10-Q 1 thq10-q63012.htm THQ 10-Q 6.30.12
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
___________________________________________________________

 FORM 10-Q 
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended June 30, 2012
 
OR
 
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from  _______   to _______                  
 
Commission file number 0-18813
___________________________________________________________
THQ INC.
(Exact Name of Registrant as Specified in Its Charter)
 
 
Delaware
 
13-3541686
 
 
(State or Other Jurisdiction of Incorporation or Organization)
 
(I.R.S. Employer
Identification No.)
 
 
 
 
 
 
 
29903 Agoura Road
 
 
 
 
Agoura Hills, CA
 
91301
 
 
(Address of principal executive offices)
 
(Zip Code)
 
Registrant's telephone number, including area code: (818) 871-5000
___________________________________________________________
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  x  No  o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes  x No  o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer  o
 
Accelerated filer  x
 
 
Non-accelerated filer  o
 
Smaller reporting company  o
 
 
(Do not check if a smaller reporting company)
 
 
 
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  o  No  x

The number of shares outstanding of the registrant's common stock as of August 3, 2012 was approximately 6,852,169.



THQ INC. AND SUBSIDIARIES
INDEX
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


2



Part I — Financial Information

Item 1.  Condensed Consolidated Financial Statements

THQ INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(Amounts in thousands, except share data)
 
 
June 30,
2012
 
March 31,
2012
 
(Unaudited)
 
(Unaudited)
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
20,937

 
$
75,977

Accounts receivable, net of allowances
4,129

 
15,994

Inventory
15,370

 
18,485

Licenses
16,134

 
21,927

Software development
90,039

 
105,220

Deferred income taxes
5,675

 
5,732

Income taxes receivable
1,290

 
687

Prepaid expenses and other current assets
25,541

 
46,011

Total current assets
179,115

 
290,033

Property and equipment, net
22,560

 
22,132

Licenses, net of current portion
41,576

 
42,594

Software development, net of current portion
26,793

 
25,348

Other long-term assets, net
12,771

 
12,687

TOTAL ASSETS
$
282,815

 
$
392,794

 
 
 
 
LIABILITIES AND STOCKHOLDERS' DEFICIT
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
50,061

 
$
42,905

Accrued and other current liabilities
52,724

 
83,693

Deferred revenue, net
48,725

 
144,686

Total current liabilities
151,510

 
271,284

Other long-term liabilities
52,121

 
53,837

Convertible senior notes
100,000

 
100,000

Commitments and contingencies (see Note 7)

 


 
 
 
 
Stockholders' deficit:
 
 
 
Preferred stock, par value $0.01, 1,000,000 shares authorized

 

Common stock, par value $0.01, 225,000,000 shares authorized as of June 30, 2012; 6,852,284 and 6,851,289 shares issued and outstanding as of June 30, 2012 and March 31, 2012, respectively
685

 
685

Additional paid-in capital
526,254

 
525,677

Accumulated other comprehensive income
11,575

 
16,026

Accumulated deficit
(559,330
)
 
(574,715
)
Total stockholders' deficit
(20,816
)
 
(32,327
)
TOTAL LIABILITIES AND STOCKHOLDERS' DEFICIT
$
282,815

 
$
392,794

 Presentation gives effect to the Reverse Stock Split, which occurred on July 5, 2012.

See notes to condensed consolidated financial statements.

3


THQ INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Amounts in thousands, except per share data)
 
 
For the Three Months
Ended June 30,
 
(Unaudited)
 
2012
 
2011
Net sales
$
133,687

 
$
195,153

Cost of sales:
 
 
 
Product costs
38,486

 
67,063

Software amortization and royalties
37,353

 
64,920

License amortization and royalties
5,749

 
8,139

Total cost of sales
81,588

 
140,122

 
 
 
 
Gross profit
52,099

 
55,031

Operating expenses:
 
 
 
Product development
9,295

 
30,189

Selling and marketing
14,639

 
50,676

General and administrative
10,132

 
12,049

Restructuring
1,389

 
(140
)
Total operating expenses
35,455

 
92,774

 
 
 
 
Operating income (loss)
16,644

 
(37,743
)
Interest and other income (expense), net
(753
)
 
443

Income (loss) before income taxes
15,891

 
(37,300
)
Income taxes
506

 
1,145

Net income (loss)
$
15,385

 
$
(38,445
)
 
 
 
 
Earnings (loss) per share — basic
$
2.25

 
$
(5.63
)
Earnings (loss) per share — diluted
$
2.00

 
$
(5.63
)
 
 
 
 
Shares used in per share calculation — basic
6,852

 
6,832

Shares used in per share calculation — diluted
8,090

 
6,832

Presentation gives effect to the Reverse Stock Split, which occurred on July 5, 2012.
 
See notes to condensed consolidated financial statements.


4


THQ INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(Amounts in thousands)
 
 
For the Three Months
Ended June 30,
 
(Unaudited)
 
2012
 
2011
Net income (loss)
$
15,385

 
$
(38,445
)
 
 
 
 
Other comprehensive income (loss):
 
 
 
Foreign currency translation gain (loss)
(4,308
)
 
2,334

Reclassification of foreign currency translation adjustments included in net income (loss)
(59
)
 

Unrealized gain (loss) on investments, net of tax of $50 and $95 for the three months ended June 30, 2012 and 2011, respectively
(84
)
 
158

Other comprehensive income (loss)
(4,451
)
 
2,492

 
 
 
 
Comprehensive income (loss)
$
10,934

 
$
(35,953
)
    
 
See notes to condensed consolidated financial statements.


