UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

FORM 10-Q

 

 

 

For the quarterly period ended June 30, 2007

 

OR

 

 

For the transition period from                 to                

 

Commission file number 0-18813

 

THQ INC.

(Exact Name of Registrant as Specified in Its Charter)

 

 

 

Registrant’s telephone number, including area code: (818) 871-5000

 

 

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 o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer x            Accelerated filer o            Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o   No x

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:  As of August 3, 2007, there were 67,204,860 shares of common stock outstanding.

THQ INC. AND SUBSIDIARIES
INDEX

Part I — Financial Information
Item 1.		Condensed Consolidated Financial Statements (Unaudited):
		Condensed Consolidated Balance Sheets — June 30, 2007 and March 31, 2007
		Condensed Consolidated Statements of Operations — for the Three Months Ended June 30, 2007 and 2006
		Condensed Consolidated Statements of Cash Flows — for the Three Months Ended June 30, 2007 and 2006
		Notes to Condensed Consolidated Financial Statements
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.		Quantitative and Qualitative Disclosures About Market Risk
Item 4.		Controls and Procedures
Part II — Other Information
Item 1.		Legal Proceedings
Item 1A.		Risk Factors
Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds
Item 3.		Defaults Upon Senior Securities
Item 4.		Submission of Matters to a Vote of Security Holders
Item 5.		Other Information
Item 6.		Exhibits
Signatures

 

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Part I — Financial Information

Item 1.  Condensed Consolidated Financial Statements

THQ INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)

		June 30, 2007			March 31, 2007
		(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents		$	136,953		$	174,748
Short-term investments		288,112			283,210
Cash, cash equivalents and short-term investments		425,065			457,958
Accounts receivable, net of allowances		37,207			67,586
Inventory		28,977			27,381
Licenses		46,953			41,406
Software development		171,879			130,512
Income taxes receivable		16,421			18,525
Prepaid expenses and other current assets		16,361			16,238
Total current assets		742,863			759,606
Property and equipment, net		48,264			45,095
Licenses, net of current portion		36,794			49,661
Software development, net of current portion		41,738			33,766
Income taxes receivable, net of current portion		6,364			2,163
Deferred income taxes		15,812			15,812
Goodwill		96,270			88,688
Other long-term assets, net		20,304			18,750
TOTAL ASSETS		$	1,008,409		$	1,013,541
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	27,404		$	28,225
Accrued and other current liabilities		140,028			143,418
Deferred income taxes		23,706			25,647
Total current liabilities		191,138			197,290
Other long-term liabilities		35,679			47,294
Commitments and contingencies (See Note 9)
Stockholders’ equity:
Preferred stock, par value $0.01, 1,000,000 shares authorized		—			—
Common stock, par value $0.01, 75,000,000 shares authorized; 67,154,397 and 66,677,721 shares issued and outstanding as of June 30, 2007 and March 31, 2007, respectively		672			667
Additional paid-in capital		490,674			471,332
Accumulated other comprehensive income		20,165			17,603
Retained earnings		270,081			279,355
Total stockholders’ equity		781,592			768,957
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY		$	1,008,409		$	1,013,541

 

See notes to condensed consolidated financial statements.

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THQ INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

		For the Three Months Ended June 30,
		2007			2006
		(Unaudited)
Net sales		$	104,485		$	138,829
Cost and expenses:
Cost of sales — product costs		43,715			48,991
Cost of sales — software amortization and royalties		12,598			25,291
Cost of sales — license amortization and royalties		13,671			16,313
Cost of sales — venture partner expense		897			709
Product development		24,632			26,236
Selling and marketing		22,803			26,711
General and administrative		19,103			15,526
Total costs and expenses		137,419			159,777
Loss from operations		(32,934		)	(20,948		)
Interest and other income, net		7,356			2,740
Loss before income taxes and minority interest		(25,578		)	(18,208		)
Income taxes		(16,304		)	(6,009		)
Loss before minority interest		(9,274		)	(12,199		)
Minority interest		—			98
Net loss		$	(9,274	)	$	(12,101	)
Loss per share — basic		$	(0.14	)	$	(0.19	)
Loss per share — diluted		$	(0.14	)	$	(0.19	)
Shares used in per share calculation — basic		66,928			64,317
Shares used in per share calculation — diluted		66,928			64,317

 

See notes to condensed consolidated financial statements.

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THQ INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

 

		For the Three Months Ended June 30,
		2007			2006
		(Unaudited)
OPERATING ACTIVITIES:
Net loss		$	(9,274	)	$	(12,101	)
Adjustments to reconcile net loss to net cash used in operating activities:
Minority interest and other		—			93
Depreciation and amortization		4,217			3,591
Amortization of licenses and software development		17,495			27,179
Loss on disposal of property and equipment		40			491
Stock-based compensation		6,032			3,007
Tax benefit related to stock-based awards		6,357			1,747
Excess tax benefit related to stock-based awards		(3,727		)	(925		)
Deferred income taxes		—			19
Changes in operating assets and liabilities:
Accounts receivable, net of allowances		30,961			(4,566		)
Inventory		(1,445		)	(9,356		)
Licenses		(1,231		)	(831		)
Software development		(58,352		)	(44,788		)
Prepaid expenses and other current assets		388			(6,386		)
Accounts payable		(1,943		)	2,422
Accrued and other liabilities		(19,886		)	(7,924		)
Income taxes		(3,932		)	(7,024		)
Net cash used in operating activities		(34,300		)	(55,352		)
INVESTING ACTIVITIES:
Proceeds from sales and maturities of short-term investments		145,904			189,680
Purchase of short-term investments		(150,886		)	(115,210		)
Other long-term assets		87			(6,308		)
Acquisitions, net of cash acquired		(4,781		)	(1,400		)
Purchases of property and equipment		(6,731		)	(3,253		)
Net cash (used in) provided by investing activities		(16,407		)	63,509
FINANCING ACTIVITIES:
Stock repurchase		—			(10,061		)
Proceeds from exercise of stock options		7,867			8,784
Excess tax benefit related to stock-based awards		3,727			925
Net cash provided by (used in) financing activities		11,594			(352		)
Effect of exchange rate changes on cash		1,318			(1,664		)
Net (decrease) increase in cash and cash equivalents		(37,795		)	6,141
Cash and cash equivalents — beginning of period		174,748			91,517
Cash and cash equivalents — end of period		$	136,953		$	97,658
Non-Cash investing activities:
Additional consideration accrued for Valusoft acquisition		$	1,800		$	1,800

 

See notes to condensed consolidated financial statements.

