THQ taking some risks with new strategy of diversification.

SANTA Monica-based equity analyst James Lin has been covering THQ Inc. for a decade. So he wasn't surprised by Wall Street's reaction last week when the Agoura Hills video game developer reported a better-than-expected first quarter, but lowered expectations for the current quarter due to increased marketing costs.

The company's first quarter net loss improved 23 percent from a year ago, to $9.27 million or 14 cents a share, but revenue fell 25 percent to $104.5 million. Analysts had expected a better top line of $112.6 million.

Shares dropped 5 percent to close at $27.21 on Aug. 1, with some of the more than two dozen analysts who cover the company concerned that THQ was going to have to hit all its marks for the rest of the fiscal year, which ends March 31, to meet the company's own expectations, let alone theirs.

Lin, who works for MDB Capital Group LLC and has a "buy" recommendation on shares, is apt to cut the company some slack. When you're hoping to increase margins by selling more original games--as opposed to products based on an established licensed character--it costs more to get a customer's attention.

"It's almost damned-if-they-do, damned-if-they-don't with them," said Lin, noting that the company's shares historically have traded at a significant discount compared to industry peers, which include Silicon Valley gaming giant Electronic Arts and Activision Inc. in Santa Monica.

THQ is best known for its games based on licensed content, such as the colorful World Wide Wrestling characters, and animated properties like last year's Disney/Pixar hit "Cars" and the new "Ratatouille," which hit both theaters and game stores in June. But nearly one-third of revenue this year is expected to come from owned intellectual properties--titles like "Juiced 2: Hot Import Nights" and "Destroy All Humans"--instead of licensed games.

"For the longest time, they've been criticized for their business model for being too dependent on licenses," Lin said. "Now that the company is systematically adding internally owned intellectual property to its portfolio, they're also getting criticized. Of course it's going to be more risky, because you have to make a significant investment up front to introduce and support the brand."

A recent example of THQ's diversification strategy is the original action-driving game "Saint's Row" introduced last year for the X-Box 360 platform, which has passed the industry benchmark of 1 million units in sales. Building a strong game IP portfolio will involve adding similar modest, but steady sellers, hoping a few might grow into an EA-style "Grand Theft Auto" mega-franchise.

THQ plans to introduce five original titles in fiscal 2008, carefully timing the releases through the holiday season so as not to compete with a highly anticipated game appealing to the same niche audience. There are even plans to introduce at least one title in January to take advantage of garners who received new devices or cash gift cards over the holidays.

Janco Partners Inc. analyst Mike Hickey, who has a "market perform" rating on shares, is skeptical about the viability of a post-holiday release, noting that stores in January are more focused on dumping unsold holiday inventory, not buying new stock.

Hickey also is concerned about the company's ability to adjust if sales on certain products come in below expectations. THQ executives maintained full-year guidance of net sales ranging from $1.12 billion to $1.15 billion, and net income ranging from $1.34 to $1.44 a share. Revenue for the current quarter should come in around $240 million--higher than analyst's expectations of $236.6 million--but net income likely will be only 10 cents due to $10 million in increased marketing costs for the original titles and some of the licensed games.

This summer has been one of the most competitive in five years, with sequels to the "Spider-Man," "Shrek" and "Harry Potter" film franchises generating strong sales of their licensed games for other companies.

"That l0 cents guidance for the second quarter really undermines their guidance for the year," he said. "They can't have any slippage or underperformance on their owned or licensed games, and we don't think that's possible. 'Ratatouille' is a new franchise--it's not 'Spider-Man.'"

Despite the concerns, THQ continues to grow as a mid-size game developer. While shares are down 17 percent so far this year, they still are up 24 percent over the past 52 weeks. In addition, the company passed the $1 billion milestone in annual revenues in fiscal 2007.

"Where THQ has an interesting niche is in the family and mass-market titles, through the licenses they have," said analyst Colin Sebastian at Lazard Capital Markets. "They've had a successful strategy during this transition time by not focusing too much on the new platforms, but serving value-focused customers who are still on the legacy platforms."

BY DEBORAH CROWE

Staff Reporter

THQ Inc. (NASDAQ: THQI)

YEAR (March 31)                2007    2006

Revenue (billions)            $1.03   $0.80
Total Expenses (millions)       949     775

Operating Income (millions)    78.2    31.8
Net Income (millions)          68.0    32.0
Earnings Per Share            $0.96   $0.45

SUMMARY

Business: Video game producer and distributor

Headquarters: Agoura Hills

CEO: Brian Farrell

Market Cap: $1.9 billion Dividend Yield: N/A

Total Liabilities: $1 billion P/E Ratio: 3.4

Long-Term Debt: 0