Shorts perspective on THQI for what's its worth.
Herb Part 2: Is THQ
Really That Much Better
Than Its Competitors?
By Herb Greenberg
Senior Columnist
1/27/00 8:30 AM ET
Be sure to check out the first installment of this
column from earlier today.
Can't help but love THQ
(THQI:Nasdaq - news), which
makes video games. Every
company in or near its
business, including industry leader (and class act)
Electronic Arts (ERTS:Nasdaq - news), has
reported lousy year-end earnings. Every company,
that is, but THQ, which issued a press release
several weeks ago saying that its biz is so good
that it won't just meet analyst expectations for the
recently completed fourth quarter -- it'll exceed
them!
What makes THQ different? What makes it immune
to the industrywide slowdown that has hurt every
other video-game maker (and retailer)? What makes
it immune from the impact of a shift to
new-generation games from Sony (SNE:NYSE
ADR - news) and Nintendo, a shift that always
results in a sales slump as consumers wait for the
new machines? And what makes it immune from
reporting disappointing news when data from NPD
Group's TRSTS report show that as of the end of
December, there were still large amounts of unsold
THQ titles in the channel? (This is the same NPD
that THQ cites in a press release earlier this week
as ranking THQ as the country's fourth-biggest
game publisher.)
The company, which expects to report earnings on
Feb. 25, says it's different because it's smarter.
"We are very focused on trying to run this like a
business," says CFO Fred Gysi. "We're very
financially oriented. We watch our numbers very
carefully. We don't get caught up in [the industry
specifics]; we view it as if we sell perishable items,
not video games. So, one thing we do carefully is
manage our inventories. So when push comes to
shove, we would rather be conservative."
He adds that despite
what the TRSTS
numbers show, the
company isn't worried
about inventories. In
fact, he says, the company has sold everything it
has shipped of titles tied to the World Wrestling
Federation (WWFE:Nasdaq - news) and Toy Story
2.
Maybe so, but short-sellers think the company is
confident for other reasons. They point to the
financial statements, specifically to two items.
The first is the amount of reserves THQ has put
aside for returns. Video-game makers recognize
revenue when they ship games to retailers, but they
usually create reserves to cover returns, which are
allowed. Reserves are a direct hit to earnings. In the
third quarter, THQ's reserves fell to 36% of accounts
receivable from 54% in the prior quarter.
Interestingly, in the same quarter, Acclaim's
(AKLM:Nasdaq - news) reserve rose to 40% from
32%. (Gysi says the reserves fell because the
company had been forced to raise them a year ago
because it wasn't sure about demand tied to an old
contract with World Championship Wrestling.
"Now we have the opposite situation," he says. "We
have the biggest brand and we're shipping
everything we can and we're selling everything we
can ship.")
The second issue is that THQ capitalizes
software-development expenses; in other words,
rather than recording them as a cost as they occur,
THQ spreads them out over the projected life of a
game. That's a trick some companies use to make
earnings growth look better than it really is.
Capitalized expenses at THQ leaped 64% to $14
million in the third quarter. Capitalizing expenses is
perfectly legitimate. "It's GAAP," Gysi says,
referring to generally accepted accounting
principles. "We do it to match our revenues with our
expenses."
But GAAP is a gray area, subject to interpretation,
and most video-game makers have chosen not to
capitalize their software expenses. Electronic Arts,
in fact, says as much in its 10-K: "Software
development costs ... are expensed as incurred."
Where does that leave THQ? Let's just say the
shorts will be looking very carefully at reserves and
capitalized expenses in the fourth-quarter report. If
one continues to fall while the other rises, "We'll
know there is a problem," one short-seller says.
"You can only stay on the treadmill for so long, and
eventually this type of behavior comes back to bite
you in a big way in the form of a massive
writedown." |