5


THQ INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Amounts in thousands) 
 
For the Three Months
Ended June 30,
 
(Unaudited)
 
2012
 
2011
OPERATING ACTIVITIES:
 
 
 
Net income (loss)
$
15,385

 
$
(38,445
)
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
 
 
 
Depreciation and amortization
2,115

 
2,897

Amortization of licenses and software development(1)
25,735

 
69,182

Loss on disposal of property and equipment
2

 
16

Restructuring charges
1,389

 
(140
)
Changes in deferred net revenue and related expenses
(47,815
)
 
(44,516
)
Amortization of debt issuance costs

 
37

Stock-based compensation(2)
615

 
1,631

Changes in operating assets and liabilities:
 
 
 
Accounts receivable, net of allowances
10,767

 
111,772

Inventory
2,959

 
5,124

Licenses
(3,787
)
 
(6,186
)
Software development
(31,961
)
 
(50,995
)
Prepaid expenses and other current assets
(1,965
)
 
(739
)
Accounts payable
7,737

 
(24,141
)
Accrued and other liabilities
(28,662
)
 
8,923

Deferred net revenue
(16
)
 
(451
)
Income taxes
(565
)
 
46

Net cash provided by (used in) operating activities
(48,067
)
 
34,015

 
 
 
 
INVESTING ACTIVITIES:
 
 
 
Other long-term assets
1

 
355

Purchases of property and equipment
(1,808
)
 
(3,303
)
Net cash used in investing activities
(1,807
)
 
(2,948
)
 
 
 
 
FINANCING ACTIVITIES:
 
 
 
Proceeds from issuance of common stock to employees

 
21

Net cash provided by financing activities

 
21

Effect of exchange rate changes on cash
(5,166
)
 
2,345

Net increase (decrease) in cash and cash equivalents
(55,040
)
 
33,433

Cash and cash equivalents — beginning of period
75,977

 
85,603

Cash and cash equivalents — end of period
$
20,937

 
$
119,036

________________________________
(1) 
Excludes amortization of capitalized stock-based compensation expense.
(2) 
Includes the net effects of capitalization and amortization of stock-based compensation expense.


See notes to condensed consolidated financial statements. 

6


THQ INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1.   Basis of Presentation
 
The condensed consolidated financial statements included in this Quarterly Report on Form 10-Q ("10-Q") present the results of operations, financial position and cash flows of THQ Inc. and its subsidiaries (collectively "THQ," "we," "us," "our," or the "Company").  In the opinion of management, the accompanying condensed consolidated balance sheets and related interim condensed consolidated statements of operations, and condensed consolidated statements of comprehensive income (loss) and condensed consolidated statements of cash flows include all adjustments, consisting only of normal recurring items, necessary for their fair presentation in conformity with accounting principles generally accepted in the United States of America.  The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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 net sales and expenses during the reporting period. Actual results could differ from those estimates. The most significant estimates relate to accounts receivable allowances, licenses, software development, revenue recognition, stock-based compensation expense and income taxes.  Interim results are not necessarily indicative of results for a full year.  The balance sheet at March 31, 2012 has been derived from the audited financial statements at that date, but does not include all of the information and notes required by accounting principles generally accepted in the United States of America for complete financial statements.  The information included in this 10-Q should be read in conjunction with the financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended March 31, 2012 (the "2012 10-K").

At June 30, 2012, we had working capital of $27.6 million, including cash and cash equivalents of $20.9 million, and we had total stockholders' deficit of $20.8 million. Although we believe our business plan is achievable, should we fail to achieve the net sales, gross margin levels, and customer payment and vendor credit terms we anticipate, or if we were to incur significant unplanned cash outlays, it would become necessary for us to obtain additional sources of liquidity or make further cost cuts (including future product development) to fund our operations, which could result in additional restructuring and impairment charges. However, there is no assurance that we would be able to obtain such financing on favorable terms, if at all, or to successfully further reduce costs in such a way that would continue to allow us to operate our business. If for any reason our projections do not materialize, we may not be able to comply with the requirements of our credit and debt facilities (see "Note 6Debt").

Principles of Consolidation. Our condensed consolidated financial statements include the accounts of THQ Inc. and our wholly-owned subsidiaries.

Reverse stock split. On January 25, 2012, we received a notification letter from NASDAQ notifying us that we were not in compliance with the $1.00 minimum bid price requirement (NASDAQ Marketplace Rule 5450(a)(1) (the "Rule") because the bid price for our common stock closed below $1.00 over the prior 30 consecutive business days. To regain compliance with this requirement, we held a special meeting of stockholders on June 29, 2012 to solicit stockholder approval of a proposal to approve an amendment to our certificate of incorporation to effect a reverse stock split ("Reverse Stock Split"). On July 2, 2012, we announced the timing and details regarding stockholder approval of the Reverse Stock Split, which was effected on July 5, 2012 at a ratio of one-for-ten with no change in par value. No fractional shares were issued in connection with the Reverse Stock Split. Stockholders who otherwise were entitled to receive fractional shares were entitled to an amount in cash (without interest or deduction) equal to the fraction of one share to which such stockholder would otherwise be entitled multiplied by $5.75. On July 23, 2012, we received a letter from NASDAQ informing us that we had regained compliance with the Rule. All consolidated per share information presented in this Form 10-Q gives effect to the Reverse Stock Split.

Summary of Significant Accounting Policies. In the three months ended June 30, 2012, we did not have any material changes to our significant accounting policies.

In June 2011, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2011-05, "Comprehensive Income (Topic 220): Presentation of Comprehensive Income" ("ASU 2011-05"). ASU 2011-05 requires companies to present the components of net income and other comprehensive income either as one continuous statement or as two consecutive statements and it eliminates the option to present components of other comprehensive income as part of the statement of changes in stockholders' equity. ASU 2011-05 does not change the items which must be reported in other comprehensive income, how such items are measured or when they must be reclassified to net income. In December 2011, the FASB issued ASU 2011-12, "Comprehensive Income (Topic 220): Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in ASU 2011-05" ("ASU 2011-12"). ASU 2011-12 defers the effective date of the specific requirement to present items that are reclassified out of accumulated other

7


comprehensive income to net income alongside their respective components of net income and other comprehensive income. All other provisions of ASU 2011-05 are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. Our adoption of this pronouncement in the three months ended June 30, 2012 did not materially impact our results of operations, financial position or cash flows. We do not expect that the proposed deferral guidance will have a material impact on our consolidated financial statements when and if adoption is required.

In December 2011, the FASB issued ASU 2011-11, "Disclosures about Offsetting Assets and Liabilities" ("ASU 2011-11"). ASU 2011-11 creates new disclosure requirements about the nature of an entity’s rights of offset and related arrangements associated with its financial instruments and derivative instruments. The disclosure requirements are effective for annual reporting periods beginning on or after January 1, 2013, and interim periods therein, with retrospective application required, which will be our quarter ending June 30, 2013. The new disclosures are designed to make financial statements that are prepared under U.S. Generally Accepted Accounting Principles more comparable to those prepared under International Financial Reporting Standards. The adoption is not expected to have a material impact on our results of operations, financial position or cash flows.

