<PAGE> 1
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
--------------
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 1998
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from ____________ to ______________
Commission file No.: 0-18813
----------------------------
THQ INC.
(Exact Name of Registrant as Specified in Its Charter)
Delaware 13-3541686
- ---------------------------------- ----------------------
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
5016 North Parkway Calabasas, Suite 100, Calabasas, CA 91302
(Address of Principal Executive Offices)
818-591-1310
(Registrant's Telephone Number, including Area Code)
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No __
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
Common stock, $0.01 par value: 10,989,344 shares (as of November 9, 1998).
<PAGE> 2
THQ INC. AND SUBSIDIARIES
INDEX
<TABLE>
<CAPTION>
Part I - Financial Information Page
- ------------------------------ ----
<S> <C> <C>
Item 1. Consolidated Financial Statements:
Consolidated Balance Sheets -
September 30, 1998 and December 31, 1997 3
Consolidated Statements of Operations -
for the Three Months and Nine Months Ended
September 30, 1998 and 1997 4
Consolidated Statement of Shareholders' Equity
for the Nine Months Ended September 30, 1998 and
the Year Ended December 31, 1997 5
Consolidated Statements of Cash Flows -
for the Nine Months Ended September 30, 1998 and 1997 6
Notes to Consolidated Financial Statements 8
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 12
Part II - Other Information
Item 6. Exhibits and Reports on Form 8-K 20
Signatures 21
</TABLE>
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Part I - Financial Information
Item 1. Financial Statements.
THQ INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
September 30, December 31,
1998 1997
------------ ------------
(unaudited)
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 21,158,000 $ 11,724,000
Accounts receivable - net 10,243,000 30,856,000
Inventory 2,894,000 1,425,000
Prepaid and deferred royalties 15,284,000 3,645,000
Software development costs 5,523,000 6,044,000
Deferred income taxes 1,666,000 1,666,000
Prepaid income taxes 3,544,000 --
Prepaid expenses and other current assets 827,000 478,000
------------ ------------
Total current assets 61,139,000 55,838,000
Property and equipment - net 1,390,000 1,163,000
Deferred royalties - net of current portion -- 500,000
Software development cost - net of current portion -- 1,300,000
Other long-term assets 2,585,000 652,000
------------ ------------
TOTAL ASSETS $ 65,114,000 $ 59,453,000
============ ============
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses $ 4,752,000 $ 10,952,000
Accrued royalties 14,173,000 9,949,000
Income taxes payable -- 3,475,000
------------ ------------
Total current liabilities 18,925,000 24,376,000
Accrued royalties - net of current portion -- 1,550,000
Commitments and Contingencies
Shareholders' equity:
Common stock, par value $.01, 35,000,000 shares authorized;
10,930,015 shares and 10,163,848 shares issued and
outstanding as of September 30, 1998 and, December 31, 1997, 109,000 4,000
respectively
Additional paid-in capital 55,337,000 47,559,000
Cumulative foreign currency translation adjustment 326,000 81,000
Accumulated deficit (9,583,000 (14,117,000)
------------ ------------
Total shareholders' equity 46,189,000 33,527,000
------------ ------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 65,114,000 $ 59,453,000
============ ============
</TABLE>
See notes to consolidated financial statements.
3
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THQ INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------------- ----------------------------
1998 1997 1998 1997
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
Net sales $ 25,963,000 $ 16,355,000 $103,742,000 $ 40,459,000
Costs and expenses:
Cost of sales 11,220,000 8,906,000 45,195,000 22,651,000
Royalties 5,042,000 2,539,000 21,095,000 6,322,000
Product development 1,148,000 309,000 3,399,000 854,000
Selling 3,167,000 1,781,000 10,854,000 4,133,000
General and administrative 1,967,000 1,180,000 6,762,000 3,206,000
In-process research and development -- -- 7,232,000 --
------------ ------------ ------------ ------------
Total costs and expenses 22,544,000 14,715,000 94,537,000 37,166,000
------------ ------------ ------------ ------------
Income from operations 3,419,000 1,640,000 9,205,000 3,293,000
Interest income, net 255,000 198,000 724,000 329,000
------------ ------------ ------------ ------------
Income before income taxes 3,674,000 1,838,000 9,929,000 3,622,000
Provision for income taxes 1,248,000 410,000 5,360,000 480,000
------------ ------------ ------------ ------------
Net income $ 2,426,000 $ 1,428,000 $ 4,569,000 $ 3,142,000
============ ============ ============ ============
Net income per share - basic $ 0.22 $ 0.15 $ 0.43 $ 0.34
============ ============ ============ ============
Net income per share - diluted $ 0.21 $ 0.13 $ 0.40 $ 0.31
============ ============ ============ ============
Shares used in per share calculation - basic 10,910,000 9,842,000 10,613,000 9,262,000
============ ============ ============ ============
Shares used in per share calculation - diluted 11,742,000 10,729,000 11,479,000 10,068,000
============ ============ ============ ============
Add back in-process research and
development $ -- $ -- $ 7,232,000 $ --
------------ ------------ ------------ ------------
Net income before in-process research
and development $ 2,426,000 $ 1,428,000 $ 11,801,000 $ 3,142,000
============ ============ ============ ============
Net income per share before in-process
research and development $ 0.21 $ 0.13 $ 1.03 $ 0.31
============ ============ ============ ============
Shares used in per share calculation 11,742,000 10,729,000 11,479,000 10,068,000
============ ============ ============ ============
</TABLE>
See notes to consolidated financial statements.