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THQ INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1.   Basis of Presentation

The condensed consolidated financial statements included in this Form 10-Q present the results of operations, financial position and cash flows of THQ Inc. (together with its subsidiaries, “THQ”, we, us, our or the “Company”).  In the opinion of management, the accompanying condensed consolidated balance sheets and related interim condensed consolidated statements of operations and condensed consolidated cash flows include all adjustments, consisting only of normal recurring items, necessary for their fair presentation in conformity with accounting principles generally accepted in the United States of America.  Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, sales and expenses.  The most significant estimates relate to licenses, software development,  accounts receivable allowances, income taxes and stock-based compensation expense.  Actual results may differ from these estimates.  Interim results are not necessarily indicative of results for a full year.  The balance sheet at March 31, 2007 has been derived from the audited financial statements at that date but does not include all of the information and notes required by accounting principles generally accepted in the United States of America for complete financial statements.  The information included in this Form 10-Q should be read in conjunction with the financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended March 31, 2007.

Fiscal Quarter.

The results of operations for the three months ended June 30, 2007 and 2006 contain the following number of weeks:

 

For simplicity, all fiscal periods in our consolidated financial statements and accompanying notes are presented as ending on a calendar month end.

2.   Cash, Cash Equivalents, Short-Term Investments and Financial Instruments

Our investments with maturities beyond one year may be classified as short-term based on their liquid nature and because such securities represent the investment of cash that is available for current operations.  All of our short-term investments are classified as available-for-sale and are carried at fair market value with unrealized gains (losses) reported as a separate component of accumulated other comprehensive income (loss) in shareholders’ equity.

The following table summarizes our cash, cash equivalents and short-term investments as of June 30, 2007 (in thousands):

					Gross		Gross
		Amortized			Unrealized		Unrealized		Fair
		Cost			Gains		Losses		Value
Cash and cash equivalents		$	136,953		—		—		$	136,953
Short-term investments:
U.S. agency securities		4,499			—		(4	)	4,495
Municipal securities		258,940			2		(122	)	258,820
Corporate notes		24,800			—		(3	)	24,797
Total short-term investments		288,239			2		(129	)	288,112
Cash, cash equivalents and short-term investments		$	425,192		2		(129	)	$	425,065

 

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The following table summarizes the gross unrealized losses and fair value of our short-term investments, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position as of June 30, 2007 (in thousands):

		Unrealized Losses Less						Unrealized Losses 12
		Than 12 Months						Months or Greater						Total
					Gross						Gross						Gross
		Fair			Unrealized			Fair			Unrealized			Fair			Unrealized
		Value			Losses			Value			Losses			Value			Losses
U.S. agency securities		$	4,495		$	(4	)	$	—		$	—		$	4,495		$	(4	)
Municipal securities		258,820			(122		)	—			—			258,820			(122		)
Corporate notes		24,797			(3		)	—			—			24,797			(3		)
Total short-term investments		$	288,112		$	(129	)	$	—		$	—		$	288,112		$	(129	)

 

The gross unrealized losses in each of the securities in the above tables were primarily caused by a decrease in the fair value of the investments as a result of an increase in interest rates.  The contractual terms of these securities do not permit the issuer to call, prepay or otherwise settle the securities at prices less than the stated par value of the security.  Accordingly, we do not consider these investments to be other-than-temporarily impaired as of June 30, 2007.

During the three months ended June 30, 2007 and 2006 there were no realized gains or losses from sales of available-for-sale securities.  In addition to the net unrealized loss in the three months ended June 30, 2007 of $81,000 from our short-term investments, we had an unrealized loss on our investment in Yuke’s Co., Ltd. (“Yuke’s”) which is classified as available-for-sale and is included in other long-term assets (see “Note 7 — Other Long-Term Assets”).

The following table summarizes the amortized cost and fair value of our short-term investments, classified by stated maturity as of June 30, 2007 (in thousands):

 

Financial Instruments.  As of June 30, 2007 and March 31, 2007, we had foreign exchange forward contracts in the notional amount of $55.8 million and $47.0 million, respectively.  The net gain recognized from foreign currency contracts during the three months ended June 30, 2007 was $0.9 million, and the net loss recognized from foreign currency contracts during the three months ended June 30, 2006 was $1.9 million, both of which are included in interest and other income and expense in our consolidated statements of operations.

3.   Licenses

Minimum guaranteed royalty payments for intellectual property licenses are initially recorded on our balance sheet as an asset (licenses) and as a liability (accrued royalties) at the contractual amount upon execution of the contract if no significant performance obligation remains with the licensor.  When a significant performance obligation remains with the licensor, we record royalty payments as an asset (licenses) and as a liability (accrued royalties) when payable rather than upon execution of the contract.  Royalty payments for intellectual property licenses are classified as current assets and current liabilities to the extent such royalty payments relate to anticipated product sales during the subsequent year and long-term assets and long-term liabilities if such royalty payments relate to anticipated product sales after one year.

We evaluate the future recoverability of our capitalized licenses on a quarterly basis.  The recoverability of capitalized license costs is evaluated based on the expected performance of the specific products in which the licensed trademark or copyright is to be used.  As many of our licenses extend for multiple products over multiple years, we also assess the recoverability of capitalized license costs based on certain qualitative factors such as the success of other products and/or entertainment vehicles utilizing the intellectual property, whether there are any future planned theatrical releases or television series based on the intellectual property and the rights holder’s continued promotion and exploitation of the intellectual property.  Prior to the related product’s release, we expense, as part of cost of sales — license amortization and royalties, capitalized license costs when we estimate such amounts are not recoverable.

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Licenses are expensed to cost of sales — license amortization and royalties at the higher of (1) the contractual royalty rate based on actual net product sales related to such license or (2) an effective rate based upon total projected revenue related to such license.  When, in management’s estimate, future cash flows will not be sufficient to recover previously capitalized costs, we expense these capitalized costs to cost of sales — license amortization and royalties.  If actual revenues or revised forecasted revenues fall below the initial forecasted revenue for a particular license, the charge to cost of sales — license amortization and royalties expense may be larger than anticipated in any given quarter.  As of June 30, 2007, the net carrying value of our licenses was $83.7 million.  If we were required to write off licenses, due to changes in market conditions or product acceptance, our results of operations could be materially adversely affected.

4.   Software Development

We utilize both internal development teams and third-party software developers to develop our software.  We account for software development costs in accordance with Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standard (“SFAS”) No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed” (“FAS 86”).  We capitalize software development costs once technological feasibility is established and we determine that such costs are recoverable against future revenues.  For products where proven game engine technology exists, this may occur early in the development cycle.  We capitalize the milestone payments made to third-party software developers and the direct payroll and overhead costs for our internal development teams.  We evaluate technological feasibility on a product-by-product basis.  Amounts related to software development for which technological feasibility is not yet met are charged as incurred to product development expense in our consolidated statements of operations.

On a quarterly basis, we compare our unamortized software development costs to net realizable value, on a product-by-product basis.  The amount by which any unamortized software development costs exceed their net realizable value is charged to cost of sales — software amortization and royalties.  The net realizable value is the estimated future net revenues from the product, reduced by the estimated future direct costs associated with the product such as completion costs, cost of sales and advertising.

