo market share. In fiscal 2009, we plan to establish strong new original franchises and to publish a slate of top licensed franchises on the Wii and DS platforms.

Initial reception for our original concept de Blob has been very encouraging and we believe that the extra time we have afforded this title will increase its long-term franchise potential. We will also be unveiling other new original properties on the Wii over the next several weeks.

In addition to these targeted investments in owned and intellectual properties, a significant portion of fiscal 2009 net sales will be driven by our well-known licensed franchises. As I mentioned in my opening remarks, we have successfully grown our WWE franchise over the past four years. We expect this franchise to grow again next year, supported by install base growth and continued overseas programming expansion. We are also very excited about the prospects for our first games based on the Ultimate Fighting Championship, one of the fastest growing sports in America and Europe. We look forward to unveiling our UFC titles to the game press Memorial Day weekend in conjunction with a live UFC event.

At the end of June, we plan to launch games based on WALLE, the next Disney Pixar film, which we believe is a terrific creative platform for gaming given its characters and theme, and as a result we expect it to outperform Ratatouille. Our Nickelodeon line up will include the latest version of [inaudible], a historically strong property now supported by television programming. In addition, the summer movie schedule for calendar 2008 is much less crowded than last year, increasing our competitive position in the kids category.

We plan to continue to execute on our strategy to develop new revenue streams through digital distribution. In fiscal 2009 we plan to launch Company Of Heroes online with Shanda for the Chinese market. Company Of Heroes online marks our first entry into the free to play, pay per download model and we are excited about the opportunity for future projects of this nature.

We have broadened our fiscal 2009 wireless portfolio including the recent renewal and expansion of our global licensing agreement with Lucas Films to develop mobile content based on Star Wars and on the upcoming Indiana Jones movie.

We look forward to growing revenues in fiscal 2009 in all the relevant digital segments: online and digital downloads, wireless and in-game advertising. With strong drive titles including Saints Row II, Red Faction III, de Blob, WALLE, WWE and UFC, we are confident in our ability to increase revenue and profitability in fiscal 2009.

As previously discussed, we plan to give our fiscal 2009 guidance on our May call. Based on our line-up, we still expect to grow at or above the market next year. As you know, operating leverage comes with driving more units per title shipped which is one of our clear goals for fiscal 2009. We believe our investments in product quality will help us to achieve this goal.

Looking beyond fiscal 2009, we are also very confident in our pipeline for fiscal 2010 and 2011. We have a robust slate of games in development based on:

Key license franchises;

Sequels and extensions of established intellectual properties;

The introduction of a select number of new intellectual properties.

We were pleased with this strong global sales of hardware in calendar 2007, which will drive software sales in 2008 and beyond. We have a strong product pipeline of both licensed franchises and owned intellectual properties to support our long-term plans for revenue and profitability growth.

We look forward to continuing to increase our international market penetration and in growing our revenues of digital content creation and distribution. We now look forward to responding to your questions. Operator, please open up the call.

Question-and-Answer Session

Operator

Your first question comes from Edward Williams - BMO Capital Markets.

Edward Williams - BMO Capital Markets

First of all with regard to the international growth, can you let us know what it was on a constant currency basis?

Brian J. Farrell

I believe -- Rasmus, correct me if I’m wrong -- that we had a favorable currency adjustments of about $22 million in the quarter.

Edward Williams - BMO Capital Markets

If you can give us a little bit color with regard to how WWE performed internationally relative to say the company wide. If half of your revenues were international for the company as a whole, how was WWE relative to that 50%?

Brian J. Farrell

Well, I will say a lot of the international growth was very broad-based as we have said a number of times, Juiced tends to over perform in overseas markets. I think our product portfolio, one of the things we have done over the years is make a much more global product portfolio which has been one of our strategic objectives.

WWE is about 50% international and 50% domestic. It is doing very, very well in markets like Spain and Portugal right now. It’s always been strong in the UK and Australia. So we look forward to continue to drive international expansion with our partnership with WWE; if they get programming and live events in these markets that tends to drive the sales as much as anything.

Edward Williams - BMO Capital Markets

Then a final question for you, I know you are not providing guidance in FY ‘09, but as you look at FY ‘09 and look at your development headcount, where are you now following the acquisition of Big Huge Games, and how should we think of that cost line item on a dollar basis relative to the change in the headcount?