Fiscal Quarter.  We report our fiscal year on a 52/53-week period with our fiscal year ending on the Saturday nearest March 31. For simplicity, all fiscal periods in our condensed consolidated financial statements and accompanying notes are presented as ending on a calendar month end.  The results of operations for the three months ended June 30, 2012 and 2011 contain the following number of weeks:
Fiscal Period
 
Number of Weeks
 
Fiscal Period End Date
Three months ended June 30, 2012
 
13 weeks
 
June 30, 2012
Three months ended June 30, 2011
 
13 weeks
 
July 2, 2011

2.   Balance Sheet Details
 
Inventory.  Inventory at June 30, 2012 and March 31, 2012 consisted of the following (amounts in thousands):
 
 
June 30,
2012
 
March 31,
2012
Finished goods
$
13,884

 
$
16,860

Components
1,486

 
1,625

Inventory
$
15,370

 
$
18,485

 
Inventory balances at June 30, 2012 and March 31, 2012 are net of reserves of $18.2 million and $21.1 million, respectively. The inventory reserve balance at June 30, 2012 consists primarily of reserves related to our uDraw Game Tablet ("uDraw").

Prepaid expenses and other current assets. Prepaid expenses and other current assets at June 30, 2012 and March 31, 2012 primarily consisted of product costs totaling $10.7 million and $33.4 million, respectively, that were deferred in connection with the deferral of related net revenue. Also included in prepaid expenses and other current assets at June 30, 2012 and March 31, 2012 were product prepayments of $0.7 million and $1.1 million, respectively.

Property and equipment, net.  Property and equipment, net at June 30, 2012 and March 31, 2012 consisted of the following (amounts in thousands):
 
 
Useful lives
 
June 30,
2012
 
March 31,
2012
Building
30 yrs
 
$
730

 
$
730

Land
 
401

 
401

Computer equipment and software
3-10 yrs
 
53,231

 
53,624

Furniture, fixtures and equipment
5 yrs
 
7,186

 
7,570

Leasehold improvements
3-6 yrs
 
13,857

 
13,005

Automobiles
2-5 yrs
 
87

 
87

 
 
 
75,492

 
75,417

Less: accumulated depreciation
 
 
(52,932
)
 
(53,285
)
 Property and equipment, net
 
 
$
22,560

 
$
22,132


8



Depreciation expense associated with property and equipment amounted to $2.1 million and $2.9 million for the three months ended June 30, 2012 and 2011, respectively.

Accrued and other current liabilities.  Accrued and other current liabilities at June 30, 2012 and March 31, 2012 consisted of the following (amounts in thousands):
 
 
June 30,
2012
 
March 31,
2012
Accrued liabilities
$
11,861

 
$
13,345

Settlement payment
4,000

 
4,000

Accrued compensation
7,408

 
13,117

Accrued third-party software developer milestones
6,298

 
15,201

Accrued royalties
23,157

 
38,030

Accrued and other current liabilities
$
52,724

 
$
83,693

 
Other long-term liabilities.  Other long-term liabilities at June 30, 2012 and March 31, 2012 consisted of the following (amounts in thousands):
 
 
June 30,
2012
 
March 31,
2012
Minimum license guarantees
$
36,367

 
$
36,405

Deferred rent
6,817

 
6,667

Accrued liabilities
7,242

 
7,127

Settlement payment
1,695

 
3,638

Other long-term liabilities
$
52,121

 
$
53,837

 
Settlement payments included in the tables above are payable to JAKKS Pacific, Inc. ("Jakks"). In the three months ended June 30, 2012 we paid $2.0 million and renegotiated the payment terms of the remaining liability such that $1.0 million will be due on each of August 30, 2012 and October 30, 2012, and ten payments of $0.4 million are due monthly beginning in February 2013, through to November 2013. Of the remaining settlement payment due to Jakks, $4.0 million is reflected in "Accrued and other current liabilities" and $1.7 million is reflected in "Other long-term liabilities" in our condensed consolidated balance sheets, reflecting the present value of the remaining consideration payable under the agreement between THQ and Jakks.  See "Note 14 — Joint Venture and Settlement Agreements" in the notes to the consolidated financial statements in our 2012 10-K for a discussion of the Jakks settlement payments.

3. Licenses and Software Development

Licenses. As of June 30, 2012 and March 31, 2012, the net carrying value of our licenses was $57.7 million and $64.5 million, respectively, and was reflected as “Licenses” and “Licenses, net of current portion” in our condensed consolidated balance sheets. At June 30, 2012, all minimum license commitments are reflected in our condensed consolidated balance sheet as the licensors have no remaining performance obligations.

Software Development. As of June 30, 2012 and March 31, 2012, the net carrying value of our software development was $116.8 million and $130.6 million, respectively, and was reflected as “Software development” and “Software development, net of current portion” in our condensed consolidated balance sheets. At June 30, 2012 we had commitments of $57.9 million that are not reflected in our condensed consolidated balance sheet due to remaining performance obligations of the external developers. Software amortization and royalties expense in the three months ended June 30, 2012 included a $5.2 million charge related to the write-off of capitalized software development due to the cancellation of an unreleased title and a $1.4 million charge related to a change in the development direction of another unreleased title. Additionally, software amortization and royalties expense in the three months ended June 30, 2012 included a net benefit of $2.3 million related to the June 1, 2012 transfer of the license we previously had to develop games based on the Ultimate Fighting Championship ("UFC"). The net benefit was the result of charges incurred related to the write-off of software development costs we had previously capitalized for the UFC game that was under development at the time of the license transfer, offset by a cash payment we received from the licensor upon the transfer of the license. All these actions were undertaken in connection with our realignment plans (see "Note 5Restructuring and Other Charges”).

