UNITED STATES
 SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

 

 

FORM 10-Q

 

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the quarterly period ended June 30, 2006
	OR
o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from             to            

 

Commission file number 0-18813

 

 

THQ INC.

(Exact Name of Registrant as Specified in Its Charter)

 

Delaware	13-3541686
(State or Other Jurisdiction of Incorporation or Organization)	(I.R.S. Employer Identification No.)
29903 Agoura Road Agoura Hills, CA	91301
(Address of principal executive offices)	(Zip Code)

 

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 4, 2006, there were 64,318,963 shares of common stock outstanding.

 

 

THQ INC. AND SUBSIDIARIES
INDEX

				Page
Part I — Financial Information
Item 1.		Consolidated Financial Statements (Unaudited):
		Consolidated Balance Sheets — June 30, 2006 and March 31, 2006
		Consolidated Statements of Operations — for the Three Months Ended June 30, 2006 and 2005
		Consolidated Statements of Cash Flows — for the Three Months Ended June 30, 2006 and 2005
		Notes to 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

 

2

 

Part I — Financial Information

Item 1.  Consolidated Financial Statements

THQ INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)

 

		June 30, 2006			March 31, 2006
		(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents		$	97,658		$	91,517
Short-term investments		205,650			280,120
Cash, cash equivalents and short-term investments		303,308			371,637
Accounts receivable, net of allowances		84,983			78,876
Inventory		38,355			28,620
Licenses		23,452			20,849
Software development		112,747			91,843
Income taxes receivable		14,186			6,832
Prepaid expenses and other current assets		19,029			12,420
Total current assets		596,060			611,077
Property and equipment, net		37,558			37,485
Licenses, net of current portion		56,462			60,623
Software development, net of current portion		20,683			17,236
Income taxes receivable, net of current portion		10,273			10,273
Goodwill		93,680			90,872
Other long-term assets, net		26,550			23,048
TOTAL ASSETS		$	841,266		$	850,614
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	38,033		$	34,871
Accrued and other current liabilities		105,260			109,421
Deferred income taxes		1,973			3,578
Total current liabilities		145,266			147,870
Other long-term liabilities		60,980			60,323
Deferred income taxes, net of current portion		10,272			10,272
Commitments and contingencies		—			—
Minority interest		1,305			1,340
Stockholders’ equity:
Preferred stock, par value $0.01, 1,000,000 shares authorized		—			—
Common stock, par value $0.01, 75,000,000 shares authorized; 64,182,951 and 64,140,977 shares issued and outstanding as of June 30, 2006 and March 31, 2006, respectively		642			642
Additional paid-in capital		401,820			397,693
Accumulated other comprehensive income		10,975			10,367
Retained earnings		210,006			222,107
Total stockholders’ equity		623,443			630,809
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY		$	841,266		$	850,614

 

See notes to consolidated financial statements.

3

 

THQ INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)

 

		For the Three Months Ended June 30,
		2006			2005
		(Unaudited)
Net sales		$	138,829		$	157,967
Cost and expenses:
Cost of sales		48,991			55,526
License amortization and royalties		16,313			13,724
Software development amortization		25,291			23,345
Product development		26,236			21,120
Selling and marketing		26,711			35,959
Payment to venture partner		709			1,912
General and administrative		15,526			14,185
Total costs and expenses		159,777			165,771
Loss from operations		(20,948		)	(7,804		)
Interest and other income, net		2,740			2,148
Loss before income taxes and minority interest		(18,208		)	(5,656		)
Income taxes		(6,009		)	(1,753		)
Loss before minority interest		(12,199		)	(3,903		)
Minority interest		98			(57		)
Net loss		$	(12,101	)	$	(3,960	)
Net loss per share — basic		$	(0.19	)	$	(0.06	)
Net loss per share — diluted		$	(0.19	)	$	(0.06	)
Shares used in per share calculation — basic		64,317			60,929
Shares used in per share calculation — diluted		64,317			60,929

 

See notes to consolidated financial statements.