Brian J. Farrell

The headcount, as we said a number of times, while growing that growth rate has been slowing. We have around 1,700 people in product development as we speak today. That number will continue to grow as we add headcount both in our existing studios. As you know, Edward, we had a pattern of acquiring studios on a very opportunistic basis when we see talent like we did in the acquisition of Big Huge Games. When we see talent in a genre that we target as strategic, we will certainly pull the trigger on those deals. So I think the big idea is we will continue to grow headcount but certainly not at the rates that we have experienced in the prior years.

That being said, I think as Rasmus said in his prepared remarks, if you look at the PD expense -- just the expense not the total investment in PD -- that line was about $40 million in the Q3 quarter. We think there were some sort of unique expenses in that quarter and we don’t think the run rate will be that high going forward.

Operator

Your next question comes from Colin Sebastian - Lazard Capital.

Colin Sebastian – Lazard Capital

Brian, when you look back at some of the issues over the year, I wonder if you could provide a little more color on the shortcomings in the product planning process? Was it in the quality of the development at the studio level or was it just less consumer appeal for those franchises than you expected?

How do you think these new initiatives you have laid out and implementing will specifically address those types of issues? Thanks.

Brian J. Farrell

That’s a very good question. Let’s take the two separately. I think it would be unwise to paint a broad brush when you ask a specific question, so I’ll be as specific as I can. With respect to Stuntman, that product we think just didn’t translate well into next generation. As I think we said on the October call, what our research has shown after launch is that Stuntman is very much an old generation game, it was a reasonable quality; it was in the high 70s in game rankings -- certainly not where we would like it be -- but it wasn’t just a product quality issue.

We believe that Stuntman was a game mechanic issue, it’s a very highly scripted game whereas now the best-selling games are generally more open, more player choice. So we just think that game mechanic didn’t translate.

Juice is a bit different, I think we were way too ambitious with that studio giving them six different platforms to support everything from new Playstation 3 development all the way down to DS. I think that was a bad decision. We don’t have any studios working on more than three SKUs simultaneously now.

So, what have we learned? I think we have learned from both those experiences. Let’s translate that into what we were looking at in fiscal ‘09. Certainly Saints Row II is building on existing technology; we know what the game play hooks are in that with a very experienced team based on a proven game design; Red Faction III, as I pointed out in my prepared remarks, has a real hook in it with its technology, the technology-based destruction is something that we think is very distinguishing for that particular product, again in our award-winning and highly talented Volition studio.

De Blob, as we said, we’re taking more time to polish that game, so that when we bring it out, we think we will have a high quality game targeted very much at that casual game consumer. So if you hear a theme it is we are not doing the things in ‘09 that we believe caused the issues in ‘08.

In addition, what I would add to that Colin, I’d like to highlight we have made some pretty significant additions to our product development team. We already had a pretty deep team in product development, and adding our VP of Creative Development and VP of Production will increase early visibility in execution over titles, not just in ‘09 but hopefully ‘10, ‘11 and beyond.

Operator

Your next question comes from Ben Schachter - UBS Securities.

Ben Schachter - UBS Securities

When you’re thinking about the quality initiatives, when we look at Saints Row and Red Faction, is there a benchmark that you will put out there for ratings in which you would say, above that number would be what you’re expecting, below you would be disappointed?

A separate question on Nintendo share, how do you expect to grow that? Will that come in general, do you think that the third parties can do better this year on Nintendo platforms than they did last year?

Brian J. Farrell

With respect to the first part of your question, as you know Ben, I think you have done a lot of work on game ranking and sales and there is a very high correlation. To put a specific number, I know people throw numbers that are 85, 90; anything in that range or above, you could be highly competitive. I think you would point to one of our competitive titles this last fall, Assassin’s Creed, ended up being a low 80s which is very solid. When you take a solid title, it’s marketed very effectively, you could sell a lot of units.

So in general, I think you need to be above 80 to really compete in that high-end genre. If you are above 85 that will increase your chances even further. if you are above 90, I think you have a chance to really hit one out of the park.

Ben Schachter - UBS Securities

I assume you think both those titles can be above 80?

Brian J. Farrell

Yes, we certainly expect those titles to be above 80.

Ben Schachter - UBS Securities

The Nintendo question?

Brian J. Farrell

The Nintendo question, it is two-pronged. I mean, we have been around on the Nintendo business for a long time as you know, Ben, and typically early in the cycle Nintendo has quite a headstart on the third parties and this round was no exception. People buy their platforms and then the Nintendo products early on are the ones of the highest quality and the most compelling, but eventually third parties like THQ tend to catch up and gain shares as the Nintendo cycles mature. We think this cycle will be very similar.

