THQ 10-K 2007
Documents found in this filing:
WASHINGTON, D.C. 20549
x ANNUAL REPORT PURSUANT TO SECTION 13
o TRANSITION REPORT PURSUANT TO SECTION 13
For the transition period from _____ to _____
Commission file number 0-18813
(Exact Name of Registrant as Specified in Its Charter)
Registrants telephone number, including area code: (818) 871-5000
Securities registered pursuant to Section 12(g) of the Act: None.
Securities registered pursuant to Section 12(b) of the Act:
Common Stock, $.01 par value
Preferred Stock Purchase Rights
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No þ
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No þ
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 þ No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. 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):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b 2 of the Act). Yes o No þ
The aggregate market value of the voting stock held by non-affiliates of the registrant as of the last business day of the registrants second fiscal quarter, September 30, 2005 was approximately $1.3 billion (based on the closing sales price of the registrants common stock on September 30, 2005). The number of shares outstanding of the registrants common stock as of January 12, 2007 was approximately 65,462,878.
DOCUMENTS INCORPORATED BY REFERENCE
The 2006 Notice of Annual Meeting of Stockholders and Proxy Statement are incorporated by reference into Part III herein.
FILED WITH THE SECURITIES AND EXCHANGE COMMISSION
FOR THE FISCAL YEAR ENDED MARCH 31, 2006
ITEMS IN FORM 10-K/A
This Annual Report on Form 10-K/A 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, subject to, upcoming and other similar expressions to help identify forward-looking statements. These forward-looking statements are subject to business and economic risk, reflect managements 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 >Annual Report. Risks and uncertainties that may affect our future results include, but are not limited to, those discussed under the heading Risk Factors, included in Item 1A herein. All references to we, us, our, THQ, or the Company in the following discussion and analysis mean THQ Inc. and its subsidiaries.
We are amending our annual report on Form 10-K for the fiscal year ended March 31, 2006, as filed on June 7, 2006 (the Original Filing), to reflect the restatement of our consolidated financial statements and the related disclosures resulting from the previously disclosed investigation of historical stock option grant practices. In this amended annual report on Form 10-K/A for the year ended March 31, 2006 (2006 Form 10-K/A), we are restating our consolidated balance sheets as of March 31, 2006 and 2005, and the related consolidated statements of operations, stockholders equity, and cash flows for each of the fiscal years ended March 31, 2006, 2005, and 2004, and each of the quarters in fiscal years 2006 and 2005. The 2006 Form 10-K/A also includes the restatement of Item 6, Selected Consolidated Financial Data for the fiscal years ended March 31, 2006, 2005, 2004 and 2003, as well as the three months ended March 31, 2003 and the fiscal year ended December 31, 2002.
We have not amended our previously-filed Annual Reports on Form 10-K or Quarterly Reports on Form 10-Q for all of the periods affected by this restatement. Instead, the financial information that has been previously filed or otherwise reported for these periods is superseded by the information in this 2006 Form 10-K/A, and the financial information contained in such previously-filed reports should no longer be relied upon.
On August 4, 2006, we received an informal inquiry from the Securities and Exchange Commission (SEC) requesting certain documents and information relating to our stock option grant practices from January 1, 1996 to the present (the Period). We publicly announced this inquiry on August 7, 2006. Prior to August 4, 2006, we were already conducting an internal review of our historical stock option grant practices with the assistance of outside counsel. We initiated the internal review following extensive news coverage and analyst reports about the option practices of numerous companies across several different industries.
Upon receipt of the notice of informal inquiry from the SEC, our Board of Directors (the Board) formed a special committee of one outside director (the Special Committee) to conduct an independent and comprehensive investigation of our historical stock option grant practices and to oversee our response to the SEC. The Special Committee retained independent outside legal counsel and forensic accountants (the Investigative Team) to aid in its investigation.
The Investigative Team reviewed the facts and circumstances surrounding stock option grants made during the period from January 1996 through September 2006 (the Period), which included grants made on 426 dates. The Investigative Team conducted an extensive investigation, incurring over 11,000 person-hours searching millions of physical and electronic documents and interviewing more than 35 current and former directors, officers, employees, and advisors. As part of its investigation, the Special Committee evaluated whether the correct measurement dates had been used under applicable accounting principles for the options granted during the Period. The measurement date as defined under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25) and related interpretations, is the first date on which all of the following are known: (1) the individual employee who is entitled to receive the option grant, (2) the number of options that an individual employee is entitled to receive, and (3) the options exercise price.
The Special Committee concluded its investigation and reported its findings to the full Board on December 2, 2006. The Special Committee concluded that there was no evidence of fraud or misconduct by any person with respect to the Companys historical stock option grant practices. The Special Committee identified instances where documentation of certain option grants was lacking. The Special Committee also determined that an incorrect measurement date for financial accounting purposes was used on a number of occasions. These errors resulted primarily from misapplication of accounting standards related to certain measurement date selection methods discussed below, which in a number of occasions resulted in employees receiving options with stated exercise prices lower than the market prices as measured based upon the measurement dates as determined by the applicable accounting standards. Most of the additional stock-based compensation expense related to these incorrect measurement dates pertained to grants made to non-executive employees. In connection with the conclusion of its review, the Special Committee recommended to the Board, and its Compensation Committee, that the Board and Compensation Committee consider and adopt certain remedial measures related to the issues raised in the Special Committees investigation. See Item 9A. Controls and Procedures for a complete discussion of our material weakness in internal controls surrounding our stock option grant practices. The Special Committee and its Investigative Team reported the Special Committees findings and remedial measures to the SEC on January 8, 2007.
As a result of the internal review and based on the conclusions of the Special Committee following the independent investigation, we have concluded that incorrect measurement dates were previously used for financial accounting and reporting purposes on a number of occasions. Therefore, we have recorded additional non-cash stock-based compensation expense and related tax effects with regard to past stock option grants and we are restating previously filed financial statements in this 2006 Form 10-K/A. These adjustments, after tax, aggregate to $10.8 million for the period from January 1, 1996 through March 31, 2006. The adjustments, after tax, for fiscal years 2006, 2005 and 2004 were $2.2 million, $1.4 million and $1.8 million, respectively.
The nature of our accounting errors were primarily in one of the following three categories of option grants:
Company-Wide Stock Option Grants not Determined with Finality. The Special Committee determined that, in connection with certain company-wide stock option grants that we made to non-executive employees in various years, we used incorrect measurement dates for accounting and reporting purposes because the list of grantees and the options awarded to each grantee was not determined with finality until a date subsequent to the measurement dates we previously used. In most such situations, our practice was to set the exercise price for the option at the closing price of our common stock on the date the Compensation Committee of the Board delegated authority to our Chief Executive Officer to award up to a specified aggregate number of options, which was prior to the date that the list of grantees and the
options awarded to each grantee was finalized by the Chief Executive Officer. We have recognized additional stock-based compensation expense of $6.7 million for the period from January 1, 1996 through March 31, 2006 related to this type of error.
Stock Option Grants Priced using Previous Day Closing Price. The Special Committee determined that in three instances throughout 1998 and 1999, the exercise price was set at the closing price of our common stock on the day prior to the Compensation Committee meeting where such grants were made. Our option plans in effect at the time stated that the grant price could not be less than the fair market value of the option on the date of grant, which was defined in the plans as the closing price of our common stock on the date of grant. The Special Committee therefore determined that the measurement date used for accounting purposes should be the date of the meeting. We have recognized additional stock-based compensation expense of $1.8 million for the period from January 1, 1996 through March 31, 2006 related to this type of error.
Incorrect Measurement Dates for New Hire Stock Option Grants. The Special Committee also identified accounting errors related to our new hire stock option grant practices. The Special Committee determined that our new hire stock option granting practice, primarily for our international employees, resulted in a measurement date for accounting purposes that was subsequent to the date that we had previously used for accounting purposes. These errors occurred because the details of stock option grants to international employees were not contained in offer letters and in most cases the number of options the individual was entitled to receive was determined after his or her start date. There were also some instances where grants were made to employees prior to the date they started providing services to the Company, generally because the employee had accepted an employment offer and his or her name was placed on a grant list that was then approved prior to his or her actual start date. We have recognized additional stock-based compensation expense of $1.6 million for the period from January 1, 1996 through March 31, 2006 related to these types of errors.
The incremental impact, per fiscal year, from recognizing additional stock-based compensation expense and related payroll tax expenses resulting from the investigation of our historical stock option grant practices is as follows (in thousands):
(1) Effective January 1, 2003, we changed our fiscal year end from December 31 to March 31. The change resulted in a three-month transitional period ended March 31, 2003. References to Transition 2003, unless otherwise indicated, refer to the three-month transitional period ended March 31, 2003. The incremental impact for the fiscal year ended March 31, 2003 (unaudited) from recognizing additional
stock-based compensation expense resulting from the investigation of historical stock option grant practices is as follows (in thousands): $2,159 pre-tax expense and $1,567 after tax expense.
Additionally, we have restated the pro forma expense under Statement of Financial Accounting Standards (SFAS) No. 123 in Note 1 of the Notes to Consolidated Financial Statements of this 2006 Form 10-K/A to reflect the impact of these adjustments.
For the convenience of the reader, this 2006 Form 10-K/A sets forth the Original Filing in its entirety, as modified and superseded where necessary to reflect the restatement. The following items have been amended principally as a result of, and to reflect, the restatement, and no other information in the Original Filing has been updated since the filing of the Original Filing or is amended hereby as a result of the restatement:
· Part IItem 1Business (amended solely to restate certain financial data included therein)
· Part IItem 1ARisk Factors
· Part IItem 3Legal Proceedings
· Part IIItem 6Selected Consolidated Financial Data
· Part IIItem 7Managements Discussion and Analysis of Financial Condition and Results of Operations
· Part IIItem 8Consolidated Financial Statements and Supplementary Data
· Part IIItem 9AControls and Procedures
· Part IVItem 15Exhibits and Consolidated Financial Statement Schedules
Other than as stated above, this 2006 Form 10-K/A does not reflect events occurring after the filing of the Original Filing, or modify or update those disclosures affected by subsequent events. This 2006 Form 10-K/A continues to speak as of the date of the Original Filing, and does not modify or update any other item or disclosures in the Original Filing.
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 Sony PlayStation 2, Microsoft Xbox, and Nintendo GameCube, and the next-generation consoles Sony PlayStation 3, Microsoft Xbox 360 and Nintendo Wii;
(1) Nintendo®, Dual Screen, Game Boy® Advance, GameCube® (GameCube) and Wii are trademarks and/or registered trademarks of Nintendo of America Inc. (Nintendo). PlayStation and the PS family logo are registered trademarks of Sony Computer Entertainment Inc., and PSP is a trademark of Sony Computer Entertainment Inc. (Sony). Microsoft, Xbox® (Xbox) and Xbox 360 are trademarks and/or registered trademarks of Microsoft Corporation (Microsoft). Microsoft, Nintendo and Sony are referred to herein collectively as the platform manufacturers or the manufacturers.
