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THQIQ
THQ, Inc. - OTC Markets

4/18/2014, 5:51 PM ET
Quote & Analysis Breaking News StockTalk Description

THQ is a leading worldwide developer and publisher of interactive entertainment software for all popular game systems, including: Home video game consoles such as Microsoft Xbox 360, Nintendo Wii, Sony PlayStation 3 and Sony PlayStation 2; Handheld platforms such as Nintendo DS, Sony PSP and wireless devices; and Personal computers (including games played online).

Our titles span a wide range of categories, including action, adventure, fighting, racing, role-playing, simulation, sports and strategy. We have created, licensed and acquired a group of highly recognizable brands, which we market to a variety of consumer demographics ranging from products targeted at children and the mass market to products targeted at core gamers. Our portfolio of licensed properties includes games based on popular fighting brands such as World Wrestling Entertainment and the Ultimate Fighting Championship; kids and family brands such as DreamWorks Animation, Disney•Pixar, Marvel Entertainment and Nickelodeon; core gamer brand Warhammer 40,000; as well as others. In addition to licensed properties, we also develop games based upon our own intellectual properties, including Company of Heroes, DeBlob, Frontlines, MX vs. ATV, Red Faction and Saints Row.

We develop our products using both internal and external development resources. The internal resources consist of producers, game designers, software engineers, artists, animators and game testers located within our internal development studios and corporate headquarters. The external development resources consist of third-party software developers and other independent resources such as artists, voice-over actors and composers. We refer to this group of development resources as our Studio System.

Our global sales network includes offices throughout North America, Europe and Asia Pacific. In the U.S. and Canada, we market and distribute games directly to mass merchandisers, consumer electronic stores, discount warehouses and other national retail chain stores. Internationally, we market and distribute games on a direct-to-retail basis in the territories where we have a direct sales force and to a lesser extent, in the territories where we do not have a direct sales force, third parties distribute our games. We also globally market and distribute games digitally via the Internet and through high-end mobile phones, such as the iPhone.

We were originally incorporated in New York in 1989 as Trinity Acquisition Corporation, which changed its name in 1991 to T.HQ, Inc. following a merger with THQ, Inc., a California corporation. We were reincorporated in Delaware as THQ Inc. in 1997. Our principal executive offices are located at 29903 Agoura Road, Agoura Hills, California 91301, and our telephone number is (818) 871-5000. Our Internet address is http://www.thq.com.

Strategy

In November 2008, we announced a more focused product strategy and an updated strategic plan. Our product strategy focuses on:

Developing a select number of high quality owned intellectual properties targeted at the core gamer, such as Saints Row 2 and the upcoming Red Faction: Guerrilla and Darksiders.

Extending our leadership in the fighting and racing categories with our World Wrestling Entertainment and Ultimate Fighting Championship licenses in the fighting category and our owned intellectual property, MX v. ATV in the racing category.

Building strong mass appeal/family game franchises such as de Blob, Big Beach Sports and Drawn to Life, which appeal to the broadening gamer demographic.

Improving the profitability of our kids business. We plan to rationalize our product line in the kids business by publishing on the most relevant platforms and by reducing development costs. We are also reinvigorating our licensed franchise portfolio with the recent additions of properties from Marvel Entertainment and DreamWorks Animation.

Expanding into the online gaming market. We plan to make targeted investments in extending key brands into the online gaming market, including Company of Heroes Online, WWE Online (working title) and our Warhammer 40,000 massive multiplayer online ("MMO") game. We also plan to exploit growing consumer segments, such as the casual MMO market, with the release of Dragonica.

We made a number of changes in fiscal 2009 to our organization to support this more focused product strategy. We restructured our product development organization under new studio management. We discontinued a number of titles in our product pipeline that did not fit our strategic objectives. As a result, to date, we have closed several of our internal studios, and reduced staff at other studios. We also reduced costs and headcount in our corporate and global publishing organizations. Upon completion of a few remaining studio personnel actions we will have reduced headcount by approximately 600 people, which is approximately 24% of our prior total staff. We also realigned our organizational structure to support this more focused product strategy.

