Thoughts on THQ – Are they really in trouble?

Just floating a few thoughts here… I might put these together in another article that I am planning, but right now, I’m just trying to sort through my own investigation into whether we have anything to worry about THQ.

THQ has been in the news lately largely due to two things: the explosion that erupted around “armchair” analyst Peter Skerritt’s Tweet that THQ had canceled its 2014 lineup and expected it to be made a buyout target, and a letter that showed up on NeoGAF purportedly from an ex-employee from THQ that made no bones about where the blame should fall. At the same time, THQ quickly put out fires with their own statement which, predictably, were opposite of all of the doomsday scenarios that were being floated. That’s January.

Before that, in December, Michael Pachter of Wedbush Securities (and prolific purveyor of financial video gaming punditry) had stated on Gamasutra that the company would run out of cash by the end of the first fiscal quarter for 2013. He wasn’t alone in his estimates with another analyst downgrading its full year revenue estimate for the company’s quarter.

Everything I’m going to post at this point is a matter of public record and can be found with a little digging. Also, as full disclosure, I own no stock in any of the companies mentioned in this article nor do I plan to initiate any positions in the next 72 hours.

That said, the picture is kind of ugly.

The Letter

Let’s start with the reputed letter from the angry ex-THQ employee. It’s correct when it says that their stock price has tanked. In fact, over the last five years, THQ’s stock price has been consistent in one thing – a long, slow descent to the $0.70 range where it ended up in January. Why?

It’s not like THQ doesn’t have a series of titles under their belt that deserve respect and which have impressed critics. At the same time, they’re not the kind of commercial blockbusters that its rivals, Activision and EA, regularly make the rounds with year after year. They sell, but they apparently don’t sell enough to drive the rest of the company’s finances higher.

In 2011, THQ shed studios like there was no tomorrow. They dropped their wireless division and closed THQ Studio Austraila and Blue Tongue. THQ Digital Phonix was also closed. Australia and Phoenix were acquired only a little more than a year earlier. That’s millions burned for what gain?

Perhaps the largest and most recent debacle were the miserable sales for uDraw on the Xbox 360 and the PS3. A year ago, it was a Wii darling. But whatever market research they had used had apparently missed the one thing that gamers already knew – the audiences between the Wii and the Xbox 360/PS3 have very different expectations of their respective platforms.

You want FPS titles, explosions, and multiplayer mayhem with Mortal Kombat, the Xbox 360/PS3 universe has what you want. You want Nintendo-only titles and a largely casual library, you hit up the Wii. It would be as if MK came out for the Wii. What would be the point? Sega saw that with MadWorld (though they were happy with the low sales) and Conduit.

The Games

THQ has a number of interesting licenses, such as with UFC and WWE, but they don’t post the kind of numbers that sales of the next Call of Duty or Battlefield/Bad Company do with their rivals. As noted before, they sell respectfully well, but apparently not well enough to offset the internal debt that the company is apparently creaking under.

To date, in comparison to the shipped copies of 2.6 million that THQ reported for Homefront in 2011, Bad Company 2 moved almost that much in March of 2010 shortly after its release. By 2011, BC2 had reportedly sold around 9 million copies.

Red Faction: Armageddon, while fun, had apparently failed to post the numbers that THQ was hoping for. This was made clear when THQ decided to shelve the series earlier in 2011 after factoring its losses into Q1.

Homefront reportedly sold 1 million copies with another 2.6 million shipped out, yet a few months later, the developer (Kaos Studios) was closed along with THQ Warrington.

It was clear that THQ wanted Homefront as a new FPS franchise in the spirit of EA and Activision’s own set in a unique world, but even with those sales, it apparently wasn’t enough to save it from mediocre reviews and deep discounts at retailers in the following months leaving the plans for it stillborn in the public eye. It doesn’t matter if the game did manage to recoup its costs.

Breaking even is certainly good news, but apparently not as profitable as THQ wished it to be and I think it’s safe to say that making a significant profit is still better than simply breaking even. Even though it’s being passed off to Crytek to continue in 2014 (whose schedule THQ has said is still on track), that’s years away and can’t realistically factor into anything now.

THQ’s fortunes in the Wii segment are also under attack as the Wii U looms just over the horizon, though how deeply this will cut into THQ’s revenues remains to be seen. I guess we’ll find out on February 2nd.

What is also strange about this picture is that according to their last fiscal report ending Q2 2011, sales of their games on consoles had actually gone up by significant amounts. THQ is making money…but again, not enough to offset other factors bleeding them dry with debt.

The Financial Picture

THQ currently has a market cap of around $47 million with last reported revenues of $665 million. The lopsided figure is some cause for concern as other analysts smarter than me have indicated that it’s usually a sign of heavy debt.

Pinging on that debt idea, its debt-to-equity ratio is at a staggering 136% – basically saying that it owes a lot of money on every dollar that it has. Now, from that I understand, that’s not a bad thing. A company like Ford has a high debt-to-equity ratio along with a low cap and high revenue. Yet they make enough money to outweigh the debt they put themselves through, so it’s not the only indicator of the health for a company.

On the other hand, you have a company like Kodak which has a low cap and high revenue. Kodak had recently filed for bankruptcy because it couldn’t meet its debt obligations which were a staggering $6 billion of debt on revenues of around $7.19 billion.

Another indicator, and one which an analyst like Pachter may have been looking at, was their free cash flow per share which is an indicator of how much money the company has over time to sustain operations. Ford is making money. THQ’s cash flow per share is in the negative numbers.

Looking at EA and Activision, both have high revenue streams and reasonably stable stock performance. Activision has World of Warcraft as a monthly cash cow while EA’s diverse library and sports portfolio continue to float its fortunes every quarter. More importantly, neither are saddled with the kind of horrendous debt to equity ratio that THQ carries.

Activision also has positive cash flow per share, though EA doesn’t while still maintaining a strong debt to equity ratio which is far lower than THQ’s. So while EA’s cash flow might be slightly negative, it’s not buckling under a perceived debt load.

This is an old song

This isn’t the first time that analysts have been bearish on THQ’s fortunes. Way back in March, 2009, analyst Mike Hickey at Janco Partners had already said that there was a 50/50 chance for THQ’s bankruptcy. Of course, it hasn’t happened, but their fortunes haven’t improved by much.

The nay saying hasn’t let up since then and the falling stock price and revenue have only gotten worse. Interestingly, Hickey has apparently blamed “corporate ineptitude” as a part of its falling fortunes, something that the letter mentioned above has used.

Based on the above, however, I’m more inclined to think that THQ is going to shed more jobs going forward. Likely what is going to happen is that the company will focus on core studios and shutter a few more to cut costs and trim its liabilities as they did most recently with their kid’s division. It will be a slow, long process, but it won’t necessarily lead to bankruptcy.

This isn’t as unusual as it sounds. Just look at what how the recession has affected downsizing at other companies to see that this is exactly what some of them will do to staunch the bleeding.

As for the buyout rumors, that all depends on whether THQ is really trying to position itself as an attractive investment or whether others will wait for it to file for a supposed bankruptcy and buy smaller chunks of it. Prospective buyers are going to have to absorb the debt unless THQ decides to sell off its licenses as a part of whatever bankruptcy plan they initiate, the same as any other company. That’s basically what Kodak has been trying to do.

At the same time, I can’t dismiss some of the negativity reported by others like Pachter. There’s too much public proof to be had that paints a grim picture of a struggling company. And if anyone is expecting THQ to come out and admit to the problems they are having, dream on. The public, and often the rank and file, are usually the last to know. But the signs are there for everyone to see.

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