4
<PAGE> 5
THQ INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
For the Year Ended December 31, 1997 and
the Nine Months Ended September 30, 1998
<TABLE>
<CAPTION>
Cumulative
Foreign Retained
Additional Currency Earnings
Preferred Common Common Paid-in Translation (Accumulated
Stock Stock Amount Capital Adjustment Deficit) Total
--------- ---------- ------------ ------------ ------------ ------------ ------------
<S> <C> <C> <C> <C> <C> <C> <C>
Balance at January 1, 1997 -- 7,109,824 $ 4,000 $ 34,558,000 $ (52,000) $(23,462,000) $ 11,048,000
Exercise of warrants and options -- 466,524 -- 1,293,000 -- -- 1,293,000
Issuance of Common stock -- 2,587,500 -- 11,708,000 -- -- 11,708,000
Net income -- -- -- -- -- 9,345,000 9,345,000
Foreign currency translation adjustment -- -- -- -- 133,000 -- 133,000
--------- ---------- ------------ ------------ ------------ ------------ ------------
Balance at December 31, 1997 -- 10,163,848 4,000 47,559,000 81,000 (14,117,000) 33,527,000
Exercise of warrants and options -- 410,984 3,000 1,626,000 -- -- 1,629,000
Issuance of Common Stock -- 355,183 2,000 6,217,000 -- -- 6,219,000
Revaluation of Common stock -- -- 65,000 (65,000) -- -- --
Net income -- -- -- -- -- 4,569,000 4,569,000
Three-for-two stock split effected in
the form of a stock dividend -- -- 35,000 -- -- (35,000) --
Foreign currency translation adjustment -- -- -- -- 245,000 -- 245,000
--------- ---------- ------------ ------------ ------------ ------------ ------------
Balance at September 30, 1998 (unaudited) -- 10,930,015 $ 109,000 $ 55,337,000 $ 326,000 $ (9,583,000) $ 46,189,000
========= ========== ============ ============ ============ ============ ============
</TABLE>
See notes to consolidated financial statements
5
<PAGE> 6
THQ INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
<TABLE>
<CAPTION>
Nine Months Ended
September 30,
-------------------------------
1998 1997
------------ ------------
<S> <C> <C>
Cash flows from operating activities:
Net income $ 4,569,000 $ 3,142,000
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation and amortization 641,000 355,000
Provision for doubtful accounts, discounts and returns 12,239,000 3,576,000
Loss on sale of investment securities 218,000 --
In-process research and development 7,232,000 --
Changes in operating assets and liabilities, net of
effects from purchase of GameFx, Inc.:
Accounts receivable 16,795,000 74,000
Inventory (1,462,000) (346,000)
Prepaid and deferred royalties and
software development costs (1,182,000) (3,230,000)
Prepaid expenses and other current assets (348,000) (287,000)
Accounts payable and accrued expenses (6,258,000) 4,026,000
Accrued royalties (5,422,000) (1,601,000)
Accrued returns and allowances (8,369,000) (2,395,000)
Accrued taxes (7,020,000) 417,000
------------ ------------
Net cash provided by operating activities 11,633,000 3,731,000
Cash flows used in investing activities:
Proceeds from sale of investment securities 863,000 --
Purchase of investment securities (1,081,000) --
Investment in joint venture (2,010,000) --
Payment for and expenses related to purchase of
GameFx, Inc. (1,275,000) --
Acquisition of equipment (526,000) (649,000)
------------ ------------
Net cash used in investing activities (4,029,000) (649,000)
Cash flows from financing activities:
Repayment of advance from bank -- (5,355,000)
Net proceeds from issuance of common stock -- 11,708,000
Proceeds from exercise of options and warrants 1,629,000 539,000
------------ ------------
Net cash provided by financing activities 1,629,000 6,892,000
Effect of exchange rate changes on cash 201,000 (130,000)
------------ ------------
Net increase in cash 9,434,000 9,844,000
Cash and cash equivalents - beginning of period 11,724,000 2,734,000
============ ============
Cash and cash equivalents - end of period $ 21,158,000 $ 12,578,000
============ ============
</TABLE>
See notes to consolidated financial statements.
(continued)
6
<PAGE> 7
Supplemental disclosure of cash flow information:
<TABLE>
<S> <C> <C>
Cash paid during the period for income taxes $ 12,360,000 $ 37,000
============ ===========
Cash paid during the period for interest $ 15,000 $ 47,000
============ ===========
</TABLE>
Non-cash Transactions:
On May 1, 1998 the Company issued 355,183 shares of Common Stock as a part of
the purchase price for GameFx, Inc. This issuance increased additional paid in
capital by $6,217,000, and was allocated among the assets acquired, part of
which were written off as in-process research and development.
See notes to consolidated financial statements.
