ITEM 1. BUSINESS
INTRODUCTION
We are a developer, publisher and distributor of interactive entertainment software for the leading hardware platforms in the home video game market. We currently publish titles for Sony's PlayStation, Sega Dreamcast, Nintendo 64, Nintendo Game Boy and Game Boy Color, and personal computers ("PCs") in most interactive software genres, including action, adventure, driving, fighting, puzzle, role playing, simulation, sports and strategy. Our customers include Wal-Mart, Toys "R" Us, Target, Kmart Stores, Kay Bee Toys, Electronics Boutique, Blockbuster, Best Buy, other national and regional retailers, discount store chains and specialty retailers.
Our games are developed both internally and under contract with independent developers, and are typically based on properties licensed from third parties. We continually seek to identify and develop titles based upon entertainment projects (such as movies, television programs and arcade games), sports and entertainment personalities, or popular sports, trends or concepts that have high public visibility or recognition or that reflect the trends of popular culture. Other than games that we release on CD-ROM for use on PCs, all of our products consist of cartridges and CD-ROMs manufactured for us by Nintendo, Sony and Sega.
Over the past four years, we have experienced significant growth in net sales and net income. During the year ended December 31, 1999, our net income grew to $32.9 million from $21.9 million in 1998 (excluding in-process research and development charge in 1998). In the year ended December 31, 1999, our net sales increased to $302.4 million from $216.1 million in 1998, $89.6 million in 1997 and $50.3 million in 1996, representing a compound annual growth rate of 157%.
We are a Delaware corporation that was incorporated in 1997. We were formerly incorporated in New York in 1989 under the name T.HQ, Inc. Our principal executive offices
are located at 27001 Agoura Road, Calabasas Hills, California 91301, and our telephone number is (818) 871-5000. Our web site is at www.thq.com.
THQ(R) is our registered trademark and trade name. Nintendo(R), Super Nintendo Entertainment System(R) ("SNES"), Game Boy(R), Game Boy Color(R) and Nintendo 64(R) are registered trademarks of Nintendo of America, Inc. ("Nintendo"). Sega(R), Genesis(R), Game Gear(R), Saturn(R) and Dreamcast(R) are registered trademarks of Sega of America, Inc. ("Sega"). Sony PlayStation(R) and Sony PlayStation 2(R) are registered trademarks of Sony Computer Entertainment Inc. ("Sony"). Nintendo, Sony and Sega are referred to herein collectively as the "manufacturers."
THE INTERACTIVE ENTERTAINMENT INDUSTRY AND TECHNOLOGY
The home interactive game market consists both of (i) cartridge-based, CD-ROM-based and DVD-ROM based software for use solely on dedicated hardware systems, and (ii) software distributed on CD-ROMs for use on PCs. Until 1996, most software for dedicated platforms was sold in cartridge form. However, CD-ROMs and DVD-ROMs have become increasingly popular because they have substantially greater data storage capacity and lower manufacturing costs than cartridges.
The first modern platform was introduced by Nintendo in 1985 using "8-bit" technology. "8-bit" means that the central processing unit, or "chip," on which the software operates is capable of processing data in 8-bit units. Subsequent advances in technology have resulted in continuous increases in the processing power of the chips that power both the platforms and PCs. As the technology of the hardware has advanced, the software designed for the platforms has similarly advanced, with faster and more complex images, more lifelike animation and sound effects and more intricate scenarios. The larger data storage capacity of CD-ROMs (and subsequent DVD-ROMs in yet to be released systems, Sony PlayStation 2, Microsoft X-Box and the Nintendo Dolphin) enables them to provide richer content and longer play. The new Sony and Microsoft systems will have a robust on-line hardware component hoping to take full advantage of the advent of broadband networking. Currently, the non-portable platforms being marketed are based primarily on 32-bit and 64-bit technology. Portable platforms are less sophisticated technologically and do not require television monitors.
The following table sets forth the year of release in the United States of each of the manufacturers' platforms for which we have published titles and the technology on which such platforms are based:
We believe that the success of a video game is dependent on the graphic look and feel of the game, the depth and variation of game play and the popularity of the property on which the game is based.
Sega launched its newest platform, Dreamcast, in Japan in the fall of 1998 and introduced it in the United States in the fall of 1999. Sony has launched the successor to the PlayStation, the PlayStation 2, in Japan. The PlayStation 2 is scheduled for launch in the U.S. market in late 2000. Nintendo has plans to launch a new platform in 2001 called the Dolphin. Microsoft has also announced a new platform, X Box, scheduled to debut in the fall of 2001. While we have not formally committed to these platforms, it is likely that we will publish for them. Software for new platforms requires different standards of design and technology to fully exploit their capabilities. The introduction of new platforms also requires that game developers devote substantial additional resources to product design and development.
BUSINESS STRATEGY
Our goals are to expand our position as a leading provider of exciting, high-quality interactive entertainment software on a variety of platforms, intelligently take advantage of opportunities provided by the internet, and to continue to emphasize profitability by maintaining strict cost controls and managing the risks associated with software development. In order to achieve these goals, management is focused on implementing the following strategies:
- BUILD CONTENT BY CAPITALIZING ON EXISTING BRANDS AND ACQUIRING NEW ONES. Brand recognition and sustainable consumer appeal allow THQ to exploit titles over an extended period of time through the release of sequels and extensions and to re-release such products at different price points. Brands represent content over which we have control either by developing our own proprietary titles or obtaining exclusive licenses to established properties for extended time periods. We intend to continue to capitalize on currently established brands such as World Wrestling Federation (through a venture with JAKKS Pacific), Nickelodeon's Rugrats, MTV Sports and Ricky Carmichael's Championship Motocross, by launching new titles on multiple hardware platforms. We also intend to increase our product content through new brands such as Scooby Doo, Power Rangers, Evil Dead and Summoner. It is our goal to expand our library of brands, reaching a broad audience, while increasing our focus on original content.
- TECHNOLOGY. We intend to publish for the next generation of video game systems. The expansion of internal product development to over 100 employees positions us to take advantage of new game technology. Pacific Coast Power & Light Company, a development studio acquired in May 1999, is focused solely on development for the new PlayStation 2 platform. Heavy Iron Studios, consisting of video game and feature film veterans, is currently working on Evil Dead
(scheduled for release in the fall of 2000) for multiple platforms. GameFx is now exclusively developing proprietary tools for the new game platforms.
- ON-LINE GAMING / E-COMMERCE. We believe our recent acquisition of Genetic Anomalies positions us to benefit from opportunities on the Internet. Genetic Anomalies' "Collectible Bits" technology has application to both on-line gaming and E-Commerce environments. The potential for this technology is evidenced by a competitor licensing it for one of their key franchises. We plan to release our first on-line title, WWF: With Authority, in mid-2000. Further, we will be examining opportunities for bringing our mass-market brands to the Internet, while preparing to take advantage of the on-line capabilities of new console systems and broadband connectivity.
- EXPAND GLOBAL REACH. While our foreign sales increased to 24.7% of total sales in 1999, we believe we can further expand our presence in foreign markets. Industry estimates indicate that the international market for interactive software is roughly equal to the U.S. market. Our acquisition of Rushware Microhandelsgesellschaft mbH and its subsidiaries (collectively "Rushware") contributed to our international growth in 1999, increasing market penetration in German speaking territories and expanding our PC business. To further grow in global markets, we intend to increase product offerings targeted to foreign consumers with titles such as Mercedes Benz Truck Racing, TOCA Touring Car Champions and Cultures. We are expanding our foreign marketing and distribution capabilities by opening new sales and marketing offices in France (November 1999) and Australia (March 2000). These new offices will bring THQ product direct to retailers in France, Australia and New Zealand, allowing THQ to potentially obtain higher sales and margins in these territories.
- CONTINUE TO EXPLOIT THE GAME BOY COLOR PLATFORM. As the largest independent domestic publisher of Game Boy titles (according to the NPD's TRST data), we will continue to take advantage of this platform. Our market position makes us an attractive partner for licensors wanting to put their products on the Game Boy system, as evidenced by our recent agreement with Fox Interactive for The Simpsons, Buffy the Vampire Slayer, Croc, and Aliens franchises. The relative low cost of developing games for the Game Boy, combined with the platform's large installed base, provides the opportunity to generate continuing sales and profits from this system with less risk than other platforms.
- MAINTAIN COST CONTROLS AND MANAGE RISK. We minimize our fixed expenses by using independent software developers, adopting warehouse and shipping systems that closely link fulfillment costs to sales volumes, and compensating sales employees and representatives based on sales volumes. In addition, we attempt to reduce the risks associated with excessive or obsolete inventory by utilizing strict ordering and inventory controls.
We intend to continue pursuing potential acquisition transactions consistent with these strategies. In addition, in order to create a closer relationship with independent developers, we may from time to time make investments or acquire minority interests in independent developers.
TITLES
We have released an aggregate of 207 titles as of December 31, 1999, consisting of 13 Nintendo Entertainment System ("NES") titles, 64 Game Boy/Game Boy Color titles, seven Sega Game Gear titles, 14 Sega Genesis titles, 47 Super Nintendo Entertainment System ("SNES") titles, three Sega Saturn titles, 28 Sony PlayStation titles, 13 Nintendo 64 titles and 18 PC titles. We continually seek to acquire licenses to publish and distribute additional titles.
The following tables set forth, for each platform, the titles (i) released by us in 1999 and anticipated to be released in 2000, and (ii) the date of release (or anticipated release) of each title. We cannot assure you that each of the titles anticipated for release in 2000 will be released when scheduled, if ever.
* Excludes titles we expect to release in 2000 but which we have not yet publicly announced. **Title released as of March 31, 2000. ***Titles for German speaking territories only.