Our Industry

The video game industry is the economic sector involved with the development, marketing and sale of video and computer games. It encompasses dozens of job disciplines and employs thousands of people worldwide. Video games have increasingly become a mainstream entertainment choice for both children and adults: 72% of the United States population between the ages of 6-44 plays video games, according to March 2008 study conducted by NPD, an independent provider of consumer and retail market research for video games and other industries. According to the International Development Group, Inc. ("IDG"), an independent consulting and advisory services company that analyzes the consumer electronics and interactive entertainment industries, sales of console, handheld and PC games (excluding wireless) reached $12.6 billion in North America, and $11.1 billion in Europe in calendar 2008.

The first modern video game platform was introduced by Nintendo in 1985. Advances in technology over the past 24 years have resulted in continuous increases in the processing power of the chips that power both the consoles and PC. Today's video game consoles—the Sony PlayStation 3, Microsoft Xbox 360 and Nintendo Wii—are not simply gaming platforms, but also function as multimedia hubs that can deliver high-quality digital movies and television programs. Video games are also played on personal computers that contain powerful graphics cards, and on advanced handheld devices such as PSP (PlayStation Portable) and Nintendo DS. Additionally, both online gaming and wireless gaming have become popular platforms for video game players over the last several years.

Our Products

We develop, market and sell video games and other interactive software and content for play on console platforms, handheld platforms, mobile devices, PCs and online. The following games generated 10% or more of our sales during the fiscal years ended March 31, 2009, 2008 and 2007: in fiscal 2009, WWE SmackDown vs. Raw 2009, Saints Row 2, and Wall-E; in fiscal 2008, WWE SmackDown vs. Raw 2008 and Ratatouille; in fiscal 2007, Cars and WWE SmackDown vs. Raw 2007.

Our games are based on intellectual property that is either wholly-owned by us or licensed from third parties. We develop our games using both internal development resources and external development resources working for us pursuant to contractual agreements. Whether a game is developed internally or externally, upon completion of development we extensively play-test each game, and if required, send the game to the manufacturer for its review and approval. Other than games we release for PCs or wireless devices, the console manufacturers or their authorized vendors manufacture our products for us. We then market and distribute our games for sale throughout the world.

Creating and Acquiring Our Intellectual Property

Our business process begins with an idea. Inspiration for our interactive entertainment software comes from many sources—from our internal studios, from our external studio partners, or from existing intellectual properties that we either license or acquire. Historically, most of our titles have been based upon licensed properties that have attained a high level of consumer recognition or acceptance. We have relationships with many well-known licensors and create games based on certain properties they own or control. Licensors generally do not grant exclusive output agreements for all of their properties with any

Ultimate Fighting Championship content

These intellectual property licenses generally grant us the exclusive use of the property for specified titles, on specified platforms and for a specified license term. The licenses are of varying duration, and we pay royalties to our property licensors generally based on our net sales of the title that includes the licensor's intellectual property. We typically advance payments against minimum guaranteed royalties over the license term. Royalty rates are generally higher for properties with proven popularity and less perceived risk of commercial failure.

A key strategic initiative is to create or acquire new intellectual properties that we own. We refer to these properties as our "owned intellectual property[ies]". Our owned intellectual property is generally created by one of our development studios or by a third-party developer with whom we contract on a work-for-hire basis. We have also acquired intellectual properties from other publishers or developers. The titles we create based on intellectual properties we own may contain certain licensed content, such as music or rights to use of a name or object (such as a brand-name vehicle). In this case, we enter into a license agreement with the content owner and pay either a fixed fee or royalty for the use of such content.

Developing Our Products

We develop our products using both internal and external development resources. The internal resources consist of producers, game designers, software engineers, artists, animators and game testers located within our internal studios located throughout North America, in the United Kingdom and in Australia, and in our corporate headquarters. The external development resources consist of third-party software developers and other independent resources such as artists, voice-over actors and composers. We refer to this collective group of development resources as our Studio System.

We make the decision as to which development resources to use based upon the creative and technical challenges of the product, including whether the intellectual property being developed into a game is licensed, an original concept that we created, or an original concept created by a third-party developer. Once we determine where a product will be developed, our product development team oversees the internal or external resources in its design, technical assessment and construction of each game.