Commencing upon product release, capitalized software development costs are amortized to cost of sales — software amortization and royalties based on the ratio of current gross revenues to total projected gross revenues.  If actual gross revenues, or revised projected gross revenues, fall below the initial projections, the charge to cost of sales — software amortization and royalties may be larger than anticipated in any given quarter.  As of June 30, 2007, the net carrying value of our software development was $213.6 million.

The milestone payments made to our third-party developers during their development of our games are typically considered non-refundable advances against the total compensation they can earn based upon the sales performance of the products.  Any additional compensation earned beyond the milestone payments is expensed to cost of sales — software amortization and royalties as earned.

5.   Goodwill

The changes in the carrying amount of goodwill for the three months ended June 30, 2007 are as follows (in thousands):

 

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6.   Other Intangible Assets

Intangible assets include licenses, software development and other intangible assets.  Intangible assets are included in other long-term assets, net, except licenses and software development, which are reported separately in the consolidated balance sheets.  Other intangible assets are as follows (in thousands):

 

				June 30, 2007									March 31, 2007
		Useful Lives		Gross Carrying Amount			Accumulated Amortization			Net Amount			Gross Carrying Amount			Accumulated Amortization			Net Amount
Software technology		2-4 years		$	902		$	(182	)	$	720		$	953		$	(715	)	$	238
Trade secrets		5 years		—			—			—			1,800			(1,800		)	—
Trade names		3-10 years		1,588			(392		)	1,196			2,100			(922		)	1,178
Non-compete / Employment contracts		1.5-6.5 years		967			(712		)	255			1,048			(828		)	220
Total other intangible assets				$	3,457		$	(1,286	)	$	2,171		$	5,901		$	(4,265	)	$	1,636

 

Amortization of other intangible assets was $225,000 and $638,000 for the three months ended June 30, 2007 and 2006, respectively.  Finite-lived other intangible assets are amortized using the straight-line method over the lesser of their estimated useful lives or the agreement terms, typically from two to ten years, and are assessed for impairment under SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”

The following table summarizes the estimated amortization expense of other intangible assets for each of the next five fiscal years and thereafter (in thousands):

 

7.   Other Long-Term Assets

In addition to other intangible assets, other long-term assets include our investment in Yuke’s, a Japanese video game developer.  For the three months ended June 30, 2007 and 2006, the unrealized holding loss related to our investment in Yuke’s was $0.3 million and $2.3 million before income taxes, respectively.

Other long-term assets as of June 30, 2007 and March 31, 2007 are as follows (in thousands):

 

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8.   Balance Sheet Details

Inventory.  Inventory at June 30, 2007 and March 31, 2007 consists of the following (in thousands):

 

Property and Equipment, net.  Property and equipment at June 30, 2007 and March 31, 2007 consists of the following (in thousands):

 

Depreciation expense associated with property and equipment amounted to $4.0 million and $3.0 million for the three months ended June 30, 2007 and 2006, respectively.

Accrued and Other Current Liabilities.  Accrued and other current liabilities at June 30, 2007 and March 31, 2007 consist of the following (in thousands):

 

Other Long-Term Liabilities.  Other long-term liabilities at June 30, 2007 and March 31, 2007 consist of the following (in thousands):

 

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9.   Commitments and Contingencies

A summary of annual minimum contractual obligations and commercial commitments as of June 30, 2007 is as follows (in thousands):

		Contractual Obligations and Commercial Commitments
		License /
Fiscal		Software
Years Ending		Development									Letters of
March 31,		Commitments(1)			Advertising(2)			Leases(3)			Credit(4)			Total
Remainder of 2008		$	78,246		$	13,540		$	10,898		$	22,816		$	125,500
2009		61,189			14,553			14,668			—			90,410
2010		46,014			14,357			14,078			—			74,449
2011		13,850			8,672			13,111			—			35,633
2012		850			2,848			11,315			—			15,013
Thereafter		1,100			4,983			24,283			—			30,366
		$	201,249		$	58,953		$	88,353		$	22,816		$	371,371

(1)             Licenses and Software Development.  We enter into contractual arrangements with third parties for the rights to intellectual property and for the development of products.  Under these agreements, we commit to provide specified payments to an intellectual property holder or developer.  Assuming all contractual provisions are met, the total future minimum contract commitments for contracts in place as of June 30, 2007 are approximately $201.2 million.  License/software development commitments in the table above include $55.8 million of commitments to licensors that are included in our consolidated balance sheet as of June 30, 2007 because the licensors do not have any significant performance obligations to us.  These commitments were included in both current and long-term licenses and accrued royalties.

(2)             Advertising.  We have certain minimum advertising commitments under most of our major license agreements.  These minimum commitments generally range from 2% to 12% of net sales related to the respective license.

(3)             Leases.  We are committed under operating leases with lease termination dates through 2015.  Most of our leases contain rent escalations.

(4)             Letters of Credit.  As of June 30, 2007, we had outstanding letters of credit of approximately $22.8 million.  Our previous credit facility expired on November 29, 2006 and we did not renew it.  On October 3, 2006, we entered into an agreement with a bank primarily to provide stand-by letters of credit to a platform manufacturer from whom we purchase products.  We pledged cash equivalents and investments to the bank as collateral in an amount equal to 110% of the amount of the outstanding stand-by letters of credit.

Other material future potential expenditures relate to the following:

Manufacturer Indemnification.   We must indemnify the platform manufacturers (Microsoft, Nintendo, Sony) of our games with respect to all loss, liability and expenses resulting from any claim against such manufacturer involving the development, marketing, sale or use of our games, including any claims for copyright or trademark infringement brought against such manufacturer. As a result, we bear a risk that the properties upon which the titles of our games are based, or that the information and technology licensed from others and incorporated into the products, may infringe the rights of third parties. Our agreements with our third-party software developers and property licensors typically provide indemnification rights for us with respect to certain matters. However, if a manufacturer brings a claim against us for indemnification, the developers or licensors may not have sufficient resources to, in turn, indemnify us.

Director Indemnity Agreements.   We have entered into indemnification agreements with the members of our Board of Directors to provide a contractual right of indemnification to our Directors to the extent permitted by law against any and all liabilities, costs, expenses, amounts paid in settlement and damages incurred by the Directors as a result of any lawsuit, or any judicial, administrative or investigative proceeding in which the Directors are sued as a result of their service as members of our Board of Directors.  The indemnification agreements provide specific procedures and time frames with respect to requests for indemnification and clarify the benefits and remedies available to Directors in the event of an indemnification request.