INTELLECTUAL PROPERTY LICENSES
Our strategy includes the creation of exciting games based on licensed properties that have attained a high level of consumer recognition or acceptance. We believe that we enjoy excellent relationships with a number of licensors, including WWF, Disney, Viacom/Nickelodeon, Time Warner and LucasArts.
We pay royalties to our property licensors that generally range from 6% to 13% of our net sales of the corresponding title. We typically pay minimum guaranteed royalties over the license term and advance payments against such guarantees. License fees tend to be higher for properties with proven popularity and less perceived risk of commercial failure. To the extent competition intensifies for licenses of highly desirable properties, we may encounter difficulty in obtaining these licenses. See "-- Competition." Licenses are of variable duration, may be exclusive for a specific title or line of titles, and may in some instances be renewable upon payment of certain minimum royalties or the attainment of specified sales levels. Other licenses are not renewable upon expiration, and we cannot assure you that we and the licensor will reach agreement to extend the term of any particular license.
Our property licenses generally grant us exclusive use of the property for the specified titles, on specified platforms, within a defined territory and during the license term. However, licensors typically retain the right to exploit the property for all other purposes, including the right to license the property for use with other platforms. Our games based on a particular property for use with one or more particular platforms may compete with games published by other companies that are based on the same property but for a different platform.
AGREEMENT WITH JAKKS PACIFIC, INC.
We have entered into an agreement with JAKKS Pacific, Inc. ("JAKKS"), to govern our relationship with respect to the WWF license we jointly obtained from Titan Sports, Inc. (now known as World Wrestling Federation Entertainment, Inc. (the "WWF")) in June 1999. Our relationship with JAKKS was established to develop, manufacture, distribute, market and sell video games pursuant to the license from the WWF. We control the venture, therefore, all transactions and balances are consolidated with the Company. The principal terms of this operating agreement are as follows:
- - We will be responsible for funding all operations of the venture, including all payments owing to the WWF.
- - For the period commencing November 16, 1999 and ending December 31, 2003, JAKKS will be entitled to receive a preferred payment equal to the greater of a fixed guaranty, payable quarterly, or specified percentages of the "net sales" from WWF licensed games (as defined) in amounts that vary based on the platform. The payment of these amounts is guaranteed by
us. We are entitled to the profits and cash distributions remaining after the payment of these amounts. At December 31, 1999, we have unearned preferred payments remaining for the initial four year period of approximately $10.4 million.
- - For periods after December 31, 2003, the amount of the preferred payment will be subject to renegotiation between the parties. An arbitration procedure is specified in the event the parties do not reach agreement.
- - We will be responsible for the day-to-day operations of the venture. We will continue to be responsible for development, sales and distribution of the WWF licensed games, while JAKKS will continue to be responsible for the approval process and other relationship matters with the WWF. We will both continue to co-market the games.
PLATFORM LICENSES
Our business is dependent on our license agreements with the manufacturers. All of these licenses are for fixed terms and are not exclusive. Each license grants us the right to develop, publish and distribute titles for use on such manufacturers' platforms, and requires that such titles be embodied in products that are manufactured solely by such manufacturers.
The following table sets forth information with respect to our platform licenses. In some instances, we have more than one platform license for a particular platform.
- ---------- (1) This license does not set a maximum number of titles that we may publish in the designated territory; however, each title must be approved by the manufacturer prior to development of the software.
Nintendo charges us a fixed amount for each cartridge. This amount varies based, in part, on the memory capacity of the cartridges. Sony charges a royalty for every CD-ROM manufactured. The amounts charged by the manufacturers include a manufacturing, printing and packaging fee as well as a royalty for the use of the manufacturer's 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 title's 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 the manufacturer and incorporated in the products, may infringe the rights of third parties. Our agreements with our independent software developers and property licensors typically provide for us to be indemnified with respect to certain matters. However, if any claim is brought by a manufacturer against us for indemnification, 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 manufacturer's 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, the manufacturer has the right to purchase from us, at the price paid by us, any product inventory manufactured by such manufacturer that remains unsold for a specified period after termination. We must destroy any such inventory not purchased by the manufacturer. Upon termination as a result of our breach or default, we must destroy any remaining inventory, subject to the right of any of our institutional lenders to sell such inventory for a specified period.
SOFTWARE DESIGN AND DEVELOPMENT
After we identify and acquire a property from a licensor, we design and develop a game with features intended to exploit the characteristics of the property and to appeal to the game's target consumers. Our software development process generally takes one of two forms.
INTERNAL DEVELOPMENT. The in-house development of product is currently conducted by our Pacific Coast Power & Light, Heavy Iron and Genetic Anomalies studios. GameFx has become our applied technology developer and is focused on the development of proprietary tools for the coming generation of gaming platforms. Our studios are staffed by producers, programmers, software engineers, artists, animators and game testers.
EXTERNAL DEVELOPMENT. Our external development is supervised by our Vice President -- Product Development. We contract with independent software developers to conceptualize and develop games under our supervision. Our agreements with software developers are usually entered into on a game-by-game basis and generally provide for the payment of the greater of a fixed amount or royalties based on actual sales. We generally pay our developers installments of
the fixed advance based on specific development milestones. Royalties in excess of the fixed advance are based on a fixed amount per unit sold and range from $.30 to $5.00 per unit for some developers, while others are based on a percentage of net sales ranging from 7% to 20%. We generally obtain ownership of the software code and related documentation. We may make strategic investments in independent developers for the purpose of securing access to proprietary software and talented developers.
Upon completion of development, each game is extensively "play-tested" by us and sent to the manufacturer for its review and approval. Related artwork, user instructions, warranty information, brochures and packaging designs are also developed under our supervision. The development cycle for a new game, including the development of the necessary software, approval by the manufacturer and production of the initial products, typically has ranged from nine to 18 months. This relatively long development cycle requires that we assess whether there will be adequate retailer and consumer demand for a game well in advance of its release.
MANUFACTURING
Sony, Nintendo and Sega are the sole manufacturers of the products sold for use on their respective platforms.
The manufacturing process begins with our placing a purchase order with a manufacturer and opening either a letter of credit in favor of the manufacturer or utilizing our line of credit with the 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. Nintendo typically delivers cartridges to us within 30 to 45 days of its receipt of an order and a corresponding letter of credit and Sony typically delivers CD-ROMs to us within 10 to 20 days. We will order our first Sega Dreamcast product in 2000.
We are required by the 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.
MARKETING, SALES AND DISTRIBUTION
We are dependent on the high name recognition of the properties on which our games are based to attract customers and to obtain shelf space in stores. Our sales activities are directed by our Senior Vice President -- Sales and Marketing, who maintains contact with major retail accounts and manages the activities of our independent sales staff and regional sales representatives.
UNITED STATES AND CANADIAN SALES. Our games are promoted to retailers by display at trade shows, such as the annual Electronic Entertainment Expo (E3). We also conduct print and cooperative retail advertising campaigns for most titles and prepare promotional materials, including product videos, to increase awareness among retailers and consumers.
Our marketing efforts for products released in 1999 included national television, print, radio and Internet advertising campaigns. Products shipped in 1999 that received television support included WCW Thunder, Rugrats Scavenger Hunt, Championship Motocross Featuring Ricky Carmichael, Road Rash 64, Rugrats Studio Tour, MTV Sports: Snowboarding and WWF Wrestlemania 2000. Our games were also supported by in-store retail promotions such as trailers, demo discs, standees, over-size boxes, posters and pre-sell giveaways. International marketing activities included television advertising for Rugrats and publicity campaigns in gaming publications, magazines and newspapers included covers, contests, product previews, reviews and game strategies. In addition, we developed product-specific Internet sites and expanded on-line publicity and advertising efforts.
Most of our sales are made directly to retailers. We distribute our games primarily to mass merchandisers and national retail chain stores, including Wal-Mart (representing 15% of net sales in 1999), Toys "R" Us (representing 11% of net sales in 1999), Target, Kmart Stores, Kay Bee Toys, Electronics Boutique, Blockbuster and Best Buy. Sales to our ten largest customers collectively accounted for approximately 65% of our gross sales in 1998 and 54% of our gross sales in 1999. We do not have any written agreements or other understandings with any of our customers that relate to their future purchases, so our customers may terminate their purchases from us at any time.
We utilize electronic data interchange with most of our major domestic 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 ship our products to our domestic customers from a public bonded warehouse in Southern California.
We supplement the efforts of our sales employees with independent sales representatives. Our agreements with our representatives set forth their exclusive territory, types of customers to be solicited, commission rate and payment terms.
The domestic retail price for our titles generally ranges between $19 and $35 for Game Boy and Game Boy Color, between $19 and $49 for PlayStation, between $20 and $60 for Nintendo 64, and between $10 and $50 for PC games.
GERMAN DISTRIBUTION. In December 1998, we acquired Rushware, a German company that now serves as our distributor and publisher in Germany and other German-speaking countries. This acquisition has increased the proportion of our foreign sales that are made in German-speaking countries. It is our expectation that we will eventually use Rushware to distribute our products throughout continental Europe. We believe that this will enable us to realize higher margins on our products distributed in these territories than if such products were to continue to be distributed by third parties.
Rushware is a party to a License and Localization Agreement with LucasArts that grants us the exclusive right to continue distributing, through August 1, 2000, the PC and PlayStation products developed and published by LucasArts in German-speaking Europe. This agreement also covers any titles that LucasArts decides to publish in these territories for the Dreamcast
platform, and provides that any future titles that LucasArts decides to publish in these territories may be added to the license. Rushware has been distributing LucasArts products in German-speaking Europe since 1988.