The development cycle for a new game depends on the platform and the complexity and scope of the game. Additionally, when developing an intellectual property into a game which is simultaneously being made into a motion picture, our development schedule is designed to ensure that our games are commercially available by the motion picture's theatrical release. The development cycle for console and PC games generally ranges from 18-24 months and the development cycle for handheld games generally ranges from 9-18 months. These development cycles require that we assess whether there will be adequate retailer and consumer demand for a game and its platform well in advance of its release.

The investments in our development, prior to reaching technological feasibility, are recorded as product development expenses in our consolidated statement of operations as well as non-capitalizable costs such as quality assurance. We had product development expenses of $109.2 million in fiscal 2009, $128.9 million in fiscal 2008 and $97.1 million in fiscal 2007.

Upon completion of development, each game is extensively play-tested by us to ensure compatibility with the appropriate hardware systems and configurations, and to minimize the number of bugs and other defects found in the products. If required, we also send the game to the manufacturer for its review and approval. To support our products after release, we provide online access to our customers on a 24 hour basis as well as operator help lines during regular business hours. The customer support group tracks customer inquiries, and we use this data to help improve the development and production processes.

Manufacturing Our Products

Other than games we release for sale on PCs, digital download, or wireless devices, our video games are manufactured for us by the platform manufacturers or their authorized vendors. We contract with various DVD replicators for the manufacturing of our PC products.

The platform game manufacturing process begins with our placing a purchase order with a manufacturer. We then send the approved software code to the manufacturer (together with related artwork, user instructions, warranty information, brochures and packaging designs) for manufacturing.

We are required by our platform licenses to provide a standard defective product warranty on all of the products sold. Generally, we are responsible for resolving, at our own expense, any warranty or repair claims. We have not experienced any material warranty claims, but there is no guarantee that we will not experience such claims in the future.

Distributing Our Products—Marketing and Sales

The manner in which we drive consumer demand for our brands across the globe has evolved significantly in recent years as we have expanded our owned and licensed franchise portfolio. At the global brand management level, we take a disciplined approach to defining and refining positioning for our key game releases. We implement extensive consumer and retail research including concept and play testing in conjunction with our development studios.

Our marketing plans vary by target demographic but generally consist of a three-pronged media plan encompassing TV, print and online advertising. Certain of our campaigns also include billboard advertising, event sponsorship, in-theater advertising and radio placements. Retail or Channel Marketing efforts for our games include pre-sell give-aways, displays and/ or demonstrations at retailer-specific trade shows, and cooperative retail advertising campaigns.

We are taking a more aggressive approach in what we term the "connected marketing" space. This includes how we build our brand in the online space via editorial opportunities; screen shot, trailer and other game content releases online; advertising; official game websites; and community outreach and management. Game trial has been a key driver of consumer demand for several of our core games, through consumer demos released at retail or online, or game demos available at kiosks stationed at sports or other entertainment events.

Publicity is another key driver of awareness for our game portfolio, as well as for THQ, as a publicly-held company. We maintain strong relationships with a broad group of business, consumer, entertainment and games enthusiast reporters across the globe, working closely to secure positive editorial coverage across broadcast, print and online editorial outlets.

Product Sales. In North America, our products are primarily sold directly to mass merchandisers, consumer electronics stores, discount warehouses and national retail chain stores. Our products are also sold to smaller, regional retailers, as well as distributors who, in turn, sell our products to retailers that we do not service directly, such as grocery and drug stores. Our domestic sales activities are led by our national sales team, which has representatives in most major markets in the United States.

Our international publishing activities are conducted via our offices throughout Europe and Asia Pacific. The international offices market and distribute to direct-to-retail customers and through distributors in both their home territories and, collectively, to approximately 60 additional territories.

We utilize electronic data interchange with most of our major customers in order to (i) efficiently receive, process, and ship customer product orders, and (ii) accurately track and forecast sell-through of products to consumers in order to determine whether to order additional products from the manufacturers. We believe that the direct relationship model we use allows us to better manage inventory, merchandise and communications. We ship all of our products to our North American customers from warehouses located in Michigan and Minnesota, and we ship most of our products to our international customers from warehouses located throughout Europe and Asia Pacific.