Our strategy to execute on that is both owned IP, really innovative titles like de Blob, we think it’s a very Nintendoesque style of game and we plan to launch that in a window away from competitive titles from Nintendo. Also highly targeted licensed titles, we are pleased with the results of WWE on that installed base. We will grow and we think we can sell more WWEs on the Wii as the installed base grows.

Again, as consumers round out their portfolio with licensed titles we think games like WALLE and some of our other more family=oriented titles will do well as well. So it’s a broad-based approach of both owned IP and licensed IP that we think will grow as the cycle continues to mature on Nintendo.

Ben Schachter - UBS Securities

Any thoughts on what you think the title share for Wii can look like this year versus PS3 and Xbox 360?

Brian J. Farrell

We have that data, I don’t have it at my fingertips, but we can discuss that on the next call when we have our formal platform metrics done. I just don’t have the data in front of me right now, Ben.

Operator

Your next question comes from Heath Terry - Credit Suisse.

Heath Terry - Credit Suisse

Brian, I wonder if you can give us some idea of what your outlook for the handheld market is like this year and how you are allocating resources between the DS and PSP, in particular which outside of your license products, which of your owned intellectual property do you think are a best fit for the handheld platform?

Brian J. Farrell

Yes, I’ll start by saying the PSP surprised us with its strength in the latter half of calendar ‘07 and some of our bigger titles targeted more older demographic like WWE and MX tend to do pretty well on the PSP. We’re going to continue to support the PSP. We have a couple of pretty excitement announcement for our PSP line-up coming out in the near future. I’m not sure of the exact timing, but we’ve been pleased with the growth in the PSP and we will continue to aggressively support them.

The DS is slightly different. As you probably know, both licensed and original properties can live very, very well on the DS. One of our top titles of the last couple of years has been Zoo Tycoon. We just announced over the last couple of days we just launched Zoo Tycoon II. It’s been one of the more successful titles on that platform.

I alluded in my prepared remarks to Drawn to Life, it was one of those titles we just didn’t know how good it was going to be and we’ve sold through several hundred thousands units worldwide on that title, a very unique title that was done on the DS.

on the license side, again, not unlike the Wii as the installed base grows people tend to build out their library of both licensed and unlicensed. We think games like WALLE, Next Nickelodeon, and some of our girls titles should do very, very well on the DS.

So, it’s a blend of both the license and unlicensed on the DS. We do see the demographics very differently on the two platforms. DS seems to be much more mass-market and younger, and PSP still seems to be little older and that’s how we’ve allocated our resources.

Operator

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

John Taylor - Arcadia

As you are looking at the software growth forecast, plus 10 to plus 12, I wonder if you can maybe talk from 30,000 feet about what you think the key variables are there? Which knobs would have to turn in order to get that number up to say a mid-teen or maybe even a high-teen kind of number?

In the old days, when you guys kind of where the kids publisher with all the portfolio licenses and stuff there really wasn’t lot of competition and I’m wondering when you think about market, how you think differently about the casual market as opposed to the kids market, because it seems like there is going to be some spillover between the two. There are a lot of people going for that casual markets that might actually take some of your kids business away. So maybe talk about those things?

Brian J. Farrell

On the software dollar growth, JT, our current thinking is in the 10% to 12% range and I think that’s fairly consistent with some of the other people we’ve seen out there.

What are the key variables? We are looking at 360 hardware as being relatively flat in terms of unit sales next year compared with this year based on where we are in the cycle. Now as we all know, the price point moves that any of the hardware guys could make, we don’t have any visibility into any of those potential moves. So certainly price cuts by either Microsoft, Sony or Nintendo could significantly drive hardware higher than we thought.

The other thing is, as you know, I don’t think anyone expected the plus 34% software dollars this year. As you know, a lot of those dollars were created by games with peripherals like Guitar Hero and Rock Band. One of the things we found in our model is that, can the market ASP stay up based on the very strong success of those titles? I think that just remains to be seen.

So if there is increased hardware and ASPs particularly on those what I will call peripheral-related items can stay up we might see software dollar growth in the mid-teens.