OTHER FOREIGN SALES. We distribute our titles in all viable international markets. In 1999, we had direct-to-retail operations in the UK and Germany. As of January 2000, we have established direct relationships with retailers in France via our new French office in Paris. We anticipate that by July 2000 we will also have direct-to-retail relationships in Australia via our new Australian office in Melbourne. Other European territories such as Italy, Spain, Benelux, etc. are handled by the UK office through strategic distribution relationships whereby we primarily supply finished goods as well as marketing support. Other non-European territories such as Brazil, Singapore, Korea, etc. are handled by international representatives in the US office through strategic distribution and licensing agreements. While the majority of our sales occur in the territories where we have direct relationships, we can supply a given title in up to forty countries worldwide.
INTELLECTUAL PROPERTY RIGHTS
Each game we release embodies a number of separately protected intellectual property rights of the manufacturer, the property licensor and, to a lesser extent, us. The licensor of the property owns the trademarks, trade names, copyrights and other intellectual property rights relating to the property on which the game is based. The manufacturer owns the patents and substantially all of the other intellectual property embodied in the product. While we own the game software embodied in the product, we believe that such software has little independent economic value. Accordingly, we must rely on the manufacturer and the property licensor with respect to protection from infringement of the property rights by third parties.
Each of the manufacturers incorporates security devices in its platforms and products to prevent unlicensed use. In addition, Nintendo requires its licensees to display the "Nintendo Seal of Approval" to notify the public that the game has been approved by Nintendo for use with a Nintendo platform.
COMPETITION
The software industry is intensely competitive. We compete, for both licenses to properties and the sale of software, with the manufacturers, each of whom is the largest developer and marketer of software for its platforms. These companies may increase their own software development efforts. As a result of their commanding positions in the industry as the manufacturers of platforms and publishers of software for their platforms, the manufacturers generally have better bargaining positions with respect to retail pricing, shelf space and purchases than do any of their licensees, including us.
In addition to the manufacturers, our competitors include Acclaim Entertainment, Inc., Activision, Inc., Electronic Arts Inc., GT Interactive Software Corp., Hasbro Inc., Midway Games Inc. and Microsoft Corporation. Each of the manufacturers has a broader software line and greater financial, marketing and other resources than us, as do some of our other competitors.
Accordingly, some of our competitors may be able to market their software more aggressively or make higher offers or guarantees in connection with the acquisition of licensed properties.
At various times, toy companies, large software companies, movie studios and others have focused on the video game market, resulting in greater competition for us. Additionally, many of our competitors are developing on-line interactive games and interactive networks that will be competitive with our interactive products. We will be "releasing" our first on-line game during 2000.
As competition for retail shelf space becomes more intense, we may need to increase our marketing expenditures to maintain sales of our titles; and as competition for popular properties increases, our cost of acquiring licenses for such properties is likely to increase, resulting in reduced margins. Prolonged price competition, increased licensing costs or reduced profit margins would have a material adverse effect on us.
In addition, the market for our products is characterized by significant price competition and we may face increasing pricing pressures from our current and future competitors. Further, as the industry transitions from the current platforms (Sony PlayStation and Nintendo 64) to the next generation platforms (Sony PlayStation 2, Nintendo Dolphin and Microsoft X-Box), there may be price erosion on the existing consoles. Accordingly, there can be no assurance that competitive pressures will not require us to reduce our prices. Any material reduction in the price of our products would adversely affect operating income as a percentage of net revenue and would require us to increase unit sales in order to maintain net revenue.
EMPLOYEES
As of December 31, 1999, we had 288 full-time employees, of whom 22 are located in the United Kingdom, 73 are located in Germany and two are located in France. None of our employees is represented by a labor union or covered by a collective bargaining agreement, and we believe that relations with our employees are good.
ITEM 2.
ITEM 2. PROPERTIES
Our executive offices occupy approximately 32,500 square feet of office space at 27001 Agoura Road, Calabasas Hills, California, pursuant to a lease expiring in September 2005. We lease additional office space for development personnel in Calabasas, Santa Clara and Culver City, California, and in Lexington, Massachusetts, for THQ UK's employees in Woking, England and for Rushware's employees in Kaarst, Germany.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Two individual shareholders have filed essentially identical purported class actions on February 18, 2000 and on March 2, 2000, respectively, in the United States District Court for the Central District of California, alleging that we and certain of our directors and senior officers violated Section 10(b) of the Securities and Exchange Act of 1934 and SEC Rule 10b-5. Each
case seeks class action status on behalf of all individuals who purchased our shares of common stock between October 26, 1999 and February 10, 2000. Each complaint alleges that we issued false and misleading statements about our financial results and prospects during the class period, and that the individual defendant directors and officers participated in the alleged scheme so as to sell their personal shares at inflated prices. We believe the claims are without merit, and intend to vigorously defend against them.
While we are a party to other legal proceedings from time to time, such legal proceedings have been ordinary and incidental to our business and have not had a material adverse effect on us.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during the fourth quarter of 1999.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS
The 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 the common stock on March 20, 1999, as reported by NASDAQ National Market, was $18.25 per share. As of March 20, 1999, there were approximately 400 holders of record of the common stock.
DIVIDEND POLICY
We have never paid cash dividends on our capital 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 principle banking agreements provide that at such times as we have any outstanding borrowings or letters of credit under that facility, we will not pay any cash dividends.
SECURITIES ISSUED IN PRIVATE TRANSACTIONS
In June 1998, in partnership with JAKKS Pacific, Inc., we signed an exclusive agreement with Titan Sports, Inc. (now known as the World Wrestling Federation Entertainment (the "WWF")) to publish electronic games based on the World Wrestling Federation franchise on all hardware platforms. In connection with this transaction, in August 1999 we issued to the WWF and a related party warrants expiring December 31, 2009 to purchase an aggregate of 281,250 shares of our common stock at $10.42 per share which had a fair value of $3.0 million at the time of issuance. These warrants were issued pursuant to the exemption from registration provided in
Section 4(2) of the Securities Act of 1933, as amended, for transactions not involving a public offering.
On May 24, 1999, in connection with our acquisition of Pacific Coast Power & Light Company ("PCP&L"), we issued an aggregate of 727,436 shares of our common stock to certain stockholders of PCP&L pursuant to the exemption from registration provided in Section 4(2) of the Securities Act of 1933, as amended.
On December 13, 1999, in connection with our acquisition of Genetic Anomalies, Inc., we issued an aggregate of 220,048 shares of our common stock to certain stockholders of Genetic Anomalies, Inc. pursuant to the exemption from registration provided in Section 4(2) of the Securities Act of 1933, as amended.
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA (IN THOUSANDS, EXCEPT PER SHARE DATA)
The following table presents certain selected consolidated financial data for the years 1995 through 1999. The information presented for each of the years ended December 31, 1997, 1998 and 1999 have been derived from, and are qualified by reference to, our audited consolidated financial statements included elsewhere herein. Those financial statements have been audited by Deloitte & Touche LLP, independent auditors. The information presented for each of the years ended December 31, 1995 and 1996 were derived from audited financial statements that are not included elsewhere herein.
This selected consolidated financial data should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements and Notes thereto included elsewhere herein.
STATEMENT OF OPERATIONS DATA
BALANCE SHEET DATA
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
We develop, publish and distribute interactive entertainment software for the major platforms sold by Nintendo, Sony and Sega and for use on PCs. See "Business -- Titles." The following table sets forth, for the periods indicated, the percentage of our revenues derived from sales of titles for the platforms indicated:
Our business cycle generally commences with the securing of a license to publish one or more titles based on a property. These licenses typically require an advance payment to the licensor and a guarantee of minimum future royalties. See "-- Recovery of Prepaid Royalties, Guarantees and Capitalized Development Costs." After obtaining the license, we begin software development for the title. Upon completion of development and approval of the title by the manufacturer, we order products and generally cause a letter of credit to be opened in favor of the manufacturer or obtain a line of credit from the manufacturer. Products are shipped at our expense to a public warehouse in California for domestic distribution, or to the United Kingdom or Germany for foreign distribution. Foreign sales to distributors in countries other than the United Kingdom and Germany are shipped at the customer's expense directly to the customer's location. Both in the United Kingdom and in Germany, we sell directly to our major retail accounts.
Unfilled sales orders are commonly referred to as "backlog." Since substantially all of our product orders are fulfilled shortly after we receive them, we do not believe that the amount of our unfilled sales orders as of the end of a period is a meaningful indicator of sales in future periods. Accordingly, we do not report the amount of our unfilled sales orders.
On May 24, 1999 and December 13, 1999, we completed mergers with Pacific Coast Power & Light Company, a California corporation ("PCP&L") and Genetic Anomalies, a Delaware corporation ("GA"), respectively. The mergers have been accounted for as poolings of interests under Accounting Principles Board Opinion No. 16. Accordingly, all prior period consolidated financial statements presented have been restated to include the combined results of operations, financial position and cash flows as if PCP&L and GA had always been part of our company.
REVENUE FLUCTUATIONS AND SEASONALITY. We have experienced, and may continue to experience, significant quarterly fluctuations in net sales and operating results due to a variety of factors. The software market is highly seasonal, with sales typically significantly higher during the fourth quarter (due primarily to the increased demand for interactive games during the year-end holiday buying season). Other factors that cause fluctuations include the timing of our release of new titles, the popularity of both new titles and titles released in prior periods, changes in the mix of titles with varying profit margins, the timing of customer orders, the timing of shipments by the manufacturers, fluctuations in the size and rate of growth of consumer demand for software for various platforms, the timing of the introduction of new platforms and the accuracy of retailers' forecasts of consumer demand. Our expenses are based, in part, on our expectations of future revenues and, as a result, operating results would be disproportionately and adversely affected by a decrease in sales or a failure by us to meet our sales expectations. There can be no assurance that we can maintain consistent profitability on a quarterly or annual basis.