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THQ INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Unaudited Interim Financial Information. The financial statements
included herein have been prepared by the Company, without audit, pursuant to
the rules and regulations of the Securities and Exchange Commission. Certain
information and footnote disclosures normally included in financial statements
prepared in accordance with generally accepted accounting principles have been
condensed or omitted pursuant to such rules and regulations. While the Company
believes that the disclosures made are adequate to make the information
presented not misleading, it is recommended that these financial statements be
read in conjunction with the consolidated financial statements and the notes
thereto included in the Company's Annual Report on Form 10-K for the year ended
December 31, 1997.
In the opinion of management, such unaudited financial statements
include all adjustments (consisting only of normal recurring adjustments)
necessary to present fairly the information set forth herein. The results for
the three and nine months ended September 30, 1998 are not necessarily
indicative of the results to be expected for the full year or for any interim
period.
Reclassifications. Certain items in the 1997 financial statements have
been reclassified to conform to the 1998 presentation.
Basic and Diluted Earnings Per Share. Basic EPS is based upon the
weighted-average number of common shares for the period. Statement of Financial
Accounting Standards ("SFAS") 128 also requires dual presentation of basic and
diluted EPS for companies with "complex capital structures". EPS for the current
and prior periods has been presented in conformity with the provisions of SFAS
128. The following table is a reconciliation of the weighted-average shares used
in the computation of basic and diluted EPS for the periods presented herein:
<TABLE>
<CAPTION>
For the Three Months Ended For the Nine Months Ended
September 30, September 30,
-------------------------- --------------------------
1998 1997 1998 1997
----------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
Net income used to compute basic
and diluted earnings per share $ 2,426,000 $ 1,428,000 $ 4,569,000 $ 3,142,000
----------- ----------- ----------- -----------
Weighted average number of shares
outstanding - basic 10,910,000 9,842,000 10,613,000 9,262,000
Dilutive effect of stock options and warrants 832,000 887,000 866,000 806,000
----------- ----------- ----------- -----------
Number of shares used to compute earnings
Per share - diluted $11,742,000 $10,729,000 $11,479,000 $10,068,000
=========== =========== =========== ===========
</TABLE>
8
<PAGE> 9
Cash and Cash Equivalents. The Company considers all highly liquid
investments with an original maturity of three months or less to be cash
equivalents.
Marketable Securities. The investment in marketable securities is stated
at the lower of cost or market. Market value is determined at the balance sheet
date.
Recently Issued Accounting Pronouncements. In June 1997, the FASB issued
SFAS No. 130, "Reporting Comprehensive Income". SFAS No. 130 establishes
standards for the reporting and display of comprehensive income and its
components (revenues, expenses, gains and losses) in a full set of general
purpose financial statements. SFAS No. 130 requires that an enterprise (a)
classify items of other comprehensive income by their nature in a financial
statement and (b) display the accumulated balance of other comprehensive income
separately from retained earnings and additional paid-in capital in the equity
section of a statement of financial position. SFAS No. 130 is effective for
fiscal years beginning after December 15, 1997. Adopting SFAS No. 130 during the
period ended September 30, 1998 did not have a material effect on the Company's
financial statements.
In June 1997, the FASB issued SFAS No. 131, "Disclosure About Segments
of an Enterprise and Related Information". SFAS No. 131 established standards
for the way that public business enterprises report information about operating
segments in annual financial statements and requires that those enterprises
report selected information about operating segments in interim financial
reports issued to stockholders. It also establishes standards for related
disclosure about products and services, geographic areas and major customers.
SFAS No. 131 is effective for financial statements for periods beginning after
December 15, 1997. Adopting of SFAS No. 131 during the period ended September
30, 1998 did not have an effect on the Company's financial statements.
In October of 1997, the Accounting Standards Executive Committee of the
American Institute of Certified Public Accountants issued Statement of Position
97-2 "Software Revenue Recognition" ("SOP 97-2"). This statement provides
guidance on applying generally accepted accounting principles in recognizing
revenues on software transactions. This Statement supercedes Statement of
Position 91-1 "Software Revenue Recognition." This Statement is effective for
transactions entered into in fiscal years beginning after December 15, 1997.
Earlier application is encouraged as of the beginning of the fiscal year or
interim period for which financial statements or information have not been
issued. Retroactive application of the provisions of this statement is
prohibited. In March 1998 SOP 98-4 deferred the effective date of a provision of
SOP 97-2. The Company has evaluated its revenue recognition policies of the
adaptation of SOP 97-2; and believes that such adoption will not have any
impact.
In February 1998, the FASB issued SFAS No. 132, "Employers' Disclosure
about Pension and Other Postretirement Benefits". SFAS No. 132 supercedes the
disclosure requirements in FASB Statements No. 87 "Employers' Accounting for
Pensions", No. 88 "Employers' Accounting for Settlements and Curtailments of
Defined Benefit Pension Plan and Termination Benefits", and No. 106 "Employers'
Accounting for Postretirement Benefit Other Than Pensions." This statement
addresses disclosure only. SFAS 132 is effective for financial
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<PAGE> 10
statements for periods beginning after December 31, 1997. Adopting of SFAS 132
during the period ended September 30, 1998 did not have an effect on the
Company's financial statements.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedge Activities". SFAS No. 133 establishes the accounting and
reporting standard for derivative instruments, including certain derivative
instruments embedded in other contracts and for hedging activities. It requires
that an entity recognize all derivatives as either asset or liability in the
statement of financial position and measure those instruments at fair value.