· Handheld platforms such as Nintendo Game Boy Advance, Nintendo Dual Screen, 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, and Cars, (which is expected to be released globally beginning in North America in June 2006); World Wrestling Entertainment®; Nickelodeon properties such as SpongeBob SquarePants, Avatar, Fairly OddParents and Nicktoons; Bratz; Power Rangers; Warhammer® 40,000; and Scooby-Doo!; as well as others. We also have licenses to create wireless products based on Star Wars and major sports leagues. In addition to licensed properties, we also publish games based upon owned intellectual properties, including Company of Heroes, Destroy All Humans!, Juiced, MX and Saints Row.
We develop our games using both internal and external resources. We currently have 14 internal development studios located in the United States, Australia, the UK and Canada. We also contract with leading third-party developers around the world to develop our products for us.
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 and to a lesser extent through third-party distribution and licensing arrangements. We also globally market and distribute games and other content for wireless devices through major wireless carriers.
We were originally incorporated in New York in 1989 as Trinity Acquisition Corporation, which changed its name in 1991 to T.HQ, Inc. following a merger with THQ, Inc., a California corporation. We were reincorporated in Delaware as THQ Inc. in 1997. Our principal executive offices are located at 29903 Agoura Road, Agoura Hills, California 91301, and our telephone number is (818) 871-5000. Our internet address is http://www.thq.com.(2)
Our corporate goal is to expand our market share while increasing profitability. Our business strategy and a detailed summary of our business operations are detailed below and should be read in conjunction with our Risk Factors, included in Item 1A herein.
In order to maximize 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 titles. We intend to do this by executing on the following strategies:
· Increase sales and profits by leveraging our leading portfolio of mass-market franchises
We have grown and diversified our products targeted at the mass-market by securing key content licenses, and have leveraged our licensed brands by introducing new products and through sales of our catalog of existing products. Our license with Pixar Animation Studios (Pixar) grants us the exclusive interactive
(2) THQ, THQ Wireless and their respective logos are trademarks and/or registered trademarks of THQ Inc.
rights to the next four Pixar animated feature films beginning with the first release following Cars. Our license agreement with World Wrestling Entertainment (WWE) through our joint venture with JAKKS Pacific, Inc., grants us the exclusive rights to publish games based on WWE across all viable game systems through 2014. Our license agreement with Nickelodeon grants us the exclusive right to publish games based on all existing and future Nickelodeon animated television and movie properties targeting kids ages 6-14 across all viable game systems through 2010. Additionally, we have a content license with MGA for their Bratz brand.
In order to increase sales and profits, our goal is to continue building high quality products based on our leading portfolio of mass-market franchises, market them aggressively and shift more development to our internal development studios. In fiscal 2006, our key Disney/Pixar and Nickelodeon titles were developed by our internal studios.
In the fiscal year ending March 31, 2007 (fiscal 2007) and beyond, we plan to execute on this strategy by shipping mass-market titles for the current and next generation of console and handheld platforms, and PC, including the following games based upon our key licenses: Disney/Pixars Cars, WWE SmackDown vs. Raw 2007, SpongeBob SquarePants: Creature from the Krusty Krab, Avatar: The Last Airbender and Bratz: Forever Diamonds.
· Expand our core gamer market share
We plan to grow our market share by expanding our products targeted to core gamers. We have worked to create and acquire our own brands and content and to secure licenses for original intellectual properties that appeal to the core gamer. In fiscal 2006 we released our popular street racing property, Juiced, which has shipped more than 1.5 million units to date, and we released our original owned title, Destroy All Humans!, which shipped nearly 1.5 million units. Also in fiscal 2006 we released our first Xbox 360 title, the owned and internally developed property, The Outfit. In fiscal 2007 we plan to release a sequel to Destroy All Humans! on current-generation console platforms and Saints Row on Xbox 360. In fiscal 2007 we also intend to release several core gamer titles on PC including: Company of Heroes, Titan Quest, Warhammer® 40,000: Dawn of War: Dark Crusade, Supreme Commander and S.T.A.L.K.E.R.: Shadow of Chernobyl.
· Increase internal development capabilities and owned intellectual property
In order to increase profitability, we believe it is important for us to expand our internal development capabilities, increase ownership of development tools and technology, and create and acquire new intellectual property. We plan to continue expanding our internal development capabilities by selectively acquiring and establishing development studios and through internal growth of our existing studios. During fiscal 2006, we expanded our internal Studio System with the acquisitions of Juice Games, located in the UK, Vigil Games, located in Austin, Texas, and with the formation of two new studios, Kaos Studios in New York City and Incinerator Games, located near San Diego, California. With the addition of these studios, we now have 14 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 approximately 1,200 people, an increase of 300 people over the prior fiscal year. Some of the releases in fiscal 2006 that were developed by our Studio System included The Incredibles: Rise of the Underminer, MX v. ATV: On the Edge, SpongeBob Square Pants: Lights, Camera, Pants, Nicktoons Unite, The Outfit and Warhammer® 40,000: Dawn of War: Winter Assault. We are dedicating significant internal development resources to developing software for next-generation console platforms and we expect to release games throughout the growth of the installed base of the hardware.
· Expand international business
In calendar 2005, we increased our market share in both Europe and Australia. As the global gaming market continues to grow, we believe that international markets represent a significant growth opportunity for us. We distribute our products in more than 75 countries and territories outside of North America. We operate international offices in the United Kingdom, Australia, France, Germany, Spain, Korea, Austria and in fiscal 2006 we established sales offices in the Netherlands, Denmark and Japan. In fiscal 2007 we will look to expand our direct sales force in Eastern Europe and Italy. In order to leverage our portfolio of popular brands and increase profitability, we plan to continue acquiring and developing content that sells well internationally (e.g., Disney/Pixar, World Wrestling Entertainment, and Juiced).
· Expand wireless interactive entertainment market share
In fiscal 2006, THQ reported $36.1 million in net sales on the wireless platform, an increase of approximately 50% over fiscal 2005. We view the wireless platform as a long-term growth area for THQ as we continue to leverage our mass-market franchises, core gamer titles, wireless sports licenses and other exclusive wireless licenses, such as Star Wars on this platform. In fiscal 2007, we plan to re-align our product portfolio to emphasize more casual game content to position ourselves for wireless platform share gains in the future.
· Pursue emerging revenue opportunities
As the interactive entertainment industry continues to evolve, new revenue streams are emerging that are expected to develop over the next five years. These opportunities include in-game advertising, downloadable content/micro-transactions, and online casual gaming. In fiscal 2006, we entered into agreements with two leading in-game advertising enabling companies to facilitate in-game advertising in future games. We also started to explore an online casual game site. Beginning in fiscal 2007, we plan to offer downloadable content on next-generation console systems from Microsoft and Sony.
As a publisher of interactive entertainment software, we consider ourselves to be part of the entertainment industry. At the most fundamental level, our products compete with other forms of entertainment, such as motion pictures, television and music, for the leisure time and discretionary spending of consumers. We believe that video games have increasingly become a mainstream entertainment choice for both children and adults. According to the International Development Group, Inc. (IDG), an independent consulting and advisory services company that analyzes the consumer electronics and interactive entertainment
industries, sales of PC, console and handheld games (excluding wireless) reached $7.5 billion in North America, and $6.5 billion in Europe in 2005. We look toward an expanding market for interactive entertainment software over the next several years due to the introduction of the next generation of console systems. We believe that improved graphics, greater online functionality and expanded artificial intelligence capabilities of the new platforms will enhance game play and help grow our industry significantly. In addition, new revenue opportunities from wireless gaming, in-game advertising and online console gaming are expected to grow to $5 billion in 2009 from $1 billion in 2005, according to DFC Intelligence and Montgomery & Co.
The first modern platform was introduced by Nintendo in 1985. Advances in technology over the past 20 years have resulted in continuous increases in the processing power of the chips that power both the consoles and PC. For the past several years, Sony has been the leader in the console market (with its PlayStation and PlayStation 2 consoles); however, Microsoft and Nintendo are large and viable competitors. In 2005, Microsoft introduced its next-generation console, Xbox 360, and both Sony and Nintendo have announced plans to release their next-generation consoles later in 2006. Nintendo has been the dominant manufacturer of handheld platforms with its Game Boy Advance. In fiscal 2005 two new handheld platforms were introduced, Nintendo DS and Sony PSP. PCs continue to be a viable interactive game platform and over the past few years, wireless devices, such as mobile phones, have become a viable gaming platform.
We currently develop and publish products for all major platforms, and this diversification continues to be a cornerstone of our strategy. In fiscal 2006, our product releases were for the Sony PlayStation 2, Microsoft Xbox and Xbox 360, Nintendo GameCube, PC, Game Boy Advance, Nintendo DS, PSP and wireless devices. As Sony and Nintendo launch their next-generation consoles, we expect to release games on each platform at or near their launch.
We develop, market and sell video games and other interactive software and content for console platforms, handheld platforms and PCs. In fiscal 2006, we published ten titles that shipped more than one million units. The following list identifies games that generated a significant portion of our sales during the fiscal years ended March 31, 2006, 2005 and 2004:
· In fiscal 2006, WWE® SmackDown® vs. Raw® 2006, Juiced, Destroy All Humans!, SpongeBob SquarePants: Lights, Camera, PANTS! and The Incredibles: Rise of the Underminer;
· In fiscal 2005, Disney/Pixars The Incredibles, The SpongeBob SquarePants Movie, and WWE SmackDown vs. Raw; and
· In fiscal 2004, Disney/Pixars Finding Nemo, SpongeBob SquarePants: Battle for Bikini Bottom, and WWE SmackDown! Here Comes the Pain.
All of our games are based on intellectual property that is either wholly-owned by us or licensed from third parties. We develop our games using both internal development resources and external development resources working for us pursuant to contractual agreements. Whether a game is developed internally or externally, upon completion of development we extensively play-test each game, and if required, send the game to the manufacturer for its review and approval. Other than games that we release for PCs or wireless devices, the manufacturers or their authorized vendors manufacture our products for us. We then market and distribute our games for sale throughout the world.
Our business process begins with the creation of intellectual property or acquisition of intellectual property rights. Traditionally, most of our titles were based upon licensed properties that have attained a high level
of consumer recognition or acceptance. We have relationships with many well-known licensors, including Disney/Pixar, Nickelodeon, World Wrestling Entertainment, Warner Bros. and MGA Entertainment.
Our intellectual property licenses usually grant us the exclusive use of the property for specified titles, on specified platforms, within a defined territory and during the license term. All of our licenses are of varying duration and we pay royalties to our property licensors based on our net sales of the title which includes the licensors intellectual property. We typically advance payments against minimum guaranteed royalties over the license term. Royalty rates are generally higher for properties with proven popularity and less perceived risk of commercial failure.
Our original intellectual property is created either by one of our 14 development studios or by a third-party developer that we contract with, in which instance, we retain all ownership rights in the intellectual property. In other instances, wherein a third-party developer creates the intellectual property and develops the game, we obtain a license that is typically exclusive and we try to retain rights to any future products based on the intellectual property.
In addition to obtaining licenses to develop intellectual property, 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 manufacturers platform. Our key platform licenses currently include:
· licenses with Nintendo to develop games for GameCube, Game Boy Advance and DS;
· licenses with Sony to develop games for PlayStation 2 and PlayStation Portable; and
· licenses with Microsoft to develop games for Xbox and Xbox 360.
