THQ Bear's Den
David Forrest ([email protected])

Let me start by saying that I won't even try and find chinks in the THQ armor with regard to recent financial performance. Earnings and revenue exploded in 1997 with gross and net margins rising substantially. At $29 1/2 just after the fourth quarter announcement, the stock has risen four-fold in the past year. Members of the Fool community have banded together in the THQ message folder to do channel checks and research on this company in a manner reminiscent of Iomega, America Online, Qualcomm, and many others. For existing shareholders, this has been nothing short of a brilliant investment to date. The real question is whether or not it will continue to be a great investment in the future.

When you look at the entertainment software industry, several large names come to mind -- Microsoft, Electronics Arts, Broderbund, Acclaim, Activision, Nintendo, etc. These names come to mind because they are the handful that have succeeded and survived where thousands of others have failed and died. Why do so many companies in this industry die? Many reasons, but the two largest causes of death are most likely the inability of small companies to string together a series of successful games as well as the problems inherent in dealing with new technological advances.

Taking those problems in reverse order, let me ask a question. How many of you are still playing your Atari or Intellivision games? I'll let you borrow my Space Invaders cartridge if I can use your Asteroids. Do you see my point? The other problem inherent in the industry is the virtual "one-hit wonders," or maybe even the "two-hit wonders." (Gotta leave room for the inevitable sequels!) These companies form and are thrown into the limelight when they release major hits. Their stocks do very well for a short time as the enthusiasm grows for a particular game, and then KABOOM! Unfortunately, many of these companies fail to follow up with more hits, and the stock price -- as well as the viability of the company -- falls apart.

Think "Biotech"

I liken this industry to the biotechnology industry. The key to any successful biotechnology firm is its ability to stuff the "pipeline" with good prospects for future success. Investors generally don't care about what happened in the past, they are most interested in the company's ability to grow beyond current levels. The only way to continue to grow revenue and earnings is to build a catalogue of successful products (thus developing a solid and consistent revenue stream) AND to continue to produce innovative new products to spur growth.

Where THQ Falls Apart

I'm sure that most THQ enthusiasts will have read up to this point and think, "Geez! Bogey's description of a successful company fits THQ to a T." Well, yes and no. The company has developed a nice base of revenue in GameBoy, Nintendo, Sega, and Sony PlayStation game sales and it continues to innovate with new games like the various WCW wrestling games, Bass Fishing, and the newer stuff coming out this year. On the face of it, this looks pretty good. However, THQ falls apart in several key areas. It's because of this that I'm a bear.

WCW -- The WCW license (purchased from Ted Turner) accounted for almost 50% of the company's revenue in 1997. The contract with Turner lasts through mid-1999. In the earnings press release, CEO Brian Farrell indicated that other companies are bidding on the WCW license, indicating that THQ is being squeezed here and will undoubtedly have to pony up a lot more cash to keep the license.

[Ed. Note: As we went to press with the THQ Dueling Fools, the company announced that the license with WCW Wrestling will not be renewed.]

The Pipeline -- Although THQ will certainly release many more titles this year, the most anticipated, and those that are hoped to bring in the most revenue, are a role-playing game called Quest 64, further WCW titles (WCW Thunder), and a game based on the Nickelodeon hit Rugrats, slated for a Christmas release. Quest 64 will be the first RPG (role-playing game) for the Nintendo 64 system and it is widely expected that the game will do very well because it is the first. However, based on some reviews that I have read, the jury is very much out on the quality of the game, with one reviewer saying "Quest 64's probably not gonna cut it."

WCW Thunder will be the third major release on the WCW license and will be in direct competition with WWF's Warzone, being published by Acclaim. Based on the reviews I've seen for WWF's product, it may be the best wrestling game to date. With steel cage matches, Battle Royals, and other cool wrestling shtick, WWF will be a formidable challenger to the WCW market share.

Rugrats should be a popular game. This is slated for the big quarter, Q4, and I imagine it will do well. Will it do well enough to propel THQ past this most recent quarter's $0.84 per share in earnings, though? Will Rugrats be the marketing hit at the end of this year that it is now? Nine months is a long time to a kid. We'll see.

The Technology -- THQ has done very well publishing games for cartridge-based game systems. Other systems, like the Sony PlayStation, are CD-ROM based. I believe that most future technological advances will move away from cartridges and more toward CD-ROMs because CD-ROM technology is more flexible and more cost efficient than the cartridges.

In fact, I think that one of the reasons THQ has done so well is because it won cartridge-based deals from the likes of Disney and Electronics Arts, even though both of those companies have publishing wings. Why don't Disney and EA want to get into the cartridge business? I imagine because the companies see it as a dying format and not something in which to invest capital. These companies can have THQ step up instead, reach out to all the various platforms, and then just collect the royalties from THQ, risk free. Then, once the cartridge business dies, these other firms aren't left with any clunky infrastructure. Unfortunately, THQ might then try and publish exclusively for the CD-ROM market and find that others in the business do it more efficiently and for less money. KABOOM!

Innovation -- The one other area where the biotech analogy falls down is that THQ isn't really a creator at all. It is a publisher. Efforts have been made to develop games itself (Pax Imperia), but even Farrell says that the company will concentrate primarily on license acquisition and publishing. In the end, this reduces THQ to being a "middleman" that will get squeezed on both ends -- by the consumer and by the developers of the games.

When history looks back, THQ will be remembered as a good publisher in the cartridge business. Because the cartridge business will give way to technology that isn't THQ's strong point or that others can do themselves, THQ is in the unfortunate position of being a middleman in a dying segment of the market. We're already seeing Ted Turner squeeze it. Additionally, the company will face increasing competition this year and may have its hopes pegged on some games that aren't exactly "sure things."

It is entirely conceivable that this stock will continue to rise. It has momentum right now and earnings comparisons for the first three quarters should be easy to handle. However, for the reasons I've outlined here, I'd be looking for a place to sell, and possibly even thinking about an entry to short. Many people have made great money on this stock to this point, and they may make more in the near future. I just hope that they don't get overzealous and lose sight of history. It isn't on their side.

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