SFAS 133 is effective for financial statements for periods beginning after June
15, 1999. The Company does not expect the impact of SFAS No. 133 to be material
in relation to its financial statements.
2. ACQUISITIONS
On May 1, 1998, the Company acquired all of the outstanding shares of an
applied technology company, GameFx, Inc., a Delaware corporation ("GameFx"),
pursuant to a merger of GameFx with and into a newly formed, wholly owned
subsidiary of the Company. The consideration paid by the Company consisted of
(i) the issuance of 355,183 shares of Common Stock, (ii) the assumption of stock
options issued by GameFx to its employees that, if and when exercised, permit
the holders thereof to acquire approximately 14,850 shares, and (iii)
approximately $800,000 in cash. The total acquisition cost was approximately
$7.5 million and was accounted for as a purchase. The purchase price was
allocated to certain intangible assets acquired and to purchased in-process
research and development ("R & D"). Purchased R & D includes the value of
products in the development stage and not considered to have reached
technological feasibility. In accordance with applicable accounting rules,
purchased in-process R & D is required to be expensed. Accordingly, $7.2 million
of the acquisition cost was expensed in the second quarter of 1998.
3. ACCOUNTS RECEIVABLE
Accounts receivable are due primarily from domestic and foreign
retailers and distributors, including mass merchants and specialty stores.
Accounts receivable at September 30, 1998 and December 31, 1997 are composed of
the following:
<TABLE>
<CAPTION>
September 30, December 31,
1998 1997
------------ ------------
<S> <C> <C>
Accounts receivable-- domestic $ 19,473,000 $ 33,787,000
Other accounts receivable-- foreign 2,196,000 5,075,000
Other receivables 607,000 133,000
Allowance for foreign doubtful accounts (37,000) (10,000)
Allowance for foreign discounts and returns (925,000) (362,000)
Allowance for domestic doubtful accounts,
discounts and returns (11,071,000) (7,767,000)
------------ ------------
Accounts receivable-- net $ 10,243,000 $ 30,856,000
============ ============
</TABLE>
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4. REINCORPORATION
On January 6, 1998, T.HQ, Inc., a New York corporation ("THQ New York"),
was merged with and into its wholly owned subsidiary, THQ Inc., a Delaware
corporation ("THQ Delaware"), for the purpose of changing the Company's state of
incorporation from New York to Delaware (the "Reincorporation"). Pursuant to the
Reincorporation each share of THQ New York's common stock, par value $.0001 per
share, outstanding prior to the Reincorporation was converted into one share of
common stock, $0.01 par value per share, of THQ Delaware.
5. OTHER LONG-TERM INVESTMENTS
In June 1998, the Company announced that, in partnership with JAKKS
Pacific Inc. ("JAKKS Pacific") (a manufacturer and marketer of toys), it had
signed an exclusive ten-year license agreement with Titan Sports Inc. ("Titan")
to publish World Wrestling Federation electronic games on all platforms. The
games will be designed, developed, manufactured and marketed by a joint venture
of the Company and JAKKS Pacific. The Company will oversee product development
and sales, and the Company and JAKKS Pacific will co-manage the marketing of the
games. The Company expects that the first game produced under this license will
be released near the end of 1999. This investment is accounted for under the
equity method of accounting for investment. The Company has a 50% ownership
interest in this joint venture. This Company's investment of $2,010,000 as of
September 30, 1998 is predominately initial funding. No commercial activity had
commenced in this joint venture as of September 30, 1998.
6. CAPITAL TRANSACTIONS
On July 23, 1998, the Company announced a three-for-two stock split,
effected in the form of a 50% stock dividend, which was distributed on August
24, 1998, to shareholders of record on August 20, 1998. The accompanying
consolidated financial statements have been adjusted to give effect to this
stock dividend.
------------------------
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
The Quarterly Report of THQ Inc. (the "Company") on Form 10-Q contains
statements which constitute forward-looking statements within the meaning of the
Private Securities Litigation Reform Act of 1995. Such statements appear in a
number of places in this Report, including, without limitation, "Management's
Discussion and Analysis of Financial Condition and Results of Operations". Such
forward-looking statements include statements regarding the intent, belief or
current expectations of the Company and its management with respect to the
matters discussed in this Report. Prospective investors are cautioned that any
such forward-looking statements involve risks and uncertainties, and that the
various uncertainties, including, without limitation, uncertainties relating to
the interactive entertainment software industry and other factors, as more
specifically set forth in the Company's Report on Form 8-K, dated September 8,
1998 with the Securities and Exchange Commission.