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 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 currently are licensed to publish and distribute titles on all platforms that are currently sold in the United States and Canada. We are licensed to publish and distribute titles for GameCube, PlayStation 2, PlayStation Portable, Xbox, Xbox 360 and Dual Screen in various additional territories, including Europe, Australia and New Zealand, 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.
The platform licenses are not exclusive and require that each title be approved by the manufacturer prior to development of the software, and once developed, manufactured solely by such manufacturer or a designated vendor of the manufacturer. The licenses establish the fees that we must pay to the manufacturer for each cartridge or disc made. Nintendo charges us a fixed amount for each Game Boy Advance cartridge manufactured. This amount varies based, in part, on the memory capacity of the cartridge. Our Nintendo, Sony and Microsoft console agreements include a charge for every disc manufactured. The amounts charged by the manufacturers for both console discs and handheld cartridges include a manufacturing, printing and packaging fee as well as a royalty for the use of the manufacturers name, proprietary information and technology, and are subject to adjustment by the manufacturers at their discretion. The manufacturers have the right to review, evaluate and approve a prototype of each title and the titles packaging.
In addition, we must indemnify the manufacturers with respect to all loss, liability and expense resulting from any claim against the manufacturer involving the development, marketing, sale, or use of our games, including any claims for copyright or trademark infringement brought against the manufacturer. As a
result, we bear a risk that the properties upon which the titles are based, or that the information and technology licensed from others and incorporated in the products, may infringe the rights of third parties. Conversely, our agreements with our third-party software developers and property licensors typically provide for us to be indemnified with respect to certain matters. If any claim is brought by a manufacturer against us for indemnification, however, our developers or licensors may not have sufficient resources to, in turn, indemnify us. Furthermore, these parties indemnification of us may not cover the matter that gives rise to the manufacturers claim.
Each platform license may be terminated by the manufacturer if a breach or default by us is not cured after we receive written notice from the manufacturer, or if we become insolvent. Upon termination of a platform license for any reason other than our breach or default, we have a limited period of time to sell any existing product inventory remaining as of the date of termination. The length of this sell-off period varies between 90 and 180 days, depending upon the platform agreement. We must destroy any such inventory remaining after the end of the sell-off period. Upon termination as a result of our breach or default, we must destroy any remaining inventory.
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 14 internal 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 collective group of development resources as our Studio System.
We make the decision as to which development resources to use based upon the creative and technical challenges of the product, whether the intellectual property which is being developed into a game is licensed, an original concept that we created, or an original concept created by a third-party developer. Once we determine where a product will be developed, our internal product development team oversees the internal or external resources in its design, technical assessment and construction of each game.
The development cycle for a new game depends on the platform and the complexity of the game. Additionally, when developing an intellectual property into a game which is simultaneously being made into a motion picture, our development schedule is designed to ensure that our games are commercially available by the motion pictures release. The development cycle for games on current generation console platforms, PC games and the Sony PSP system generally ranges from 12 to 24 months, Game Boy Advance ranges from 6 to 9 months, Nintendo DS ranges from 9 to 12 months and wireless games range from 6 to 9 months. The development cycle for the next generation of games on Microsoft Xbox 360 can range from 12 to 36 months depending on the overall complexity and scope of the game, and we anticipate a similar development cycle for the next generation of games on Sony PlayStation 3 and Nintendo Wii. These relatively long development cycles require that we assess whether there will be adequate retailer and consumer demand for a game well in advance of its release. The investments in such development, prior to reaching technological feasibility, are recorded as product development expenses in our consolidated statement of operations. We had product development expenses of $85.3 million in fiscal 2006, $73.6 million in fiscal 2005 (as restated) and $37.8 million in fiscal 2004 (as restated).
Upon completion of development, each game is extensively play-tested by us to ensure compatibility with the appropriate hardware systems and configurations and to minimize the number of bugs and other defects found in the products. If required, we also send the game to the manufacturer for its review and approval. To support our products after release, we provide online access to our customers on a 24 hour basis as well as operator help lines during regular business hours. The customer support group tracks customer inquiries, and we use this data to help improve the development and production processes.
Other than games that we release for sale on PCs or wireless devices, our video games are manufactured for us by the platform manufacturers or their authorized vendors. We contract with various PC replicators for the manufacturing of our PC products.
The platform game manufacturing process begins with our placing a purchase order with a manufacturer. We then send the software code and a prototype of the game to the manufacturer (together with related artwork, user instructions, warranty information, brochures and packaging designs) for approval, defect testing, and manufacture.
We are required by our platform licenses to provide a standard defective product warranty on all of the products sold. Generally, we are responsible for resolving, at our own expense, any warranty or repair claims. We have not experienced any material warranty claims, but there is no guarantee that we will not experience such claims in the future.
Our marketing activities vary depending upon whether a video game title is based upon a licensed or an original property. A licensed property has pre-existing brand popularity and thus often requires less initial effort by us to promote. Our marketing efforts for titles based upon original properties begin well in advance of a titles release and focus on building positive awareness of our game concepts with consumers and retailers. We conduct consumer and retail research, which provides us with feedback to position a title prior to its release. Our public relations promotional activities for original titles in fiscal 2006 included coverage in broadcast, print and online media targeting enthusiast, lifestyle and major mainstream outlets. Additionally, we continue to increase our corporate public relations efforts by establishing relationships with leading technology and business reporters.
Our marketing efforts for products released in fiscal 2006 covered a broad range of media including, television, print, in-theater, radio, internet advertising and promotional events. Most of our major new releases in fiscal 2006 received television support. Our games were also supported by promotional activities such as trailers, demo discs, over-sized boxes, standees, posters, pre-sell giveaways at retail stores, game kiosks at sporting and outdoor events, rebates and contests with national packaged goods companies and fast food restaurants, and co-marketing efforts with the hardware manufacturers. Our games are promoted to retailers by display at trade shows such as the annual Electronic Entertainment Expo (E3) and select retailer specific trade shows. We also conduct print and cooperative retail advertising campaigns for most titles and prepare a range of promotional sales and marketing materials to increase awareness among retailers.
We strive to create global brand awareness for our products. Consistent with our strategy to build and maintain franchise properties with global appeal, our international marketing efforts include localization of products to conform to consumer preferences and languages in the countries in which each title is distributed. This structure is designed to maximize market performance in all territories.
North American Sales. In North America, our products are primarily sold directly to mass merchandisers, consumer electronics stores, discount warehouses and national retail chain stores. Our products are also sold to smaller, regional retailers, as well as distributors who, in turn, sell our products to retailers that we do not service directly, such as grocery and drug stores. Our domestic sales activities are led by our national sales team, which has representatives in most major markets in the United States.
We utilize electronic data interchange with most of our major North American customers in order to (i) efficiently receive, process, and ship customer product orders and (ii) accurately track and forecast sell-through of products to consumers in order to determine whether to order additional products from the manufacturers. We believe that the direct relationship model we use in North America allows us to better
manage inventory, merchandise and communications. We ship most of our products to our domestic customers from warehouses located in Canada, Michigan and Minnesota.
The domestic retail prices for our titles currently range between: (i) $15 and $35 for handheld platforms; (ii) $15 and $65 for console platforms; and (iii) $10 and $55 for PC games. The domestic retail price for our wireless games currently range between $5 and $8 for a one time purchase and between $2 and $4 for a monthly subscription.
International Sales. Our international sales activities operate via our offices in the United Kingdom, Australia, France, Germany, Korea, Japan, Spain, Austria, Denmark and The Netherlands. International offices market and distribute direct-to-retail customers and through sub-distributors in both their home territories and to approximately 70 additional territories.
Our largest customers worldwide include Best Buy, GameStop, Target, Toys R Us and Wal-Mart. We also sell our products to other national and regional retailers, discount store chains and specialty retailers. Our largest customer, Wal-Mart, accounted for 19% of our worldwide sales in fiscal 2006. A substantial reduction, termination of purchases, or business failure by any of our largest customers would have a material adverse effect on us.
The interactive entertainment software market is highly seasonal, with sales typically significantly higher during the third quarter of our fiscal year, due primarily to the increased demand for interactive games during the year-end holiday buying season.
The video game industry is intensely competitive. It is characterized by the continuous introduction of new titles and the development of new technologies. Our business is driven by hit titles, which requires us to invest significantly in production and in marketing. Competition in the video games segment is also based on product quality and features, timing of product releases, brand-name recognition, access to distribution channels, and effectiveness of marketing and price.
We compete both for licenses to properties and the sale of interactive entertainment software with Sony, Microsoft and Nintendo, each of which is a large developer and marketer of software for its own platforms. Each of these competitors also has the financial resources to withstand significant price competition and to implement extensive advertising campaigns, particularly for prime-time television spots. In addition to the manufacturers, our competitors include publishers and developers of interactive entertainment software, such as Activision, Atari, Electronic Arts, LucasArts, Namco, Sega, Take-Two Interactive Software, Ubisoft, and Vivendi Games.
In addition, some of our competitors are very large, diversified corporations that have begun to develop games based upon their own highly recognizable brands, and, as a result, stand to become more direct competitors. Disneys Buena Vista games division recently expanded its internal software game publishing efforts and Viacom has expanded its efforts in interactive entertainment software publishing.
As of March 31, 2006, we employed approximately 1,600 people, of whom over 600 were outside the United States. We believe that our ability to attract and retain qualified employees is a critical factor in the successful development of our products and that our future success will depend, in large measure, on our ability to continue to attract and retain qualified employees. None of our employees are represented by a labor union or covered by a collective bargaining agreement and we consider our relations with employees to be favorable.
Financial Information About Geographic Areas
See Item 7 Management Discussion and Analysis of Financial Condition and Results of Operations and Note 19 of notes to consolidated financial statements included in Item 8.
We file annual, quarterly and current reports, proxy statements and other information with the Securities and Exchange Commission (SEC). Our SEC filings, including our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports filed or furnished pursuant to Section 13(a) of the Exchange Act are available to the public free of charge over the internet at our website at http://www.thq.com or at the SECs web site at http://www.sec.gov. Our SEC filings will be available on our website as soon as reasonably practicable after we have electronically filed or furnished them to the SEC. Information contained on our website is not incorporated by reference into this annual report on Form 10-K/A. You may read and copy any materials we file with the SEC at the SECs Public Reference Room at 450 Fifth Street, N.W., Washington D.C. 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. You can view our Code of Business Conduct and Ethics and our Code of Ethics for Executive Officers and Other Senior Financial Officers free of charge on the corporate governance section of our website. If we make any substantive amendments to our Code of Ethics for Executive Officers and Other Senior Financial Officers or if any waivers of such code are granted, we will post them on our web site.
Our business is subject to many risks and uncertainties which may affect our future financial performance. Some of those important risks and uncertainties which may cause our operating results to vary or which may materially and adversely affect our operating results are as follows:
Our industry is in a transition phase and the introduction of new platforms could materially impact the sales of our products.
In recent years, we have successfully developed video games for the Microsoft Xbox, Nintendo GameCube and Sony PlayStation 2. In late 2005, Microsoft launched its new console, the Xbox 360. Sony has announced plans to launch the PlayStation 3 and Nintendo has announced plans to launch the Wii in late 2006. When new platforms are announced or introduced into the market, consumers typically reduce their purchases of entertainment software products for current platforms in anticipation of new platforms becoming available. During these periods, sales of our game console entertainment software products may be expected to slow or even decline until new platforms are introduced and achieve wide consumer acceptance. If sales of our products unexpectedly decline due to slowing consumer demand during this transition, this could materially impact our financial results.
