Wall Street Strategies'  Instablog

Shares of videogame publisher THQ Inc. (THQI) surged on almost four times the average daily volume on September 22.  What the heck was happening to justify that type of volume?  Well, it was none other than renewed buyout speculation.  I have consistently stated that consolidation in the game publisher sector is desperately needed ahead of the next console cycle, which I expect to begin in 2012.  If there is anything that has stood out in the financial results from companies such as Electronic Arts (ERTS), Activision Blizzard (ATVI), and THQ it’s that development costs have gotten completely out of hand.  To develop a top-tier title over a 18-24 month time horizon it could cost a publisher in excess of $10.0 million, and there is no guarantee that the return on investment will be recouped as gamers are a fickle bunch (a bad review score from the Medacritic review agency could crush demand alone).  Google Midway Games, and you will see a sad tale about a company that couldn’t recoup its cost of capital and was subsequently crushed in the middle of the current console cycle.  Consolidating the base of publishers would bring down development costs as designers would have reduced bargaining leverage, among other considerations such as distribution efficiencies.

I poured through a litany of comments in the blogosphere regarding a THQ buyout last night.  Those with disclosed short positions panned a deal.  Those with an objective perspective were generally upbeat, and realistic.  Let me outline an unbiased snapshot into what a would be suitor is seeing in THQ:

1. An installed base of game consoles that stands to double from current levels by the time the next cycle commences
2. An area of entertainment that has held up remarkably well in the present recession and past economic downturns
3. A company that has 40.0% plus of revenues coming from international operations (an experienced team on the ground is invaluable)
4. A stable of games, though mostly licensed, that could perform even better at retail if additional marketing dollars are thrown behind releases
5. A streamlined cost base following a restructuring that began in November 2008
6. Strategy in place to capture online opportunities
7. Kids friendly portfolio of games with improved economics
8. Annual licensing costs which are set to drop from $79.0 million in the fiscal year ended March 2010 to $13.8 million by fiscal year ended March 31, 2012

Through studio closures, increased attention on game quality and a hit franchise in UFC THQ has dramatically improved its free cash flow prospects for FY10 and beyond.  Keep in mind that the next iterations of UFC and Red Faction will be released on a higher installed base of current generation consoles now that manufacturers (Sony, Microsoft) are lowering price-points some four years into the game cycle.  Conservatively, we estimate THQ could generate about $50.0 million in EBITDA for FY11; applying a multiple of 15.0x to that projection (below Activision Blizzard) one has an $11.00 stock.  While the attractiveness of THQ as an acquisition candidate is not unnoticed in our analysis, it’s not the linchpin in the thesis.

Written by Brian Sozzi, a Research Analyst for Wall Street Strategies (www.wstreet.com) specializing in the apparel/hardline goods sectors of the retail industry.   For more information about Mr. Sozzi, refer to the company's website, wstreet.com.