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Legal Proceedings

WWE related Lawsuits

New York lawsuit.  On October 19, 2004, World Wrestling Entertainment, Inc. (“WWE”) filed a lawsuit in the United States District Court for the Southern District of New York (the “Court”) against JAKKS Pacific, Inc. (“JAKKS”), THQ,  THQ/JAKKS Pacific LLC (the “LLC”), and others, alleging, among other claims, improper conduct by JAKKS, certain executives of JAKKS, an employee of the WWE and an agent of the WWE in granting the WWE videogame license to the LLC. The complaint seeks various forms of relief, including monetary damages and a judicial determination that, among other things, the WWE videogame license is void. On March 30, 2005, WWE filed an amended complaint, adding both new claims and THQ’s president and chief executive officer, Brian Farrell, as a defendant. In August 2005, the Court directed the parties to file briefs on the three federal law claims alleged by the Plaintiffs (i.e., Robinson-Patman, and Sherman Act, and a threshold issue concerning the Plaintiff’s RICO claim). The motions to dismiss the amended complaint based on these issues were fully briefed and argued and, on March 31, 2006, the Court granted the defendants’ motion to dismiss the Robinson-Patman Act and Sherman Act claims and denied the defendants’ motion seeking to dismiss the RICO claims on the basis of the threshold “enterprise” issue that was briefed (the “March 31 Order”).

On April 7, 2006, the Company and the other defendants sought certification to appeal from the portion of the March 31 Order denying the motion to dismiss the RICO claim on the one ground that was briefed. Shortly thereafter, WWE filed a motion for re-argument with respect to the portion of the March 31 Order that dismissed the Sherman Act claim and, alternatively, sought judgment with respect to the Sherman Act claim so that it could pursue an immediate appeal. At a court hearing on April 26, 2006, the Court deferred a ruling on the requests for partial judgment and for certification and set briefing schedules with respect to the remaining grounds for defendants’ motion to dismiss the RICO claim, currently the sole remaining basis for federal jurisdiction in this action, that were not the subject of the first round of briefing. The Court also established a briefing schedule for WWE’s motion for re-argument of the dismissal of the Sherman Act claim. The briefing was completed in August of 2006 and a hearing was held in September of 2006.  The Court has not yet ruled on the pending motions. Discovery in this action remains stayed.

THQ believes that neither it, nor Brian Farrell, is primarily accused of any wrongdoing in the complaint or the amended complaint, and believes that either there is no basis for terminating the WWE videogame license, or that THQ will be made whole by those whose conduct is eventually found to be unlawful. We intend to vigorously protect our rights and, if necessary, pursue appropriate claims against third parties.

Connecticut lawsuit.  On October 12, 2006, WWE filed a separate lawsuit against the Company and the LLC in the Superior Court of the State of Connecticut, alleging that the Company’s agreements with Yuke’s Co., Ltd. (“Yukes”), a developer and distributor in Japan, violated a provision of the WWE videogame license prohibiting sublicenses without WWE’s written consent.  The lawsuit seeks, among other things, a declaration that the WWE is entitled to terminate the video game license and seek monetary damages.  On February 8, 2007, the Company and the LLC jointly moved to strike one of the claims, for violation of  the Connecticut Unfair Trading Practices Act; on March 28, 2007, the Court denied that motion, without prejudice to the defendants’ ability to raise the same issue at a later date.  On February 22, 2007, the Court established a schedule for this case, including discovery, and ordering that the case be “exposed for trial” as of October 14, 2008.  However, on March 30, 2007, WWE moved for leave to amend its pleadings to add allegations and claims substantially similar to those already pending in WWE’s lawsuit in the Southern District of New York and to “cite in” the other defendants from that action.  The defendants objected to this motion.  At a hearing on May 8, 2007, the Court granted WWE’s request to amend the complaint and add defendants.  The Court also suspended deadlines under its existing scheduling order and indicated it will re-examine the schedule after the new defendants have been served and have appeared.  The amended complaint was served on the Company and Brian Farrell on or about May 10, 2007.  On July 30, 2007, in response to a request by JAKKS Pacific, Inc. and certain other defendants, which THQ and Brian Farrell joined, the Court stayed proceedings in the Connecticut state court action for a period of four months.  The Company believes it and the LLC have several bases for defending any claim of breach of the WWE videogame license agreement resulting from the manner of distribution of WWE-licensed products in Japan and other Asian territories.  We intend to vigorously defend ourselves against the claims raised in this action, including those raised in the amended complaint.

We cannot estimate a possible loss, if any, that we would have due to the litigation with the WWE. Games we develop based upon our WWE videogame license have contributed to approximately 15% of our net sales during each of the three years in the period ended March 31, 2007. The loss of the WWE license would have a negative impact on our future financial results.

Operating Agreement with JAKKS Pacific, Inc. 

 

In June 1999 we entered into an operating agreement with JAKKS that governs our relationship with respect to the WWE videogame license.  Pursuant to the terms of this agreement, JAKKS is entitled to a preferred payment from revenues derived from exploitation of the WWE videogame license.   The amount of the preferred payment to JAKKS for the period beginning July 1, 2006 and ending December 31, 2009 (the “First Subsequent Distribution Period”) is to be determined by agreement or, failing that, by arbitration.

 

The parties have not reached agreement on the preferred payment for the First Subsequent Distribution Period. Accordingly, as provided in the operating agreement, the parties are in the process of selecting an arbitrator to resolve this dispute.  Although we believe continuation of the previous preferred payment would represent significantly excessive compensation to JAKKS for the First Subsequent Distribution Period, we are not able to predict the outcome of the arbitration or otherwise estimate the amount of the preferred payment for the First Subsequent Distribution Period.  Accordingly, we are currently accruing for a preferred payment to JAKKS at the previous rate.  However, we have advised JAKKS that we do not intend to make any payment until the amount of the preferred payment payable to JAKKS for the First Subsequent Distribution Period is agreed or otherwise determined as provided in the operating agreement.  On April 30, 2007, we filed a petition to compel arbitration and appoint an arbitrator in the Superior Court of the State of California for the County of Los Angeles, West District.  Our petition seeks a court order compelling JAKKS to comply with the arbitration provisions in the operating agreement and establishing a process and timeline for selecting an arbitrator.  On or about May 22, 2007, JAKKS filed a response to our petition, as well as an application for provisional relief requesting that, pending conclusion of the arbitration, THQ either be enjoined from distributing to itself any proceeds from the joint venture since June 2006 or be compelled to resume payments to JAKKS at the same rate that was in effect prior to June 2006.  On June 19, 2007, the Court established a process for selecting an arbitrator in this matter and denied JAKKS' request for preliminary relief pending conclusion of the arbitration.  In accordance with the process established by the Court, on August 3, 2007 the Court selected an arbitrator and we expect the arbitration to commence in the near future.

 

We do not expect the resolution of this dispute to have a material adverse impact on our results of operations, financial position or cash flows.