Additionally, delays in the launch of the platforms, hardware shortages, technical problems or lack of consumer acceptance of the next generation platforms could adversely affect our sales of products for these platforms, adversely affecting sales of products we develop and publish for the platforms.
During the platform transition, pricing for our products may decline, materially impacting our revenues and profitability.
As demand for games on the current generation of platforms declines, the prices of our games may also decline. Reduced pricing of our products may result in credits or allowances to our customers, which could materially affect our profitability.
Platform transitions are generally marked by escalating development costs, which could materially affect our profitability.
New platforms have historically required the development of new software and also have the effect of undermining demand for products based on older technologies. Because product development cycles are difficult to predict, we must make substantial product development and other investments in technologies for a particular platform well in advance of introduction of the platform. If the platforms for which we develop new software products or modify existing products are not released on a timely basis or do not attain significant market penetration, or if we develop products for a delayed or unsuccessful platform, our business and financial results could be significantly harmed.
We must continue to develop and sell new titles in order to remain profitable.
Our profitability has directly resulted from our ability to develop and sell successful new titles for use on multiple platforms. Consumer preferences for games are difficult to predict, and even the most successful titles remain popular for only limited periods of time, often less than six months. The life cycle of a game generally consists of a relatively high level of sales during the first few months after introduction, followed by a decline in sales. In some instances, a sales decline may also be accompanied by decreasing sales prices, which may result in credits or allowances to our customers.
We rely on a relatively small number of licensed brands for a significant portion of our sales.
Games we develop based upon a small number of licensed brands make up a substantial portion of our sales each year. In fiscal 2006, sales of titles for our three top-selling brands, Disney / Pixar, Nickelodeon and World Wrestling Entertainment (WWE) comprised 47% of our net sales; in fiscal 2005, 52% of our net sales were based on titles from such brands; and in fiscal 2004, 50% of our net sales were based on titles from such brands. A limited number of licensed brands may continue to produce a disproportionately large amount of our sales. Due to this dependence on a limited number of brands, the failure of one or more products based on these brands to achieve anticipated results or the loss of a license pursuant to which we develop games for such brands may significantly harm our business and financial results.
We are currently involved in litigation with the WWE with respect to our video game license. Since WWE titles make up a significant portion of our sales, our inability to retain the license could harm us. See, Item 3 Legal Proceedings for a more detailed discussion of this litigation.
Our inability to acquire or create intellectual property rights which have a high level of consumer recognition or acceptance could harm us.
A significant portion of our net sales in fiscal 2006, fiscal 2005 and fiscal 2004 were derived from products based on popular licensed properties. A decrease in the popularity of the underlying property of our licenses could negatively impact our ability to sell products based on such licenses.
We also generate revenue from wholly-owned intellectual property. The success of our internal brands depends on our ability to create original ideas which appeal to the avid gamer. Titles based on wholly-owned intellectual property can be expensive to develop and market since they do not have a built-in consumer base or licensor support. Our inability to create new products targeted at the core gamer could impact our operations.
Our inability to enter into agreements with the manufacturers to develop, publish and distribute titles on their platforms could seriously impact our operations.
We are dependent on the platform manufacturers (Microsoft, Nintendo and Sony) and our non-exclusive licenses with them, both for the right to publish titles for their platforms and for the manufacture of our products for their platforms. Our existing platform licenses require that we obtain approval for the
publication of new games on a title-by-title basis. As a result, the number of titles we are able to publish for these platforms, and our sales from titles for these platforms, may be limited. Should any manufacturer choose not to renew or extend our license agreement at the end of its current term, or if any license was terminated, we would be unable to publish additional titles for that manufacturers platform, which could negatively affect our operating results.
Additionally, since each of the manufacturers publishes games for its own platform, and also manufactures products for all of its other licensees, a manufacturer may give priority to its own products or those of other publishers in the event of insufficient manufacturing capacity. Unanticipated delays in the delivery of products could also negatively affect our operating results.
Video game product development schedules are difficult to predict and can be subject to delays. Postponements in shipments can substantially impact our earnings in any given quarter.
Our ability to meet product development schedules is affected by a number of factors, including the creative processes involved, the coordination of large and sometimes geographically dispersed development teams required by the increasing complexity of our products, and the need to refine and tune our products prior to their release. We have in the past experienced development delays for several of our products. Failure to meet anticipated production schedules may cause a shortfall in our expected sales and profitability and cause our operating results to be materially different from expectations. Delays that prevent release of our products during peak selling seasons or in conjunction with specific events, such as the release of a related movie, could adversely affect our financial performance. Further, since we havent developed or released a game for the Sony PlayStation 3 or the Nintendo Wii, and since the Microsoft Xbox 360 is new to the market, product development schedules for the next generation platforms may be difficult to predict and may cause us to delay the launch of certain products.
We rely on external developers for the development of some of our titles.
Some of our titles are developed by third-party developers. We have no direct control over the business, finances and operational practices of these external developers. A delay or failure to complete the work performed by external developers may result in delays in, or cancellations of, product releases. The future success of externally developed titles will depend on our continued ability to maintain relationships and obtain developer agreements on favorable terms with skilled external developers. Our competitors may acquire the businesses of key developers or sign them to exclusive development arrangements. In either case, we would not be able to continue to engage such developers services for our products, except for those that they are contractually obligated to complete for us. We cannot guarantee that we will be able to establish or maintain such relationships with external developers and failure to do so could result in a material adverse effect on our business and financial results.
Defects in our game software could harm our reputation or decrease the market acceptance of our products.
Our game software may contain defects. In addition, because we do not manufacture our games for console platforms, we may not discover defects until after our products are in use by retail customers. Any defects in our software could damage our reputation, cause our customers to terminate relationships with us or to initiate product liability suits against us, divert our engineering resources, delay market acceptance of our products, increase our costs or cause our revenue to decline.
We rely on a small number of customers that account for a significant amount of our sales.
Our largest single customer, Wal-Mart, accounted for 19% of our gross sales in fiscal 2006, 14% of our gross sales in fiscal 2005 and 19% of our gross sales in fiscal 2004. A substantial reduction, termination of purchases, or business failure by any of our largest customers would have a material adverse effect on us.
Increased sales of used video game products could lower our sales.
Some of our customers, such as Blockbuster and Hollywood Video, specialize in renting video games. These customers also may sell video games that have been rented by their customers after a certain period of time following each titles release. Increased sales of used video games, which are generally priced lower than new video games, could negatively affect our sales of new titles and thus our revenues.
A significant portion of our revenue is derived from our international operations, which may subject us to economic, political, regulatory and other risks.
In fiscal 2006 we derived 39% of our revenues from our international operations, up from 38% in fiscal 2005. We intend to continue expanding our international operations, which may subject us to many risks, including: different consumer preferences, unexpected changes in regulatory requirements, tariffs and other barriers, difficulties in staffing and managing foreign operations, and possible difficulties collecting foreign accounts receivable. These factors or others could have an adverse effect on our future foreign sales or the profits generated from these sales.
Sales generated by our international offices will generally be denominated in the currency of the country in which the sales are made. To the extent our foreign sales are not denominated in U.S. dollars, our sales and profits could be materially and adversely affected by foreign currency fluctuations.
Competition in the interactive software entertainment industry may lead to reduced sales of our products and reduced market share.
Our industry is intensely competitive. We compete for both licenses to properties and the sale of games with the platform manufacturers and other publishers. As a result of their commanding positions in the industry, the manufacturers may have better bargaining positions with respect to retail pricing, shelf space and retailer accommodations than do any of their licensees, including us. Some of our competitors have greater name recognition among consumers and licensors of properties, a broader product line, or greater financial, marketing and other resources than we do. Accordingly, these competitors may be able to market their products more effectively or make larger offers or guarantees in connection with the acquisition of licensed properties.
As competition for popular properties increases, our cost of acquiring licenses for such properties may increase, resulting in reduced margins. In addition, as competition for retail shelf space becomes more intense, we may need to increase our marketing expenditures to maintain sales of our titles. Prolonged price competition, increased licensing costs or reduced profit margins would have a negative effect on our business and financial results.
Competition with emerging forms of home-based entertainment may reduce sales of our products.
We also compete with other forms of entertainment and leisure activities. For example, we believe the overall growth in the use of the internet and online services by consumers may pose a competitive threat if customers and potential customers spend less of their available time using interactive entertainment software and more using the internet and online services.
Competition for qualified personnel is intense in the interactive software entertainment industry and failure to hire and retain qualified personnel could seriously harm our business.
We rely to a substantial extent on the management, marketing, sales, technical and software development skills of a limited number of employees to formulate and implement our business plan. Our success depends to a significant extent upon our ability to attract and retain key personnel. Competition for employees can be intense and the process of locating key personnel with the right combination of skills is often lengthy. The loss of services of key personnel could have a material adverse effect on us.
Consolidation in the interactive software entertainment industry presents challenges with respect to resources and integration of acquired businesses.
Consistent with our strategy to expand our internal development capabilities and distribution channels, we intend to continue to pursue acquisitions of companies, intellectual property rights and other assets that can be acquired on acceptable terms and which we believe can be operated or exploited profitably. As our industry continues to consolidate, we face significant competition in making acquisitions, which may constrain our ability to complete suitable transactions.
Further, as we acquire companies, we are faced with additional challenges. The integration of newly acquired companies operations with our existing operations takes management time and effort. Additionally, there is a risk of loss of key employees, customers and vendors of the recently-acquired companies. Also, if we issue equity securities to pay for an acquisition, the ownership percentage of our existing stockholders would be reduced and the value of the shares held by our existing stockholders could be diluted. If we use cash to pay for an acquisition, the payment could significantly reduce the cash that would be available to fund our operations or to use for other purposes. Acquisition financing may not be available on favorable terms or at all. We may also be required to amortize significant amounts of identifiable intangible assets in connection with future acquisitions, which could adversely affect our reported earnings. Future acquisitions may also require us to assume contingent liabilities that could have a negative effect on our future results of operations.
Emerging technologies, such as games for wireless devices, require capital investments and present many unknown risks.
Wireless network and mobile phone technologies are undergoing rapid innovation. New mobile phones with more advanced processors and supporting advanced programming languages continue to be introduced in the market. We have no control over the demand for, or success of, these products. However, if we fail to anticipate and adapt to these and other technological changes, our market share and our operating results may suffer. Our future success in providing wireless games and other content will depend on our ability to adapt to rapidly changing technologies, develop applications to accommodate evolving industry standards and improve the performance and reliability of our applications. In addition, the widespread adoption of networking or telecommunications technologies or other technological changes could require substantial expenditures to modify or adapt our entertainment applications.
The markets for our applications are also characterized by frequent new mobile phone model introductions and shortening mobile phone model life cycles. The development of new, technologically advanced applications to match the advancements in mobile phone technology is a complex process requiring significant research and development expense, as well as the accurate anticipation of technological and market trends. As the life cycle of mobile phone models and other wireless devices shortens, we will be required to develop and adapt our existing applications and create new applications more quickly. These efforts may not be successful. Any failure or delay in anticipating technological advances or developing and marketing new applications that respond to any significant change in
technology or customer demand could limit the available channels for our applications and limit or reduce our sales.
