I believe that THQ (THQI) is trading far below its fair valuation on overhyped bankruptcy fears. In this article, I will provide an overview of THQ and my investment approach. I plan to release a follow-up article with in-depth sales analytics, in-depth catalyst overview, in-depth IP valuation, and a look at respective takeover candidates. With my model based on a 30% bankruptcy ($0), 30% takeover ($12), 30% mediocre turnaround ($15) and 10% full turnaround ($50) by 2014, and after applying a 20% discount rate, I am giving THQ a "fair value" price target of $9.10.
There is no in-depth coverage readily available on the internet and several misleading titles are floating around the web today, suggesting that THQ is "exploring a sale." (Article One and Article Two). These articles avoid discussion of the actual buyout possibilities and are clearly click baiting. There is also a lot of misinformation floating around that states THQ is out of cash and it appears that analysts were out of touch with Darksiders II reality. The latter is inexcusable due to publicly available sales data and the recent departure of a key exec (Darksiders Creative Director!!), and larger firms probably have access to better research than I have. Any analyst who claims the Darksiders II disappointment or THQ's cash issues were a surprise should consider a new career.
THQ's stock troubles are best seen in both a 2 year and 1 month perspective (both below from Yahoo Finance). THQ has lost 98% from its 2-year peak of $64.10 and 69% from its 1-month peak of $3.72. THQ has gone from an all-time (2007) peak market cap of $2.4B to its current level of $8M. Electronic Arts (EA), Activision Blizzard (ATVI), and Microsoft Gaming Studios (MSFT) are primary competitors, but these companies spend more on a week of advertising for a single game than THQ's current market cap.
A Brief History of THQ's Troubles
THQ hit an all-time peak in April 2007 with a split-adjusted stock price of $362, and a market cap of $2.4B. Since then, THQ has served as an excellent case study of poor management, or as Peter Lynch would say "diworsification." THQ signed licensing deals with Disney (DIS) and Nickelodeon, and purchased several gaming studios. The largest fiasco was Big Huge Games (Rise of Nations fame), which was re-sold a year later for a massive loss. THQ posted a yearly loss each year beginning in early 2007, and never recovered from the lack of direction. Quality was abandoned (Homefront) and great franchises (Red Faction and Warhammer) failed to draw gamers. The largest single mistake was the uDraw gaming tablet, announced in August 2010, THQ estimates this fiasco cost it over $100M, or over 12x its current market cap. Not surprisingly, Wall Street loved the idea and boosted THQ stock by 13% in one week to a split-adjusted price of $38.
To sum it up: THQ has missed on practically everything since 2007 while racking up massive losses. Only one major success has occurred in the past five years, the development of the Saint's Row franchise.
My Take on the Recent Report and Turnaround Progress
The most shocking factor about THQ is the market's reaction to what I considered to be a great report. My largest fear was that Company of Heroes 2 would be botched and that Metro: Last Light would be overlooked like Darksiders II. THQ's honesty-first approach about requiring more time to publish quality content and a transparent look at cash needs is a refreshing change. Any analyst worth his salt should have seen the Darksiders II disappointment coming, and THQ's cash crunch has been apparent. THQ beat analyst expectations for its financial position, so the over 69% monthly drop is shocking.
The market's reaction to previously publicly available information is indefensible in terms of the efficient market hypothesis. My gamer friends told me back in Spring 12 that I should bet against THQ's release of Darksiders II, that DS1 was a "great game, but underrated" and they planned to "wait for a drop to $20 in three months before buying." Gamers don't wait to purchase Call of Duty or Halo because they know the price tag will stay high, the content is gripping, and the multiplayer creates a network effect. Darksiders II failed due to a self-fulfilling prophesy from the gaming world. Disappointing sales data of 732k in the first month (released almost two months ago) confirmed these suspicions, but I figured the market already knew. THQ's report of 1.4M shipped and potential sales from a launch title Wii U port, boosted the potential returns, but the stock dropped 69% because THQ stated the obvious regarding its financial position, which was actually less worse than already projected?