Profit margins may vary over time as a result of a variety of factors. Profit margins for cartridge products can vary based on the cost of the memory chip used for a particular title. As games have become more complex by providing richer playing capabilities, the trend in the interactive entertainment software industry has been to utilize chips with greater capacity and thus greater cost. CD-ROMs have significantly lower per unit manufacturing costs than cartridge-based products, generally resulting in higher royalties for CD-ROM based products. We anticipate that the next generation of DVD based games will follow a cost and royalty model similar to the CD-ROM based console model.
RECOVERY OF PREPAID ROYALTIES, GUARANTEES AND CAPITALIZED DEVELOPMENT COSTS. We typically enter into agreements with licensors of properties and developers of titles that require advance payments of royalties and/or guaranteed minimum royalty payments. We cannot guarantee that the sales of products for which such royalties are paid will be sufficient to cover the amount of these required royalty payments. We capitalize our advances to developers as prepaid royalties and capitalize internal software development costs for each title incurred after the establishment of technological feasibility of the title. Amortization of these payments and costs is determined on a title-by-title basis based on the greater of (i) the ratio of current gross revenues for a title to the sum of its current and anticipated gross revenues, or (ii) the straight-line method over the estimated remaining economic life of the title. We analyze these capitalized costs quarterly and write off associated prepaid and deferred royalties and software development costs when, based on our estimate, future revenues will not be sufficient to recover such amounts. As of December 31, 1999, we had prepaid royalties and capitalized development costs of $40.3 million. If we were required to write off prepaid royalties or capitalized development costs in excess of the amounts reserved, our results of operations could be materially and adversely affected.
DISCOUNTS, ALLOWANCES AND RETURNS; INVENTORY MANAGEMENT. In general, except for PC titles, our arrangements with our distributors and retailers do not give them the right to return products to us (other than damaged or defective products) or to cancel firm orders. However, we sometimes negotiate accommodations to retailers (and, less often, to distributors) when demand
for specific games falls below expectations, in order to maintain our relationships with our customers. These accommodations include our not requiring that all booked orders be filled, negotiated price discounts and credits against future orders. We may also permit the return of products. Arrangements made with distributors and retailers for PC titles do customarily require us to accept product returns.
At the time of product shipment, we establish allowances based on estimates of future returns, customer accommodations and doubtful accounts with respect to such products. We base this amount on our historical experience, retailer inventories, the nature of the titles and other factors. For the years ended December 31, 1997, 1998 and 1999, we took provisions of approximately $10.5 million, $20.8 million and $35.0 million, respectively, against gross sales made during such periods. As of December 31, 1999, our aggregate reserve against accounts receivable for returns, customer accommodations and doubtful accounts was approximately $24.2 million.
The identification by us of slow-moving or obsolete inventory, whether as a result of requests from customers for accommodations or otherwise, would require us to establish reserves against such inventory or to write-down the value of such inventory to its estimated net realizable value.
NET OPERATING LOSS CARRYFORWARDS. At December 31, 1999, we had $9,259,000 of net operating loss ("NOL") carryforwards incurred since 1993 for federal income tax purposes, and $638,000 for state. Various equity transactions during 1996 resulted in an "ownership change" for purposes of Sections 382 and 383 of the Internal Revenue Code of 1986, as amended. As a result, the amount of the NOL carryforwards available to reduce our federal income tax liability in years in which we have taxable income is limited to an amount equal to approximately $2.2 million per year through the year 2011, when the carryforwards expire.
YEAR 2000 DISCLOSURE
Many computer programs used only two digits to identify years. These programs were designed without consideration for the effect of the change in century, and if not corrected, could have failed or created erroneous results at the year 2000. Essentially all of our information technology-based systems, as well as many non-information based systems, were potentially affected by the Year 2000 issue.
In order to prepare for the Year 2000 issue, we implemented the following remediation plan for technology-based systems:
1. Identification of all applications and hardware with potential Year 2000 issues.
2. For each item identified, perform an assessment to determine an appropriate action plan and timetable for remediation of each item.
3. Implementation of the specific action plan.
4. Test each application upon completion.
5. Place the new process into production and conduct system integration testing.
We successfully implemented the above remediation plan for all affected information technology-based systems and other remediation plans related to non-Management Information Systems and to products sold before the turn of the century. Following the arrival of the Year 2000, we have not experienced any problems with products or materials manufactured and/or supplied by third parties. There was no interruption in our ability to order and deliver our products and transact business with our suppliers and customers. We have received no notification from customers regarding Year 2000 issues related to products we have sold. We continue to monitor our systems, suppliers and products for any unanticipated issues that may not yet have manifested.
The total cost of achieving Year 2000 compliance was approximately $200,000. All costs related to achieving Year 2000 compliance are based on management's best estimates.
EURO CURRENCY CONVERSION
On January 1, 1999, eleven of the fifteen member countries of the European Union adopted the Euro as their common legal currency. The Euro trades on currency exchanges and is available for non-cash transactions. From January 1, 1999 through January 1, 2002, participating countries can also maintain their national ("legacy") currencies as legal tender for goods and services. Beginning January 1, 2002, new Euro-denominated bills and coins will be issued, and legacy currencies will be withdrawn from circulation no later than July 1, 2002. Our operating subsidiaries in the United Kingdom and Germany have been affected by the Euro conversion and have established plans to address any business issues raised, including the competitive impact of cross-border price transparency. It is not anticipated that there will be any near term business ramifications; however, the long-term implications, including any changes or modifications that will need to be made to business and financial strategies, are still being reviewed. From an accounting, treasury and computer system standpoint, the impact from the Euro currency conversion is not expected to have a material impact on the financial position or results of operations of THQ and its subsidiaries.
RESULTS OF OPERATIONS
The following table sets forth, for the periods indicated, the components of our net sales and our consolidated operating data as a percentage of net sales:
COMPARISON OF THE YEAR ENDED DECEMBER 31, 1999 TO THE YEAR ENDED DECEMBER 31,
The following table sets forth, for the years ended December 31, 1999 and 1998, the titles released during such periods for the platforms indicated:
Our net sales increased to $302,357,000 in the year ended December 31, 1999, from $216,111,000 in the same period of 1998, as a result of increased foreign sales, a larger number of products shipped, and the market success of key titles. For the year ended December 31, 1999, net sales of our Rugrats titles, WCW titles and WWF titles, were $84,204,000 (27.8% of net sales), $64,615,000 (21.4% of net sales), and $42,011,000 (13.9% of net sales), respectively.
Our foreign net sales grew to $74,656,000 for the year ended December 31, 1999, from $29,132,000, in the same period of 1998, and increased as a percentage of net sales to 24.7% from 13.5%. The increase in our foreign net sales in 1999 was attributable to the addition of our Rushware subsidiary (which added the LucasArts brand in Germany as well as European specific product) and the success of key titles such as wrestling and Rugrats in certain foreign markets.
Our cost of sales for the year ended December 31, 1999 decreased slightly as a percentage of net sales to 44.5% from 46.3% in the same period of 1998, primarily as a result of the increase in PlayStation and CD-ROM product sales which generally have more favorable gross margins than cartridge products.
Our royalty expense for the year ended December 31, 1999 decreased as a percentage of net sales to 16.0% from 22.3% in the same period in 1998. Sales in 1999 consisted of some in-house titles carrying minor or no royalties, LucasArts games in Europe which carry no royalties, and selected successful titles which had favorable royalty rates.
Our product development expenses increased from $6,849,000 in 1998 to $12,770,000 in 1999. This increase reflects the addition of three internal studios during the year and an increase in our corporate product development group to better manage our increased volume of titles in development.
For the year ended December 31, 1999, our selling and marketing expenses increased by $15,115,000 compared to the year ended December 31, 1998, as a result of several significant advertising and promotional campaigns to promote our WWF titles, Rugrats, Championship Motocross and MTV Sports brands as well increased warehouse expenses, infrastructure and personnel costs (both domestic and foreign) incurred as a result of our growth in 1999.
For the year ended December 31, 1999, we incurred expense in the amount of $6,119,000 to our venture partner, JAKKS Pacific. Pursuant to the arrangement regarding the license with the WWF, THQ pays JAKKS Pacific a preferred return on product sales and JAKKS Pacific shares in other income derived from the license.
Our general and administrative expenses for the year ended December 31, 1999 remained relatively constant as a percentage of net sales at 5.0% compared to 4.8% for the same period of 1998, but increased in dollar terms by $4,533,000 over 1998. This increase can be attributed to the expansion of our corporate offices, amortization of a new sales and financial accounting software package, and a full year of general and administrative expenses for Rushware.
The in-process research and development charge of $7,232,000 incurred during 1998 represents purchase costs relating to the acquisition of GameFx. Purchased research and development includes the value of products in the development stage and not considered to have reached technological feasibility. The technology purchased was completed in 1999 and did not result in a commercially successful product.
For the year ended December 31, 1999, interest income increased by $262,000 compared to 1998, as a result of increased cash flows from operations and higher average investment balances during the period.
During the year ended December 31, 1999 we recorded a tax provision of $18,287,000, an increase of $8,945,000 over 1998. The effective tax rate for 1999 was 35.7% compared to 39.0% in 1998. The 1998 effective tax rate was negatively impacted by the fact that the purchased in-process research and development costs of $7,232,000 were not deductible for tax purposes. The negative impact of the in-process research and development was offset by the partial reversal of the valuation reserve against deferred tax assets. The 1999 effective tax rate was positively impacted by the reversal of the remaining $2,461,000 valuation allowance.