OVERVIEW
The Company develops, publishes and distributes interactive
entertainment software ("Software") for the major hardware Platforms
("Platforms") sold by Nintendo and Sony (the "Manufacturers") and for use on
personal computers ("PCs"). The following table sets forth, for the periods
indicated, the percentage of the Company's revenues derived from sales of
Software titles ("Titles") for the Platforms indicated:
<TABLE>
<CAPTION>
Three Months Nine Months
Ended September 30, Ended September 30,
--------------------- --------------------
Platform 1998 1997 1998 1997
- -------- ------- ------- ------- -------
<S> <C> <C> <C> <C>
Nintendo 64 43.0% -- 45.3% 0.3%
PlayStation 44.7% 19.9% 43.6% 29.6%
PC 5.5% -- 1.1% 0.7%
16-bit 0.9% 32.1% 1.5% 29.9%
Game Boy 4.8% 48.0% 7.9% 39.1%
Other 1.1% -- 0.6% 0.4%
</TABLE>
The Company's business cycle generally commences with the securing of a
license to publish one or more Titles based upon entertainment projects (such as
movies, television programs and arcade games), sports and entertainment
personalities, or popular sports trends or concepts ("Properties"). Such
licenses typically require an advance payment to the licensor and a guarantee of
minimum future royalties. See "-- Recovery of Prepaid Royalties, Guarantees and
Capitalized Development Costs." After obtaining the license, the Company
commences Software development for the Title. Upon completion of development and
approval of the Title by the Manufacturer, the Company orders products and
generally causes a letter of credit to be opened in favor of the Manufacturer or
obtains a line of
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credit from the Manufacturer. Products are shipped at the Company's expense to a
public warehouse in California for domestic distribution or in the United
Kingdom for foreign distribution. Foreign sales to distributors in countries
other than the United Kingdom are shipped at the customer's expense directly to
the customer's location.
The Company has unfilled sales orders the amount of which fluctuates
from time to time, commonly referred to as "backlog." However, substantially all
of the Company's product orders are fulfilled shortly after they are received.
Accordingly, the Company does not believe that the amount of its unfilled sales
orders as of the end of a period is a meaningful indicator of sales in future
periods.
Revenue Fluctuations and Seasonality. The Company has experienced and
may continue to experience significant quarterly fluctuations in net sales and
operating results due to a variety of factors, including the timing of releases
of new Titles by the Company, the popularity of both new Titles and Titles
released in prior periods, fluctuations in the mix of Titles with varying profit
margins, the timing of customer orders, the timing of shipments by the
Manufacturers, fluctuations in the size and rate of growth of consumer demand
for Software for various Platforms, the timing of the introduction of new
Platforms and the accuracy of retailers' forecasts of consumer demand. The
Company's expenses are based, in part, on its expectations of future revenues
and, as a result, operating results would be disproportionately and adversely
affected by a decrease in sales or a failure by the Company to meet its sales
expectations. In addition, the Software market is highly seasonal, with sales
typically significantly higher during the fourth quarter (due primarily to the
increased demand for interactive games during the year-end holiday buying
season). There can be no assurance that the Company can maintain consistent
profitability on a quarterly or annual basis.
Profit margins may vary over time as a result of a variety of other
factors. Profit margins for cartridge products can vary based on the cost of the
memory chip used for a particular title. As Software has grown more complex, the
trend in the Software industry has been to utilize chips with greater capacity
and thus greater cost. CD-ROMs have significantly lower per unit manufacturing
costs than cartridge-based products. However, these savings may be offset by
typically higher development costs for Titles published on CD-ROMs; such higher
costs result from the creation of increased and enhanced content to take
advantage of the greater storage capacity available on CD-ROMs.
Recovery of Prepaid Royalties, Guarantees and Capitalized Development
Costs. The Company typically enters into agreements with licensors of Properties
and developers of Titles that require advance payments of royalties and/or
guaranteed minimum royalty payments. There can be no assurance that the sales of
Products for which such royalties are paid will be sufficient to cover the
amount of these required royalty payments. The Company capitalizes its advances
to developers as prepaid royalties and capitalizes internal Software development
costs for each PC Title incurred after the establishment of technological
feasibility of the Title. (The Company has not incurred material internal
development costs for console Titles). Amortization of these payments and costs
is determined on a Title-by-Title basis based on the greater of (i) the ratio of
current gross revenues for a Title to the sum of its current and
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anticipated gross revenues, or (ii) the straight-line method over the estimated
remaining economic life of the Title. The Company analyzes such capitalized
costs quarterly and writes off associated prepaid and deferred royalties and
Software development costs when, based on the Company's estimate, future
revenues will not be sufficient to recover such amounts. As of September 30,
1998, the Company had prepaid royalties and software development costs of $20.8
million. If the Company were required to write off prepaid royalties or
capitalized development costs in excess of the amounts reserved therefor, the
Company's results of operations could be materially and adversely affected.
Discounts, Allowances and Returns; Inventory Management. Although the
Company's arrangements with its customers generally do not give such customers
the right to return products to the Company (other than defective products) or
to cancel firm orders, the Company often negotiates accommodations to retailers
(and, less often, to distributors) when demand for specific Titles falls below
expectations for the purpose of maintaining its relationships with its
customers. Such accommodations consist of acquiescing to the customer's request
that not all booked orders be filled or that not all shipped orders be accepted,
negotiated price discounts, credits against future orders and, less often, the
return of products to the Company. It is the Company's practice to accept all
returns of defective or damaged products.
