Herb Part 2: Is THQ Really That Much Better Than Its Competitors?
By Herb Greenberg
Senior Columnist
1/27/00 8:30 AM ET
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."
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