With respect to the kids and casual market, we agree with you and that’s why as you heard us talk about titles like de Blob and some of our upcoming announcements also things like Drawn to Life, we are not just going after kids, we are going after very broad demographics. We are very pleased with what’s going on in our ValuSoft division, some of their efforts in making very casual games, not only on PC now but also in the console space with things like American Girl and things like that.

So we’ve recognized that competition and we think by having some of the best licenses like Pixar or like Nickelodeon, those are terrific licenses to build on, but we are not resting on our laurels there, we are investing heavily in things like de Blob and Drawn to Life sequels that we think we can, along with those and the IPs we will be unveiling over the next several weeks show you that we have a very broad-based casual games line up rather than just kids line up.

John Taylor - Arcadia

I don’t know if you’ve done this or not, but if you look at THQ’s share of all Nintendo platforms where you were stronger traditionally than maybe in the other ones, do you expect to be able to hold that share level across all Nintendo platforms as you go through the next couple of years?

Brian J. Farrell

Let me tell two things. First of all, we are not pleased with our share on Nintendo platforms to date. We think we can do a lot better on both DS and the Wii. But in order to get back to our rather dominant positions on the Nintendo platforms, we don’t need to get back to prior cycle levels to grow at or above the market. So it remains to be seen just how high up is. But certainly we think we can do a lot better on the Nintendo platforms.

John Taylor - Arcadia

Thank you

Operator

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

Tony Gikas - Piper Jaffray

You talked a little bit about your outlook for software growth in calendar 2008, any feedback from retailers at this point, what their outlook is for full fiscal year? Also on the PlayStation III hardware sales, some of the publishers have been talking about PS III picking up quite a bit this year. Do you believe that that will be the case, and what has to happen for that to actually play out?

Do you anticipate any further changes to your SKU plan or your business plan as a result of some weakness with the PlayStation III business? Are you in that? Do you have that much visibility yet or really no SKU plan changes?

Brian J. Farrell

With respect to software growth, yes, we do discuss our projections with retail. As part of our model we do a number of things. We talk to retailers. We talk to a number of sell side folks and then we also subscribe to a number of external services that provide data to us and then we triangulate. It is an art not a science and we do update our model quarterly. So yes, we do get input from a number of levels.

I think that general sentiment we’re hearing and something I think is very important for everyone to focus on is 2007 was an unbelievable year for hardware virtually across the board. The number of hardware units sold was I believe a record. In context, we don’t even think 360 and PS III performed all that well. So when we look into 2008, all that hardware sold in ‘07 should drive some pretty good software sales in calendar ‘08 and then we also see 360 and potentially PS III picking up some momentum in ‘08.

Specifically the second part of your question, how does PS III pickup, I think the pipeline of titles including our own is much more robust as we get into ‘08 calendar. Sony like Microsoft as we mentioned a moment ago certainly has price moves they can make eventually, we have no idea if they are going to actually do those in ‘08, but they certainly have a lot room to go in order to stimulate demand.

The final part of your question, no; the PS III is off to a slower start, but it is still a very viable platform not only here but the Sony share in Europe is becoming even more broad-based so we intend to continue to support PlayStation III aggressively, and if you look at our line up, I mean, most of our real pillar titles in fiscal ‘09 will have a PS III components.

Operator

Your next question comes from Michael Savner - Banc of America Securities.

Michael Savner - Banc of America Securities

Brian, can you just give us your comfort level with the balance sheet and more specifically, the software development that’s currently capitalized? Obviously it’s come down sequentially and you’ve accelerated some of the writedown. How much flexibility or leeway do you have with necessary existing revenue on titles that are in the field right now or is there are still some risk that you may want to reevaluate those reserves at some point going forward? Do you feel like you have cleaned that out?

Brian J. Farrell

With respect to our comfort level on the balance sheet, the fact that it’s down is so significantly sequentially, obviously to be very direct it was the result of accelerated amortization on a handful of titles and the writeoff of several others. So, no, we don’t think there is anything left in that balance that wasn’t unscrubbed to a very high degree over the last 90 days.

So no, that number is down, I think it’s even down from the prior year. So obviously that number has been scrubbed very aggressively.

Michael Savner - Banc of America Securities

As we look back over the last fiscal year and you oftentimes talked about a target of 35, I think it was 30% to 40% of your revenue coming from owned IP. Obviously for reasons that you’ve already discussed there were issues this year.