At the time of product shipment, the Company establishes allowances
based on estimates of future returns, customer accommodations and doubtful
accounts with respect to such products, based on the Company's historical
experience, retailer inventories of the Titles and other factors. For the year
ended December 31, 1997 and the nine months ended September 30, 1998, provisions
of $3.6 million and $12.2 million, respectively, were taken against gross sales
made during such periods, and as of September 30, 1998, the Company's aggregate
reserve against accounts receivable for returns, customer accommodations and
doubtful accounts was $12.0 million.
The identification by the Company of slow-moving or obsolete inventory,
whether as a result of requests from customers for accommodations or otherwise,
would require the Company to establish reserves against such inventory or to
write-down the value of such inventory to its estimated net realizable value.
Revenues and Expenses of Joint Venture. In June 1998, the Company
announced that, in partnership with JAKKS Pacific, it had signed an exclusive
agreement with Titan to publish WWF electronic games on all Platforms. The games
will be designed, developed, manufactured and marketed by a joint venture of the
Company and JAKKS Pacific. The Company and JAKKS Pacific will share equally any
profits generated by this joint venture after recoupment of advances paid by the
Company and JAKKS Pacific to Titan.
YEAR 2000 DISCLOSURE
The inability of computers, software and other equipment utilizing
microprocessors to recognize and properly process data fields containing a
2-digit year is commonly referred to as the "Year 2000 Compliance" issue. As the
year 2000 approaches, such systems may be unable
14
<PAGE> 15
to accurately process certain date-based information. The Company has reviewed
all significant internal applications and believes that no material
modifications are necessary to ensure Year 2000 Compliance.
In addition, the Company is in the process of communicating with others
with whom it does significant business (including its major retail accounts and
certain providers of Product distribution information services), to determine
their Year 2000 Compliance readiness and the extent to which the Company is
vulnerable to any third party Year 2000 Compliance. However, there can be no
guarantee that the systems of other companies on which the Company's systems
rely will be timely converted, or that a failure to convert by another company,
or a conversion that is incompatible with the Company's systems, would not have
a material adverse effect on the Company.
The total cost to the Company of these Year 2000 Compliance activities
has not been and is not anticipated to be material to its financial position or
to its results of operations. These costs and the date on which the Company
plans to complete the Year 2000 Compliance modification and testing processes
are based on management's best estimates, which were derived utilizing numerous
assumptions of future events including the continued availability of certain
resources, third party modification plans and other factors. However, there can
be no guarantee that these estimates will be achieved and actual results could
differ from those plans.
15
<PAGE> 16
RESULTS OF OPERATIONS
Net Sales
The following table sets forth, for the periods indicated, the
components of the Company's net sales and its consolidated operating data as a
percentage of net sales:
<TABLE>
<CAPTION>
Three Months Nine Months
Ended September 30, Ended September 30,
------------------- -------------------
1998 1997 1998 1997
----- ----- ----- -----
<S> <C> <C> <C> <C>
Domestic sales 89.6% 95.3% 84.8% 82.1%
Foreign sales 10.4 4.7 15.2 17.9
----- ----- ----- -----
Net sales 100.0% 100.0% 100.0% 100.0%
Costs and expenses:
Cost of sales 43.2% 54.5% 43.6% 56.0%
Royalties 19.4 15.5 20.3 15.6
Product development 4.4 1.9 3.3 2.1
Selling 12.2 10.9 10.5 10.2
General and administrative 7.6 7.2 6.5 8.0
In-process research and
development -- -- 7.0 --
----- ----- ----- -----
Total costs and expenses 86.8% 90.0% 91.2% 91.9%
----- ----- ----- -----
Income from operations 13.2% 10.0% 8.8% 8.1%
Interest income, net 1.0 1.2 0.7 0.8
----- ----- ----- -----
Income before income taxes 14.2 11.2 9.5 8.9
----- ----- ----- -----
Net income 9.3% 8.7% 4.4% 7.8%
===== ===== ===== =====
</TABLE>
Title Releases
The following table sets forth, for the three months and nine months
ended September 30, 1998 and 1997, the Titles released during such periods for
the Platforms indicated:
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------ --------------------------------
1998 1997 1998 1997
-------------- -------------- --------------- ---------------
<S> <C> <C> <C> <C>
PC CD-Rom 3 -- 4 1
Nintendo 64 -- -- 1 --
PlayStation 3 1 7 5
SNES -- 1 2 6
Genesis -- 1 -- 3
Game Boy -- 1 1 6
-------------- -------------- --------------- ---------------
Total 6 4 15 21
============== ============== =============== ===============
</TABLE>
16
<PAGE> 17
COMPARISON OF THE THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 1998, TO THE
THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 1997
The Company's net sales increased 58.7% to $25,963,000 in the three
months ended September 30, 1998, from $16,355,000 in the same period of 1997, as
a result of increased demand for previously released Titles as well as growth in
foreign sales. For the three months ended September 30, 1998, net sales of WCW
vs. NWO for the Nintendo 64, Quest 64 (the Company's second Nintendo 64 title),
WCW Vs the World for the Sony PlayStation, WCW Nitro for the Sony PlayStation
and Brunswick Circuit Pro Bowling for the Sony PlayStation were $7,318,000
(28.2% of the net sales), $3,202,000 (12.3% of net sales), $3,184,000 (12.2% of
net sales), $2,855,000 (11.0% of net sales), and $1,853,000 (7.1% of net sales),
respectively. In the third quarter of 1997, net sales of the Company's Madden
NFL 98 for the Sega Genesis, Disney Game Boy re-releases (Aladdin, Duck Tales,
The Jungle Book, and The Lion King) and WCW Vs the World for the Sony
PlayStation, were $3,717,000 (22.7% of net sales), $2,330,000 (14.2% of net
sales) and $1,700,000 (10.4% of net sales), respectively. Due to the higher
sales volume of 32-bit and 64-bit Titles (which generally have more favorable
gross margins) in the three months ended September 30, 1998, the Company
experienced gross margins of 56.8% versus 45.5% in the comparable period of
1997.
