As fellow SA contributor J Mintzmyer detailed recently in his article Tremendous Upside Potential On A THQ Bet, THQ's (THQI) longstanding problems have finally come to a head where now the company is on the verge of insolvency. The company will very likely need to restructure or sell itself in order to survive the next six months. With that in mind, it is worth taking a look at the liabilities senior to the equity to determine how much enterprise value is needed for the equity to have value. However, there is a possibility that through a restructuring process, even if the equity has some theoretical value, it ends up cancelled; alternatively, in the event of a sale, a premium could be offered to entice the equity holders to sell.
The following table lays out the liabilities of the company, as I believe a restructuring professional or strategic buyer would look at them:
The convertible notes (CUSIP: 72443AB2) are bonded debt and will certainly need to be paid off at par before the equity holders benefit. If we were evaluating the bonds as an investment, we could look at the market value of those instruments to see if we are made whole at the current purchase price. The bonds last traded around 25% of par, but volume is light. Anyone wanting to build a position in this credit would need to pay much more than that figure to accumulate more than a couple percent of the float.
Other long-term liabilities largely include future minimum royalties for licenses. Since we will be assigning some value to these licenses, we will also need to take account of the liability. Other amounts in this category include items such as rents.
For individuals that may be interested in purchasing the bonds: good luck, these do not appear to trade in anything less than institutional size. Convertible bonds are also usually very difficult for individuals to acquire even in larger liquid names.
Accounts payable and accrued liabilities are also included in the figure because these amounts typically cannot be negotiated away and would need to be settled before economics flow to the equity.
It is worth noting the one item that has been left off, which is deferred revenue. These amounts have to do with the need to service the back catalog (patches, servers, etc.) and the basic accounting rule of matching expenses with revenues. When THQ sells a product, its liability is not complete on a going concern basis because it will spend money on the games after the sale. The deferred revenue account is not a cash item, and the actual liability on THQ's part is highly variable depending on how the current situation is resolved.
With $255 million of liabilities, let us now consider what the assets would need to be worth to cover these amounts:
For the intellectual property, what I did was merely list all the franchises that likely have value and then came up with estimates to make the total number $255 million. The value of doing it this way is to create an over / under framework to work from. If you think one is more or less, simply mark it as such. Cash and accounts receivable are the easy and small parts of this exercise and should be easy for everyone to understand.
My own opinion is that THQ is a distressed seller and it will not get top dollar for any asset. There are healthy gaming companies in the marketplace, but their focus has turned away from consoles and PCs. The price will have to be right for someone to step in with a purchase. Furthermore, gaming companies really want the cream of the crop assets that can really move the needle for them and which create long standing franchises with plenty of recurring revenue opportunity.
Unfortunately for THQ, assets like Company of Heroes do not really fit this bill; although it is a great franchise, it does not have the same ability to have the same type of release schedule as the mega hit games like Halo. Homefront will likely always be secondary title, although it has potential so its value is more based on optionality than current success. A buyer then is really only focused on Saint's Row as a primary asset but may believe it will be able to turn one or two of the other assets in the deeper portfolio into something larger, which gives the remaining portfolio option value. The conclusion here is that I think any upside to valuation will really have to come from Saint's Row.
In a strategic purchase, a buyer will have to pay a premium on the equity to get a deal done quickly and assure itself of success. There are not many better ways to destroy a company in distress than arguing with existing shareholders as to how much value they will receive. Nevertheless, it is a small amount in the grand scheme of things, but important for current shareholders as the price could double or triple for little cost to a buyer. This would be a great scenario for holders of the current equity and I think looking at the IP it could make sense for a buyer.
On the other hand, a restructuring would likely be devastating for existing equity holders and the problem is that the company needs short-term cash to generate value from these franchises. The company may also need to significantly reduce head count and suffer through expenses to right size itself. This capital injection will not come cheap. First, the existing debt will need to convert to equity so that new debt, even in small amounts, can be raised. The company may also need new equity commitments, which are very hard to acquire for such a small company. An equity investor's discount rate for putting in $10 to $20 million will be in excess of 25%.
Looking at the situation, my view is that the company has only months to sell itself or it will go through a strategic prepackaged bankruptcy in concert with the bond holders. The management team will have the opportunity in this process to issue itself new equity options that have a chance of being in the money and right size its work force in an efficient manner as well.
While there is some hope for an exchange of the bonds into equity, leaving the existing equity outstanding, management has every incentive to put the company into bankruptcy and virtually none to keep existing equity holders in the ownership structure. Add to this fact that an exchange would need to clear a 90% to 100% hurdle and the chances look even more remote.
For those taking a bet on this stock, a sale to a strategic buyer is probably the only way out, but the return could be a double or triple. Any extra value that potential investors evaluating the intellectual property ascribe to those assets is upside and it is certainly possible that my analysis has missed something in that regard; however, at least perhaps we have established the bar those assets have to cross in order for the equity to make a return.
With respect to the bonds, at 25% of par they look like a good deal for those inclined to take risk, but getting a hold of them will not be easy.