As you look into ‘09, even with broad strokes since you are not going to give guidance yet, can you give us a sense of where you hope that mix to fall? I know you said that you’d hoped that there would be a good balance. But I guess I’m thinking about, are you going to look for a some similar type of percentage of revenue coming from owned IP in fiscal ‘09?

Then of that subgroup, what percent do you think would be relied upon from new owned IPs, on titles that you have not yet released?

Brian J. Farrell

Yes, as much as I’d like to answer the question as specifically as you are asking, if we haven’t yet completed our annual operating plan for our fiscal ‘09, Michael. So I just don’t have a number, I hate to throw out a number just to get a number out there. But if you think about the titles we’ve discussed, WALLE should perform very well and that’s a licensed title; UFC will be added to the portfolio, that’s a licensed title. So we should see some very strong growth in our licensed business. But that being said, I mean two of our real drive titles in next fiscal year Red Faction and Saints Row are owned, internally developed IP.

The only one that I would consider new is de Blob on Wii and DS so not a terribly risky title and then one in the fourth quarter called Darksiders, since it is in our fourth fiscal quarter, we are not talking about it much now but you will see a lot more on that title as we get closer.

I think the investments are the best if you will in fiscal ‘09 are really on known titles like Saints Row and Red Faction in addition to big licensed WWE, WALLE, Nickelodeon and UFC. We will give you our number based on our[OLP] on the May call.

Operator

Your next question comes from the line of Doug Creutz - Cowen and Company.

Doug Creutz - Cowen and Company

Could you can talk a little bit about how the Warhammer 40K is coming along? Do you think that’s a fiscal ‘10 title or is it too early to say? Thanks.

Brian J. Farrell

I actually love the Warhammer 40K MMO. I was actually down as part of this review, down in our Austin studio back in November and I was very pleasantly surprised by what I have seen there. But it is still very early in development as we said a number of times, we think we have an experienced team and one of the things I’m learning from those people is these things take time to do right and we’re going to take the time to do it right on that title.

So as we get closer to what we think will be a launch date and we will certainly announce that but what I will say about that title is so far so good.

Operator

Your next question comes from the line of Brent Thill - Citi.

Brent Thill - Citi

Brian, you have had a couple of organizational changes, I guess, just in terms of if you dig one layer deeper is there going to be ripple through in terms of how you’re structuring the organization or should we consider now with these announcements that you have essentially turned the corner if you will relative to some of the senior management changes you have made?

Brian J. Farrell

I think we have made the changes that we’ve needing to make. I mean it’s been a very difficult time. But again as I said before, we made the tough calls and I am delighted to have both Danny and Roy in their senior positions here. I think they are experienced, which is outlined in the press release. Danny has a long experience in the creative business, a lot of time at EA. Roy has actually run a couple of our studios, so he comes out of our very successful studio systems; his most recent position was in at Rainbow Studios where he was responsible for things like Cars and the resurgence of the MX franchise. So we got a couple of real pros who built their positions in-house, so we are looking forward to marching forward with those guys and the rest of the organization and executing our plan of high-quality products produced on time and on budget.

Brent Thill - Citi

You mentioned Frontline, can you just elaborate in terms of what your most excited, maybe what you’re seeing in terms of the sell through for the titles coming up on launch. What are the other key aspects that you are excited about with that release?

Brian J. Farrell

Frontline as a multiplayer game really cuts some new ground. We will be releasing the multiplayer demo in probably about a week. Microsoft will put it up on Xbox Live. As you know, the team we hired to do that product, their roots are in the battlefield franchise, and we think we’ve taken that to the next level. We believe it will be the first 32 player Xbox Live multiplayer game. The PC game can get even more people simultaneously online in this very robust multiplayer game. So we think it has a tremendous hook.

Unlike its competition it’s not linear in script, it’s very open world so it’s a very different game. But that being said, we just wanted to be conservative in our financial approach to the game. We are very, very proud of the quality and how it shines as multiplayer game.

Operator

Your next question comes from the line of Edward Urban - Bear Stearns.

Edward Urban - Bear Stearns

On Frontline, can you speak to the specific development issues that resulted in the cancellation of the PS III SKU of that franchise?

Secondly, you highlighted Saints Row II a number of times, I’m just wondering if you can comment on your release strategy relative to the competitive product you see that’s out there this year, what your thoughts are just in terms of competitive positioning overall?