4

 

THQ INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)

 

		For the Three Months Ended June 30,
		2006			2005
		(Unaudited)
OPERATING ACTIVITIES:
Net loss		$	(12,101	)	$	(3,960	)
Adjustments to reconcile net loss to net cash used in operating activities:
Minority interest and other		93			57
Depreciation and amortization		3,591			3,268
Amortization of licenses and software development		27,179			23,400
Loss on disposal of property and equipment		491			9
Equity-based compensation		3,007			326
Tax benefit related to equity-based awards		1,747			1,925
Excess tax benefit related to equity-based awards		(925		)	—
Deferred income taxes		19			1,090
Changes in operating assets and liabilities:
Accounts receivable, net of allowances		(4,566		)	(13,884		)
Inventory		(9,356		)	(3,582		)
Licenses		(831		)	(2,871		)
Software development		(44,788		)	(28,499		)
Prepaid expenses and other current assets		(6,386		)	4,174
Accounts payable		2,422			5,297
Accrued and other liabilities		(7,924		)	763
Income taxes		(7,024		)	(5,857		)
Net cash used in operating activities		(55,352		)	(18,344		)
INVESTING ACTIVITIES:
Proceeds from sales and maturities of short-term investments		189,680			79,900
Purchase of short-term investments		(115,210		)	(84,456		)
Other long-term assets		(6,308		)	(459		)
Acquisitions, net of cash acquired		(1,400		)	(2,000		)
Purchases of property and equipment		(3,253		)	(6,871		)
Net cash provided by (used in) investing activities		63,509			(13,886		)
FINANCING ACTIVITIES:
Stock repurchase		(10,061		)	—
Proceeds from exercise of stock options		8,784			9,353
Excess tax benefit related to equity-based awards		925			—
Net cash provided by (used in) financing activities		(352		)	9,353
Effect of exchange rate changes on cash		(1,664		)	35
Net increase (decrease) in cash and cash equivalents		6,141			(22,842		)
Cash and cash equivalents — beginning of period		91,517			98,175
Cash and cash equivalents — end of period		$	97,658		$	75,333
Non-cash investing activities:
Additional consideration accrued for ValuSoft acquisition		$	1,800		$	2,800

 

See notes to consolidated financial statements.

5

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

1.   Basis of Presentation

The 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 consolidated balance sheets and related interim consolidated statements of operations and 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.  Examples include price protection, returns and doubtful accounts.  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, 2006 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 Management’s Discussion and Analysis and financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended March 31, 2006.

Reclassifications.

Certain reclassifications have been made to the prior periods consolidated financial statements to conform to current period consolidated financial statements.

In the fourth quarter of fiscal 2006, we reclassified warehousing expenses from selling and marketing to cost of sales.  Classification of these expenses as a component of cost of sales is a practice that is consistent with others within our industry.  The reclassified warehousing expenses for the three months ended June 30, 2005 were $1.2 million.

In the first quarter of fiscal 2007, we reclassified certain depreciation and amortization expenses from general and administrative expenses to selling and marketing expenses and to product development expenses.  Depreciation and amortization expenses are now classified in our consolidated statement of operations based upon the assets’ underlying function.  The reclassified depreciation and amortization expenses for the three months ended June 30, 2005 was $0.2 million to selling and marketing expenses and $2.1 million to product development expenses.

Fiscal Year and Fiscal Quarter.

Effective April 1, 2006, our fiscal year will be reported on a 52/53-week period.  Beginning with the current fiscal year ending March 31, 2007, we will end our fiscal year on the Saturday nearest March 31.  The results of operations for the three months ended June 30, 2006 and 2005 contain the following number of weeks:

Fiscal Period		Number of Weeks		Fiscal Period End Date
Three months ended June 30, 2006		13 weeks		July 1, 2006
Three months ended June 30, 2005		13 weeks		June 30, 2005

 

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

6

---

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

(In thousands)		June 30,  2006			March 31, 2006
Cash and cash equivalents		$	97,658		$	91,517
Short-term investments:
Available-for-sale securities:
Corporate notes and bonds		19,000			19,000
Municipal securities		186,650			261,120
Total short-term investments		205,650			280,120
Cash, cash equivalents and short-term investments		$	303,308		$	371,637

 

We had $205.7 million and $280.1 million of investments in auction rate securities as of June 30, 2006 and March 31, 2006, respectively.