COMPARISON OF THE YEAR ENDED DECEMBER 31, 1998 TO THE YEAR ENDED DECEMBER 31,
The following table sets forth, for the years ended December 31, 1997 and 1998, the titles released during such periods for the platforms indicated:
Our net sales increased to $216,111,000 in 1998, from $89,579,000 in 1997, primarily as a result of higher unit sales per title shipped. For the year ended December 31, 1998, net sales of our WCW titles, Rugrats titles and Quest 64 release were $140,441,000 (65.0% of net sales), $17,741,000 (8.2% of net sales) and $17,367,000 (8.0% of net sales), respectively.
Our foreign net sales grew to $29,132,000 for the year ended December 31, 1998, from $13,998,000, in the same period of 1997, yet decreased as a percentage of net sales to 13.5% from 15.6%, as a consequence of our substantial increase in domestic sales. Our foreign sales in 1998 were attributable to the release of WCW titles, and World Cup 98 and Small Soldiers for the Game Boy platform in foreign markets in 1998, as well as continued demand for previously released titles.
Our cost of sales for 1998 decreased significantly as a percentage of net sales to 46.3%, from 53.7% in 1997, primarily as a result of the increase in sales of PlayStation titles (which generally have more favorable gross margins than cartridge titles for Nintendo's platforms).
Our royalty expense for 1998 increased $33,367,000 over the same period in 1997 and increased as a percentage of our net sales to 22.3% from 16.5% in 1997. The rise reflects the fact that license and development royalty rates on the 32-bit and 64-bit games released in 1998 were higher than those typical for older platforms.
Our product development expenses increased by $4,962,000 in 1998 as compared to 1997. This was due in part to the increased costs associated with the development of 32-bit, 64-bit, PC and on-line games, and also reflects operating costs due to increased personnel in connection with the acquisition of GameFx in May 1998.
Our selling and marketing expenses increased by $11,592,000 in 1998 over 1997, as a result of increased marketing efforts for new titles. This consisted primarily of television, print and retail cooperative advertising and increased warehouse expense (which is the result of increased sales volume). Selling and marketing expenses as a percentage of our net sales were 9.4% in 1998 as compared to 9.7% in 1997.
Our general and administrative expenses for 1998 decreased as a percentage of net sales to 4.8%, from 6.3% for 1997, but increased in dollar terms by $4,803,000 over 1997. This
increase occurred both domestically and internationally and was in response to the growth we experienced in 1998.
The in-process research and development charge of $7,232,000 incurred during 1998 represents purchase costs relating to the acquisition of GameFx. Purchased research and development includes the value of products in the development stage and not considered to have reached technological feasibility.
LIQUIDITY AND CAPITAL RESOURCES
Our principal uses of cash are product purchases, guaranteed payments to licensors, advance payments to developers and the costs of internal software development. In order to purchase products from the manufacturers, we typically open letters of credit in their favor or obtain a line of credit from the manufacturer. As of December 31, 1999, we had obligations with respect to future guaranteed minimum royalties of $31,404,000.
Our cash and cash equivalents increased to $21,303,000 at December 31, 1999 from $19,063,000 at December 31, 1998. Cash used in operating activities for 1999 was $7,109,000, reflecting our use of working capital to partially fund our growth. As of March 20, 2000 our cash and cash equivalents were $35,878,000.
Accounts receivable at December 31, 1999 increased from December 31, 1998 as a result of increased sales volume and the later shipment of key titles during the fourth quarter of 1999 compared to the same period of 1998. Prepaid and deferred royalties and software development costs increased from December 31, 1998 as a result of our entering into several new licensing contracts and the significant increase in the number of products in development at the end of 1999. See "--Recovery of Prepaid Royalties, Guarantees and Capitalized Development Costs." Accrued royalties also increased, in part, as a result of new contracts for licenses and product development. Additionally, increased demand for certain titles sold in 1999 resulted in royalties due in excess of the minimum guarantees on the related contracts. Inventory and related accounts payable decreased during 1999 as the 1998 balance reflected the advanced purchases of product relating to the expiration of the WCW license. Such product was purchased prior to the termination date of the license (December 28, 1998) and was sold during the first half of 1999.
The amount of our accounts receivable is subject to significant seasonal variations as a consequence of the seasonality of our sales, and is typically highest at the end of the year. As a result, our working capital requirements are greatest during our third and fourth quarters. We believe that our cash on hand, funds provided by operations, and our revolving credit facilities will be adequate to meet our anticipated requirements for operating expenses, product purchases, guaranteed payments to licensors and software development through 2000.
Our capital expenditures were $4,413,000 in 1999 reflecting a significant investment in new operational and financial systems. We expect to make capital expenditures of between $4,000,000 and $5,000,000 in 2000 as we continue to invest in our business systems and next generation development tools.
Net cash provided by financing activities for 1999 was $11,981,000, and was provided by the short-term borrowings and the exercise of options and warrants to purchase our common stock.
CREDIT FACILITIES. In December 1998, we entered into two trade finance agreements (as amended) with Union Bank of California that established a revolving credit facility. These agreements currently expire on June 1, 2000. The principal agreement (as amended) permits us to borrow (and maintain obligations under outstanding letters of credit) up to $43,000,000, subject to the following:
- We may maintain outstanding letters of credit for product purchases of up to $38 million in the aggregate through the end of February 2000;
- We may maintain outstanding letters of credit for product purchases of up to $25 million in the aggregate between March 1, 2000 and June 1, 2000;
- We may borrow up to $30 million through February 29, 2000, $25 million during March 2000, and $15 million during April and May 2000, (including amounts owing as a result of draws under letters of credit), but we are required to not have any borrowings for a period of at least 60 days during each year of the term of the agreement.
Our other agreement with Union Bank is for our United Kingdom subsidiary, T.HQ International Ltd., and permits that subsidiary to obtain product purchase letters of credit of up to $7 million in the aggregate.
These credit facilities are secured by a lien on substantially all of our assets and those of T.HQ International Ltd. Amounts outstanding under these credit facilities bear interest, at our choice, at either a) the bank's prime rate (8.5% at December 31, 1999) or b) the London Interbank Offered Rate (5.69% at December 31, 1999) plus 1.85%. As of December 31, 1999, we had $16,702,000 in outstanding borrowings under these credit facilities and had obligations in respect of outstanding letters of credit of $8,134,000. As of March 20, 2000 we had no outstanding borrowings and outstanding letters of credit amounted to $1,800,000.
These agreements contain financial covenants, including the requirement that we:
- maintain the ratio of our cash, cash equivalents and accounts receivable, to our current liabilities (including advances by the bank), at not less than 1.00:1.00 at the end of each quarter;
- maintain minimum shareholders' equity;
- maintain the ratio of our total liabilities to our shareholders' equity at not greater than 1.10:1.00 as of December 31, 1998 and 1.00:1.00 as of the end of each quarter thereafter;
- achieve operating profits of at least $1 each quarter; and
- maintain the ratio of the value of our inventory as of the last day of any quarter, to our cost of goods sold for the four consecutive quarters ending on that day (or four times our cost of goods sold for the last quarter, if greater), at not more than 1.00:10.50.
These agreements also contain customary non-financial covenants including restrictions on the incurrence of debt and encumbrances and limitations on sales of assets, mergers and acquisitions, dividends, capital expenditures and annual lease obligations.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to certain market risks arising from transactions in the normal course of business, principally risk associated with interest rate and foreign currency fluctuations.
INTEREST RATE RISK
Our interest rate risk is immaterial due to the short maturity of the debt. We have no fixed rate debt.
FOREIGN CURRENCY RISK
We have not hedged our foreign currency exposure in the past. It is possible that in the future we will enter into foreign currency contracts in order to manage or reduce foreign currency market risk.
Our earnings are affected by fluctuations in the value of our subsidiaries' functional currency as compared to the currencies of our foreign denominated sales and purchases. The results of operations of our subsidiaries, as reported in U.S. dollars, may be significantly affected by fluctuations in the value of the local currencies in which we transact business. Such amount is recorded upon the translation of the foreign subsidiaries' financial statements into U.S. dollars, and is dependent upon the various foreign exchange rates and the magnitude of the foreign subsidiaries' financial statements. During the year ended December 31, 1999, our foreign currency translation loss
adjustment was $902,000. Currency transaction gains and losses for the years ended December 31, 1997, 1998 and 1999 were not significant. A hypothetical 10% change in the relevant currency rates at December 31, 1999 would not result in a material gain or loss. In addition to the direct effects of changes in exchange rates, which are a changed dollar value of the resulting sales and related expenses, changes in exchange rates also affect the volume of sales or the foreign currency sales price as competitors' products become more or less attractive.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Financial Statements and supplementary data, together with the report of Deloitte & Touche LLP dated February 24, 2000, required by this Item are included in Item 14 of this annual report and are incorporated herein by reference.
Please note that the Financial Statements included herein reflect a correction made to an inter-company consolidation error in our fourth quarter financial results as previously announced on February 23, 2000. The correction reduced both revenues and cost of goods sold by approximately $4,067,000, (3.1% and 6.5%, respectively, for the quarter and 1.3% and 2.9%, respectively, for the year), as compared to what was announced on February 23, 2000. The correction does not impact earnings per share, net income, gross margins or operating expenses. In addition, we have included in the Financial Statements the fair market value of the warrants issued to the WWF. This addition resulted in an increase of $3,063,000 million to deferred royalties net - of current portion and to additional paid-in capital, as compared to what was included in the Balance Sheet that was in our press release of February 23, 2000. This addition does not impact the Statement of Operations.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required under this Item relating to members of the Board of Directors and Executive Officers of THQ will be included in our 2000 Notice of Annual Meeting of Shareholders and Proxy Statement under the headings "Election of Directors," "Executive Officers," "Key Employees," "Compliance with Section 16 of the Securities Exchange Act of 1934" and "Director and Officer Holdings," which will be filed within 120 days after the close of our fiscal year, and is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required under this Item relating to executive compensation will be included in our 2000 Notice of Annual Meeting of Shareholders and Proxy Statement under the heading "Executive Compensation," which will be filed within 120 days after the close of our fiscal year, and is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required under this Item relating to security ownership of certain beneficial owners and management will be included in our 2000 Notice of Annual Meeting of Shareholders and Proxy Statement under the heading "Principal Shareholders," which will be filed within 120 days after the close of our fiscal year, and is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required under this Item relating to certain relationships and related transactions will be included in our 2000 Notice of Annual Meeting of Shareholders and Proxy Statement under the headings "Employment Agreements" and "Director and Officer Transactions," which will be filed within 120 days after the close of our fiscal year, and is incorporated herein by reference.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES.