Brian J. Farrell

Two good questions. Yes, the Frontline PS III I think we talked about in our last call, it was based on the unreal engine which as we talked about on prior calls and as many of our competitors have commented, it’s just not optimized yet, the unreal engine for open world on PS III. We could have gotten it done, it would have be at least 60 to 90 days behind the lead SKUs. We don’t think that’s good for branding and we don’t think that’s also a good use of a very talented team.

So, as much as we would have like to have gotten it out on the PS III, it’s really the fact that the unreal engine just didn’t perform in the open world as we would have expected, caused that to be behind its lead 360 in PC SKUs.

With respect to Saints Row II, now that GTA has announced their date of April 29th, obviously we will give them a fair amount of running room in the market before we launch. We are currently working with our retail partners to try and determine what we think the best launch window for that title is.

Competitively I don’t think a lot of people understand that we have two different games between GTA and Saints Row II. We are great fans of GTA and the genre, we think it’s going to be a terrific game and it’s going to sell a lot of units. But we also thing we have taken Saints Row II in a different direction that highly differentiates the product. We got some terrific online co-op play, we have character customization, we have some really neat things will be unveiling when we unveil the product about the direction we’ve taken the product.

The good news for us is we have a very differently positioned game and we think there is room in the market for two high quality games.

Operator

Your next question comes from the line of Justin Post - Merrill Lynch.

Justin Post - Merrill Lynch

On your prior press release you talk about fiscal ‘10 and you cancelled a couple of games. I know it is really early to be talking about that but how is your pipeline what you say over the next three years for new IP, how do you feel about that?

Brian J. Farrell

That’s one of the unfortunate things about our pre-announcement is in retrospect I think we should give a lot more visibility on the effect on the fiscal ‘10 pipeline, which was negligible. As you probably know, all companies including us, review products and kill products routinely that just aren’t making the cut. It was just in one big announcement we had to highlight four at once.

So our fiscal ‘10 pipeline is in great shape as we said in the pre-announcement, we cut a total of a total of four SKUs only one of those was a studio that we closed and then the other just products have been replaced by the studios that they are working on the other projects. So the net effect on fiscal ‘10 is negligible at best.

Justin Post - Merrill Lynch

How do you feel about hardware sales in January? There has been a lot of concern the consumer has a slowed down over the last six weeks. What are you seeing out there in the current marketplace?

Brian J. Farrell

I mean it is one month and we are coming off a record hardware year and the economy as we all know is fairly squishy. I think it’s way too early to start reading into that any trend. Obviously anyone looking at the economy now has to be concerned about the overall resiliency of the consumer. But one thing we do hear back from our retail partners consistently is that the media game category continues to be one of the shinning spots in their store environments. They attributed that in good times people buy entertainment and in bad times people buy entertainment. So we haven’t seen any effect on our business or orders yet and obviously if we see any changes we will update you.

Justin Post - Merrill Lynch

The two data points on the balance sheet, it looks like AR is up. How much of that is attributable to the late shipment of MX. Can you quantify that?

On the short-term capitalized software expense, how do you feel about that balance entering the calendar year?

Brian J. Farrell

Well, taking the second part of the question first on the capped software, I think Michael asked the question about the capped software. Obviously it’s down tremendous amount sequentially, and also down from the prior year which as Rasmus said in his prepared remarks, we’ve been expensing more than capitalizing and we wrote off those projects we thought that cannot compete in the marketplace. So we’re very comfortable with that level of cap software at those reduced levels.

With respect to the effect of the MX late shipment, I don’t have the exact numbers in front of us but obviously that title was released on December 21 so all those receivables were generated in the last two weeks of the quarter. As Rasmus said in his remarks, we collected well over $90 million in the first couple weeks of January. So that was a timing anomaly which has adjusted itself.

Justin Post - Merrill Lynch

Last question on Ultimate Fighting Championship. I know it’s in the fiscal year, I guess it’s going to be late March. How confident are you that it makes the year end? If you had to go to fiscal ‘10, would that be something you really don’t want to see at this point? What’s your timing on that?

Rasmus Van Der Colff

The timing is for the calendar first quarter. The idea is as you probably know is we don’t want it to compete directly with our WWE franchise which is generally a November launch. So we’re trying to give it at a fair amount of space. The product we signed the license well over a year ago, the product is a year into development with another year to go and all systems are go.

Justin Post - Merrill Lynch

Do you expect THQ share to really improve on the Wii? Do you think that’s a big opportunity for the company?

Brian J. Farrell

We expect our share on the Wii will improve in calendar ‘08.