During the three months ended June 30, 2006 and June 30, 2005 there were no realized gains or (losses) from sales of available-for-sale securities and there were no unrealized gains or (losses) from available-for-sale securities except for 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”).

In the fourth quarter of fiscal 2006 we changed the presentation of our proceeds from sales and maturities of short-term investments and purchases of short-term investments in our consolidated statements of cash flows.  The statements of cash flows presented in these financial statements present the gross amount of these transactions during each of the three months ended June 30, 2006, and 2005.  The previously reported statement of cash flows for the three months ended June 30, 2005 presented these activities at a net transactional level.  As a result, the amounts reported in these financial statements for our proceeds from sales and maturities of short-term investments and purchases of short-term investments are higher than previously reported.  The change in presentation does not impact the net proceeds from sales and maturities of short-term investments and purchases of short-term investments, our cash flow from investing activities or our overall change in cash and cash equivalents.

Financial Instruments.  As of June 30, 2006 and March 31, 2006, we had foreign exchange forward contracts in the notional amount of $70.4 million and $60.3 million, respectively.  The net loss recognized from foreign currency contracts during the three months ended June 30, 2006 was $1.9 million and the net gain recognized from foreign currency contracts during the three months ended June 30, 2005 was $1.2 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 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) 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 sales during the subsequent year and long-term assets and long-term liabilities if such royalty payments relate to anticipated 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 license amortization and royalties, capitalized license costs when we believe such amounts are not recoverable.

Licenses are expensed to 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 license amortization and royalties.  If actual revenues or revised forecasted revenues fall

7

---

below the initial forecasted revenue for a particular license, the charge to license amortization and royalties expense may be larger than anticipated in any given quarter.  As of June 30, 2006, the net carrying value of our licenses was $79.9 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 software development amortization.  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 software development amortization 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 software development amortization may be larger than anticipated in any given quarter.  As of June 30, 2006, the net carrying value of our software development was $133.4 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 software development amortization as earned.

5.   Goodwill

In accordance with our accounting policy, we performed an annual review of goodwill for impairment during the quarter ended June 30, 2006, and found no impairment.  We will perform a similar review in future quarters ended June 30, or more frequently if indicators of potential impairment exist. Our impairment review process is based on a discounted future cash flow approach that uses our estimates of revenue for the reporting units, driven by assumed success of our products and product release schedules, and estimated costs as well as appropriate discount rates.  These estimates are consistent with the plans and estimates that we use to manage the underlying businesses.

The changes in the carrying amount of goodwill for the three months ended June 30, 2006 are as follows (in thousands):

Balance at March 31, 2006		$	90,872
Additional consideration accrued for ValuSoft acquisition		1,800
Effect of foreign currency translation		1,008
Balance at June 30, 2006		$	93,680

 

8

---

6.   Other Intangible Assets

Other intangible assets are included in other long-term assets, net, and are as follows (in thousands):

 

		June 30, 2006											March 31, 2006
		Useful Lives		Gross Carrying Amount			Accumulated Amortization			Net Amount			Gross Carrying Amount			Accumulated Amortization			Net Amount
Software technology		2-3 years		$	3,181		$	(2,432	)	$	749		$	3,055		$	(2,085	)	$	970
Trade secrets		5 years		1,800			(1,620		)	180			1,800			(1,530		)	270
Customer list		4-5 years		1,474			(655		)	819			1,414			(550		)	864
Trade names		3-10 years		3,289			(906		)	2,383			3,196			(739		)	2,457
Non-compete / Employment contracts		3-7 years		1,069			(726		)	343			1,055			(656		)	399
Total				$	10,813		$	(6,339	)	$	4,474		$	10,520		$	(5,560	)	$	4,960

 

Amortization of other intangible assets was $638,000 and $651,000 for the three months ended June 30, 2006 and 2005, 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 assessed for impairment under SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”

As of June 30, 2006, future amortization of other finite-lived intangible assets was estimated as follows (in thousands):

 

Fiscal Year Ending March 31,
Remainder of 2007		$	1,545
2008		1,007
2009		584
2010		242
2011		242
Thereafter		854
		$	4,474

 

7.   Other Long-Term Assets

In addition to other intangible assets, other long-term assets include our investment in Yuke’s.  For the three months ended June 30, 2006, the unrealized holding loss related to our investment in Yuke’s was $2.3 million.  For the three months ended June 30, 2005, the unrealized holding gain related to our investment in Yuke’s was $2.8 million.