See Index to Financial Statements.
(b) REPORTS ON FORM 8-K.
None.
(c) EXHIBITS.
- ----------
*Management contract or compensatory plan or arrangement required to be filed as an exhibit hereto pursuant to Item 14(c) of Form 10-K.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Dated: March 28, 2000 THQ INC.
By: /s/ Brian J. Farrell --------------------------------- Brian J. Farrell, President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
THQ INC.
All financial statement schedules have been omitted since either (i) the schedule or condition requiring a schedule is not applicable or (ii) the information required by such schedule is contained in the Consolidated Financial Statements and Notes thereto.
INDEPENDENT AUDITORS' REPORT
To the Shareholders of THQ Inc., Calabasas, California
We have audited the accompanying consolidated balance sheets of THQ Inc. and subsidiaries (the "Company") as of December 31, 1998 and 1999, and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 1998 and 1999, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1999 in conformity with accounting principles generally accepted in the United States of America.
DELOITTE & TOUCHE LLP
Los Angeles, California February 24, 2000
THQ INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
See notes to consolidated financial statements.
THQ INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
See notes to consolidated financial statements.
THQ INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
Years Ended December 31, 1997, 1998 and 1999
(continued)
See notes to consolidated financial statements.
THQ INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
SUPPLEMENTAL SCHEDULE OF NON-CASH ACTIVITIES:
In 1998 and 1999, income taxes payable and additional paid-in capital include tax benefits of $1,603,000 and $6,763,000, respectively, resulting from disqualified dispositions of common stock by officers and employees of THQ acquired through the exercise of stock options.
In 1999, we consolidated the venture with JAKKS Pacific resulting in the consolidation of our $2,010,000 investment.
On August 2, 1999 we issued to the WWF and a related party warrants expiring December 31, 2009 to purchase 281,250 shares of common stock at $10.42 per share, which had a fair value at the time of issuance of $3,063,000. (See Note 13).
On May 1, 1998 we issued 532,776 shares of common stock as part of the purchase price for GameFx, Inc. This issuance increased common stock and additional paid-in capital by $2,000 and $6,217,000, respectively, and was allocated among the net assets acquired, part of which was written off as in-process research and development. (See Note 12).
On December 2, 1998 we issued 249,930 shares of common stock as part of the purchase price for Rushware Microhandelsgesellschaft mbH ("Rushware"). This issuance increased common stock and additional paid-in capital by $2,000 and $4,430,000, respectively, and was allocated among the net assets acquired. (See Note 12).
DETAILS OF 1998 ACQUISITIONS:
In 1999, we renegotiated the purchase of Rushware and received a payment of $2,540,000 from the sellers.
THQ INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. DESCRIPTION OF BUSINESS
BUSINESS. THQ Inc., a Delaware corporation, is a developer, publisher and distributor of interactive entertainment software for the leading hardware platforms in the home video game market. We currently publish titles for Sony's PlayStation, Sega Dreamcast, Nintendo 64, Nintendo Game Boy and Game Boy Color, and personal computers ("PCs") in most interactive software genres, including action, adventure, driving, fighting, puzzle, role playing, simulation, sports and strategy. Our customers include Wal-Mart, Toys "R" Us, Target, Kmart Stores, Kay Bee Toys, Electronics Boutique, Blockbuster, Best Buy, other national and regional retailers, discount store chains and specialty retailers.
Unless the context otherwise requires, references in this document to "THQ" or the "Company" include THQ Inc. and all of its wholly owned subsidiaries.
LICENSE AGREEMENTS. We have two license agreements with Sony pursuant to which we have the non-exclusive right to utilize the Sony name and its proprietary information and technology in order to develop and market software for use with the 32-bit Sony PlayStation in the United States and Canada, and Europe, respectively, which expire in August 2002 and December 2005, respectively.
We have various license agreements with Nintendo pursuant to which we have the non-exclusive right to utilize the Nintendo name and its proprietary information and technology in order to develop and market software for use with the 64-bit Nintendo 64, and with the Nintendo Game Boy portable game consoles. The license agreements with Nintendo for such hardware platforms expire at various times from 2000 through 2002.
We also have two license agreements with Sega pursuant to which we have the non-exclusive right to utilize the Sega name and its proprietary information and technology in order to develop and market software for use with the 128-bit Sega Dreamcast in the United States and Canada, Latin America, Europe, Australia and New Zealand, respectively, which expire in September 2003 and October 2003, respectively.
Our business is dependent on these license agreements with Sony, Nintendo and Sega. Substantially all of our products are manufactured by Sony, Nintendo and Sega, who charge us a fixed amount for each CD-ROM or cartridge manufactured, which charge includes a manufacturing, printing and packaging fee as well as a royalty for the use of their respective names, proprietary information and technology.
In addition, we must indemnify Sony, Nintendo or Sega as appropriate, with respect to all loss, liability and expense resulting from any claim against Sony, Nintendo or Sega involving the development, marketing, sale or use of our titles, including any claims for copyright or trademark infringement brought against Sony, Nintendo or Sega. As such, we bear the risk that the properties and information and technology licensed from Sony, Nintendo or Sega and
incorporated in the software may infringe the rights of third parties. Generally, we are entitled to indemnification from our software developers and property licensors to cover our indemnification obligations to Sony, Nintendo or Sega but no assurance can be given that, if any claim is brought against us, the developers and/or licensors will have sufficient resources to indemnify us.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION. The consolidated financial statements include the accounts of THQ Inc. and our wholly owned subsidiaries. All material intercompany balances and transactions have been eliminated in consolidation.
FOREIGN CURRENCY TRANSLATION. Assets and liabilities of foreign operations are translated at current rates of exchange while results of operations are translated at average rates in effect for the period. Translation gains or losses are shown as a separate component of shareholders' equity. Foreign currency gains and losses result from exchange rate changes for transactions denominated in currencies other than the functional currency. We have not experienced significant foreign currency transaction gains or losses.
CASH EQUIVALENTS. We consider all highly liquid investments purchased with maturities less than three months to be cash equivalents.
FAIR VALUES OF FINANCIAL INSTRUMENTS. The carrying value of our draws on our line of credit from our banks are considered to approximate their fair value because the interest rate of these instruments is based on variable reference rates.
CONCENTRATIONS OF CREDIT RISK. Financial instruments which potentially subject us to concentration of credit risk consist principally of cash and cash equivalents and accounts receivable. We place cash and cash equivalents with high credit-quality institutions and limit the amount of credit exposure to any one institution. Most of our sales are made directly to mass merchandisers and national retailers. Due to the increased volume of sales to these channels, we have experienced an increased concentration of credit risk, and as a result, may maintain individually significant receivable balances with such mass merchandisers and national retailers. While we frequently monitor and manage this risk, financial difficulties on the part of one or more of our major customers may have a material adverse effect on us.
Sales (before returns and allowances) to a major customer represented 10%, 19% and 15% of gross sales in the years ended December 31, 1997, 1998 and 1999, respectively. This customer accounted for approximately 32% and 18% of accounts receivable at December 31, 1998 and 1999, respectively. Sales (before returns and allowances) to another major customer represented 19%, 13% and 11% of gross sales in the years ended December 31, 1997, 1998 and 1999, respectively. This customer accounted for approximately 12% and 15% of accounts receivable at December 31, 1998 and 1999, respectively. We perform ongoing credit evaluations of our customers and maintain an allowance for potential credit losses.
INVENTORY. Inventory, which consists principally of finished products, are stated at the lower of cost (moving weighted average) or market. We estimate the net realizable value of slow-moving inventory on a title by title basis, and charge the excess of cost over net realizable value to cost of sales.
PROPERTY AND EQUIPMENT. Property and equipment are stated at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets. Leasehold improvements are amortized over the shorter of their useful lives or the remaining lease term. Property and equipment consist of the following at:
ROYALTIES, SOFTWARE DEVELOPMENT COSTS AND PROJECT ABANDONMENT LOSS. Advance royalty payments for intellectual property licenses are recorded as prepaid royalties. All minimum guaranteed royalty payments are initially recorded as an asset (prepaid and deferred royalties) and as a liability (accrued royalties) at the contractual amount upon execution of the contract. Royalty payments for intellectual property licenses are classified as current assets and current liabilities to the extent they relate to anticipated sales during the subsequent year and long-term assets and long-term liabilities if the sales are anticipated after one year.
We utilize both independent software developers (who are paid advances against future royalties) and internal development teams to develop our software. Under generally accepted accounting principles, such software development costs are capitalizable when technological feasibility has been established. Technological feasibility for console entertainment software has been established by Sony, Nintendo and Sega for use with their respective hardware platforms. We are currently capitalizing the costs of video games under development at our Heavy Iron and PCP&L studios. At December 31, 1999, we had capitalized in software development costs of $1,034,000 at our studios. During 1999 we recognized no amortization of capitalized software development costs.