9



Impairment analysis. We evaluate the future recoverability of our capitalized licenses and software development on a quarterly basis in connection with the preparation of our financial statements.  In this evaluation, we compare the carrying value of such capitalized costs to their net realizable value, on a product-by-product basis.  The net realizable value is determined using Level 3 inputs, specifically, the estimated future net sales from the product, reduced by the estimated future direct costs associated with the product such as completion costs, cost of sales, and selling and marketing expenses.  Net sales inputs are developed using recent internal sales performance for similar titles, adjusted for current market trends and comparable products. As certain of our licenses extend for multiple products over multiple years, we also assess the recoverability of capitalized license costs based on certain qualitative factors such as the success of other products and/or entertainment vehicles utilizing the intellectual property, whether there are any future planned theatrical releases or television series based on the intellectual property and the rights holder's continued promotion and exploitation of the intellectual property.

We did not record any software development impairment charges in the three months ended June 30, 2012. In the three months ended June 30, 2011 we recognized software development impairment charges of $0.6 million.

4.   Other Long-Term Assets
 
Other long-term assets include our investment in Yuke's, a Japanese video game developer.  We own approximately 15% of Yuke's, which is publicly traded on the Nippon New Market in Japan.  This investment is classified as available-for-sale and reported at fair value with unrealized holding gains and losses excluded from earnings and reported as a component of accumulated other comprehensive income until realized.  The pre-tax unrealized holding loss related to our investment in Yuke's for the three months ended June 30, 2012 was $0.1 million. For the three months ended June 30, 2011 the pre-tax unrealized gain related to our investment in Yuke's was $0.3 million. As of June 30, 2012, the inception-to-date unrealized holding gain on our investment in Yuke's was $1.3 million.  Due to the long-term nature of this relationship, this investment is included in "Other long-term assets, net" in our condensed consolidated balance sheets.
 
Other long-term assets as of June 30, 2012 and March 31, 2012 consisted of the following (amounts in thousands):
 
 
June 30,
2012
 
March 31,
2012
Investment in Yuke's
$
4,506

 
$
4,641

Deferred financing costs
1,351

 
1,510

Other
6,914

 
6,536

Total other long-term assets
$
12,771

 
$
12,687

 

5.   Restructuring and Other Charges

Restructuring charges and adjustments are recorded as "Restructuring" expenses in our condensed consolidated statements of operations and generally include costs such as, severance and other employee-based charges in excess of standard business practices, costs associated with lease abandonments (less estimates of sublease income), charges related to long-lived assets, and costs of other non-cancellable contracts. 

Fiscal 2013 First Quarter Realignment and other associated charges. On June 1, 2012, we entered into an agreement to transfer our license to develop future games based on the Ultimate Fighting Championship ("UFC"). This action resulted in the closure of the studio developing the UFC game that was under development at the time of the license transfer. The following table summarizes the components and activity under the fiscal 2013 first quarter realignment, classified as "Restructuring" in our condensed consolidated statements of operations, for the three months ended June 30, 2012, and the related restructuring reserve balances (amounts in thousands):


10


 
 
Three Months Ended June 30, 2012
 
 
Lease and Contract Terminations
 
Net Asset Impairments
 
Total
Beginning balance
 
$

 
$

 
$

Charges to operations
 
915

 
293

 
1,208

Non-cash write-offs
 

 
(293
)
 
(293
)
Cash payments, net of sublease income
 
(38
)
 

 
(38
)
Foreign currency and other adjustments
 
119

 

 
119

Ending balance
 
$
996

 
$

 
$
996



In connection with the transfer of the license we had with the UFC, we recorded a net benefit of $2.3 million (recorded within “Cost of sales — Software amortization and royalties” in our condensed consolidated statement of operations). The net benefit was the result of charges incurred related to the write-off of software development costs we had previously capitalized for the UFC game that was under development at the time of the license transfer, offset by a cash payment we received from the licensor upon the transfer of the license. Additionally, we incurred charges of $0.9 million related to cash severance and other employee-based charges (recorded within operating expenses in our condensed consolidated statements of operations) associated with the closure of the studio that had been developing the UFC game that was under development at the time of the license transfer.

Additionally, in the three months ended June 30, 2012, we incurred a $5.2 million charge related to the write-off of capitalized software development due to the cancellation of an unreleased title and a $1.4 million charge related to a change in the development direction of another unreleased title (recorded within “Cost of sales — Software amortization and royalties” in our condensed consolidated statements of operations). These actions were taken in June 2012 in connection with an evaluation of our products under development by our new President, appointed on May 25, 2012.

We do not expect any significant future charges under the fiscal 2013 first quarter realignment, other than additional facility-related charges and adjustments in the event actual and estimated sublease income changes.

Fiscal 2012 Fourth Quarter Realignment and other associated charges. On January 26, 2012, we initiated a plan of restructuring in connection with our updated business strategy in order to better align our operating expenses with the lower expected future revenue. The following table summarizes the components and activity under the fiscal 2012 fourth quarter realignment, classified as "Restructuring" in our condensed consolidated statements of operations, for the three months ended June 30, 2012, and the related restructuring reserve balances (amounts in thousands):

 
 
Three Months Ended June 30, 2012
 
 
Lease and Contract Terminations
 
Net Asset Impairments
 
Total
Beginning balance
 
$
536

 
$

 
$
536

Charges to operations
 
17

 

 
17

Non-cash write-offs
 

 

 

Cash payments, net of sublease income
 
(85
)
 

 
(85
)
Foreign currency and other adjustments
 
(59
)
 

 
(59
)
Ending balance
 
$
409

 
$

 
$
409


Since the inception of the fiscal 2012 fourth quarter realignment through June 30, 2012, total restructuring charges amounted to $1.2 million.

In connection with these actions, in the three months ended June 30, 2012, we incurred a benefit of $0.3 million related to changes in estimates of cash severance and other employee-based charges (recorded within operating expenses in our condensed consolidated statements of operations). Additionally, in the three months ended June 30, 2012, we incurred a benefit of $2.0 million related to the release of a license obligation that had been accrued at March 31, 2012 in connection with our negotiations

11


with one of our previous kids' licensors (recorded within “Cost of sales — License amortization and royalties” expense in our condensed consolidated statements of operations). We do not expect any significant future charges under the fiscal 2012 fourth quarter realignment, other than additional facility-related charges and adjustments in the event actual and estimated sublease income changes.