The Company's net sales increased 156% to $103,742,000 in the nine
months ended September 30, 1998, from $40,459,000 in the same period of 1997, as
a result of a significant increase in unit volumes for some newly released
Titles and continued demand for previously released Titles. Gross margin for the
nine months ended September 30, 1998 increased as a percentage of net sales to
56.4% from 44.0% in the same period of 1997. As with the results of the three
months ended September 30, 1998, the increase in gross margin percentage was due
to a higher sales volume of 32-bit and 64-bit Titles for the nine months ended
September 30, 1998.
Foreign net sales increased to $2,705,000 (10.4% of total net sales)
from $775,000 (4.7% of total net sales) in the three months ended September 30,
1998 and 1997, respectively. This increase in foreign net sales is attributable
to the release of G.Darius for the Sony PlayStation and Redjack: Revenge of the
Brethren for the PC CD-ROM in foreign markets in 1998 as well as continued
demand for previously released wrestling Titles. Foreign net sales grew to
$15,787,000 in the nine months ended September 30, 1998, from $7,236,000 in the
same period of 1997, yet decreased as a percentage of net sales to 15.2% from
17.9%, due to the substantial increase in domestic sales.
Royalty expense for the three and nine months ended September 30, 1998
increased as a percentage of net sales to 19.4% and 20.3% from 15.5% and 15.6%
for the same periods in 1997. This rise reflects the fact that rates on 32-bit
and 64-bit license and development contracts are higher than those typically
experienced on 8-bit and 16-bit contracts (older technology platforms) as well
as the fact that there has been an increase in rates paid to licensors and
developers generally for 32-bit and 64-bit contracts.
Product development expense for the three and nine months ended
September 30, 1998 increased by $839,000 and $2,545,000, respectively, compared
to the same periods in 1997.
17
<PAGE> 18
This was due in part to the increased costs associated with the development of
32-bit, 64-bit and PC CD-ROM Titles, and also reflects the addition of the
GameFx studio on May 1, 1998.
For the three months and nine months ended September 30, 1998, selling
expenses increased by $1,386,000 and $6,721,000, respectively, compared to the
same periods of 1997, as a result of increased marketing efforts for new Titles,
an increase in retail cooperative advertising and a television ad campaign to
promote the launch of Quest 64. The increase in selling expenses over prior
periods was also due in part to increased infrastructure and personnel costs
(both domestic and foreign) incurred as a result of the Company's growth.
General and administrative expenses for the three months and nine months
ended September 30, 1998, increased by $787,000 and $3,556,000, respectively,
but general and administrative expenses for the nine months ended September 30,
1998, decreased as a percentage of net sales versus the nine months ended
September 30, 1997. The increase in both domestic and foreign administrative
costs were in response to the growth experienced by the Company during the nine
months ended September 30, 1998.
The in-process research and development charge of $7,232,000, incurred
during the second quarter of 1998, represents purchased costs relating to the
acquisition of GameFx Inc., an applied technology company focused on the
development of interactive entertainment software utilizing proprietary 3D
acceleration technology. See Note 2 of Notes to Consolidated Financial
Statements.
LIQUIDITY AND CAPITAL RESOURCES
The Company's cash and cash equivalents increased $9,434,000 from
$11,724,000 at December 31, 1997 to $21,158,000 at September 30, 1998. Cash
provided by operating activities for the nine months ended September 30, 1998
was $11,633,000.
The Company's principal uses of cash are product purchases, guaranteed
payments to licensors, advance payments to developers and the costs of internal
Software development. In order to purchase products from the Manufacturers, the
Company typically opens letters of credit in their favor or obtains a line of
credit from the Manufacturer. As of September 30, 1998, the Company had
obligations with respect to future guaranteed minimum royalties of $14,173,000,
all of which are payable within the subsequent twelve months.
Accounts receivable decreased from December 31, 1997 to September 30,
1998, as a result of the timing of sales and collections during the period.
Prepaid and deferred royalties and Software development costs increased from
December 31, 1997 as a result of the Company entering into several new contracts
for both Properties and new product development. See "-- Recovery of Prepaid
Royalties, Guarantees and Capitalized Development Costs." Since the Company
records as a liability the entire guarantee of a contract at its inception,
accrued royalties also increased significantly from December 31, 1997. Accounts
payable and accrued expenses decreased significantly from December 31, 1997 as a
result of the timing of large product receipts in the last part of 1997 and the
timing of payments on accounts payable.