The 6 month financial progress from THQ (Q4-12 to Q2-13) has been mostly positive while the stock has lost 81% of its value. THQ has released two games - Darksiders II and WWE '13, both of which had very positive reviews, both from critics and gamers, and with massive overhang THQ's current surplus has only declined $15.5M ($21M to $5.5M). This decline is likely overstated since the uDraw inventory was practically worthless and long-term liabilities have also decreased by $9.5M. Over the summer, at E3, all three marquee titles for spring 2013 received strong reception. Two negatives that occurred include a slip on sales for Darksiders II (not a 'real' surprise) and a brief delay of the three marquee titles (hardly uncommon for independent gaming titles- e.g. Half Life and Doom/Quake).
Leadership at THQ
Jason Rubin, of Naughty Dog (Crash Bandicoot and Jak & Daxter) fame, was appointed as President of THQ late last May, and his changes have been very noticeable. Also noticeable is that Rubin successfully sold Naughty Dog to Sony (SNE) and his tech. venture Flektor to News Corp. (NWS) Rubin's presence has been strong at THQ, with key changes beginning with an immediate divestiture of UFC licensing rights, and a cancellation of a Saint's Row DLC expansion in favor of a new game. Rubin promoted a studio veteran, Ron Moravek (from Relic, Company of Heroes), as the new VP of Production which underscores his insistence on studio integration. Finally, when Darksiders II disappointed, the key director was quickly sent packing.
THQ's leadership package has a creative compensation package that will require THQ to trade at $20 and $30 split-adjusted for ten consecutive days. This was viewed as a "realistic target" as recently as last June, and highlights how far Wall Street has shifted on THQ. Jason Rubin, from an interview 4 ½ months ago, demonstrates that he's aiming high with the turnaround, and I still believe he's credible. He's not going to let THQ fall short with sub-par titles, so the slight delays are not surprising.
Value Breakdown: IP Back Catalog
I will release a follow-up article discussing the breakdown of these titles and their respective valuations, but as an overview, THQ owns the content for Saint's Row, Company of Heroes, Metro, Red Faction, Frontlines, Homefront, Darksiders and has extensive licensing history with the Warhammer and WWE franchises. I estimate this IP and licensing connection to be worth a minimum of $200M. I will also discuss potential takeover candidates, with a look at some unconventional targets, primarily Zynga (ZNGA) and Gamestop (GME) - feel free to sound off!
Company of Heroes 2, Metro: Last Light, South Park: The Stick of Truth, and the next Saint's Row release are the big catalysts for 2013. I will discuss each of these in more detail in a follow-up article, but initial reactions for each game (minus the next SR, which is very secretive) are very positive. The links above each demonstrate the content and related commentary, and a quick Google search will bring more details if you do not wish to wait for a more in-depth follow-up article.
I use a zero-return bankruptcy potential of around 30% in my projection model. Personally, I see the risk as closer to 10%, but I think with bankruptcy-prone investments, it's always best to double or triple the applied risk factor. I also used a 'high-risk' discount of 20% when I typically prefer to apply 10% to equities. Adjusting for these factors, I believe THQ is worth $13.96, or effectively undervalued by a factor over 12. It's hard to believe that I'm "that much smarter" than the market, so please take my entire model with a grain of salt. The market clearly sees a potential closer to 90%. I believe this investment has the potential to be a once in a lifetime find, but I also realize the risk of complete loss. If you find my article interesting (and hopefully helpful), please 'Follow' me, to be notified of the release of the 2-3 follow-up editions in the next two weeks.
I advise treating these shares like lottery tickets. If you find my expected value percentages realistic including the $200M takeover value, than you can see that THQ is clearly underpriced. For the risk-seeking investor, I recommend a 1-5% portfolio allocation in these shares, preferably in a non-taxable account. If you are afraid of a total loss, or have liquidity needs, steer clear of THQ. This one is going to be wild. My money is where my mouth is with roughly 4% of my portfolio here with a cost basis of just over $2 (70% of shares post-results).