Fiscal 2012 Second Quarter Realignment. On August 9, 2011, we announced a plan to realign our internal studio development teams and video games in development in order to better match our resources with our target portfolio of interactive entertainment and continue our transition away from traditional console games based on licensed kids' titles and movie entertainment properties.  The following table summarizes the components and activity under the fiscal 2012 second quarter realignment, classified as "Restructuring" in our condensed consolidated statements of operations, for the three months ended June 30, 2012, and the related restructuring reserve balances (amounts in thousands):

 
 
Three Months Ended June 30, 2012
 
 
Lease and Contract Terminations
 
Net Asset Impairments
 
Total
Beginning balance
 
$
2,341

 
$

 
$
2,341

Charges to operations
 
77

 

 
77

Non-cash write-offs
 

 

 

Cash payments, net of sublease income
 
(300
)
 

 
(300
)
Foreign currency and other adjustments
 
(9
)
 

 
(9
)
Ending balance
 
$
2,109

 
$

 
$
2,109


Since the inception of the fiscal 2012 second quarter realignment through June 30, 2012, total restructuring charges amounted to $4.2 million.

We do not expect any future charges under the fiscal 2012 second quarter realignment, other than additional facility-related charges and adjustments in the event actual and estimated sublease income changes.

Fiscal 2012 First Quarter Realignment. In the first quarter of fiscal 2012, we announced the closure of our studio located in the U.K. as we continued to refine our video game line-up and utilize studio locations in more cost effective markets. The following table summarizes the components and activity under the fiscal 2012 first quarter realignment, classified as "Restructuring" in our condensed consolidated statements of operations, for the three months ended June 30, 2012, and the related restructuring reserve balances (amounts in thousands):

 
 
Three Months Ended June 30, 2012
 
 
Lease and Contract Terminations
 
Net Asset Impairments
 
Total
Beginning balance
 
$
585

 
$

 
$
585

Charges to operations
 
6

 

 
6

Non-cash write-offs
 

 

 

Cash payments, net of sublease income
 
(52
)
 

 
(52
)
Foreign currency and other adjustments
 
(11
)
 

 
(11
)
Ending balance
 
$
528

 
$

 
$
528


Since the inception of the fiscal 2012 first quarter realignment through June 30, 2012, total restructuring charges amounted to $0.8 million.

There were no other significant charges recorded in the three months ended June 30, 2012 related to this realignment. In the three months ended June 30, 2011, there were no charges incurred in connection with this realignment plan that were classified as "Restructuring" in our condensed consolidated statements of operations. However, in that same period we incurred $1.7 million of cash severance and other employee-based charges (recorded within operating expenses in our condensed consolidated statements

12


of operations) and a $1.4 million charge related to the cancellation of an unannounced title that had been under development at the studio that was closed (recorded within “Cost of sales — Software amortization and royalties” in our condensed consolidated statements of operations). We do not expect any future charges under the fiscal 2012 first quarter realignment, other than additional facility related charges and adjustments in the event actual and estimated sublease income changes.

Fiscal 2011 Fourth Quarter Realignment. In the fourth quarter of fiscal 2011, we performed an assessment of our product development and publishing staffing models. This resulted in a change to our staffing plans to better address peak service periods, as well as better utilize shared-services and more cost-effective locations. The following table summarizes the components and activity under the fiscal 2011 fourth quarter realignment, classified as "Restructuring" in our condensed consolidated statements of operations, for the three months ended June 30, 2012, and the related restructuring reserve balances (amounts in thousands):
 
 
Three Months Ended June 30, 2012
 
 
Lease and Contract Terminations
 
Net Asset Impairments
 
Total
Beginning balance
 
$
321

 
$

 
$
321

Charges to operations
 
50

 

 
50

Non-cash write-offs
 

 

 

Cash payments, net of sublease income
 
(128
)
 

 
(128
)
Foreign currency and other adjustments
 
7

 

 
7

Ending balance
 
$
250

 
$

 
$
250


Since the inception of the fiscal 2011 fourth quarter realignment through June 30, 2012, total restructuring charges amounted to $0.6 million. There were no other significant charges recorded in the three months ended June 30, 2012 related to this realignment.

Restructuring expenses recorded during the three months ended June 30, 2011 related to studio closures and were insignificant. Additionally, in the three months ended June 30, 2011, we incurred $1.7 million of cash severance charges related to eliminated positions (recorded within operating expenses in our condensed consolidated statements of operations). We do not expect any future charges under the fiscal 2011 fourth quarter realignment, other than additional facility related charges and adjustments in the event actual and estimated sublease income changes.

Fiscal 2009 Realignment. During the twelve months ended March 31, 2009 ("fiscal 2009"), we updated our strategic plan in an effort to increase our profitability and cash flow generation.  We significantly realigned our business to focus on fewer, higher quality games, and established an operating structure that supports our more focused product strategy.  The fiscal 2009 realignment included the cancellation of several titles in development, the closure or spin-off of several of our development studios, and the streamlining of our corporate organization in order to support the new product strategy, including reductions in worldwide personnel. We do not expect any future charges under the fiscal 2009 realignment, other than additional facility related charges and adjustments in the event actual and estimated sublease income changes.
 
The following table summarizes the restructuring lease and contract termination activity under the fiscal 2009 realignment for the three months ended June 30, 2012 and 2011, and the related restructuring reserve balances (amounts in thousands):
 
 
 
Three Months Ended June 30,
 
 
2012
 
2011
Beginning balance
 
$
1,211

 
$
1,335

Charges (benefit) to operations
 
31

 
(143
)
Non-cash write-offs
 

 

Cash payments, net of sublease income
 
(99
)
 
(173
)
Foreign currency and other adjustments
 
(20
)
 
(4
)
Ending balance
 
$
1,123

 
$
1,015


Since the inception of the fiscal 2009 realignment through June 30, 2012, total restructuring charges amounted to $18.8 million.

The aggregated restructuring accrual balances at June 30, 2012 and March 31, 2012 of $5.4 million and $5.0 million, respectively, related to future lease payments for facilities vacated under all of our realignment plans (offset by estimates of future sublease

13


income), and accruals for other non-cancellable contracts.  As of June 30, 2012, $2.4 million of the restructuring accrual is included in "Accrued and other current liabilities" and $3.0 million is included in "Other long-term liabilities" in our condensed consolidated balance sheet.  As of March 31, 2012, $1.9 million of the restructuring accrual was included in "Accrued and other current liabilities" and $3.1 million was included in "Other long-term liabilities" in our condensed consolidated balance sheet.  We expect the final settlement of this accrual to occur by August 1, 2015, which is the last payment date under our lease agreements that were vacated.