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10.   Stock-based Compensation

Prior to July 20, 2006, we utilized two stock option plans:  the THQ Inc. Amended and Restated 1997 Stock Option Plan (the “1997 Plan”) and the THQ Inc. Third Amended and Restated Nonexecutive Employee Stock Option Plan (the “NEEP Plan”). The 1997 Plan provided for the issuance of up to 14,357,500 shares available for employees, consultants and non-employee directors, and the NEEP plan provided for the issuance of up to 2,142,000 shares available for nonexecutive employees of THQ of which no more than 20% was available for awards to our nonexecutive officers and no more than 15% was available for awards to the nonexecutive officers or general managers of our subsidiaries or divisions.  The 1997 Plan and the NEEP Plan were cancelled on July 20, 2006, the same day THQ’s stockholders approved the THQ Inc. 2006 Long-Term Incentive Plan (“LTIP”).

Under the 1997 Plan, we granted incentive stock options, non-qualified stock options, performance accelerated restricted stock (“PARS”) and performance accelerated restricted stock units (“PARSUs”).  The NEEP Plan provided for the grant of only non-qualified stock options to non-executive officers of the Company.  The LTIP provides for the grant of stock options (including incentive stock options), stock appreciation rights (“SARs”), restricted stock awards, other stock unit awards, and performance awards (in the form of performance shares or performance units) to eligible directors and employees of, and consultants or advisors to, the Company.  Subject to certain adjustments, the total number of shares of THQ common stock that may be issued under the LTIP shall not exceed 6,000,000 shares.  Shares subject to awards of stock options or SARs will count as one share for every one share granted against the share limit, and all other awards will count as 1.6 shares for every one granted against the share limit.  As of June 30, 2007, we had 4,549,926 shares under the LTIP available for grant.

The purchase price per share of common stock purchasable upon exercise of each option granted under the 1997 Plan, the NEEP Plan and the LTIP may not be less than the fair market value of such share of common stock on the date that such option is granted.  Generally, options granted under our plans become exercisable over three years and expire on the fifth anniversary of the grant date.  PARS and PARSUs that have been granted to our officers under the 1997 Plan and the LTIP vest with respect to 100% of the shares subject to the award on the fifth anniversary of the grant date; provided, however, 20% of the shares subject to each award will vest on each of the first through fourth anniversaries of the grant date if certain performance targets for the Company are attained each fiscal year.  In the three months ended June 30, 2007, it was determined that certain performance targets had been met with respect to our fiscal year ended March 31, 2007 and as such certain of our officers vested in 20% of their awards.   PARSUs granted to our non-employee directors under the 1997 Plan are currently fully vested.  Deferred Stock Units (“DSUs”) granted to our non-employee directors under the LTIP vest immediately, however, may not be paid to a director until thirteen (13) months after the date of grant.  The fair value of our nonvested restricted stock is determined based on the closing trading price of our common stock on the grant date.  The fair value of PARS, PARSUs and DSUs granted is amortized over the vesting period.

In March 2007, we offered our non-executive employees the ability to participate in an employee stock purchase plan (“ESPP”).  Pursuant to our ESPP, eligible employees may authorize payroll deductions of up to 15 percent of their base salary, subject to certain limitations, to purchase shares at 85 percent of the lower of the fair market value of our common stock on the first day of the offering period or the last.  Our first offering period began on March 1, 2007 and will end on August 31, 2007.  The fair value of the stock purchased under the ESPP is amortized over the offering period.  As of June 30, 2007, we had 500,000 shares available for issuance under the ESPP.

Any references we make to unspecified “stock-based compensation” and “stock-based awards” are intended to represent the collective group of all our awards and purchase opportunities:  stock options, PARS, PARSUs, DSUs and ESPP.  Any references we make to “nonvested shares” and “vested shares” are intended to represent our PARS, PARSU and DSU awards.

The expense related to stock-based compensation recognized in our statements of operations was $6.0 million and $3.1 million, respectively, for the three months ended June 30, 2007 and 2006.  The total income tax benefit recognized in the statement of operations for stock-based compensation expense was $2.9 million and $1.5 million, respectively, for the three months ended June 30, 2007 and 2006.  Stock-based compensation capitalized into software development during the three months ended June 30, 2007 and 2006 was $1.7 million and $650,000, respectively.  In the three months ended June 30, 2007 and 2006 we had $1.8 million and zero, respectively, of software amortization related to previously capitalized stock-based compensation.  No amounts were capitalized in years prior to fiscal 2007.

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For the three months ended June 30, 2007 and 2006, stock-based compensation expense recognized in the statement of operations was as follows (in thousands):

 

FAS 123R requires that stock-based compensation expense be based on awards that are ultimately expected to vest and accordingly, stock-based compensation expense recognized in the three months ended June 30, 2007 and 2006 has been reduced by estimated forfeitures.  Our estimate of forfeitures is based on historical forfeiture behavior as well as any expected trends in future forfeiture behavior.

The fair value of stock options granted during the three months ended June 30, 2007 was estimated on the date of grant using the Black-Scholes option pricing model with the weighted-average assumptions noted in the table below.  Anticipated volatility is based on implied volatilities from traded options on our stock and on our stock’s historical volatility.  The expected term of our stock options granted is based on historical exercise data and represents the period of time that stock options granted are expected to be outstanding.  Separate groups of employees that have similar historical exercise behavior are considered separately for valuation purposes.  The risk-free rate for periods within the expected lives of our options are based on the US Treasury yield in effect at the time of grant.

 

A summary of our stock option activity for the three months ended June 30, 2007 is as follows (in thousands, except per share amounts):

							Weighted-
							Average
				Weighted-			Remaining
				Average			Contractual		Aggregate
				Exercise			Term		Intrinsic
		Shares		Price			(in years)		Value
Outstanding at April 1, 2007		7,564		$	19.15
Granted		1,015		$	33.19
Exercised		(484	)	$	16.24
Forfeited/expired/cancelled		(128	)	$	22.06
Outstanding at June 30, 2007		7,967		$	21.07		3.2		$	78,640
Vested and expected to vest		7,091		$	20.71		3.1		$	72,321
Exercisable at June 30, 2007		3,009		$	15.54		2.1		$	45,061

 

The aggregate intrinsic value is calculated as the difference between the exercise price of a stock option and the quoted price of our common stock at June 30, 2007.  It excludes stock options that have exercise prices in excess of the quoted price of our common stock at June 30, 2007.  The aggregate intrinsic value of stock options exercised during the three months ended June 30, 2007 and 2006 was $8.6 million and $5.4 million, respectively.

The weighted-average grant-date fair value per share of options granted during the three months ended June 30, 2007 and 2006 was $10.89 and $8.38.

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A summary of the status of our nonvested shares as of June 30, 2007 and changes during the three months then ended, is as follows (in thousands, except per share amounts):

 

The weighted-average grant-date fair value of nonvested shares granted during the three months ended June 30, 2006 was $25.96.