Other long-term assets as of June 30, 2006 and March 31, 2006 are as follows (in thousands):

		June 30, 2006			March 31, 2006
Investment in Yuke’s		$	6,945		$	9,217
Other intangible assets (see Note 6)		4,474			4,960
Other		15,131			8,871
Total other long-term assets		$	26,550		$	23,048

 

8.   Balance Sheet Details

Inventory.  Inventory at June 30, 2006 and March 31, 2006 consists of the following (in thousands):

		June 30,			March 31,
		2006			2006
Components		$	5,447		$	1,530
Finished goods		32,908			27,090
Inventory		$	38,355		$	28,620

 

 

9

Property and Equipment, net.  Property and equipment at June 30, 2006 and March 31, 2006 consists of the following (in thousands):

		Useful		June 30,			March 31,
		Lives		2006			2006
Building		30 yrs		$	719		$	719
Land		—		401			401
Computer equipment and software		3-10 yrs		46,326			44,776
Furniture, fixtures and equipment		5 yrs		7,880			7,324
Leasehold improvements		3-6 yrs		8,383			7,847
Automobiles		2-5 yrs		133			128
				63,842			61,195
Less: accumulated depreciation				(26,284		)	(23,710		)
				$	37,558		$	37,485

 

Depreciation expense associated with property and equipment amounted to $3.0 million and $2.7 million for the three months ended June 30, 2006 and 2005, respectively.

Accrued and Other Current Liabilities.  Accrued and other current liabilities at June 30, 2006 and March 31, 2006 consist of the following (in thousands):

 

		June 30,			March 31,
		2006			2006
Accrued liabilities		$	37,606		$	34,194
Accrued compensation		22,507			21,864
Accrued payment to venture partner		691			1,419
Accrued royalties		44,456			51,944
Accrued and other current liabilities		$	105,260		$	109,421

 

Other Long-Term Liabilities.  Other long-term liabilities at June 30, 2006 and March 31, 2006 consist of the following (in thousands):

		June 30,			March 31,
		2006			2006
Accrued royalties		$	58,000		$	58,025
Accrued liabilities		2,980			2,298
Other long-term liabilities		$	60,980		$	60,323

 

9.   Commitments and Contingencies

A summary of annual minimum contractual obligations and commercial commitments as of June 30, 2006 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 2007		$85,209		$17,809		$9,785		$3,220		$116,023
2008		45,392		14,616		12,511		—		72,519
2009		39,613		14,268		11,992		—		65,873
2010		37,000		13,028		11,597		—		61,625
2011		22,000		7,332		10,965		—		40,297
Thereafter		—		—		32,084		—		32,084
		$229,214		$67,053		$88,934		$3,220		$388,421

 

10

---

(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, 2006 are approximately $229.2 million.

License/software development commitments in the table above include $70.1 million of commitments to licensors that are included in our consolidated balance sheet as of June 30, 2006 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, 2006, we were in compliance with all the covenants under our credit facility, had outstanding letters of credit of approximately $3.2 million and no borrowings.

Operating Agreement with JAKKS Pacific, Inc.  Under our operating agreement with JAKKS Pacific, Inc. (“JAKKS”), the preferred payment to be paid to JAKKS related to our sales of WWE-licensed products (the “Preferred Return”) for the period from July 1, 2006 through December 31, 2009 (the “Second Distribution Period”) is subject to renegotiation between the parties.  In the event the parties are not able to agree upon the Preferred Return for the Second Distribution Period, the operating agreement provides for the matter to be submitted to binding arbitration.  The parties are currently in negotiations regarding the Preferred Return to JAKKS for the Second Distribution Period, but have not yet reached agreement.  We are currently in the process of scheduling arbitration to resolve this matter.