6.  Debt
 
Credit Facility
 
On September 23, 2011, we entered into a Credit Agreement and a Security Agreement with Wells Fargo Capital Finance, LLC (“Wells Fargo”), which were amended pursuant to Amendment Number One to Credit Agreement and Security Agreement dated July 23, 2012 (collectively, as so amended, the “Credit Facility”). The Credit Facility provides for a revolving facility of up to $50.0 million. The Credit Facility allows for up to $10.0 million to be used as a letter of credit subfacility.

The Credit Facility has a four-year term; however, it will terminate on June 16, 2014 if any obligations are then still outstanding under the $100.0 million 5% convertible senior notes more fully described below. Borrowings under the Credit Facility bear interest at a rate equal to an applicable margin plus, at our option, either a variable base rate or a LIBOR rate. The applicable margin for base rate loans ranges from 2.25% to 2.5% and for LIBOR rate loans ranges from 3.75% to 4.0%, in each case, depending on the level of our revolving borrowings. Debt issuance costs capitalized in connection with the Credit Facility totaled $1.3 million; these costs are being amortized over the term of the Credit Facility. We are required to pay other customary fees, including an unused line fee based on usage under the Credit Facility as well as fees with respect to letters of credit.
During the three months ended June 30, 2012 there were no borrowings under the Credit Facility and accordingly there was no related interest expense in that period. In the three months ended June 30, 2012, amortization of debt issuance costs related to the Credit Facility was $0.1 million; this amount was capitalized as part of our in-process software development costs (as further discussed below). There were no outstanding borrowings under the Credit Facility as of June 30, 2012. During the three months ended June 30, 2012, we established a letter of credit for $0.6 million under the Credit Facility that is related to a lease we have for one of our studio locations.

The Credit Facility provides for certain events of default such as nonpayment of principal and interest when due, breaches of representations and warranties, noncompliance with covenants, acts of insolvency, default on certain agreements related to indebtedness, including the $100.0 million 5% convertible senior notes more fully described below, and entry of certain judgments against us. Upon the occurrence of a continuing event of default and at the option of the required lenders (as defined in the Credit Facility), all of the amounts outstanding under the Credit Facility may be declared to be immediately due and payable and any amount outstanding will bear interest at 2.0% above the interest rate otherwise applicable.  In the event availability on the Credit Facility is below 12.5% (16% beginning January 1, 2013) of the maximum revolver amount, the Credit Facility requires that we maintain certain financial covenants.  As of June 30, 2012, we had availability in excess of 12.5% and therefore we were not subject to the financial covenants. In the event the financial covenants become applicable, we would be required to have EBITDA, as defined in the Credit Facility, of $9.8 million for the four quarters ended June 30, 2012. Beginning September 30, 2012, the EBITDA requirements are replaced with a requirement that we must maintain an annual fixed charge coverage ratio, as defined in the Credit Facility, of at least 1.1 to 1.0.
The Credit Facility is guaranteed by most of our domestic subsidiaries and secured by substantially all of our assets. The Credit Facility contains financial reporting covenants and other customary affirmative and negative covenants, including, among other terms and conditions, limitations (subject to certain permitted actions) on our ability to: create, incur, guarantee or be liable for indebtedness; dispose of assets outside the ordinary course; acquire, merge or consolidate with or into another person or entity; create, incur or allow any lien on any of their respective properties; make investments or capital expenditures; or pay dividends or make distributions.
As of June 30, 2012, we were in compliance with all applicable covenants and requirements under the Credit Facility.
 
Convertible Senior Notes

On August 4, 2009, we issued $100.0 million 5% convertible senior notes ("Notes").  After offering costs, the net proceeds to THQ were $96.8 million.  The Notes are due August 15, 2014, unless earlier converted, redeemed or repurchased.  The Notes pay interest semiannually, in arrears on February 15 and August 15 of each year, beginning February 15, 2010, through maturity and are convertible at each holder's option at any time prior to the close of business on the trading day immediately preceding the

14


maturity date.  The Notes are our unsecured and unsubordinated obligations. All share and per share information presented gives effect to the Reverse Stock Split, which occurred on July 5, 2012.
 
The Notes are initially convertible into shares of our common stock at a conversion rate of 11.7474 shares of common stock per $1,000 principal amount of Notes, equivalent to an initial conversion price of approximately $85.13 per share.  At this conversion rate and upon conversion of 100% of our Notes outstanding at June 30, 2012, our Notes would convert into 1.2 million shares of common stock.  The conversion rate is subject to adjustment in certain events such as a stock split, the declaration of a dividend or the issuance of additional shares.  Also, the conversion rate will be subject to an increase in certain events constituting a make-whole fundamental change; provided, however, that the maximum number of shares to be issued thereunder cannot exceed 1.5 million, subject to adjustment.  We considered all our other commitments that may require the issuance of stock (e.g., stock options, restricted stock units, warrants, and other potential common stock issuances) and have determined that as of June 30, 2012, we have sufficient authorized and unissued shares available for the conversion of the Notes during the maximum period the Notes could remain outstanding. The Notes will be redeemable, in whole or in part, at our option, at any time after August 20, 2012 for cash, at a redemption price of 100% of the principal amount of the Notes, plus accrued but unpaid interest, if the price of a share of our common stock has been at least 150% of the conversion price then in effect for specified periods. 

In the case of certain events such as the acquisition or liquidation of THQ, or delisting of our common stock from a U.S. national securities exchange, holders may require us to repurchase all or a portion of the Notes for cash at a purchase price of 100% of the principal amount of the Notes, plus accrued and unpaid interest.

Costs incurred related to the Notes offering amounted to $3.2 million and are classified as "Other long-term assets, net" in our condensed consolidated balance sheets at June 30, 2012; these costs are being amortized over the term of the Notes.

In the three months ended June 30, 2012 and June 30, 2011 all interest expense and amortization of debt issuance costs related to the Notes were capitalized to software development. The effective interest rate, before capitalization of any interest expense and amortization of debt issuance costs, was 5.64% for the three months ended June 30, 2012 and 2011.

