I've been at Toy Fair the whole week. There are some really neat products in development. The most impressive product I saw was called Cybiko. cybiko.com
Anyway, I'm eager to see what Farrell has to say next Wednesday, re: Q1 and Q2 (and the rest of the year). I have some thoughts on recent developments. There are two possibilities: Either THQ has been deceiving us shareholders or they have lost their uncanny ability to control the business. Either way, the outlook for 2000 appears somewhat bearish.
We know several things so far. We just don't know how or why they are happening, nor do we know the ultimate implications.
1. THQ's reserves declined in Q3 1999.
2. There was massive insider selling in November.
3. THQ announced a great Q4 and similar expectations for 2000 in early January, but dropped a bombshell on us only one month later.
4. Q1 and Q2 should be much lower than last year, but full year results should be better than last year.
5. THQ has yet to issue a public statement discussing the forward guidance that they shared with analysts.
6. No one at THQ has returned my calls.
Here are the hypothetical possibilities for each point:
1. THQ's reserves declined in Q3 1999.
Farrell's explanation was that WCW shipments were heavily reserved for in Q1 and Q2 1999, since the license had expired and lots of product was shipped. Since THQ didn't know it would sell completely, they raised reserves. When the sell-through indicated that returns would be minimal, THQ returned the reserve level to normal. This is what they say. It may be true, but I know that WCW titles (especially Revenge) have been priced at $10-15 for several months, raising the possibility that retailers were getting price concessions for THQ to avoid taking a big hit themselves. If this is the case, reserves could decline even further in Q4 (we may not know until the 10-K in March).
If THQ management has been deceiving us, they may have lied during the conference call about the reason for the reserves decline. If they've been honest with us, they may have had some problems with international sales and reserves.
2. There was massive insider selling in November.
This happens all the time, but in 1999, the selling was higher than I can remember. Lucky for management, the stock was at its high at the time.
If THQ has been dishonest with us, the insiders could have known about some problems in the near future, and they figured the stock would not see $39 for awhile. If they've been honest with us, then the selling was just a case of great timing. They still thought the outlook was great in November.
3. THQ preannounced a great Q4 and similar expectations for 2000 in early January, but dropped a bombshell on us only one month later.
I assume the reason for the press release was to illustrate the contrast of THQ vs. competitors. THQ was having a great Q4, while others were seeing weakness. The stock had already declined to the 20s, but it was still a normal correction for the stock. What I can't figure out is how everything seemed great in early January, but a month later, estimates needed to be slashed.
If management has been deceiving us, then they issued the press release to halt the stock's slide. But we don't know why they would do that, since they've seldom, if ever, intervened with a PR in the past. Still, they may have been completely honest in the PR, but they were hinting that the coast was clear. If they weren't being dishonest, the case is almost as bad, because it suggests that something happened during January and early February to force THQ to cut estimates. They were surprised by something (poor sales, returns, runaway expenses, write-offs, etc.).
4. Q1 and Q2 should be much lower than last year, but full year results should be better than last year.
We know that the N64 market (and to a lesser extent, the overall market) is softer than usual. But is THQ's apparent shortfall in the first half due to weak sales, high expenses, or both? We know there were 1 million WM2K units sold through in 2 months. That's excellent! One would assume that THQ would ship another 500K in January, and another 500K in March, assuming it still sells. And best of all, Smackdown should be a better seller than WM2K. The gaming press has recommended it and picked it as a top-seller. If so, then wouldn't retailers want THQ to ship a million in March? And perhaps another million in Q2? And there are plenty of other decent titles in Q1 and Q2, such as the GBC titles.
So perhaps sales are not going to be worse than last year, especially since THQ recognizes revenues from the WWF titles. For that same reason, the expenses will be higher, but the net effect shouldn't be too different than the WCW profit margins. Of course, we still have no idea what the arrangement b/w JAKK and THQ is, so it's guesswork. If sales are flat with last year (still surprising), then expenses must be very high. I have been expecting higher expenses, but I figured that they'd be covered by sales. We know that THQ has been doing ads on TV all the time, which is very expensive. Also, the acquisition of Genetic Anomalies should add a lot to product development costs. And who knows about the costs of the new European office, which should have been in Q4?
What I can't understand is how they expect Q4 to carry the whole year to 20+% higher than last year. Believe me, I know they have a fantastic lineup in Q4, and the market will be heading up when the PS2 comes out. And I think that THQ could easily earn $1.25 in Q4.
They told analysts that Q1 and Q2 would be bad, but the whole year would be good. If THQ has been dishonest with us, then they may know that the whole year is going to be bad (for whatever reason), and they're probably just holding a carrot out in Q3-4 to support the stock until they have a chance to sell more stock after Q1 results are reported. If this is the case, we will hear more bad news sometime during Q2.
If THQ has been honest with us, then they must have lost the reigns on the whole operation. Why else would they suddenly realize that Q1 and Q2 would be bad (and get blindsided with that realization)? That's a bad sign for the future (depending upon the cause), since it suggests that THQ was not keeping its eye on the ball (or maybe management is not as far-seeing/well-prepared as we previously thought).
