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I've been amassing research on THQ (THQI) and was preparing a follow-up report for next Monday, when I was just notified of the company's request to file a late 10Q. While the late 10Q request wasn't surprising, the contents were a shocker:

"THQ Inc. (the "Company") was unable, without unreasonable effort or expense, to file its Quarterly Report on Form 10-Q for the quarter ended September 30, 2012 (the "Form 10-Q") with the Securities and Exchange Commission by November 8, 2012. In connection with the Company's Credit Agreement with Wells Fargo Capital Finance, LLC ("Wells Fargo"), which was amended pursuant to Amendment Number One dated July 23, 2012 (collectively, as so amended, the "Credit Facility"), on November 7, 2012, the Company was informed by Wells Fargo that loan availability on the Credit Facility was less than 12.5% of the maximum revolver amount on one or more occasions as of and after the fiscal quarter ended September 30, 2012, and accordingly, one or more events of default have occurred under the terms of the Credit Facility, including the failure to comply with financial covenants for the fiscal quarter ended September 30, 2012. The Company is currently in discussions with Wells Fargo regarding the asserted defaults and believes that it will reach an agreement with Wells Fargo with respect to such defaults. Wells Fargo has continued to fund requests from the Company after September 30, 2012 while Wells Fargo and the Company attempt to reach an agreement. There can be no assurance, however, that the Company will achieve an agreement with Wells Fargo."

How Did it 'Default?'

In order for THQ to become "in default," according to the terms described in the 10Q from 1Q-13, two distinct events must occur:

1) Availability on the Credit Facility must be below 12.5%. (This is a $50M facility, so THQ must draw down over $43.75M. If THQ draws over $43.75M (or $42M after January 1, 2013), then the "financial covenants take effect.")

2) THQ must maintain a fixed charge coverage ratio of less than 1.0 to default. (According to the financial covenants, after September 30, 2012, THQ must maintain an annual fixed charge coverage ratio of at least 1.1 to 1.0.)

The shocking factor is that according to the recent 2Q-13 results, THQ had $29M left on the Credit Facility and had $36M in cash. Therefore to achieve technical default, THQ would have spent a net amount of anywhere from $22.75M to $58.75M (depending on how much cash it tapped).

Failing the fixed charge coverage is not surprising since THQ will not be likely to hit positive EBIT until this quarter end at the earliest.

What Does This Mean?
If THQ remains in 'default,' it must pay back the entire facility immediately and its interest rate is increased by 2%. The facility interest rates are between 2-4%, so the interest bump is not a huge impact. However, THQ would need to find cash to cover the $44-$50M that is due.

Here's the really important question: Did THQ spend $23M marketing WWE '13 and hit a technical default with $36M in cash on the side, or is THQ out of cash and in default?

I firmly believe the former is more likely. If the cash was only dropped for WWE '13 marketing, first week sales were strong with 500K units moved on the three consoles, and this should be no major issue after a few weeks.

If the latter is somehow true, I think a shareholder lawsuit and possible corporate fraud case could stem from the clearly misleading results on Tuesday.

What Happens if it's the Worst Case?

There are 4 possible outcomes:

1) Wells Fargo works with THQ to amend the covenants.

2) Wells Fargo refuses to work with THQ - and the company must seek another bank facility.

3) THQ cannot attain a bank facility and must resort to private equity.

4) THQ cannot attain any funding and declares bankruptcy.

#4 is the worst case of the worst cases, but #3 is the worst case of the feasible options.

In a #3 situation, I predict convertible debt of $50-$100M with a conversion price of $4-$5. Obviously, the lower the conversion price, the more diluted the shareholders become. In the absolute worst case of market ($1.40) conversion and a $100M debt issue, shareholders will be diluted over 90%. Ultimately, the conversion price terms will depend on how many private equity bidders are available.

In an alternate scenario, a company such as Zynga (NASDAQ:ZNGA) which has said it wants to enter 'hardcore gaming' and has already made acquisition moves could swoop in and buy out THQ. I think a $200M takeover target is a minimum for this content. Even after assuming all debt, shareholders could still see over $10 per share.

What to Do?

I believe the $100M bonds are very attractive at this point. At 25c on par, they are a steal, but I haven't been able to find any through my brokerage.

If you have the common stock, it's already priced for this 90% dilution scenario and nothing really changes. At $200M value (another Seeking Alpha contributor pegs $255M), the 90% dilution places THQ stock around $1.20. I will follow very closely over the weekend and will release the rest of my research where relevant. Obviously a 'technical default' three days after announcing $29M of Credit Facility availability was not expected.

Disclosure: I am long THQI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: THQ Is In Technical Default On Credit Facility