As discussed in "Management's Discussion and Analysis of Financial Condition and Results of Operations," we typically only allow returns for our personal computer products; however, we may decide to provide price protection or allow returns for our video games after we analyze: (i) inventory remaining in the retail channel, (ii) the rate of inventory sell-through in the retail channel, and (iii) our remaining inventory on hand. We maintain a policy of giving credits for price protection and returns, but do not give cash refunds.

Platform License Agreements

Before we can develop, market, or sell video games on a console or handheld platform, we must enter into a license agreement with the manufacturer of such platform. The current "platform manufacturers" are Microsoft, Nintendo and Sony. Each of these platform license agreements allows us a non-exclusive right to use, for a fixed term and in a designated territory, technology that is owned by the platform manufacturer in order to publish our games on such platform. We are currently licensed to publish titles on the Microsoft Xbox 360; the Sony PlayStation 3, PlayStation 2, and PlayStation Portable; and the Nintendo Wii and DS; in most countries throughout the world. As each platform license expires, if we intend to continue publishing games on such platform, we must enter into a new agreement or an amendment with the licensor to extend the term of the agreement. Certain agreements, such as the licenses with Sony for the PlayStation 3 and PlayStation 2 and with Microsoft for the Xbox 360, automatically renew each year unless either party gives notice by the applicable date that it intends to terminate the agreement.

Our platform licenses require that each title be approved by the manufacturer. The manufacturers have the right to review, evaluate and approve a prototype of each title and the title's packaging and marketing materials. Once a title is developed and has been approved by the manufacturer, the title is manufactured solely by such manufacturer or a designated vendor of the manufacturer. The licenses establish the payment terms for the manufacture of each cartridge or disc made, which generally provide for a charge for every cartridge or disc manufactured. The amounts charged by the manufacturers for both console discs and handheld cartridges include a manufacturing, printing and packaging fee as well as a royalty for the use of the manufacturer's name, proprietary information and technology, and are subject to adjustment by the manufacturers at their discretion.

The platform license agreements also require us to indemnify the manufacturers with respect to all loss, liability and expense resulting from any claim against the manufacturer involving the development, marketing, sale, or use of our games, including any claims for copyright or trademark infringement brought against the manufacturer. Each platform license may be terminated by the manufacturer if a breach or default by us is not cured after we receive written notice from the manufacturer, or if we become insolvent.

Upon termination of a platform license for any reason other than our breach or default, we have a limited period of time to sell any existing product inventory remaining as of the date of termination. The length of this sell-off period varies between 90 and 180 days, depending upon the platform agreement. We must destroy any such inventory remaining after the end of the sell-off period. Upon termination as a result of our breach or default, we must destroy any remaining inventory within a minimum number of days as specified by the manufacturer.

Seasonality

The interactive entertainment software market is highly seasonal, with sales typically significantly higher during the third quarter of our fiscal year, due primarily to the increased demand for interactive games during the year-end holiday buying season.

Major Customers

Our largest customers worldwide include Best Buy, GameStop, Target, Toys "R" Us, Metro Group, and Wal-Mart. We also sell our products to other national and regional retailers, discount store chains and specialty retailers. Wal-Mart and GameStop each accounted for more than 10% of our gross sales in fiscal 2009, 2008 and 2007. We sell our products to Wal-Mart pursuant to individual purchase orders placed by Wal-Mart and sell our products to GameStop pursuant to individual purchase orders placed by GameStop. We have two "Vendor" agreements with Wal-Mart (one for our console products and one for our PC products) that we entered into in 2001 and 2002, respectively, that address certain standard terms and conditions between us and Wal-Mart, such as payment terms; however, the agreements do not contain any commitment for Wal-Mart to purchase, or for us to sell, any minimum level of products. We do not have any agreements with GameStop. With respect to both Wal-Mart and GameStop, as well as our other customers, the customer submits a purchase order for each purchase request, and that purchase order contains basic pricing and delivery terms for such purchase. None of the purchase orders individually, with any customer, accounted for more than 10% of the Company's consolidated net revenue for the fiscal years ended March 31, 2009, 2008 or 2007. A substantial reduction, termination of purchases, or business failure by any of our largest customers could have a material adverse effect on us.