SEC Informal Inquiry.  On August 4, 2006, we received a letter of informal inquiry from the Securities and Exchange Commission requesting certain documents and information relating to our stock option grant practices from January 1, 1996 to the present.  We intend to cooperate fully with all matters related to this request.  Our audit committee, which is comprised of independent directors of the board, intends to retain independent counsel to continue our internal review and oversee our response to the Securities and Exchange Commission.

With respect to other future potential expenditures, there have been no material changes outside the normal course of business to the potential expenditures disclosed in Item 8 to our Annual Report on Form 10-K for the fiscal year ended March 31, 2006, under “Note 17 — Commitments and Contingencies,” as of the date hereof.

We are involved in routine litigation arising in the ordinary course of our business.  In the opinion of our management, none of such pending litigation, other than potentially the litigation previously disclosed in our Annual Report on Form 10-K for the fiscal year ended March 31, 2006, under “Note 17 — Commitments and Contingencies,” will have a material adverse effect on our consolidated financial condition or results of operations.

10.   Equity-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.  As of June 30, 2006, we had 1,376,472 shares under the 1997 Plan available for grant and 245,031 shares under the NEEP Plan available for grant.  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

11

---

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.

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 the 1997 Plan and the NEEP Plan 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 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.  To date, no vesting of PARS or PARSUs has been accelerated.  PARSUs granted to our non-employee directors vest one year after their grant date.  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 and PARSUs granted is amortized over the period(s) in which the related services are rendered.

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

Prior to April 1, 2006, we accounted for our equity-based compensation using the intrinsic value method in accordance with Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and the disclosure-only provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended (“FAS 123”).  Generally no expense related to stock options was recognized in the statement of operations for the years ended March 31, 2006 and prior, as those stock options had exercise prices that were equal to the market value of the underlying common stock on the date of grant.  Effective April 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123(R), “Share-Based Payment,” (“FAS 123R”) using the modified prospective transition method.  Under that transition method, results for prior periods have not been restated.

The compensation expense related to equity-based compensation was $3.1 million and $326,000 for the three months ended June 30, 2006 and 2005, respectively.  The total income tax benefit recognized in the statement of operations for equity-based compensation was $1.5 million and $125,000 for the three months ended June 30, 2006 and 2005, respectively.  Equity-based compensation cost capitalized during the three months ended June 30, 2006 and 2005, was $650,000 and zero, respectively, and is included in software development in the consolidated balance sheet.

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

		Three Months Ended June 30,
		2006			2005
Product development		$	795		$	36
Selling and marketing		393			23
General and administrative		1,908			267
Total equity-based compensation		$	3,096		$	326

 

FAS 123R requires that equity-based compensation expense be based on awards that are ultimately expected to vest and accordingly, equity-based compensation recognized in the three months ended June 30, 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.

Prior to the adoption of FAS 123R, we presented all tax benefits of deductions resulting from our equity-based awards as operating cash flows in the statement of cash flows.  FAS 123R requires the cash flows resulting from the tax benefits arising out of tax deductions in excess of the compensation recognized for the equity-based awards (“excess tax benefits”) to be classified as financing cash flows.  Prior to our adoption of FAS 123R on April 1, 2006, the $925,000 excess tax benefit classified as a financing cash inflow in the three months ended June 30, 2006 would have been classified as an operating cash inflow.

The fair value of each stock option granted during the three months ended June 30, 2006 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

12

---

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 contractual life of the option is based on the US Treasury yield in effect at the time of grant.

		Three Months Ended June 30, 2006
Dividend yield		0	%
Anticipated volatility		36	%
Weighted-average risk-free interest rate		4.9	%
Expected lives		3.5 years

 

A summary of our stock option activity as of June 30, 2006, and changes during the three months then ended 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, 2006		9,075		$	16.00
Granted		891		25.40
Exercised		(579	)	14.95
Forfeited/expired/cancelled		(362	)	17.59
Outstanding at June 30, 2006		9,025		$	16.93		3.1		$	47,202
Exercisable at June 30, 2006		3,711		$	14.51		2.0		$	26,471

 

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, 2006.  It excludes stock options that have exercise prices in excess of the quoted price of our common stock at June 30, 2006.  The weighted-average grant-date fair value of stock options granted during the three months ended June 30, 2006 and 2005 was $8.38 and $8.58, respectively.  The total intrinsic value of stock options exercised during the three months ended June 30, 2006 and 2005 was $5.4 million and $5.6 million, respectively.