The unrecognized compensation cost, that we expect to vest, related to our nonvested stock-based awards at June 30, 2007, and the weighted-average period over which we expect to recognize that compensation, is as follows (in thousands):

 

Cash received from exercises of stock options for the three months ended June 30, 2007 and 2006 was $7.9 million and $8.8 million, respectively.  The actual tax benefit realized for the tax deductions from exercises of all stock-based awards totaled $6.6 million and $1.7 million for the three months ended June 30, 2007 and 2006, respectively.

The fair value of all our stock-based awards that vested during the three months ended June 30, 2007 and 2006 was $7.7 million and $5.6 million, respectively.

Non-Employee Stock Warrants.   In prior years, we have granted stock warrants to third parties in connection with the acquisition of licensing rights for certain key intellectual property. The warrants generally vest upon grant and are exercisable over the term of the warrant. The exercise price of third-party stock warrants is equal to their fair market value of our common stock at the date of grant. No third-party stock warrants were granted or exercised during the three months ended June 30, 2007 and 2006.

In fiscal 2005 we granted 240,000 stock warrants to third parties to purchase up to 240,000 shares of our common stock at an exercise price of $13.49 per share in connection with a license agreement that allows us to utilize intellectual property owned by such third parties. The stock warrants vested upon grant and have a six-year term. The fair value of the stock warrants was determined using the Black-Scholes pricing model, assuming a risk-free rate of 2.9%, a volatility factor of 67% and the six-year term as noted above. The fair value of these stock warrants was $2.0 million.

At June 30, 2007 and 2006, we had 390,000 stock warrants outstanding with weighted average exercise prices per share of $12.32.  In fiscal 2006, 112,500 stock warrants expired unexercised.

In accordance with EITF No. 96-18, “Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring or in Connection with Selling Goods or Services,” we measure the fair value of these warrants on the measurement date. The fair value of each stock warrant is capitalized and amortized to expense when the related product is released and the related revenue is recognized. Additionally, as more fully described in Note 3, the recoverability of intellectual property licenses is evaluated on a quarterly basis with amounts determined as not recoverable being charged to expense. In connection with the evaluation of capitalized intellectual property licenses, any capitalized amounts for related third-party stock warrants are additionally reviewed for recoverability with amounts determined as not recoverable being amortized to

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expense. For the three months ended June 30, 2007 and 2006, $128,000 and $356,000, respectively, was amortized and included in cost of sales — license amortization and royalties expense.

11.   Capital Stock Transactions

As of March 31, 2007 we had $8.5 million authorized and available for common stock repurchases.  On May 16, 2007 we announced that our Board authorized the repurchase of up to $25.0 million of our common stock from time to time on the open market or in private transactions.  During the three months ended June 30, 2007, we did not repurchase any of our common stock and as such, we had $33.5 million authorized and available for common stock repurchases as of June 30, 2007.  On July 31, 2007 we announced that our Board authorized the repurchase of up to $25.0 million of our common stock from time to time on the open market or in private transactions, bringing the amount authorized and available for common stock repurchases up to $58.5 million as of that date.  There is no expiration date for the authorized repurchases.

On July 30, 2007 we amended our certificate of incorporation to increase our authorized number of shares of common stock to 225,000,000, from 75,000,000.

12.  Income Taxes

In July 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109” (“FIN 48”).  FIN 48 contains a two step approach to recognizing and measuring uncertain income tax positions.  The first step is to evaluate the uncertain tax position for recognition. Each position is evaluated based on its technical merits and a determination is made whether it is “more likely than not” that the position would be sustained upon examination by a tax authority with full knowledge of the facts and circumstances. No benefit is recognized for a tax position that does not meet the “more likely than not” recognition threshold.  The second step is to measure the tax benefit of each position. The tax benefit is the largest amount which is more than 50% likely to be realized upon ultimate settlement.  FIN 48 is effective for fiscal years beginning after December 15, 2006. Our adoption of FIN 48 on April 1, 2007 had no impact on our beginning retained earnings balance.

We file income tax returns in the U.S. and various foreign jurisdictions.

As of April 1, 2007, we had $19.3 million in unrecognized tax benefits, of which $10.6 million would impact our tax rate if recognized.

We recognize accrued interest and penalties related to unrecognized tax benefits in our consolidated statement of operations. These items are classified as interest expense, which is included in interest and other income, net in our consolidated statement of operations. As of April 1, 2007, we had accrued $0.7 million for interest and zero for the potential payment of penalties.

As of April 1, 2007, we were subject to a U.S. Federal income tax examination for the tax years 1999 through March 31, 2005, and to a non-U.S. income tax examination for the fiscal year ended March 31, 2005. In addition, we are subject to a California income tax examination for the calendar year 2000 and a Texas franchise tax examination for the years 2001 through fiscal 2004.

During the first quarter of fiscal 2008, we received a favorable resolution to our U.S. Federal income tax examinations for the years 1999 through March 31, 2005. The resolution of these examinations resulted in the recognition of $7.2 million of unrecognized tax benefits of which $6.5 million favorably impacted the effective tax rate.

We do not anticipate any significant changes in our unrecognized tax benefits over the next twelve months.

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13.   Net Loss Per Share

Basic loss per share is computed as net loss divided by the weighted average number of shares outstanding for the period.  Diluted loss per share reflects the potential dilution that could occur from common shares issuable through stock-based compensation plans including stock options, stock-based awards and purchase opportunities under our ESPP.  The following table is a reconciliation of the weighted-average shares used in the computation of basic and diluted net loss per share for the periods presented (in thousands):

 

14.   Comprehensive Loss

The table below presents the components of our comprehensive loss for the three months ended June 30, 2007 and 2006 (in thousands):

 

The foreign currency translation adjustments relate to indefinite investments in non-U.S. subsidiaries and thus are not adjusted for income taxes.

15.   Segment and Geographic Information

We operate in one reportable segment in which we are a developer, publisher and distributor of interactive entertainment software for home video game consoles, handheld platforms and personal computers.  The following information sets forth geographic information on our net sales and total assets for the three months ended June 30, 2007 and 2006 (in thousands):

		North America			Europe			Asia Pacific			Consolidated
Three months ended June 30, 2007
Net sales to unaffiliated customers		$	66,093		$	25,406		$	12,986		$	104,485
Total assets		887,314			94,132			26,963			1,008,409
Three months ended June 30, 2006
Net sales to unaffiliated customers		$	82,846		$	46,853		$	9,130		$	138,829
Total assets		750,771			76,331			14,164			841,266

 

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Information about THQ’s net sales by platform for the three months ended June 30, 2007 and 2006 is presented below (in thousands):

 

16.   Recently Issued Accounting Pronouncements

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurement” (“FAS 157”).  FAS 157 provides a single definition of fair value, together with a framework for measuring it, and requires additional disclosure about the use of fair value to measure assets and liabilities.  FAS 157 emphasizes that fair value is a market-based measurement, not an entity-specific measurement, and sets out a fair value hierarchy with the highest priority being quoted prices in active markets.  FAS 157 is effective for fiscal years beginning after November 15, 2007, which will be our fiscal year 2009.  We are evaluating the impact, if any, the adoption of this statement will have on our results of operations, financial position or cash flows.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities — Including an Amendment of FASB Statement No. 115” (“FAS 159”). FAS 159 permits an entity to choose to measure many financial instruments and certain other items at fair value at specified election dates. Subsequent unrealized gains and losses on items for which the fair value option has been elected will be reported in earnings. FAS 159 is effective for fiscal years beginning after November 15, 2007, which will be our fiscal year 2009. We are evaluating the impact, if any, the adoption of this statement will have on our results of operations, financial position or cash flows.