18
<PAGE> 19
The amount of the Company's accounts receivable is subject to
significant seasonal variations due to the seasonality of sales, and is
typically highest at the end of the year. As a result, the Company's working
capital requirements are greatest during its third and fourth quarters. The
Company believes that cash on hand, funds provided by operations, and the
Company's revolving credit facility will be adequate to meet the Company's
anticipated requirements for operating expenses, product purchases, guaranteed
payments to licensors and Software development through 1998. The Company has not
made, and does not anticipate making, material additional capital expenditures
in 1998.
Revolving Credit Facility. The Company has entered into an agreement
with Imperial Bank that established its revolving credit facility ("Revolving
Credit Facility"). The current term of the Revolving Credit Facility expires
August 31, 1999.
The Revolving Credit Facility permits the Company to maintain
outstanding borrowings of up to $23 million between September 1 and January 31
and up to $15 million at other times, subject to the requirement that borrowings
be zero for at least 30 consecutive days each year. Amounts borrowed under the
Revolving Credit Facility are secured by substantially all of the assets of the
Company, but the Company's availability under the Revolving Credit Facility is
not based on the value of any of such assets. Amounts outstanding under the
Revolving Credit Facility bear interest at Imperial Bank's prime rate. As of
September 30, 1998, the Company had no outstanding borrowings under the
Revolving Credit Facility and had obligations in respect of outstanding letters
of credit issued by Imperial Bank of $21.4 million.
The Revolving Credit Facility contains financial covenants, including
maintenance of (i) a minimum tangible net worth of not less than $42 million,
(ii) net current assets of not less than $20 million, (iii) a current ratio of
not less than 1.5, (iv) a ratio of total liabilities (excluding subordinated
indebtedness) to tangible net worth of not more than 1.0, and (v) profitability
in each fiscal year. The Revolving Credit Facility also contains customary
non-financial covenants generally operative only at such times as the Company
has any outstanding borrowings, including, among others, restrictions on the
incurrence of debt, encumbrances on or sales of assets, mergers and
acquisitions, dividends, annual capital expenditures and annual lease
obligations.
--------------------
19
<PAGE> 20
Part II - Other Information
Item 6. Exhibits and Reports on Form 8-K.
(a) Exhibits.
Exhibit
Number Title
3.1 Certificate of Incorporation (filed as Exhibit 3.1 to the Company's
Registration Statement on Form S-3 (File No. 333-32221) and
incorporated herein by reference).
3.2 Amendment to Certificate of Incorporation (filed as Exhibit 3.2 to the
Company's Registration Statement on Form S-3 (File No. 333-32221) and
incorporated herein by reference).
3.3 Amended and Restated Bylaws (filed as Exhibit 3.3 to the Company's
Quarterly Report on Form 10-Q for the fiscal quarter ended June 30,
1998 and incorporated herein by reference).
27 Financial Data Schedule.
(b) Reports on Form 8-K
(i) Current Report on Form 8-K dated July 27, 1998
reporting under Items 5 and 7.
(ii) Current Report on Form 8-K dated August 12, 1998
reporting under items 5 and 7.
(iii) Current Report on Form 8-K dated September 8, 1998
reporting under Item 5.
20
<PAGE> 21
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Dated: November 13, 1998 THQ INC.
By: /s/ BRIAN J. FARRELL
-----------------------------------
Brian J. Farrell
President and Chief
Executive Officer
THQ INC.
By: /s/ FRED GYSI
-----------------------------------
Fred Gysi
Vice President Finance
and Administration
Principal Accounting Officer
21
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
CONSOLIDATED BALANCE SHEETS, THE CONSOLIDATED STATEMENTS OF OPERATIONS AND
CONSOLIDATED STATEMENTS OF CASH FLOWS AND IS QUALIFIED IN ITS ENTIRETY BY
REFERENCE TO SUCH FINANCIAL STATEMENTS FOUND IN FORM 10-Q AS FILED WITH THE SEC
ON NOVEMBER 13, 1998.
</LEGEND>
<CURRENCY> US DOLLARS
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> SEP-30-1998
<EXCHANGE-RATE> 1
<CASH> 21,158,000
<SECURITIES> 0
<RECEIVABLES> 22,276,000
<ALLOWANCES> 803,000
<INVENTORY> 2,894,000
<CURRENT-ASSETS> 61,139,000
<PP&E> 2,168,000
<DEPRECIATION> 778,000
<TOTAL-ASSETS> 65,114,000
<CURRENT-LIABILITIES> 18,925,000
<BONDS> 0
0
0
<COMMON> 109,000
<OTHER-SE> 46,080,000
<TOTAL-LIABILITY-AND-EQUITY> 65,114,000
<SALES> 103,742,000
<TOTAL-REVENUES> 103,742,000
<CGS> 45,195,000
<TOTAL-COSTS> 45,195,000
<OTHER-EXPENSES> 49,342,000
<LOSS-PROVISION> 635,000
<INTEREST-EXPENSE> 15,000
<INCOME-PRETAX> 9,929,000
<INCOME-TAX> 5,360,000
<INCOME-CONTINUING> 4,569,000
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 4,569,000
<EPS-PRIMARY> .20
<EPS-DILUTED> .19
</TABLE>