We may not be able to protect our intellectual property rights against piracy, infringement of our patents by third parties, or declining legal protection for intellectual property.
We defend our intellectual property rights and combat unlicensed copying and use of software and intellectual property rights through a variety of techniques. Preventing unauthorized use or infringement of our rights is difficult. Unauthorized production occurs in the computer software industry generally, and were a significant amount of unauthorized production of our products to occur, it could materially and adversely affect our results of operations. We hold copyrights on the products, manuals, advertising and other materials owned by us and we maintain certain trademark rights. We regard our titles, including the underlying software, as proprietary and rely on a combination of trademark, copyright and trade secret laws as well as employee and third-party nondisclosure and confidentiality agreements, among other methods to protect our rights. We include with our products a shrink-wrap or click-wrap license agreement or limitations on use of the software. It is uncertain to what extent these agreements and limitations are enforceable, especially in foreign countries. Policing unauthorized use of our products is difficult, and software piracy is a persistent problem, especially in some international markets. Further, the laws of some countries where our products are or may be distributed either do not protect our products and intellectual property rights to the same extent as the laws of the United States, or are poorly enforced. Legal protection of our rights may be ineffective in such countries. We cannot be certain that existing intellectual property laws will provide adequate protection for our products.
Third parties may claim we infringe their intellectual property rights.
Although we believe that we make reasonable efforts to ensure that our products do not violate the intellectual property rights of others, from time to time we receive notices from others claiming we infringe their intellectual property rights. The number of these claims may grow. Responding to these claims may require us to enter into royalty and licensing agreements on less favorable terms, require us to stop selling or to redesign affected products, or to pay damages or to satisfy indemnification commitments with our customers including contractual provisions under various license arrangements. If we are required to enter into such agreements or take such actions, our operating margins may decline as a result.
Our reported financial results could be affected by changes in current accounting principles.
Recent actions and public comments from the Securities and Exchange Commission have focused on the integrity of financial reporting generally. Similarly, Congress has considered a variety of bills that could affect certain accounting principles. The Financial Accounting Standards Board and other regulatory accounting agencies have recently introduced several new or proposed accounting standards, such as accounting for stock options, some of which represent a significant change from current practices. Changes in our accounting for stock options will materially increase our reported expenses when we adopt Statement of Financial Accounting Standard No. 123R in the first quarter of fiscal 2007.
We cannot be certain of the future effectiveness of our internal controls over financial reporting or the impact of the same on our operations or the market price for our common stock.
Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, we are required to include in our Annual Report on Form 10-K our assessment of the effectiveness of our internal controls over financial reporting. Furthermore, our independent registered public accounting firm is required to audit our assessment of the effectiveness of our internal controls over financial reporting and separately report on whether it believes we maintain, in all material respects, effective internal controls over financial reporting. Although we believe that we currently have adequate internal controls procedures in place except for those surrounding
our stock option grant practices, we cannot be certain that future material changes to our internal controls over financial reporting will be effective. If we cannot adequately maintain the effectiveness of our internal controls over financial reporting, we might be subject to sanctions or investigation by regulatory authorities, such as the Securities and Exchange Commission. Any such action could adversely affect our financial results and the market price of our common stock.
Fluctuations in our quarterly operating results due to seasonality in the interactive software entertainment industry could result in substantial losses to investors.
We have experienced, and may continue to experience, significant quarterly fluctuations in sales and operating results. The interactive software entertainment market is highly seasonal, with sales typically significantly higher during the year-end holiday buying season. Other factors that cause fluctuations include:
· the timing of our release of new titles as well as the release of our competitors products;
· the popularity of both new titles and titles released in prior periods;
· the profit margins for titles we sell;
· the competition in the industry for retail shelf space;
· fluctuations in the size and rate of growth of consumer demand for titles for different platforms; and
· the timing of the introduction of new platforms and the accuracy of retailers forecasts of consumer demand.
We believe that quarter-to-quarter comparisons of our operating results are not a good indication of our future performance. We may not be able to maintain consistent profitability on a quarterly or annual basis. It is likely that in some future quarter, our operating results may be below the expectations of public market analysts and investors and as a result of the factors described above and others described throughout this Risk Factors section, the price of our common stock may fall or significantly fluctuate.
Rating systems and future legislation may make it difficult to successfully market and sell our products.
Currently, the interactive software entertainment industry is self-regulated and rated by the Entertainment Software Rating Board. Our retail customers take the Entertainment Software Rating Board rating into consideration when deciding which of our products they will purchase. If the Entertainment Software Rating Board or a manufacturer determines that a product should have a rating directed to an older or more mature consumer, we may be less successful in our marketing and sales of a particular product.
Recently, legislation has been introduced at the local, state and federal levels for the establishment of a government mandated rating and governing system in the United States and in foreign countries for our industry. Various foreign countries already allow government censorship of interactive entertainment products. We believe that if our industry were to become subject to a government rating system, our ability to successfully market and sell our products could be adversely affected.
Any significant downturn in general economic conditions which results in a reduction in discretionary spending could reduce demand for our products and harm our business.
Our product sales are affected by the retail customers ability and desire to spend disposable income on the purchase of our games. Any significant downturn in general economic conditions which results in a reduction in discretionary spending could result in a reduction in demand for our products and could harm
our business. Such industry downturns have been, and may continue to be, characterized by diminished product demand and subsequent erosion of average selling prices.
Because of these and other factors affecting our operating results and financial condition, past financial performance should not be considered a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods.
Risk Factors Related to the Special Committee and Company Investigations and the Restatement
The Staff of the Securities and Exchange Commission has notified us that it is conducting an informal inquiry concerning our historical stock option grant practices and this inquiry could require us to expend significant resources and could result in an unfavorable outcome.
On August 7, 2006, THQ announced that we had received an informal inquiry from the Securities and Exchange Commission (SEC) requesting certain documents and information relating to our stock option grant practices from January 1, 1996 to the present. We do not know when this inquiry will be resolved or what actions, if any, the SEC may take as a result of this inquiry. Responding to this inquiry could require the expenditure of significant financial resources. An unfavorable outcome could require us to pay damages or penalties, or result in other remedies imposed upon us, any of which could have a material adverse affect on our business, results of operations, financial position and cash flows.
Our common stock is subject to potential delisting from the NASDAQ Stock Market as a result of our inability to timely file our Quarterly Report on Form 10-Q with the Securities and Exchange Commission.
On November 13, 2006, THQ filed a Form 12b-25 with the SEC to report that we would not timely file our Quarterly Report on Form 10-Q for the quarter ended September 30, 2006. On November 22, 2006 we announced that we received a NASDAQ Staff Determination letter on November 16, 2006 indicating that, as a result of our inability to timely file the Form 10-Q, we were not in compliance with the requirements for the continued listing of our common stock as set forth in NASDAQ Marketplace Rule 4310(c)(14), and that our common stock is, therefore, subject to delisting from the NASDAQ Global Select Market. We requested and have been granted a hearing before a NASDAQ Listing Qualifications Panel (Panel) to review the Staff Determination. Our oral hearing is scheduled for February 1, 2007 and the delisting action has been stayed pending a final written decision by the Panel. There can be no assurance that the Panel will grant the Registrants request for continued listing.
As a result of our delayed filing of our Form 10-Q for the quarter ended September 30, 2006, our inability to maintain our Form S-3 eligibility may adversely affect our ability to raise future capital or complete acquisitions.
As a result of our delayed filing of our Form 10-Q for the quarter ended September 30, 2006, we will be ineligible to register our securities on Form S-3 for sale by us or resale by other security holders until we have timely filed all periodic reports under the Securities Exchange Act of 1934 for one year from the date the Form 10-Q for the quarter ended September 30, 2006 was due. In the meantime, we have the ability to use Form S-1 to raise capital or complete acquisitions, which could increase the transaction costs and adversely affect our ability to raise capital or complete acquisitions of other companies during this period.
Pending civil litigation relating to our stock option granting practices could have a material adverse effect on the Company.
We and certain of our directors and current and former officers are defendants in three shareholder derivative actions relating to our stock option granting practices. See Note 21, Subsequent Events Related to the Special Committee and Company Investigations and the Restatement in the Notes to Consolidated Financial Statements for a more detailed description of these proceedings. These actions are in their
preliminary stages, and we intend to vigorously defend ourselves. These lawsuits could divert management time and attention from day-to-day operations, result in significant legal expenses, and result in an outcome that could have a material adverse effect on our business, financial condition, results of operations and cash flows.
The following is a summary of the principal leased offices maintained by us as of May 26, 2006:
In addition to the leased facilities listed above, we also lease office space in various countries outside of the U.S. in order to support the international sales, marketing and administrative efforts of our wireless platform. The majority of these leased facilities are occupied by Minick Holdings AG and its subsidiaries, of which we have a 50% ownership interest.
We also own 10,820 square feet of space in Phoenix, Arizona which serves as our data center and motion capture studio.
World Wrestling Entertainment.
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, the THQ/JAKKS joint venture, 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 video game license to the THQ/JAKKS joint venture. The complaint seeks various forms of relief, including monetary damages and a judicial determination that, among other things, the THQ/JAKKS video game license is void. On March 30, 2005, WWE filed an amended complaint, adding both new claims and THQs 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 Plaintiffs 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 WWEs motion for re-argument of the dismissal of the Sherman Act claim. The briefing and argument of these motions is scheduled to be completed by September 2006. Discovery in this action remains stayed. On June 2, 2006, we filed a motion to dismiss the RICO claims against THQ and Brian Farrell. 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 license with THQ, 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.
On March 30, 2006, WWEs counsel wrote a letter to our counsel and counsel for JAKKS, alleging breaches by the THQ/JAKKS joint venture of the video game license related to the manner of distribution and payment of royalties to the WWE with respect to sales of the WWE video games in Japan. WWE demanded that the alleged breaches be cured within the time periods provided in the video game license, while reserving all of its rights, including its alleged right of termination of the video game license. On April 28, 2006, our counsel responded on behalf of the THQ/JAKKS joint venture, asserting, among other things, that the WWE had been aware and had consented to the manner of distribution in Japan and the payment of royalties with respect to such sales and, in addition, had separately released the joint venture from any claims with respect to such matter as a result of a settlement of a royalty audit of the THQ/JAKKS joint venture. We have also provided documentation to the WWEs counsel in support of our position. WWEs counsel has subsequently responded by letter, reiterating its claims and reservation of all rights, and has requested additional information regarding sales of WWE video games in Japan and certain other Asian countries. We are currently developing our response to WWEs counsels most recent communications. We believe we have several bases for defending any claim of breach of the video game license agreement resulting from the manner of distribution of WWE-licensed products inJapan and other Asian territories.
Due to the early status of this litigation with WWE we cannot estimate a possible loss, if any. Games we develop based upon our WWE license have contributed to approximately 15% of our net sales during each of the three years in the period ended March 31, 2006. The loss of the WWE license would have a negative impact on our future financial results.