Capitalization of Interest Expense

We capitalize interest expense and related amortization of debt issuance costs as part of in-process software development costs.  Capitalization commences with the first capitalized expenditure for the software development project and continues until the project is completed. We amortize these balances to "Cost of sales - Software amortization and royalties" as part of the software development costs.  In the three months ended June 30, 2012 and 2011 we capitalized $1.5 million and $1.4 million, respectively, of interest expense and related amortization of debt issuance costs.

7.   Commitments and Contingencies
 
A summary of annual minimum contractual obligations and commercial commitments as of June 30, 2012 is as follows (amounts in thousands):
 
 
 
Contractual Obligations and Commercial Commitments (6)
Fiscal
Years Ending
March 31,
 
License /
Software
Development
Commitments (1)
 
Advertising (2)
 
Leases (3)
 
Debt (4)
 
Other (5)
 
Total
Remainder of 2013
 
$
57,685

 
$
13,020

 
$
11,087

 
$

 
$
3,071

 
$
84,863

2014
 
19,413

 
1,907

 
14,010

 

 
3,624

 
38,954

2015
 
13,600

 
1,163

 
12,413

 
100,000

 
424

 
127,600

2016
 
7,500

 
594

 
7,493

 

 
90

 
15,677

2017
 
7,867

 
513

 
4,610

 

 

 
12,990

Thereafter
 
6,000

 
375

 
11,690

 

 

 
18,065

 
 
$
112,065

 
$
17,572

 
$
61,303

 
$
100,000

 
$
7,209

 
$
298,149

 
(1)
Licenses and Software Development.  We enter into contractual arrangements with third parties for the rights to exploit intellectual property and for the development of products.  Under these agreements, we commit to provide specified payments to an intellectual property holder or developer.  Assuming all contractual provisions are met, the total future minimum contract commitments for such agreements in place as of June 30, 2012 are $112.1 million. License commitments in the table above include $54.1 million of commitments payable to licensors that are included in both "Accrued and other current liabilities"

15


and "Other long-term liabilities" in our June 30, 2012 condensed consolidated balance sheet because the licensors do not have any remaining significant performance obligations.

(2)
Advertising.  We have certain minimum advertising commitments under many of our major license agreements. These minimum commitments are based upon the specific arrangements we have with the respective licensors and range from fixed amounts to specified percentages of projected net sales (ranging from 5%-10%) related to the respective licenses.

(3)
Leases.  We are committed under operating leases with lease termination dates through 2020.  Most of our leases contain rent escalations.  Of these obligations, $2.4 million and $3.0 million are accrued and classified as "Accrued and other current liabilities" and "Other long-term liabilities," respectively, in our June 30, 2012 condensed consolidated balance sheet due to the abandonment of certain lease obligations in connection with our realignment plans (see "Note 5Restructuring and Other Charges"). We expect future sublease rental income under non-cancellable agreements of approximately $2.1 million; this income is not contemplated in the lease commitments shown in the table above.

(4)
Debt.  We issued the Notes on August 4, 2009.  The Notes pay interest semiannually, in arrears on February 15 and August 15 of each year, beginning February 15, 2010, through maturity and are convertible at each holder's option at any time prior to the close of business on the trading day immediately preceding the maturity date.  Absent any conversions or required repurchases of the Notes, we expect to pay $5.0 million in fiscal 2013 and 2014, and $2.5 million in fiscal 2015, for an aggregate of $12.5 million in interest payments over the remaining term of the Notes (see "Note 6Debt").

(5)
Other.  As discussed more fully in "Note 14 — Joint Venture and Settlement Agreements" in the notes to the consolidated financial statements in our 2012 10-K, amounts payable to Jakks totaling $6.0 million are reflected in the table above. The present value of these amounts is included in "Accrued and other current liabilities" and "Other long-term liabilities" in our condensed consolidated balance sheet at June 30, 2012 (see "Note 2Balance Sheet Details"). The remaining other commitments included in the table above are also included as current or long-term liabilities in our June 30, 2012 condensed consolidated balance sheet.

(6)
We have omitted unrecognized tax benefits from this table due to the inherent uncertainty regarding the timing and amount of certain payments related to these unrecognized tax benefits.  The underlying positions have not been fully developed under audit to quantify at this time.  At June 30, 2012, we had $3.9 million of unrecognized tax benefits.  See "Note 9Income Taxes" for further information regarding the unrecognized tax benefits.

Manufacturer Indemnification. We must indemnify the platform manufacturers (Microsoft, Nintendo, Sony) of our games with respect to all loss, liability and expenses resulting from any claim against such manufacturer involving the development, marketing, sale or use of our games, including any claims for copyright or trademark infringement brought against such manufacturer. As a result, we bear a risk that the properties upon which the titles of our games are based, or that the information and technology licensed from others and incorporated into the products, may infringe the rights of third parties. Our agreements with our third-party software developers and property licensors typically provide indemnification rights for us with respect to certain matters. However, if a manufacturer brings a claim against us for indemnification, the developers or licensors may not have sufficient resources to, in turn, indemnify us.

Indemnity Agreements. We have entered into indemnification agreements with the members of our Board of Directors, our Chief Executive Officer and our Chief Financial Officer, to provide a contractual right of indemnification to such persons to the extent permitted by law against any and all liabilities, costs, expenses, amounts paid in settlement and damages incurred by any such person as a result of any lawsuit, or any judicial, administrative or investigative proceeding in which such person is sued as a result of service as a member of our Board of Directors, as Chief Executive Officer or as Chief Financial Officer. The indemnification agreements provide specific procedures and time frames with respect to requests for indemnification and clarify the benefits and remedies available to the indemnitees in the event of an indemnification request.

Litigation.

Federal Securities Class Action Case

A purported class action lawsuit on behalf of purchasers of THQ common stock between May 3, 2011 and February 3, 2012 (the "Class Period"), styled Zaghian vs. THQ Inc., et al., was filed against the Company and certain executive officers of the Company on June 15, 2012, in the United States District Court for the Central District of California, Southern Division.  The complaint alleges that the defendants knowingly made materially false and misleading statements regarding the Company's uDraw GameTablet during the Class Period.  The complaint seeks unspecified damages, reasonable attorneys' and experts' fees and costs and other relief.  The Company and the other defendants believe the complaint is without merit and intend to vigorously defend

16


the pending lawsuit.