Operator

Your next question comes from Eric Handler - Lehman Brothers.

Eric Handler - Lehman Brothers

I really don’t want to get too much into guidance right now, but when you think about next year and figure you’d grow at the industry rate, you have a benefit from your accelerated amortization. Can you at least give some sense of where you hope a little bit may be within a range of where your operating margins might be?

Brian J. Farrell

Again as we said, we haven’t done our annual operating plans. So we just don’t want to throw any numbers out there without having done the numbers. But just for clarity, the accelerated amortization related to titles shipped in the last fiscal year so it really doesn’t have any impact on fiscal ‘09.

Eric Handler - Lehman Brothers

Then ‘10 titles, it’s negligible as well?

Brian J. Farrell

That’s correct.

Eric Handler - Lehman Brothers

As you continue on your development of 360 and PS3 products, are you finding it easier to get things on time when you start with the PS product and then move things over to the 360, or is it easier the other way?

Brian J. Farrell

I think if you ask anyone in development whether us or any of our competitors, now that all of us have native PS3 development, getting quality SKUs out on both platforms is not as challenging as the time when we all started on 360 because that is all we had and then trying to get them over to PS3 was very challenging.

But I think certainly THQ and I presume a lot of our competitors have passed that inflection point now.

Operator

Your final question comes from the line of Jeetil Patel - Deutsche Bank.

Jeetil Patel - Deutsche Bank

Embedded in your 10% to 12% industry growth guidance for calendar ‘08, can you talk about what kind of a Playstation 2 software sales drop you expect in calendar ’08? Do you think it is more than 50% or less than 50%?

Brian J. Farrell

I don’t have the model in front of me. What I will say Jeetil is we have modeled it consistent with prior years in the cycle. The PS2 market, I frankly thought showed some pretty solid strength in calendar ‘07, but at some point it’s going to continue to weaken and that certainly is our expectation if we are down more than 50% next year on a software dollar basis that would not surprise us.

Jeetil Patel - Deutsche Bank

Secondly, we’re getting into the heart of this cycle and as you look at all the development studios that different products you have and obviously you are making some changes here, but do you think that the overall profitability behind the businesses just as good as it was last cycle?

If I look at your numbers they seem to be profitability-wise lower than where we were in the same period in the last cycle, so I am at least trying to understand what the scalability of the business looks like -- not for you, for the industry as a whole -- as we step into next year to three years into the meat of the cycle?

Brian J. Farrell

I think you make a good point, but the way we look at both year by year, but more importantly on a product-by-product basis. As you know Jeetil, what drives profitability in the business the cycle is only one part of the equation; the biggest part of it is who has the hits? When THQ has hits our operating margins are superior to our competitors and in years like fiscal ‘08 when we do not have hits, they do not.

So I don’t think there is anything endemic or really cyclical about it. The real question is can we outperform the market in terms of creating or shipping more units per title that we ship? That is the real key to operating leverage and some of the cyclicality is because it’s great to have a higher installed base of hardware to ship into, but it’s really more product-by-product basis. If you make hits and ship more units per title, you make more money.

Jeetil Patel - Deutsche Bank

The Street is looking for about a 65% incremental margin in fiscal ‘09 with pretty decent growth; that seems to be the highest levels attained by the company probably by the industry in general. But I guess how do you feel about the 65% incremental margin? Is that still attainable since I was trying to go back and look at a time when we did that?

Brian J. Farrell

Yes, I’m not talking about 65% on a dollar base.

Jeetil Patel - Deutsche Bank

65 on the net change in operating profit dollars versus the net change in revenue into fiscal ‘09 versus fiscal ‘08?

I mean obviously it’s a difficult comp on fiscal ‘08, given the changes, but I guess is it still possible that you did it on a two-year basis in terms of incremental margins?

Brian J. Farrell

Well I think the way we are thinking about it is positive. Again, we are not commenting or not giving our guidance yet, so I don’t want to get back into that. But what I will say is the converse of what I just said about getting operating leverage on more units per titles shift, we did not get that in ‘08. So to the extent we can achieve any reasonable numbers on that in ‘09 that’s should significantly drive operating margins. I think we need to leave it at that until we get our model fixed.

Julie MacMedan

I think that’s the last question. So that concludes our third quarter call. We appreciate your time and thank you for joining us today.

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Source: THQ Inc. F3Q08 (Qtr End 12/31/07) Earnings Call Transcript
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