THQ’s Debt Problems: Deep Stock Analysis for Investors

The following is an excerpt from a report compiled by Michael Pachter of Wedbush Securities. 

After the market close on Tuesday, THQ (NASDAQ:THQI) announced that it had entered into a forbearance agreement with Wells Fargo Capital Finance (“Wells Fargo”) and certain lenders after having previously been unable to comply with the financial covenants of its $50 million credit facility. Under the terms of the agreement, Wells Fargo and the lenders have agreed to forbear from exercising certain rights and remedies against THQ, which include declaring all obligations under the credit facility due and payable after an event of default. The forbearance period will terminate on the earliest of: A,  January 15, 2013, B, another event of default, or C, a breach or default of the forbearance agreement, which includes a requirement that THQ maintains excess availability of at least $4 million. Wells Fargo and the lenders have agreed to make additional loans to THQ during the forbearance period.

On November 9, THQ notified investors of its inability to file its form 10-Q in a timely manner without unreasonable effort or expense as it assessed the impact of the asserted events of default of the terms of the credit facility. The events of default were triggered by the company’s inability to comply with the financial covenants of its credit facility, as loan availability on the credit facility was less than 12.5% of the maximum revolver amount on one or more occasions as of and after the quarter ended September 30, 2012. Wells Fargo continued to fund requests from the company after September 30, 2012 while the two sides attempted to reach an agreement.

THQ also announced that Paul Pucino, Executive Vice President and Chief Financial Officer, had resigned as of November 21, 2012, but that he may provide transition services through December 3, 2012. Mr. Pucino joined THQ in January 2009 from Classmates Media Corporation, where he served as executive vice president and CFO.

In addition, THQ announced that it has entered into exclusive negotiations with an unidentified financial sponsor regarding financing alternatives that could lead to significant and material dilution to shareholders. We view the hiring of a financial sponsor as a sign that the company’s financial situation continues to deteriorate, and we think it is likely that the sponsor will seek to restructure the company’s debt ($100 million face amount, current value of approximately $20 million) as equity. Information about the financial sponsor’s identity, deal size, structure, or timing will not be disclosed until negotiations have concluded, and a transaction is not certain. Earlier this month, in conjunction with Q2:13 results, THQ announced that it had hired Centerview Partners, an investment banking and advisory firm that provides advice on mergers and acquisitions, financial restructurings, valuation, and capital structure, to evaluate strategic alternatives.  In our view, THQ requires an infusion of at least $50 million in capital, suggesting that its equity holders could be diluted significantly, perhaps by as much as 50% or more.

Liquidity is a major concern after the most recent round of game delays. THQ recently delayed Company of Heroes 2 and Metro: Last Light (both now expected to be March 2013 releases) and South Park: The Stick of Truth (now expected to be a May 2013 release) by two months apiece as each game was challenged and guaranteed to fall short of design specs if released on time. THQ ended Q2:13 with $36 million of cash, including $21 million drawn from its $50 million credit facility, however the size of the draw appears to have been significantly larger at least once, triggering the aforementioned events of default. With a history of game delays and faulty forecasting, and a cash burn that we estimate to be close to $15 million per month ($10 million for R&D and $5 million for other expenses), revenue generation is essential to keep THQ operating, and we question the duration of the company’s viability as a public entity.  We think that the company’s line of credit will terminate early next year, as we think it is unlikely to satisfy its forbearance conditions.

Maintaining our NEUTRAL rating and suspended price target. THQ’s situation continues to deteriorate dramatically, and it has been in turnaround mode for the last five years. The recent game delays, hiring of a financial advisor, financial sponsor negotiations, and refusal to take questions after reporting Q2:13 results increase our skepticism that a turnaround plan can be executed before the company runs out of cash.  We do not believe THQ is investable for most institutions.

Risks include changes to game release timing, greater-than-expected deterioration of the average selling price ASP for game software, the effects of competition, changing macroeconomic factors, and lower-than-expected consumer demand for video game hardware.

Michael Pachter is an analyst at Wedbush Securities.