Prepaid royalty and software development costs are expensed, as a part of royalties expense, at the contractual royalty rate based on actual net product sales. When, in management's estimate, future revenues will not be sufficient to recover previously capitalized
advances or software development costs, we expense these items as project abandonment losses. Such abandonment losses are solely attributable to changes in market conditions or product quality considerations. Research and development costs are expensed as incurred.
IMPAIRMENT OF LONG-LIVED ASSETS. We evaluate long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. If the estimated future cash flows (undiscounted and without interest charges) from the use of an asset are less than the carrying value, a write-down would be recorded to reduce the related asset to its estimated fair value.
REVENUE RECOGNITION. Revenue is recognized when products are shipped, provided that no significant vendor support obligations remain outstanding, and provided that collection of the resulting receivable is deemed probable by management. Although we generally sell our products on a no-return basis, in certain circumstances we may allow returns, price concessions, or allowances on a negotiated basis. We estimate such returns and allowances based upon management's evaluation of our historical experience and current industry trends. Such estimates are deducted from gross sales. Software is sold under a limited 90-day warranty against defects in material and workmanship. To date, we have not experienced material warranty claims. (See Note 5).
ADVERTISING. Advertising and sales promotion costs are generally expensed as incurred, except for production costs associated with the media campaigns which are deferred and charged to expense at the first run of the ad. Advertising costs were $850,000, $5,659,000 and $10,108,000 in the years ended December 31, 1997, 1998 and 1999, respectively.
STOCK BASED COMPENSATION. We account for our employee stock plans under the intrinsic value method prescribed by Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees."
INCOME TAXES. Deferred income taxes are provided for temporary differences between the financial statement and income tax bases of our assets and liabilities, based on enacted tax rates. A valuation allowance is provided when it is more likely than not that some portion or all of the deferred income tax assets will not be realized.
BASIC AND DILUTED EARNINGS PER SHARE. The following table is a reconciliation of the weighted-average shares used in the computation of basic and diluted EPS for the years presented:
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS. In June 1998, the FASB issued Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133 establishes the accounting and reporting standards for derivative financial instruments and for hedging activities. It requires that an entity measure all derivatives at fair value and recognize them in the balance sheet as an asset or liability, depending upon the entity's rights or obligations under the applicable derivative contract. SFAS 133 as amended, is effective for financial statements for periods beginning after June 15, 2000. We are currently evaluating the potential impact of adopting SFAS No. 133.
PERVASIVENESS OF ESTIMATES. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The most significant estimates relate to prepaid and deferred royalties, software development costs, accrued returns and allowances and the allowance for doubtful accounts.
3. BUSINESS COMBINATIONS
On May 24, 1999 we completed a merger with PCP&L. In the merger, each share of PCP&L was converted into 0.09008 shares of our common stock, or approximately 727,000 shares. In addition, outstanding PCP&L employee stock options were assumed by us and converted, at the same conversion rate, into options to purchase approximately 196,000 shares of our common stock.
On December 13, 1999 we completed a merger with Genetic Anomalies, Inc., a Delaware corporation ("GA"). In the merger, each share of GA was converted into 0.0536 share of our common stock, or approximately 220,000 shares. In addition, outstanding GA employee stock
options were assumed by us and converted, at the same conversion rate, into options to purchase approximately 45,000 shares of our common stock.
The mergers have been accounted for as poolings of interests under Accounting Principles Board Opinion No. 16. Accordingly, all prior period consolidated financial statements presented have been restated to include the combined results of operations, financial position and cash flows as if PCP&L and GA had always been part of our company.
All transactions between us, PCP&L and GA have been eliminated in the consolidated financial statements. The results of operations for the separate companies and the combined amounts presented in the consolidated financial statements follow.
4. CREDIT FACILITY
In December 1998, we entered into two trade finance agreements (as amended) with Union Bank of California that established a revolving credit facility. These agreements currently expire on June 1, 2000. The principal agreement (as amended) permits us to borrow (and maintain obligations under outstanding letters of credit) up to $43,000,000, subject to the following:
- We may maintain outstanding letters of credit for product purchases of up to $38,000,000 in the aggregate through the end of February 2000;
- We may maintain outstanding letters of credit for product purchases of up to $25,000,000 in the aggregate between March 1, 2000 and June 1, 2000;
- We may borrow up to $30,000,000 through February 29, 2000, $25 million during March 2000, and $15,000,000 during April and May 2000, (including amounts owing as a result of draws under letters of credit), but we are required to not have any borrowings for a period of at least 60 days during each year of the term of the agreement.
Our other agreement with Union Bank is for our United Kingdom subsidiary, T.HQ International Ltd., and permits that subsidiary to obtain product purchase letters of credit of up to $7 million in the aggregate.
These credit facilities are secured by a lien on substantially all of our assets. Amounts outstanding under these credit facilities bear interest, at our choice, at either a) the bank's prime rate (8.5% at December 31, 1999) or b) the London Interbank Offered Rate (5.69% at December 31, 1999) plus 1.85%. As of December 31, 1999, we had $16,702,000 in outstanding borrowings under these credit facilities and had obligations in respect of outstanding letters of credit of $8,134,000.
These agreements contain financial covenants, including the requirement that we:
- maintain the ratio of our cash, cash equivalents and accounts receivable, to our current liabilities (including advances by the bank), at not less than 1.00:1.00 at the end of each quarter;
- maintain minimum shareholders' equity;
- maintain the ratio of our total liabilities to our shareholders' equity at not greater than 1.10:1.00 as of December 31, 1998 and 1.00:1.00 as of the end of each quarter thereafter;
- achieve operating profits of at least $1 each quarter; and
- maintain the ratio of the value of our inventory as of the last day of any quarter, to our cost of goods sold for the four consecutive quarters ending on that day (or four times our cost of goods sold for the last quarter, if greater), at not more than 1.00:10.50.
These agreements also contain customary non-financial covenants including restrictions on the incurrence of debt and encumbrances and limitations on sales of assets, mergers and acquisitions, dividends, capital expenditures and annual lease obligations.
Rushware Revolving Credit Facilities. Rushware was a party to three separate revolving credit agreements with three German banks, each of which permitted Rushware to borrow up to 5 million Deutsche marks (approximately $3 million) to finance the working capital requirements of Rushware and its subsidiaries. These borrowings were secured by substantially all of the assets of Rushware and its subsidiaries. Each of these agreements expired during 1999.
As of December 31, 1998, we had $3,856,000 in outstanding borrowings under this credit facility. All Rushware borrowings were guaranteed by THQ Inc.
5. ACCOUNTS RECEIVABLE AND ACCRUED RETURNS AND ALLOWANCES
Accounts receivable is due primarily from domestic and foreign retailers and distributors, including mass merchants and specialty stores. Accounts receivable at December 31, 1998 and 1999 are composed of the following:
The allowance for domestic accrued returns and allowances consists of the following:
The allowance for foreign accrued returns and allowances consists of the following:
6. EMPLOYEE PENSION PLAN
We sponsor for our U.S. employees a defined contribution plan under Section 401(k) of the Internal Revenue Code. The plan provides that employees may defer up to 12% of annual compensation, and that we will make a matching contribution equal to each employee's deferral, up to 4% of compensation. We may also contribute funds to the plan in the form of a profit sharing contribution. Expenses under the plan were $119,000, $400,000, and $477,000 in 1997, 1998 and 1999, respectively.
7. INCOME TAXES
The provision for income taxes consists of the following:
A reconciliation of the provision for income taxes at the federal statutory rate to the provision recorded in the accompanying financial statements is as follows:
The components of deferred income tax assets (liabilities) are as follows:
The valuation reserve decreased $2,231,000, $2,992,000 and $2,461,000 during 1997, 1998 and 1999, respectively.
As of December 31, 1999 we had federal and state net operating loss carryforwards of approximately $9,259,000 (expiring from 2009 to 2011) and approximately $638,000 (expiring in 2000), respectively.
At December 31, 1999 we had accumulated foreign earnings of $3,249,000. We do not plan to repatriate these earnings, therefore, no U.S. income tax has been provided on the foreign earnings. Additionally, we have not tax effected the cumulative translation adjustment as we have no intention of repatriating foreign earnings.
Various equity transactions during 1996 resulted in an "ownership change" as defined in the Internal Revenue Code. As a result, the amount of our net operating loss carryforward available to reduce our federal income tax liability in future years in which we have taxable income will be limited to an annual amount of approximately $2,225,000.
8. STOCK OPTION PLAN
We have two stock option plans (the "1990 Plan" and "1997 Plan"), which provide for the issuance of up to 1,462,500 and 4,125,000 shares, respectively, available for employees, consultants and non-employee directors. As of December 31, 1999, 13,428 options under the 1990 Plan and 830,962 options under the 1997 Plan were available for grant. Stock options granted under the option plans may be incentive stock options or nonstatutory stock options. Options may be granted under the option plans to, in the case of incentive stock options, all employees (including officers) of THQ; or, in the case of nonstatutory stock options, all employees (including officers) or non-employee directors of THQ.
The exercise price per share of all options granted under the plans in 1997, 1998 and 1999 has been the market price of the stock on the date of the grant. Stock options issued by PCP&L and GA were issued at below market value. These options were accounted for under APB 25 and we have recognized compensation expense of $21,000, $187,000 and $464,000 for 1997, 1998 and 1999, respectively. Generally, options granted become exercisable over three years and expire within five years from the date of grant.
Options granted and shares exercised relating to options granted outside of our stock option plans during 1997, 1998 and 1999 are listed below. Share exercise prices for these options equal the market price of our common stock at the date of the grant.