Update on 2003 SEC inquiry. On July 11, 2003 we were informed by the staff of the Securities and Exchange Commission (the SEC) that the SEC was conducting a non-public formal investigation entitled In the Matter of Certain Video Game Manufacturers and Distributors. In connection with the investigation, the SEC requested information from us and informed us that other companies in the video game industry had received similar requests for information. The investigation was focused on certain accounting practices, with specific emphasis on revenue recognition. The SEC advised us that its investigation is non-public and should not be construed as an indication from the SEC or its staff that any violations of the law have occurred, nor should it reflect negatively upon any person, entity or security. We cooperated fully with the SEC in its investigation into this matter. Recently, we were advised by the SEC staff that they have concluded their inquiry with respect to THQ and have no present intention to make an enforcement recommendation.
Additionally, we are involved in routine litigation arising in the ordinary course of our business. In the opinion of our management, none of this pending routine litigation will have a material adverse effect on our consolidated financial condition or results of operations.
See Note 21, Subsequent Events Related to the Special Committee and Company Investigations and the Restatement in the Notes to Consolidated Financial Statements for more information regarding legal and regulatory proceedings that arose following March 31, 2006.
There were no matters submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this Annual Report.
THQs common stock is quoted on the NASDAQ National Market under the symbol THQI. The following table sets forth, for the periods indicated, the high and low closing sales prices of our common stock as reported by the NASDAQ National Market:
The last reported price of our common stock on May 26, 2006, as reported by NASDAQ National Market, was $23.10 per share.
As of May 26, 2006 there were approximately 287 holders of record of our common stock.
We have never paid cash dividends on our common stock. We currently intend to retain future earnings, if any, to finance the growth and development of our business and, therefore, we do not anticipate paying any cash dividends in the future. Our principal credit facility agreement provides that we will not pay any cash dividends without consent of the bank.
Information for our equity compensation plans in effect as of March 31, 2006 is as follows (amounts in thousands, except per share amounts):
(1) Represents the aggregate number of shares of THQ common stock to be issued upon exercise of individual compensation arrangements with employee and non-employee option and warrant holders. The outstanding options were primarily granted under the Companys Third Amended and Restated Non-executive Employee Stock Option Plan (the NEEP Plan). For a description of the material features of the NEEP Plan, see Note 15Stock-based Compensation in the notes to the consolidated financial statements.
In fiscal 2005 we granted 240,000 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 warrants vested upon grant and have a six-year term. The fair value of the 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 warrants was $2.0 million.
There were no repurchases of our common stock by the Company during the three months ended March 31, 2006.
The following table summarizes certain selected consolidated financial data, which should be read in conjunction with our consolidated financial statements and Notes thereto and with Managements Discussion and Analysis of Financial Condition and Results of Operations included elsewhere herein. Effective January 1, 2003, we changed our fiscal year end from December 31 to March 31. The change resulted in a three-month transitional period ended March 31, 2003. References to Transition 2003, unless otherwise indicated, refer to the three-month transitional period ended March 31, 2003. Since the change in fiscal year end affects the comparability of the information reflected in the selected financial data, we have included unaudited results for the period from April 1, 2002 through March 31, 2003. Other than this unaudited period, the selected consolidated financial data presented below as of and for each of the fiscal years and Transition 2003 in the five-year period ended March 31, 2006 are derived from our audited consolidated financial statements. The consolidated balance sheets as of March 31, 2006, and 2005, and the consolidated statements of operations for the fiscal years ended March 31, 2006, 2005 and 2004, and the report thereon are included elsewhere in this Form 10-K/A. The information presented in the following
tables has been adjusted to reflect the restatement of our financial results, which is more fully described in the Explanatory Note immediately preceding Part I, Item 1 and in Note 2, Restatement of Consolidated Financial Statements in Notes to Consolidated Financial Statements of this Form 10-K/A. The adjustments, after tax, for fiscal years 2006, 2005, 2004, 2003, Transition 2003 and fiscal 2002 were $2.2 million, $1.4 million, $1.8 million, $1.6 million, $304,000 and $1.8 million, respectively.
Other than as included in this Form 10-K/A, we have not amended our previously-filed Annual Reports on Form 10-K or Quarterly Reports on Form 10-Q for the periods affected by this restatement. The financial information that has been previously filed or otherwise reported for these periods is superseded by the information in this Annual Report on Form 10-K/A, and the financial information contained in such previously-filed reports should no longer be relied upon.
(a) Net income includes a $7.8 million benefit for research and development income tax credits claimed for prior years.
(b) Net income includes a $4.0 million benefit for a settlement of a dispute with directors and officers insurance carrier, net of tax.
(c) Net income includes a charge of $1.8 million due to the other than temporary impairment of our investment in Yukes Co., Ltd. (See Note 9Other Long-Term Assets in Notes to Consolidated Financial Statements). We also changed our fiscal year end from December 31 to March 31, effective January 1, 2003.
(d) Net income includes a charge of $7.9 million, net of tax, for the cancellation of 20 SKUs as well as a charge of $4.6 million, net of tax, related to the settlement of a class action lawsuit and a charge of $1.1 million, net of tax, related to the write-off of inventory and software development for WWF branded games that we had been prevented from shipping pursuant to an action by the World Wide Fund for Nature against World Wrestling Entertainment, Inc. and a charge of $2.8 million, net of tax, related to the discontinuation of our online joint venture in the United Kingdom (Network Interactive Sports, Ltd.).
Notes related to restatement:
(1) See the Explanatory Note immediately preceding Part I, Item 1 and in Note 2, Restatement of Consolidated Financial Statements in Notes to Consolidated Financial Statements of this Form 10-K/A.
(2) The Selected Financial Data for the fiscal year ended March 31, 2003, Transition 2003 and the year ended December 31, 2002 has been restated to reflect adjustments related to stock-based compensation expense and the associated tax impacts as further described in the Explanatory Note immediately preceding Part I, Item 1 of this Form 10-K/A. As a result of these adjustments, net income was reduced by $1.6 million, $304,000 and $1.8 million for the year ended March 31, 2003, Transition 2003 and the year ended December 31, 2002, respectively as follows:
We determined the effects of the restatement on periods prior to fiscal 2002 to be immaterial and have not restated such years separately. The impact on net income for periods prior to fiscal 2002 are contained in the table in the Explanatory Note immediately preceding Part I, Item 1 of this Form 10-K/A. Previously reported stock-based compensation expense in each of the periods prior to fiscal 2002 was nominal.
The following is a discussion of our operating results and the primary trends that affect our business. Certain of these trends and other statements made herein may be forward-looking within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are included herein because management believes that an understanding of these trends is important to understand our results for the fiscal year ended March 31, 2006 (fiscal 2006), 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-K/A, including in the remainder of Managements Discussion and Analysis of Financial Condition and Results of Operations or the consolidated financial statements and related notes. The discussion and analysis herein may be understood more fully by reference to the consolidated financial statements and notes to the consolidated financial statements. Additionally, readers should refer to our cautionary statement on page 1 herein as well as Risk Factors set forth in Item 1A. All references to we, us, our, THQ, or the Company in the following discussion and analysis mean THQ Inc. and its subsidiaries.
The following information has been adjusted to reflect the restatement of our financial results, which is more fully described in the Explanatory Note immediately preceding Part I, Item 1 and in Note 2, Restatement of Consolidated Financial Statements in Notes to Consolidated Financial Statements of this Form 10-K/A. The net of tax impact of the adjustments on our results of operations amounted to $2.2 million, $1.4 million and $1.8 million in fiscal years 2006, 2005 and 2004, respectively.
In addition, options determined to have been granted with an exercise price below the fair market value of our common stock on the actual grant date and vesting subsequent to December 2004 result in nonqualified deferred compensation for purposes of Section 409A of the Internal Revenue Code, and holders are subject to an excise tax on the value of the options in the year in which they vest. We have determined that options to purchase approximately 1.1 million shares of our common stock held by current and former employees may be subject to adverse tax consequences under Section 409A.
In order to mitigate the unfavorable personal tax consequences under Section 409A, in December 2006 we unilaterally corrected the affected options that remain outstanding to increase the exercise price to the fair market value of our common stock on the revised measurement date, and to give the option holders a cash payment equal to the difference between the initial exercise price and the increased exercise price (Cash Payment). We estimate that the Cash Payment will be approximately $2.4 million and will be made in the fourth quarter of fiscal 2007. We will account for the impact of the corrected options as a stock option modification under SFAS 123R.
We also plan to compensate individuals who have exercised options for the consequences of Section 409A. We estimate that we will incur additional compensation expense of $1.6 million in the third quarter of fiscal 2007 in connection with all the actions described above.
Net sales in fiscal 2006 increased 7% over the fiscal year ended March 31, 2005 (fiscal 2005), from $756.7 million to $806.6 million. The increase in net sales for fiscal 2006 was primarily attributable to worldwide sales of 10 titles that sold more than one million units. In fiscal 2005, we published six titles which shipped more than one million units.
In fiscal 2006, our operating margin declined by 570 basis points over fiscal 2005, to 4% of net sales. Our operating margin declined in fiscal 2006 due primarily to (i) higher catalog sales as a percentage of total
net sales (ii) a change in development strategy for our WWE games wherein we ceased internal product development for wrestling games and as a result we wrote-off the underlying capitalized software development costs to software development amortization, and (iii) high price protection and software development amortization for the current-generation title Full Spectrum WarriorTM: Ten Hammers.
Net income for fiscal 2006 (as restated) was $32.1 million, or $0.49 per diluted share, compared to net income of $61.4 million, or $1.02 per diluted share, for fiscal 2005 (as restated). Fiscal 2006 results reflect increased investment in development of video games for next generation consoles. Net income for fiscal 2005 was positively affected by $7.8 million, or $0.13 per diluted share, from the recognition of research and development income tax credits claimed for prior years.
Cash provided by operations was $42.8 million during fiscal 2006, as compared to $60.5 million in fiscal 2005. The decline in cash provided by operations was primarily due to lower net income, higher spending for software development, and higher payments of accrued expenses, partially offset by lower cash spending for licenses.
We expect net sales in fiscal 2007 to increase 12% to 18% as compared to fiscal 2006, resulting in expected net sales of $900 to $950 million. Key titles that we expect to release in fiscal 2007 are Cars on nine platforms, Saints Row on Xbox360 and WWE Smackdown vs. Raw 2007. We also expect to release titles based on Nickelodeon brands and core gamer PC titles such as Company of Heroes and Supreme Commander. We expect our SKU count in fiscal 2007 to increase to approximately 70 from 64 in fiscal 2006 and title count to remain flat in fiscal 2007 compared to fiscal 2006. Our catalog sales are expected to be 25% of our product mix, down from 34% in fiscal 2006.
The following discussion of fiscal 2007 expected results excludes equity based compensation, such as the impact of expensing stock options under SFAS 123R, Share-Based Payment (SFAS No. 123R), a revision of SFAS No. 123, that we will adopt in our first quarter of fiscal 2007. We expect cost of sales to decline slightly as a percentage of net sales in fiscal 2007 compared to fiscal 2006. License amortization and royalties expense, as a percentage of net sales, are expected to decline in fiscal 2007 as we have more original properties in our product mix. Software development amortization, as a percentage of net sales, is expected to increase in fiscal 2007 as compared to fiscal 2006, primarily due to the higher development costs for games on next-generation platforms and product development expense is expected to decrease in fiscal 2007 as many next generation titles have reached technological feasibility. General and administrative costs are expected to remain constant in absolute dollars and decline as a percentage of net sales. We expect operating margins to improve from 4% in fiscal 2006 to 8 to 9% in fiscal 2007. The effective tax rate in fiscal 2007 is expected to be 30% and is subject to change based on changes in geographical profits and other factors. Based on an expected fully diluted share count of 68 million, we expect earnings per share of $0.90 to $1.00 in fiscal 2007. For fiscal 2007, we expect the impact of equity based compensation to be approximately $0.16 per fully diluted share.