A summary of the status of our nonvested shares as of June 30, 2006 and changes during the three months then ended, is as follows (in thousands, except per share amounts):

				Weighted-
				Average
				Grant-date
		Shares		Fair Value
Nonvested shares at April 1, 2006		259		$	19.63
Granted		128		25.96
Vested		—		—
Forefeited/cancelled		(33	)	20.44
Nonvested shares at June 30, 2006		354		$	21.84

 

The weighted-average grant-date fair value of nonvested shares granted in the three months ended June 30, 2006 and 2005 was $25.96 and $18.57, respectively.

The fair value of our equity-based awards that vested in the three months ended June 30, 2006 and 2005 is $5.6 million and $3.8 million, respectively.

 

13

The unrecognized compensation cost, that we expect to vest, related to our nonvested equity-based awards at June 30, 2006, and the weighted-average period over which we expect to recognize that compensation, is as follows (in thousands):

 

		Unrecognized Compensation Cost at June 30, 2006			Weighted- Average Period (in years)
Stock options		$	22,407		2.0
Nonvested shares		5,122			4.3
		$	27,529

 

Cash received from exercises of stock options for the three months ended June 30, 2006 and 2005 was $8.8 million and $9.4 million, respectively.  The actual tax benefit realized for the tax deductions from all equity-based awards totaled $1.7 million and $1.9 million for the three months ended June 30, 2006 and 2005, respectively.

Proforma information for periods prior to the adoption of FAS 123R

Prior to the adoption of FAS 123R, we accounted for our equity-based compensation to employees using the intrinsic value method in accordance with APB 25 and the disclosure-only provisions of FAS 123.  Employee equity-based compensation expense recognized under FAS 123R was not reflected in our results of operations for the three months ended June 30, 2005.  Forfeitures of our equity-based awards were reflected in our disclosures as they occurred.  Previously reported amounts have not been restated.

The fair value of each option grant was estimated on the date of grant using the Black-Scholes option-pricing model. The following weighted-average assumptions were used for option grants made under our stock option plans during the three months ended June 30, 2005:

 

		Three Months Ended June 30, 2005
Dividend yield		0	%
Anticipated volatility		55	%
Weighted-average risk-free interest rate		3.73	%
Expected lives		4 years

 

The following table shows what our net loss and loss per share would have been for the three months ended June 30, 2005, had compensation cost for our equity-based compensation been measured based on the estimated fair value at the grant dates in accordance with the provisions of FAS 123 (in thousands, except per share amounts): 

		Three Months  Ended June 30, 2005
Net loss — as reported		$	(3,960	)
Add: Stock-based employee compensation expense included in reported net income (loss), net of related tax effects		225
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(2,936		)
Net loss — pro forma		$	(6,671	)
Loss per share:
Basic — as reported		$	(0.06	)
Basic — pro forma		$	(0.11	)
Diluted — as reported		$	(0.06	)
Diluted — pro forma		$	(0.11	)

 

14

---

11.   Capital Stock Transactions

On August 9, 2005, we announced that our Board of Directors (“Board”) declared a three-for-two stock split of our shares of common stock to be effected in the form of a 50% stock dividend (the “Dividend”).  The Dividend was distributed on September 1, 2005 to stockholders of record as of the close of business on August 19, 2005. Cash was paid in lieu of issuance of fractional shares.  The par value of our common stock was maintained at the pre-split amount of $0.01.  All references in the accompanying consolidated financial statements to number of shares, sales price and per share amounts of our common stock have been retroactively restated to reflect the increased number of shares of common stock outstanding as of the earliest period presented. In addition, stockholders’ equity has been restated to give retroactive recognition to the Dividend by reclassifying from paid-in capital to common stock the par value of the additional shares of common stock issued pursuant to the Dividend.  The Dividend did not dilute rights to stockholders under the Amended and Restated Rights Agreement between THQ and Computershare Investor Services, LLC, as Rights Agent, dated as of August 22, 2001, as amended by the First Amendment to the Amended and Restated Rights Agreement, dated as of April 9, 2002.