The following table summarizes information about stock options outstanding at December 31, 1999:
The estimated fair value of the options granted in 1997, 1998 and 1999 was $3,336,000, $13,591,000 and $15,441,000, respectively. We apply Accounting Principles Board Opinion No. 25 and related Interpretations in accounting for stock option plans. Accordingly, no compensation cost for our stock option plans has been recognized in 1997, 1998 or 1999. Had compensation cost for our stock option plans been determined based on the fair value at the grant dates for awards under the plans consistent with SFAS No. 123, Accounting for Stock Based Compensation, our net income and earnings per share for the years ended December 31, 1997, 1998 and 1999 would have been reduced to the pro forma amounts indicated below:
The fair market value of options granted under the stock option plans during 1997, 1998 and 1999 was determined using the Black-Scholes option pricing model utilizing the following assumptions:
9. RELATED PARTY TRANSACTIONS
In 1997, 1998 and 1999, we paid Inland Productions, Inc., a software developer in which we acquired a 25% interest on July 1, 1996, $985,000, $4,891,000, and $4,905,000, respectively. As of December 31, 1998 and 1999, we owed Inland Productions, Inc. $166,000 and $137,000, respectively.
10. CAPITAL STOCK TRANSACTIONS
In February 1999, in settlement of litigation, we issued warrants expiring March 19, 2000 to Millennium Partners to purchase 150,000 shares of common stock at $16.08 per share. The fair value of the warrants at issuance was $564,000.
During the years ended December 31, 1997, 1998 and 1999, the number of warrants to purchase our common stock exercised were 34,000, 113,000 and 64,000, respectively. We received proceeds from the exercise of such warrants totaling $123,000, $827,000 and $766,000, in the years ended December 31, 1997, 1998 and 1999, respectively. At December 31, 1999 outstanding warrants were 387,000 at an average exercise price of $12.01.
In connection with obtaining the World Wrestling Federation license (See Note 13), in August 1999 we issued to the WWF and a related party warrants expiring December 31, 2009 to purchase 281,250 shares of common stock at $10.42 per share having a fair value of $3,063,000 at the time of issuance.
On May 21, 1997, GA issued 53,603 shares and received proceeds of $471,000.
On February 14, 1997, we completed a public offering of 3,375,000 shares of our common stock. In conjunction with the offering, we granted to the underwriters an over-allotment option, exercisable within 30 days of February 11, 1997, to purchase up to 506,250 additional shares of the common stock at the public offering price of $3.33 per share. On March 11, 1997, the underwriters exercised their over-allotment option. All of these shares were newly
issued and sold on behalf of us. The net proceeds of the 3,881,250 shares sold were approximately $11,708,000.
On July 23, 1998, and October 26, 1999, we announced three-for-two stock splits, effected in the form of a 50% stock dividends, which were distributed on August 24, 1998, and December 1, 1999, respectively, to shareholders of record on August 20, 1998 and November 15, 1999, respectively. The accompanying consolidated financial statements have been adjusted to give effect to these stock splits for all periods presented.
On May 1, 1998, we issued 532,776 shares of common stock in connection with the acquisition of GameFx, Inc. (See Note 12). In December 1998, we issued 249,930 shares of common stock as part of the purchase cost of Rushware Microhandelsgesellschaft mbH. (See Note 12).
On May 24, 1999, we issued 727,436 shares of common stock as part of the purchase price for Pacific Coast Power & Light Company. On December 13, 1999, we issued 220,048 shares of common stock in connection with the acquisition of Genetic Anomalies, Inc. (See Note 3).
11. REINCORPORATION
On January 6, 1998, T.HQ, Inc. a New York corporation ("THQ New York"), was reincorporated as a Delaware corporation. Pursuant to the reincorporation, each share of THQ New York's common stock, par value $.0001 per share, outstanding prior to the reincorporation was converted into one share of common stock, $0.01 par value per share, of THQ Delaware.
12. OTHER LONG-TERM ASSETS
On July 1, 1996, we acquired a 25% interest in Inland Productions, Inc. ("Inland"), a software developer for home entertainment game systems. This investment consisted of $300,000 in cash and 118,485 shares of common stock valued at $300,000, and is included in other long-term assets in the accompanying balance sheet. The investment exceeded our equity in the underlying net assets by $613,000, which is being amortized over five years. The equity in the operating results of Inland is not material to the results of operations.
On August 2, 1996, we acquired the business of Heliotrope Studios, Inc. ("Heliotrope"), an interactive software developer for personal computers. The excess of the cost of the acquisition over the estimated fair value of assets acquired (approximately $265,000) was included in other long-term assets in the accompanying balance sheet. Such excess cost was being amortized over five years. In 1998, the operation was closed and the remaining asset value of $203,000 was expensed.
On May 1, 1998, we acquired all of the outstanding shares of an applied technology company, GameFx, pursuant to a merger of GameFx with and into our newly formed, wholly owned subsidiary. The consideration paid by us consisted of (i) the issuance of 523,776 shares of common stock, (ii) the assumption of stock
options issued by GameFx to its employees that, if and when exercised, permit the holders thereof to acquire approximately 22,275 shares and (iii) approximately $1,273,000 in cash. The total acquisition cost was approximately $7.5 million and was accounted for as a purchase. The purchase price was allocated to certain intangible assets acquired and to purchased in-process research and development ("R & D"). Purchased R & D includes the value of products in the development stage and not considered to have reached technological feasibility. In accordance with applicable accounting rules, purchased in-process R & D is expensed. Accordingly, $7,232,000 of the acquisition cost was expensed in the second quarter of 1998. Approximately $260,000 of the purchase price was allocated to other intangible assets and is being amortized over five years.
In December 1998, we acquired all of the outstanding shares of Rushware Microhandelsgesellschaft mbH and its subsidiaries, Softgold Computerspiele GmbH and ABC Spielspass GmbH ("Rushware") for consideration consisting of approximately $1,582,000 in cash and 249,930 shares of common stock with a fair value of $4,432,000 which was accounted for as a purchase. In 1999 we renegotiated the purchase of Rushware and received a payment of $2,540,000 from the sellers. Rushware, based in Germany, is a leading German distributor of interactive entertainment software for personal computers. Rushware now serves as our distributor and publisher in Germany and other German-speaking countries.
13. AGREEMENT WITH JAKKS PACIFIC, INC. AND TITAN SPORTS INC.
We have entered into an arrangement with JAKKS Pacific, Inc. ("JAKKS"), to govern our relationship with respect to the WWF license we jointly obtained from Titan Sports, Inc. (now known as World Wrestling Federation Entertainment, Inc. (the "WWF")) in June 1999. Our relationship with JAKKS was established to develop, manufacture, distribute, market and sell video games pursuant to the license from the WWF. We control the venture, therefore, all transactions and balances are consolidated with the Company. The principal terms of this operating agreement are as follows:
- - We will be responsible for funding all operations of the venture, including all payments owing to the WWF.
- - For the period commencing November 16, 1999 and ending December 31, 2003, JAKKS will be entitled to receive a preferred payment equal to the greater of a fixed guaranty, payable quarterly, or specified percentages of the "net sales" from WWF licensed games (as defined) in amounts that vary based on the platform. The payment of these amounts is guaranteed by us. We are entitled to the profits and cash distributions remaining after the payment of these amounts. At December 31, 1999, we have unearned preferred payments remaining for the initial four year period of approximately $10.4 million.
- - For periods after December 31, 2003, the amount of the preferred payment will be subject to renegotiation between the parties. An arbitration procedure is specified in the event the parties do not reach agreement.
- - We will be responsible for the day-to-day operations of the venture. We will continue to be responsible for development, sales and distribution of the WWF licensed games, while JAKKS will continue to be responsible for the approval process and other relationship matters with the WWF. We will both continue to co-market the games.
The license agreement with the WWF extends through December 31, 2009, with an option for a five-year automatic extension if we pay them a specified minimum amount during the initial ten-year period of the agreement. As of December 31, 1999, we have guaranteed royalty payments remaining for the initial ten-year period of approximately $15 million. The
agreement provides for an accelerated earnout depending on the volume of WWF video game sales.
14. COMMITMENTS AND CONTINGENCIES
ROYALTIES. At December 31, 1998 and 1999, accrued royalties were $16,320,000 and $31,404,000, respectively. Royalties are classified as current liabilities if initial sales are to commence within one year.
LEASES. We are committed under operating leases with lease termination dates to 2005. Minimum future rentals pursuant to these leases as of December 31, 1999 are as follows:
Rent expense was $278,000, $490,000, and $1,648,000 in 1997, 1998 and 1999, respectively.
LEGAL PROCEEDINGS. Two individual shareholders have filed essentially identical purported class action lawsuits on February 18, 2000 and March 2, 2000, respectively, in the United States District Court for the Central District of California, alleging that we and certain of our directors and senior officers violated Section 10(b) of the Securities and Exchange Act of 1934 and SEC Rule 10b-5. Each case seeks class action status on behalf of all individuals who purchased our shares of common stock between October 26, 1999 and February 10, 2000. Each complaint alleges that we issued false and misleading statements about our financial results and prospects during the class period, and that the individual defendant directors and officers participated in the alleged scheme so as to sell their personal shares at inflated prices. We believe the claims are without merit, and intend to vigorously defend against them.
We are involved in routine litigation arising in the ordinary course of our business. In the opinion of our management, none of the pending litigation will have a material adverse effect on our consolidated financial condition for results of operations.
15. OPERATIONS IN GEOGRAPHIC AREAS
We develop, market and distribute software products. The following information sets forth geographic information on our sales and long-lived assets for the years ended December 31, 1997, 1998 and 1999:
16. QUARTERLY FINANCIAL DATA (UNAUDITED)
Our summarized quarterly financial data is as follows:
EXHIBIT INDEX
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*Management contract or compensatory plan or arrangement required to be filed as an exhibit hereto pursuant to Item 14(c) of Form 10-K.