Transition to next-generation console systems. Our industry is currently in a transition phase as sales of games for the existing platforms decline and sales of games for new platforms begin to accelerate as new hardware installed bases grow. Microsoft recently launched Xbox 360; Sony and Nintendo have announced plans to introduce new console platforms in calendar 2006 and in fiscal 2005 Nintendo and Sony each launched new handheld platforms. In terms of volume and pricing, sales of interactive entertainment software have traditionally decreased in transition years, as consumers decrease their purchases of software for current generation hardware while they wait for the release of the new platforms. Our strategy during this transition is to: leverage our current brands and catalog titles and selectively introduce high-potential
new franchises for the growing installed base of current-generation hardware and the high-end PC market; establish unique new intellectual properties early in the cycle on next-generation platforms; leverage our handheld leadership; continue to grow wireless revenues and profitability; and pursue emerging revenue opportunities.
Increase in development costs. The next-generation consoles have increased functionality (e.g., realistic environments, artificial intelligence and on-line game play) over their current generation counterparts. The increased functionality delivers a more exciting gaming experience but adds complexity to the development of video games for these new consoles. This complexity increases the overall cost to develop these games and accordingly, during fiscal 2007, we expect our average software development costs to increase as we develop games for these new consoles.
Software pricing. We expect the average selling price of video games on current generation systems will continue to decline as the industry transitions to next-generation console systems. Traditionally video game sales have decreased in transition years, as consumers decrease their purchases of software for current generation hardware while they wait for the release of the new platforms. As the installed base of next-generation hardware grows, and as net sales of video games made for play on those next-generation consoles increases, we expect the average selling price of video games to increase, having a positive impact on our margin.
Increase in installed base. With the introduction of new console platforms, the overall installed base of video game platforms has historically increased. Platform manufactures have reduced pricing on their existing consoles and we expect to continue to ship both new titles and games from our expansive catalog of previously released titles made for play on these consoles. As the installed base of next-generation console platforms increases, we plan to release titles based on our most popular owned and licensed franchise games and weve already built a substantial line-up of games to take advantage of the accelerating market growth which is expected to begin in calendar 2007.
International growth. In fiscal 2006, approximately $31 million of our overall net sales increase of $50 million was attributable to international growth. The international installed base of video game platforms continues to increase and we are focused on expanding our international presence by identifying territories wherein we see opportunity and establishing a direct sales presence to seize such opportunities. In addition to our sales force presence, we are focused on releasing and aggressively marketing titles with international appeal.
The Managements Discussion and Analysis of Financial Condition and Results of Operations discusses our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. The estimates discussed below are considered by management to be critical because they are both important to the portrayal of our financial condition and results of operations and because their application places the most significant demands on managements judgment, with financial reporting results relying on estimates about the effect of matters that are inherently uncertain. Specific risks for these critical accounting estimates are described in the following paragraphs. For all of these estimates, management cautions that actual results may differ materially from these estimates under different assumptions or conditions.
Allowances for price protection, returns and doubtful accounts. We derive revenue from sales of packaged software for video game systems and personal computers and sales of content and services for wireless devices. Product revenue is recognized net of allowances for price protection and returns and various
customer discounts. We typically only allow returns for our personal computer products; however, we may decide to provide price protection or allow returns for our video game systems or personal computer products after we analyze: (1) inventory remaining in the retail channel, (2) the rate of inventory sell- through in the retail channel, and (3) our remaining inventory on hand. We maintain a policy of giving credits for price protection and returns, but do not give cash refunds.
We establish sales allowances based on estimates of future price protection and returns with respect to current period product revenue. We analyze historical price protection granted, historical returns, current sell-through of retailer and distributor inventory of our products, current trends in the video game market and the overall economy, changes in customer demand and acceptance of our products, and other related factors when evaluating the adequacy of the price protection and returns allowance. In addition, management monitors the volume of our sales to retailers and distributors and their inventories, because slow-moving inventory in the distribution channel can result in the requirement for price protection or returns in subsequent periods. In the past, actual price protection and returns have not generally exceeded our reserves. However, actual price protection and returns in any future period are uncertain. While management believes it can make reliable estimates for these matters, if we changed our assumptions and estimates, our price protection and returns reserves would change, which would impact the net revenue we report. In addition, if actual price protection and returns were significantly greater than the reserves we have established, the actual results of our reported net sales would decrease. Conversely, if actual price protection and returns were significantly less than our reserves, our reported net sales would increase.
Similarly, management must use significant judgment and make estimates in connection with establishing allowances for doubtful accounts in any accounting period. Management analyzes customer concentrations, customer credit-worthiness and current economic trends when evaluating the adequacy of the allowance for doubtful accounts. Material differences may result in the amount and timing of our bad debt expense for any period if management made different judgments or utilized different estimates. If our customers experience financial difficulties and are not able to meet their ongoing financial obligations to us, our results of operations may be adversely impacted.
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) 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 holders continued promotion and exploitation of the intellectual property. Prior to the related products 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 managements 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 below the initial forecasted revenues for a particular license, the charge to license amortization and royalties expense may be larger than anticipated in any given quarter. As of March 31, 2006, the net carrying value of our licenses was $81.5 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.
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 SFAS No. 86, Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed. 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 gross revenues from the product, reduced by the estimated future costs of completing the product.
Commencing upon product release, capitalized software development costs are amortized to software development amortization based on the ratio of current revenues to total projected revenues. If actual revenues, or revised projected revenues, fall below the initial projections, the charge to software development amortization may be larger than anticipated in any given quarter. As of March 31, 2006, the net carrying value of our software development was $109.1 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 are expensed to software development amortization as earned.
Goodwill. We perform our annual review for goodwill impairment during the quarters ending June 30, or more frequently if indicators of potential impairment exist. We performed our goodwill impairment review for the quarters ended June 30, 2005 and June 30, 2004, and in both reviews we found no impairment. 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 anticipated 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. We performed similar impairment tests for indefinite-lived intangible assets and found no impairment. The success of our products is affected by the ability to accurately predict which platforms and which products we develop will be successful. Also, our revenues and earnings are dependent on our ability to meet our product release schedules. Due to these and other factors described in Item 1A Risk Factors we may not realize the future net cash flows necessary to recover our goodwill.
Based on these judgments and assumptions, we determine whether we need to take an impairment charge to reduce the value of the goodwill and indefinite-lived intangible assets stated on our balance sheets to reflect their estimated fair values. Judgments and assumptions about future values are complex and often subjective. They can be affected by a variety of factors, including, but not limited to, significant negative industry or economic trends, significant changes in the manner or use of the acquired assets or the strategy of our overall business and significant underperformance relative to expected historical or projected future
operating results. Although we believe the judgments and assumptions we have made in the past have been reasonable and appropriate, there is nonetheless a high degree of uncertainty and judgment involved.
We continue to encounter the risks and difficulties faced with launching or acquiring a new business. When the business is a development studio, we look for ways to maximize the talent and intellectual property within the studio. We make judgments and assumptions as to the commercial success and quantity of games developed by a particular studio. Different judgments and assumptions could materially impact our reported financial results. For example, if we do not develop games with the same commercial success or the same number of games as we have estimated, we may need to take an impairment charge against goodwill in the future. More conservative assumptions of the anticipated future benefits from these businesses would result in lower fair values which could result in impairment charges, which would decrease net income and result in lower asset values on our balance sheets. Conversely, less conservative assumptions would result in higher fair values which could result in lower impairment charges and higher net income.
Income taxes. As part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves: (1) estimating our current tax exposure in each jurisdiction including the impact, if any, of changes or interpretations to applicable tax laws and regulations, (2) estimating additional taxes resulting from tax examinations and (3) making judgments regarding the recoverability of deferred tax assets. To the extent recovery of deferred tax assets is not likely based on our estimates of future taxable income in each jurisdiction, a valuation allowance is established.
The calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax regulations. We recognize liabilities for anticipated tax audit issues in the U.S. and other tax jurisdictions based on our estimate of whether, and the extent to which, additional taxes will be due. Our estimate for the potential outcome for any uncertain tax issue, including our recent claim for research and development income tax credits, requires judgment. We believe we have adequately provided for any reasonably foreseeable outcome related to these matters. However, our future results may include favorable or unfavorable adjustments to our estimated tax liabilities in the period the assessments are made or resolved or when statutes of limitation on potential assessments expire.
As a result of the items discussed above, our actual effective income tax rates can differ from the projected effective income tax rates used when preparing our consolidated financial statements.
In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123R, Share-Based Payment (SFAS No. 123R), a revision of SFAS No. 123. SFAS No. 123R requires companies to, among other things, measure all employee stock-based compensation awards using a fair value method and record the expense in the companys consolidated financial statements. The provisions of SFAS No. 123R, SEC Staff Accounting Bulletin (SAB) No. 107, Share-Based Payment and other related clarifying pronouncements, are effective no later than the beginning of the next fiscal year that begins after June 15, 2005. We will adopt the new requirements in our fiscal year beginning April 1, 2006 using the modified prospective transition method, wherein prior period amounts will not be restated. In addition to the recognition of expense in the financial statements, under SFAS No. 123R, any excess tax benefits received upon exercise of options will be presented as a financing activity inflow rather than as an adjustment of operating activity as currently presented. Based on our current analysis and information, management has determined the adoption of SFAS No. 123R will have a material impact on our consolidated results of operations and earnings per share. We expect the adoption of SFAS No. 123R will result in amounts that are similar to our current pro forma disclosures under SFAS No. 123.
In November 2005, the FASB issued Staff Position No. FAS 115-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (FSP No. 115-1). FSP No. 115-1 provides accounting guidance for identifying and recognizing other-than-temporary impairments of debt and equity securities, as well as cost method investments in addition to disclosure requirements. FSP No. 115-1 is effective for reporting periods beginning after December 15, 2005, and earlier application is permitted. We adopted FSP No. 115-1 in our fiscal fourth quarter beginning January 1, 2006, and this adoption did not have a material impact on our consolidated results of operations and earnings per share.
Our net income for fiscal 2006 (as restated) was $32.1 million, or $0.49 per diluted share, as compared to $61.4 million, or $1.02 per diluted share in the restated prior fiscal year (as restated). Our restated results did not effect net sales in either fiscal 2006 or fiscal 2005.
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 fiscal 2006 and 2005 (in thousands):
Net sales in fiscal 2006 increased 7% over the prior fiscal year, from $756.7 million to $806.6 million. The increase in net sales was primarily due to the following:
· An increase in the number of titles that shipped more than one million units in the fiscal year from six in fiscal 2005 to 10 in fiscal 2006.