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Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations               

This Quarterly Report on Form 10-Q contains, or incorporates by reference, certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements include, but are not limited to, (1) projections of revenues, expenses, income or loss, earnings or loss per share, cash flow projections and other financial items; (2) statements of our plans and objectives, including those relating to product releases; (3) statements of future economic performance; and (4) statements of assumptions underlying such statements. We generally use words such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “forecast,” “future,” “intend,” “may,” “plan,” “positioned,” “potential,” “project,” “scheduled,” “set to,” “upcoming” and other similar expressions to help identify forward-looking statements. These forward-looking statements are subject to business and economic risk, reflect management’s current expectations, estimates and projections about our business, and are inherently uncertain and difficult to predict. Our actual results could differ materially. The forward-looking statements contained herein speak only as of the date on which they were made, and we disclaim any obligation to update any forward-looking statements to reflect events or circumstances after the date of this Quarterly Report.

Our business is subject to many risks and uncertainties which may affect our future financial performance. For a discussion of our risk factors, see “Part II - Item 1A. Risk Factors.”

Overview

The following is a discussion of our operating results and the primary trends that affect our business.  Management believes that an understanding of these trends is important to understand our results for the quarter ended June 30, 2007, as well as our future prospects.  This summary is not intended to be exhaustive, nor is it intended to be a substitute for the detailed discussion and analysis provided elsewhere in this Form 10-Q, including in the remainder of “Management’s Discussion and Analysis of Financial Condition and Results of Operations” or the consolidated financial statements and related notes.  The discussion and analysis herein should be read in conjunction with the consolidated financial statements, notes to the consolidated financial statements, and management’s discussion and analysis (which includes additional information about our accounting policies, practices and the transactions that underlie our financial results) contained in our Annual Report on Form 10-K for the fiscal year ended March 31, 2007.  All references to “we,” “us,” “our,” “THQ,” or the “Company” in the following discussion and analysis mean THQ Inc. and its subsidiaries.

About THQ

We are a leading worldwide developer and publisher of interactive entertainment software for all popular game systems, including:(1)

·                  Home video game consoles such as Microsoft Xbox 360, Microsoft Xbox, Nintendo Wii, Nintendo GameCube, Sony PlayStation 3 and Sony PlayStation 2;

·                  Handheld platforms such as Nintendo Dual Screen, Nintendo Game Boy Advance, PSP portable entertainment system (“PSP system”), wireless devices; and

·                  Personal computers.

Our titles span a wide range of categories, including action, adventure, fighting, racing, role-playing, simulation, sports and strategy.  We have created, licensed and acquired a group of highly recognizable brands, which we market to a variety of consumer demographics ranging from products targeted at children and the mass market to products targeted at core gamers.  Our portfolio of licensed properties includes the Disney•Pixar properties Finding Nemo, The Incredibles, Cars and Ratatouille; World Wrestling Entertainment®; Nickelodeon properties such as SpongeBob SquarePants™, Avatar, Barnyard and Nicktoons; Bratz™; MotoGP; Warhammer® 40,000™; and the Ultimate Fighting Championship®; as well as others.  We also have licenses to create wireless games and other wireless content based on Disney•Pixar’s Ratatouille as well as Star Wars and major sports leagues.  In addition to licensed properties, we also develop games based upon owned intellectual properties, including Company of Heroes™, Destroy All Humans! ®, Juiced™, MX vs. ATV™, Red Faction, Saints Row™ and Stuntman®.

Our business is dependent upon entering into license agreements with the platform manufacturers, which allow us the right to develop, publish and distribute titles for use on such manufacturer’s platform. Our platform licenses include licenses to publish on consoles and handheld platforms manufactured by Nintendo, Sony and Microsoft.  Each license is for a fixed term, and as each license expires, we generally enter into a new agreement or an amendment with the licensor to extend the term of the agreement. Certain agreements, such as the licenses with

(1)             Nintendo®, Dual Screen, Game Boy® Advance, GameCube® and Wii are trademarks and/or registered trademarks of Nintendo of America Inc. (“Nintendo”).  “PSP” is a trademark and "PlayStation" and the "PS" Family logo are registered trademarks of Sony Computer Entertainment Inc. (“Sony”).  Microsoft, Xbox®,  Xbox 360™ and the Xbox logos are either registered trademarks or trademarks of Microsoft Corporation (“Microsoft”) in the U.S. and/or in other countries and are used under license from Microsoft.  Microsoft, Nintendo and Sony are referred to herein collectively as the “platform manufacturers” or the “manufacturers.”

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Sony and Microsoft for PlayStation 2 and Xbox 360, respectively, automatically renew each year unless either party gives notice by the applicable date that it intends to terminate the agreement. Additionally, each agreement designates a territory in which we can publish and distribute titles.  We are currently licensed or are in negotiations to license rights to publish and distribute titles on all platforms that are currently sold in the United States and Canada.  Our key platform licenses also allow us to publish and distribute titles in Europe, Australia, New Zealand and Japan. We are also licensed to publish and distribute titles for GameCube, PlayStation 2, Xbox and Xbox 360 in various additional territories, including parts of Asia and Central and South America. We expect to enter into additional platform licenses and extend current licenses as new platforms are launched or our current agreements expire.

We develop our products using both internal and external development resources.  The internal resources consist of producers, game designers, software engineers, artists, animators and game testers located within our 16 internal development studios and corporate headquarters.  The external development resources consist of third-party software developers and other independent resources such as artists.  We refer to this group of development resources as our Studio System.

Our global sales network includes offices throughout North America, Europe and Asia Pacific.  In the U.S. and Canada, we market and distribute games directly to mass merchandisers, consumer electronic stores, discount warehouses and other national retail chain stores.  Internationally, we market and distribute games on a direct-to-retail basis in the territories where we have a direct sales force and to a lesser extent, in the territories where we do not have a direct sales force, third parties distribute our games.  We also globally market and distribute games and other content for wireless devices through major wireless carriers.