And if they really do believe that 2000 will unfold as they say, then how do can we trust their ability to predict 10 months into the future when they couldn't see 1 month out in early January? That's the part that's the most troubling to me.
5. THQ has yet to issue a public statement discussing the forward guidance that they shared with analysts.
There's no doubt that THQ should have mentioned this information in a PR, rather than in a private call. But THQ should have mentioned this during the January 7th PR, in conjunction with the announcement of a great Q4 and overall 2000. If they thought everything was great back then, that's a problem, too. See point #4 above.
Despite all the selloff on massive volume, rumor, FUD, broken uptrends, etc., THQ has still not acknowledged their earnings guidance for 2000. Perhaps we now know what caused all those other selloffs in the past, despite the lack of any news. The answer? Information sessions with analysts. We know THQ has never felt any responsibility for the individual investor. After all, we're just noisy weaklings who have only minor influence on the stock's long-term rise. It's the big institutions who carry the stock. Perhaps Farrell felt the need to curry favor with analysts by slipping them the answers to the test before the rest of the market saw them. Perhaps it makes sense, but it's not right. And since when has Farrell cared about Wall Street? He's always said that he'll run the business and let the stock take care of itself. Or let the analysts worry about the stock. A change of plan?
The explanation behind this point has little bearing on the operations of THQ as a business. But it does tell me, without a doubt, that management doesn't give a damn about us. We can't really trust that they'll do the right thing to enhance shareholder value. After all, they only own a few % of the company (or maybe less after November), so it's not a big deal to them.
6. No one at THQ has returned my calls.
Perhaps it's because Deborah Lake is no longer at THQ. She was always very good at returning calls and answering questions. Or perhaps they don't feel the need to talk to most investors, because we don't matter much.
Summary
Dishonest scenario (hypothetical!):
Management identified a problem with the business in early Q4, and they lowered reserves appropriately (a.k.a. reached into the cookie jar). Q4 continued to be problematic, so reserves continued to be lowered, and insiders sold at the top. To stem the stock's slide, THQ announces the acquisition of Genetic Anomalies, hoping that an Internet-related announcement would spark a rally like that of Electronic Arts'. They release a bullish PR on 1/7 to support the stock after the Internet announcement failed to do so. Q4 reserves had to be drawn down to cover returns or higher expenses in Q4, so they would be much lower than usual as Q1 began. Two weeks later, they announce the sell-through figures for WM2K, but the stock doesn't go up. On 1/24, they announce a misleading PR about being the #4 console publisher in 1999 according to TRSTS, contrary to subsequent announcements by Midway and the TRSTS data (they were really #5). The stock still didn't go up. Q1 was turning out to be worse than Q4, so THQ had to use up much of the remaining reserves to keep Q1 comfortably profitable. But management knew that unless Q2 were better than Q1, the cookie jar would be empty, and there would be a break-even Q2 at best. THQ "informs" analysts, but promises a decent Q3 and a great Q4, since most stocks trade on future prospects. Although management knows that Q3 and Q4 may not be as good as they say now (assuming the problem is company-specific), they will release the bad news bit by bit.
I sincerely hope that this scenario is wrong. Obviously, it's extreme. The only thing that could make it worse would be a Cendant/CUC-like move wherein the acquisitions of the past 2 years were used to cover expenses and inflate revenues. That would take the cake. Perhaps more likely is the following scenario:
Honest scenario (hypothetical):
Q3 reserves were taken down because WCW sold through, as Farrell said in the conference call. Q4 was very good. Insiders took some profits that were well-deserved for a great 1999. Everything was great through early February, when THQ was blindsided by some profit-margin-killing force (lower sales, higher returns, runaway expenses, etc.). THQ goofed by breaking the news to analysts, rather than to everyone in the world, perhaps thinking that the response would be less negative. Think again, it seems.
Is THQ's management crooked or have they simply fumbled the ball in the short-term? Either way, the outlook for 2000 appears bearish.
It's almost guaranteed that Q4 2000 and beyond will be great for video game companies. And THQ's lineup looks very good for 2000. They have lots of great licenses, they have some decent development talent, and a potentially successful Internet strategy. As long as the company's business is not broken, the long-term outlook is still very favorable.
But if the credibility of management is a question mark (for whatever reason), then what kind of risk are we facing going forward?
As most of you know, I've been a fairly large shareholder for more than 4 years, and I've been one of the more consistent THQ bulls. I've generally been objective (most of the time), and I've always raised issues that were potentially problematic and dealt with them fairly. At this time, though, I'm not comfortable holding such a large position. This week, I've sold 2/3 of my position. It was a very difficult decision to make, but the uncertainty about management and FY2000 earnings makes the risk substantially greater. I'm still going to see what the Q4 conference call brings. At that point, I'll reevaluate my outlook.
Let's hope this is just one big misunderstanding, and the bottom has been set at $17.38.
Todd |
