Friday Video Game Update: Will THQ Survive?

Sales of video game software in October were strong, rising 35% year over year compared to expectations of 20-25%. But hold on before you run out and buy a basket of video game stocks, because there are definite winners and losers.

I won't recap the October number, you can read about it here. Instead, I'd like to focus on THQ (THQI) as a cautionary tale. THQ came into the current console cycle (meaning: the release of the Xbox 360, Playstation 3, and Nintendo Wii) in a strong position. The company was growing, and management had a plan to increase their intellectual property. As opposed to licensed games where THQ pays a fee for using certain characters or stories (i.e. to Disney/Pixar, for making a game based on the movie Cars), intellectual property would be fully owned by the company, resulting in higher profit margins. Think Take-Two (TTWO) and Grand Theft Auto.

Additionally, as it became clear the Wii was going to be the big console winner, some speculated that THQ would benefit due to its past success on Nintendo (NTDOY) platforms and a history of family-friendly games. THQ management believed this themselves. Everything was lining up well for THQ. You can read about their plans and their optimism in old conference call transcrips on Seeking Alpha. Here are some highlights from CEO Brian Ferrill on the August 2007 call:

On today's call, I would like to share with you our THQ is continuing to execute on our strategies to drive revenue and margin growth. Specifically, we plan to, one, grow annual revenues from our big family and casual franchises. Two, sequel and extend our growing portfolio of owned intellectual properties. Three, introduce one to three new intellectual properties each year that have long-term franchise potential....

At these years E3, it was clear that Nintendo’s new platforms are truly expanding the markets for video games and we are excited to build upon our heritage as the leading independent publisher on Nintendo’s hardware....

We plan to ship more than 1 million units each of five owned properties, Stuntman, Juiced, Frontlines, MX vs. ATV and Destroy All Humans!

But, in the end, it all comes down to executing on good, popular games. By THQ's own admission, titles like Stuntman and Juiced were simply not competitive. Now I wonder if THQ can survive to see the next cycle. Activision (ATVI) has solidified its position by combining with Blizzard and a gazillion World of Warcraft addicts. Electronic Arts (ERTS) has been struggling, but the sports games keep the cash flowing. Some say Take-Two is a one-hit wonder, but it's a heckuva hit (Grand Theft Auto) and they have arguably some of the best creative talent in the business (Bioshock was very impressive). THQ, in my opinion, doesn't come close with its slate of games.

My friend The Long/Short Trader is more optimistic on THQ (after being pessimistic in 2007), based on the Ultimate Fighting Championship license and a possible takeover bid. While it wouldn't surprise me if THQ got snapped up by Disney or Electronic Arts, I'm beginning to wonder if that isn't the only way THQ can make it. When the next console cycle begins, video game publishers will need to ramp up spending to develop the next generation of games. Even though THQ currently has no debt, they are not expected to make a profit in FY09. They are struggling just when the industry should be near peak profitability for the cycle.

So, the best option for THQ, in my opinion, is to shop themselves to a bigger player. They may survive as an independent company, but they are on the road to being a second-rate publisher. Indeed, the stock shows that they look less like strong and healthy Activision and more like totally dysfunctional Midway (MWY). Ouch. (Click on the chart to enlarge, but beware--it's ugly.)