Overview of Financial Results for the Three Months Ended June 30, 2007

Our net loss for the three months ended June 30, 2007 was $9.3 million, or $0.14 per diluted share, compared to a net loss of $12.1 million, or $0.19 per diluted share, for the three months ended June 30, 2006.  Our net loss for the three months ended June 30, 2007 includes: i) $6.0 million ($3.1 million, net of taxes), or $0.05 per diluted share, net of taxes, of stock-based compensation expense and ii) $6.5 million or $0.10 per diluted share of previously unrecognized tax benefits related to prior years.  Our net loss for the three months ended June 30, 2006 includes $3.1 million ($1.6 million, net of taxes), or $0.03 per diluted share after tax, of stock-based compensation expense.

Our profitability is dependent upon revenues from the sales of our video game software.  Profitability is also affected by the costs and expenses associated with developing and publishing our games.  Net sales in the three months ended June 30, 2007 decreased 25% from the same period last fiscal year, to $104.5 million from $138.8 million.  The decline in our net sales was primarily due to launching only one new title in the current quarter, Ratatouille, which was released at the end of the quarter in North America, compared to the same period last fiscal year that had five new releases, including Cars, which released earlier in that quarter in North America.

Costs and expenses decreased by 14% in the three months ended June 30, 2007, to $137.4 million from $159.8 million in the three months ended June 30, 2006.  The decrease in costs and expenses in the three months ended June 30, 2007 was primarily due to the decrease in software amortization and royalties related to our decrease in net sales.

Cash used in operations was $34.3 million during the three months ended June 30, 2007, as compared to cash used in operations of $55.4 million in the three months ended June 30, 2006.  The decrease in cash used in operations was primarily a result of a decrease in accounts receivable partially offset by an increase in software development spending.

Our business is highly seasonal, with the highest levels of consumer demand and a significant percentage of our net sales occurring in the December quarter.

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Our Strategy

In order to increase our revenues and expand market share, we believe it is important to offer a broad portfolio of titles for all ages that are playable on all popular platforms.  We are also focused on increasing the profitability of our business.  We intend to do this by executing on the following strategies:

·      increase sales and profits from our leading portfolio of mass-market franchises,

·      sequel and extend our growing portfolio of owned intellectual property,

·      pursue growing trends of digital content creation and distribution, and

·      expand our international business.

Additional information on our strategy as well as prospective business trends is included in our Annual Report on Form 10-K for the fiscal year ended March 31, 2007.

In fiscal 2008, we expect to increase the revenue and profitability of our business from our revenue and profit achieved in fiscal 2007.  During the three months ended June 30, 2007, we successfully launched Ratatouille on nine separate platforms, including new generation consoles Microsoft Xbox 360 and Nintendo Wii.  We also entered into an agreement with leading Chinese game operator Shanda Interactive Entertainment Ltd. to bring our award winning PC title, Company of Heroes™ to the online market in mainland China in calendar 2008.  This agreement supports both our international expansion and digital content and distribution strategies.

We continue to increase our internal development capabilities and acquire and create intellectual property.  At June 30, 2007, we had 16 studios, which are staffed by producers, game designers, software engineers, artists, animators and game testers.  Our worldwide product development operations have grown and now include more than 1,600 people across our internal Studio System.  We plan to continue expanding our internal development capabilities by selectively acquiring and establishing development studios and through internal growth of our existing studios.  We are dedicating significant internal development resources to developing software tools and technologies for new generation platforms, and we expect to release games throughout the growth of the installed base of those platforms.

In order to expand our international business, we continue to focus on releasing content with international appeal (e.g., Disney•Pixar, WWE, Juiced, and MotoGP) and on expanding our direct sales force.  Additionally, we are looking to expand our direct sales force into Eastern Europe, and we continue to explore opportunities in Asia, especially China.

We are re-aligning our wireless product portfolio to emphasize more casual game content to position ourselves for wireless platform share gains in the future.  We continue to grow new revenue streams as they continue to develop (e.g., in-game advertising and downloadable content/micro-transactions) and will become more significant to our business over time.

Critical Accounting Estimates

There have been no material changes to our critical accounting estimates as described in Item 7 to our Annual Report on Form 10-K for the fiscal year ended March 31, 2007, under the caption “Critical Accounting Estimates,” except for our adoption of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109” (“FIN 48”).

FIN 48 contains a two step approach to recognizing and measuring uncertain income tax positions.  The first step is to evaluate the uncertain tax position for recognition. Each position is evaluated based on its technical merits and a determination is made whether it is “more likely than not” that the position would be sustained upon examination by a tax authority with full knowledge of the facts and circumstances. No benefit is recognized for a tax position that does not meet the “more likely than not” recognition threshold.  The second step is to measure the tax benefit of each position. The tax benefit is the largest amount which is more than 50% likely to be realized upon ultimate settlement.  See “Note 12 — Income Taxes” in the notes to the consolidated financial statements for further information regarding our adoption of FIN 48.

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Results of Operations - Comparison of the Three Months Ended June 30, 2007 and 2006

Net Sales

We derive revenue principally from sales of packaged interactive software games designed for play on video game consoles, handheld devices and personal computers.  We also derive revenue through downloads by mobile phone users of our wireless content.

The following table details our net sales by territory for the three months ended June 30, 2007 and 2006 (in thousands):

		Three Months Ended June 30,										Increase/			%
		2007					2006					(Decrease)			Change
North America		$	66,093		63.3	%	$	82,846		59.7	%	$	(16,753	)	(20.2	)%
Europe		25,406			24.3	%	46,853			33.7	%	(21,447		)	(45.8	)%
Asia Pacific		12,986			12.4	%	9,130			6.6	%	3,856			42.2	%
International		38,392			36.7	%	55,983			40.3	%	(17,591		)	(31.4	)%
Consolidated net sales		$	104,485		100.0	%	$	138,829		100.0	%	$	(34,344	)	(24.7	)%

 

North America net sales in the three months ended June 30, 2007 were primarily driven by the current quarter release of Ratatouille, catalog sales of the June 30, 2006 quarter release of Cars and the December 31, 2006 quarter release of WWE SmackDown vs. Raw 2007.

International net sales in the three months ended June 30, 2007 were primarily driven by strong sales of our catalog titles, led by Cars from the Disney•Pixar franchise, WWE SmackDown vs. Raw 2007 and Nicktoons: Battle for Volcano Island.

The decline in our net sales was primarily due to launching only one new title in the current quarter, Ratatouille, which was released at the end of the quarter in North America, compared to the same period last fiscal year that had five new releases, including Cars, which released earlier in that quarter in North America.

We expect net sales in North America to continue to constitute the largest portion of our consolidated net sales in fiscal 2008.  We expect to grow our international sales mix in fiscal 2008, as we expand our product portfolio and direct sales forces.

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