· Higher fiscal 2006 sales of new original, owned properties targeted to the core gamer, Juiced, Destroy All Humans! and The Outfit, our first next generation console title, as compared tocore gamer titles released in the prior fiscal year: Full Spectrum Warrior, The Punisher and Warhammer 40,000: Dawn of War.
· International net sales increased $30.5 million and 11% in fiscal 2006 as compared to fiscal 2005 due to continued sales and marketing expansion in the international markets as well as the release of games with increased international appeal.
· The continued sales of games released in prior fiscal years (we refer to this as catalog sales).
· Higher sales of games on handheld platforms due to the introduction of Nintendo Dual Screen and PlayStation Portable.
· These items were partially offset by lower fiscal 2006 sales of titles based on two of our key brands: The Incredibles: Rise of the Underminer and SpongeBob SquarePants: Lights, Camera, PANTS! as
compared to fiscal 2005 releases: The Incredibles and The SpongeBob SquarePants Movie, which were released in conjunction with their respective movie releases.
Year-over-year net sales growth in North America was primarily due to sales of original, owned properties targeted to the core gamer, Destroy All Humans! and Juiced, sales of games based on our WWE SmackDown vs. Raw franchise on current generation console platforms as well as the first-time release of the WWE SmackDown vs. Raw franchise on PSP. These items were partially offset by lower fiscal 2006 sales of The Incredibles: Rise of the Underminer and SpongeBob SquarePants: Lights, Camera, PANTS! as compared to fiscal 2005 releases of The Incredibles and The SpongeBob SquarePants Movie, which were released in conjunction with their respective movie releases.
While we expect net sales in North America to continue to constitute the largest portion of our net sales in fiscal 2007, we expect net sales for North America as a percentage of total sales to decrease slightly as we continue to expand our international direct sales and product mix.
Year-over-year international net sales growth was primarily due to increased sales of our original, owned properties targeted to the core gamer, Juiced and Destroy All Humans!, as compared to Full Spectrum Warrior and The Punisher in the prior fiscal year, as well as increased sales of games based on our WWE SmackDown vs. Raw franchise on current generation console platforms and the first-time release of the WWE SmackDown vs. Raw franchise on PSP. These items were partially offset by lower fiscal 2006 sales of The Incredibles: Rise of the Underminer and SpongeBob SquarePants: Lights, Camera, PANTS! as compared to fiscal 2005 releases of The Incredibles and The SpongeBob SquarePants Movie, which were released in conjunction with their respective movie releases.
Changes in foreign currency rates reduced reported international net sales by $11.4 million or 3% in fiscal 2006, as compared to the prior fiscal year. Excluding the impacts of foreign exchange rates, international net sales increased by 15% in fiscal 2006.
We will continue to focus on growing sales internationally in fiscal 2007, as we expand our product portfolio and direct sales forces in the international markets. In early 2006, we established offices in Denmark and Japan to facilitate direct sales of our products into the Nordic territories and the Japanese market. We plan to expand our direct sales force into Italy and Eastern Europe and we continue to explore opportunities in Asia, especially China.
Our worldwide net sales by platform for fiscal 2006 and fiscal 2005 are as follows (in thousands):
Net sales for console platforms increased 7% for fiscal 2006 as compared to the prior fiscal year. We released 31 and 30 new console SKUs in fiscal 2006 and 2005, respectively.
Sony PlayStation 2 Net Sales (in thousands)
In fiscal 2006, net sales of video games for PlayStation 2 (PS2) were primarily driven by the release of WWE SmackDown! vs. Raw 2006, Juiced and Destroy All Humans!, as well as catalog sales. In fiscal 2005, net sales of video games for PS2were primarily driven by the release of WWE SmackDown! vs. Raw, The Incredibles, and The SpongeBob SquarePants Movie, as well as catalog sales. We released 12 and 14 new SKUs in fiscal 2006 and 2005, respectively. A SKU is a version of a title designed for play on a particular platform. Net sales increased $20.4 million in fiscal 2006 as compared to the prior fiscal year primarily due to:
· higher sales of our two new owned, original properties targeted to the core gamer: Juiced and Destroy All Humans!, as compared to core gamer titles released in fiscal 2005: Full Spectrum Warrior, MX v. ATV Unleashed and The Punisher;
· higher sales of WWE SmackDown! vs. Raw 2006 as compared to the prior year release of WWE SmackDown! vs. Raw;
· higher catalog sales mainly attributable to increases in sales of games based on our WWE and MX franchises, as well as Disney/Pixars The Incredibles and The SpongeBob SquarePants Movie;
· partially offset by lower fiscal 2006 sales of The Incredibles: Rise of the Underminer as compared to the fiscal 2005 release of The Incredibles, which was released in conjunction with its movie release.
Sony announced it would release its next-generation console, PlayStation 3, in November 2006. We expect sales of games for PlayStation 2 to decline in the future as consumer demand shifts to PlayStation 3.
Microsoft Xbox and Xbox 360 Net Sales (in thousands)
In fiscal 2006, net sales of video games for Xbox and Xbox 360 were primarily driven by the release of WWE Wrestlemania 21, Destroy All Humans!, The Outfit and Juiced. In fiscal 2005 net sales of video games for Xbox were primarily driven by the release of Full Spectrum Warrior, The Incredibles and The Punisher. We released 12 and eight new SKUs in fiscal 2006 and 2005, respectively. Net sales increased by $22.0 million in fiscal 2006 as compared to the prior fiscal year primarily due to:
· the release of The Outfitfor Xbox 360 whereas there were no Xbox 360 SKUs released in fiscal 2005;
· sales of our new release WWE Wrestlemania 21: there were no WWE titles released on Xbox in fiscal 2005;
· higher sales of our two new owned, original properties targeted to the core gamer: Juiced and Destroy All Humans!, as compared to core gamer titles released in fiscal 2005: MX v. ATV Unleashed and The Punisher;
· four additional SKUs released in fiscal 2006 as compared to fiscal 2005;
· partially offset by lower sales of Full Spectrum Warrior: Ten Hammers, as compared to Full Spectrum Warrior released in fiscal 2005;
· and partially offset by lower fiscal 2006 sales of The Incredibles: Rise of the Underminer as compared to fiscal 2005 wherein we released The Incredibles which was released in conjunction with its movie release.
In November 2005, Microsoft launched its next-generation console, Xbox 360, in North America, Europe and Japan. We expect to release new SKUs in fiscal 2007 for Xbox 360. As the installed base of Xbox 360 hardware grows, we expect to bring more titles to the platform, including games targeted to the core gamer such as our new, owned intellectual property Saints Row, titles based on our WWE license and a game based on Disney/Pixars Cars. We expect sales of games for Xbox to decline as consumer demand shifts to games for the Xbox 360.
Nintendo GameCube Net Sales (in thousands)
In fiscal 2006, net sales of video games for GameCube were primarily driven by the release of WWE Day of Reckoning 2, SpongeBob SquarePants: Lights, Camera, PANTS!, Nicktoons: Unite and The Incredibles: Rise of the Underminer, as well as catalog sales. In fiscal 2005, net sales of video games for GameCube were primarily driven by the release of The Incredibles, WWE Day of Reckoning and The SpongeBob SquarePants Movie. We released seven and eight new SKUs in fiscal 2006 and 2005, respectively. Net sales decreased by $13.9 million in fiscal 2006 as compared to the prior fiscal year primarily due to:
· lower sales of our fiscal 2006 releases of The Incredibles: Rise of the Underminer and SpongeBob SquarePants: Lights, Camera, PANTS! as compared to fiscal 2005 releases of The Incredibles and
The SpongeBob SquarePants Movie, both which were released in conjunction with their respective movie releases;
· lower sales of our fiscal 2006 release of WWE Day of Reckoning 2, as compared to WWE Day of Reckoning in the prior fiscal year;
· partially offset by sales of our fiscal 2006 release of Bratz: Rock Angelz with no comparable title in the prior fiscal year.
We expect net sales from GameCube products to decline in fiscal 2007, as compared to fiscal 2006, due to a reduced SKU count and the upcoming launch of Nintendos next-generation console, Wii. We expect sales of games for GameCube to decline in the future as consumer demand shifts to video games made for Wii.
Net sales for handheld platforms increased 16% for fiscal 2006 as compared to the prior fiscal year. We released 22 and 20 new handheld SKUs in fiscal 2006 and 2005, respectively. Both Nintendo and Sony have launched new handheld platforms, Dual Screen (DS) and PlayStation Portable (PSP), respectively. Consistent with our expectations, net sales of games for those new platforms increased in fiscal 2006, while net sales of games for Game Boy Advance declined.
Nintendo Game Boy Advance Net Sales (in thousands)
In fiscal 2006, net sales of video games for Game Boy Advance were primarily driven by the release of Bratz: Rock Angelz, SpongeBob SquarePants: Lights, Camera, PANTS! and The Incredibles: Rise of the Underminer, as well as sales of our Game Boy Advance Double Packs. Game Boy Advance Double Packs feature two previously released titles on one cartridge, providing us with a way to reintroduce our top selling mass-market titles. In fiscal 2005, net sales of video games for Game Boy Advance were primarily driven by the release of The Incredibles, The SpongeBob SquarePants Movie and Sonic Advance 3, as well as catalog titles. We released 10 and 19 new SKUs in fiscal 2006 and 2005, respectively. Net sales decreased by $32.9 million in fiscal 2006 as compared to the prior fiscal year primarily due to:
· lower sales on our fiscal 2006 releases of The Incredibles: Rise of the Underminer and SpongeBob SquarePants: Lights, Camera, PANTS! as compared to fiscal 2005 releases of The Incredibles and The SpongeBob SquarePants Movie, both which were released in conjunction with their respective movie releases;
· strong prior year performance of Sonic Advance 3 without a comparable game released in fiscal 2006;
· nine fewer SKUs released in fiscal 2006 as compared to fiscal 2005 and an overall decline in the Game Boy Advance market due to the introduction of DS and PSP into the handheld video game market;
· partially offset by a 21% increase in sales of catalog titles, mainly Game Boy Advance Double Packs.
We expect net sales from the Game Boy Advance products to decline in fiscal 2007, as compared to fiscal 2006, due to a reduced SKU count as we expand our offerings to DS and PSP.
Nintendo Dual Screen Net Sales (in thousands)
In fiscal 2006, net sales of video games for DS were primarily driven by the release of Zoo Tycoon, SpongeBob SquarePants: Yellow Avenger and The Incredibles: Rise of the Underminer. We released eight and one new SKUs in fiscal 2006 and 2005, respectively. Net sales increased by $29.7 million in fiscal 2006 as compared to the prior fiscal year. The increase is due to the increased number of titles released in fiscal 2006 as compared to the prior fiscal year.
As the installed base of DS hardware grows, we expect to continue to bring more titles to the platform, including our market-leading family brands, games based on Disney/Pixars Cars,and titles based on Nickelodeon properties such as SpongeBob SquarePants and Nicktoons.
PlayStation Portable Net Sales (in thousands)
In fiscal 2006, net sales of video games for PSP were driven by the release of WWE SmackDown vs. Raw 2006. We released four and zero new SKUs in fiscal 2006 and fiscal 2005, respectively. As the installed base of PSP hardware grows, we expect to bring more titles to the platform, including our market-leading family brands, games based on Disney/Pixars Cars,and titles based on our own Juiced brand.
Wireless Net Sales (in thousands)