On September 10, 2002, November 21, 2002, and February 5, 2004, 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 with a total authorized repurchase amount of $75.0 million.  At March 31, 2006 there was $22.1 million available for future repurchases.  During the three months ended June 30, 2006, we repurchased $10.1 million of our common stock.  As of June 30, 2006, we have repurchased 3,949,000 shares of our common stock for approximately $63.0 million, leaving $12.0 million available for future repurchases.  There is no expiration date for the authorized repurchases.

12.   Net Loss Per Share

The following table is a reconciliation of the weighted-average shares used in the computation of basic and diluted loss per share for the periods presented (in thousands):

		For the Three Months Ended June 30,
		2006			2005
Net loss used to compute basic and diluted earnings per share		$	(12,101	)	$	(3,960	)
Weighted-average number of shares outstanding — basic		64,317			60,929
Dilutive effect of stock options and warrants		—			—
Number of shares used to compute loss per share — diluted		64,317			60,929

 

13.   Comprehensive Loss

The table below presents the components of our comprehensive loss for the three months ended June 30, 2006 and 2005 (in thousands):

		For the Three Months Ended June 30,
		2006			2005
Net loss		$	(12,101	)	$	(3,960	)
Other comprehensive loss:
Foreign currency translation adjustment		2,027			(1,363		)
Unrealized gain (loss) on investments, net of tax of $853 and $861, respectively		(1,419		)	1,913
Other comprehensive loss		608			550
Comprehensive loss		$	(11,493	)	$	(3,410	)

 

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

 

15

14.   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 sales and total assets for the three months ended June 30, 2006 and 2005 (in thousands):

 

		North America			Europe			Asia Pacific			Consolidated
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
Three months ended June 30, 2005
Net sales to unaffiliated customers		$	86,236		$	62,144		$	9,587		$	157,967
Total assets		674,501			76,315			12,689			763,505

 

Information about THQ’s net sales by platform for the three months ended June 30, 2006 and 2005 is presented below (in thousands):

		Three Months Ended June 30,
Platform		2006			2005
Consoles
Sony PlayStation 2		$	35,640		$	60,314
Microsoft Xbox		8,067			43,036
Microsoft Xbox 360		11,949			—
Nintendo GameCube		11,699			3,355
		67,355			106,705
Handheld
Nintendo Game Boy Advance		20,535			26,664
Nintendo Dual Screen		12,747			63
Sony PlayStation Portable		11,031			—
Wireless		7,635			10,261
		51,948			36,988
PC		19,170			14,107
Other		356			167
Total Net Sales		$	138,829		$	157,967

 

16

---

15.   Recently Issued Accounting Pronouncements

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments” (“FAS 155”), an amendment of SFAS No. 133 and SFAS No. 140, allowing companies to elect fair value measurement for instruments in their entirety in cases otherwise requiring a derivative to be bifurcated.  FAS 155 is effective for all financial instruments acquired or issued in fiscal years beginning after September 15, 2006, which will be our fiscal year 2008.  We do not expect the adoption of this statement to have material impact on our results of operations, financial position or cash flows.

In March 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets” (“FAS 156”), an amendment of SFAS No. 140, amending various accounting guidance for servicing assets and liabilities.  FAS 156 is effective for fiscal years beginning after September 15, 2006, which will be our fiscal year 2008.  We do not anticipate a significant impact on our results of operations, financial position or cash flows from the adoption of this statement.

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 tax positions accounted for in accordance with SFAS No. 109.  The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount which is more than 50% likely of being realized upon ultimate settlement.  This provision is effective for fiscal years beginning after December 15, 2006, which will be our fiscal year 2008.  We are evaluating the impact, if any, this statement will have on our results of operations, financial position or cash flows.

 

17