Additionally, we are subject to ordinary routine claims and litigation incidental to our business. We do not believe that any liability from any reasonably foreseeable disposition of such claims and litigation, individually or in the aggregate, would have a material adverse effect on our financial position or results of operations.

8.   Stock-based Compensation
 
All share and per share information presented gives effect to the Reverse Stock Split, which occurred on July 5, 2012.

Subject to certain adjustments, as of June 30, 2012, the total number of shares of THQ common stock reserved for issuance under our Long-Term Incentive Plan (“LTIP”) was 1.9 million shares. 

On May 25, 2012, we appointed Jason Rubin ("Rubin") as our President and Jason Kay ("Kay") as our Chief Strategy Officer. As inducements to their employment, both were granted equity awards as follows:
stock option awards of 95,000 and 55,000 shares of our common stock, respectively. These awards have an exercise price of $6.10 per share (the fair market value of a share of our stock on May 25, 2012 adjusted for the Reverse Stock Split) and vest in three equal annual installments on the anniversary date of the grant, and are subject to continued employment; and
restricted stock unit awards of 95,000 and 55,000 shares of our common stock, respectively. These awards will vest in two equal installments based on the achievement of certain stock price performance goals that must be met prior to the fourth anniversary of this award. The first half of these awards will vest on the first date that the company’s common stock equals or exceeds $20.00 per share for ten consecutive trading days, and the second half of these awards will vest on the first date that our common stock equals or exceeds $30.00 per share for ten consecutive trading days, and are subject to continued employment.
Additionally, Rubin and Kay were granted, collectively, stock option awards of 307,176 shares of our common stock with an exercise price of $6.10 per share (the "Matching Award"). These shares will vest in full on the first date prior to March 31, 2013 that Rubin alone, or together with Kay, purchases shares of our common stock having a value at the time of purchase of at least $1.5 million. In the event this purchase of common stock is made by Rubin and Kay together, Rubin must purchase at least $1.0 million of the common stock with the remaining portion purchased by Kay, and this Matching Award would then be allocated to Rubin and Kay in direct proportion to the aggregate value of the common stock that each purchased. If the award does not vest prior to March 31, 2013, it will be terminated and forfeited as of that date.

The stock options and restricted stock units granted to Rubin and Kay were granted outside of a stockholder-approved plan, pursuant to the “Employment Inducement Awards” exemption of the Nasdaq Listing Rules.

9Income Taxes

We evaluate our deferred tax assets on a regular basis to determine if a valuation allowance is required. A cumulative taxable loss in recent years provides significant negative evidence in considering whether deferred tax assets are realizable. As we have had U.S. taxable losses in recent years, we can no longer rely on common tax planning strategies to use our U.S. tax losses and we are precluded from relying on projections of future taxable income to support the recognition of deferred tax assets. As such, the ultimate realization of deferred tax assets is dependent upon the existence of sufficient taxable income generated in the carryforward periods.

Our income tax expense for the three months ended June 30, 2012 and 2011 was $0.5 million and $1.1 million, respectively, primarily related to foreign tax jurisdictions. These amounts represent effective tax rates for the three months ended June 30, 2012 and 2011 of 3.2% (provision on net income) and 3.1% (provision on a loss), respectively. The rate for the three months ended June 30, 2012 and 2011 differs from the U.S. federal statutory rate of 35% primarily due to a benefit from the valuation allowance.

Our unrecognized tax benefits increased by $0.1 million in the three months ended June 30, 2012, from $3.8 million at March 31, 2012 to $3.9 million at June 30, 2012, of which $3.1 million would impact our effective tax rate if recognized. Due to inherent uncertainty we are not able to determine the timing and recognition of our unrecognized tax benefits. Additionally, due to the valuation of our deferred tax assets, any benefit recognized would not be realized in our effective tax rate for at least the next 12 months.

We conduct business internationally and, as a result, one or more of our subsidiaries files income tax returns in U.S. Federal, U.S. state, and certain foreign jurisdictions.  Accordingly, we are subject to examination by taxing authorities throughout the world, including Australia, China, France, Germany, Italy, Japan, Korea, Luxembourg, Netherlands, Spain, Switzerland, and the U.K.  Certain state and certain non-U.S. income tax returns are currently under various stages of audit or potential audit by applicable

17


tax authorities and the amounts ultimately paid, if any, upon resolution of the issues raised by the taxing authorities may differ materially from the amounts accrued for each year.  We are no longer subject to U.S. Federal, state, and local or foreign jurisdiction income tax examinations by tax authorities for March 31, 2007 and prior years.    
 
At June 30, 2012, approximately 75% of our cash and cash equivalents were domiciled in foreign tax jurisdictions.  We expect to repatriate all or a portion of these funds to the U.S., and we may be required to pay additional taxes (such as foreign withholdings) in certain foreign jurisdictions, which we do not expect to be significant. We do not anticipate that such repatriation, in the short-term, would result in actual cash payments in the U.S., as the taxable event would likely be offset by the utilization of our net operating losses and tax credits. 

Our policy is to recognize interest and penalty expense, if any, related to uncertain tax positions as a component of income tax expense.  As of June 30, 2012, we had no amounts accrued for interest and for the potential payment of penalties.

10.   Earnings (Loss) Per Share
 
All earnings (loss) per share information presented gives effect to the Reverse Stock Split, which occurred on July 5, 2012. The following table is a reconciliation of the weighted-average shares used in the computation of basic and diluted earnings (loss) per share for the periods presented (amounts in thousands):
 
 
For the Three Months
Ended June 30,
 
2012
 
2011
Net income (loss) used to compute basic earnings (loss) per share
$
15,385

 
$
(38,445
)
Adjustment to add-back amortization of previously capitalized interest expense and debt amortization costs associated with the Notes
759

 

Net income (loss) used to compute diluted earnings (loss) per share
$
16,144

 
$
(38,445
)
 
 
 
 
Weighted-average number of shares outstanding — basic
6,852

 
6,832

Dilutive effect of potential common shares
63

 

Conversion of the Notes
1,175

 

Number of shares used to compute earnings (loss) per share — diluted
8,090

 
6,832


For the three months ended June 30, 2012, the result of the if-converted calculation applied to the Notes was dilutive and as such we included the potential conversion of 1.2 million shares under our Notes in our diluted earnings per share calculation as shown in the table above.  For the three months ended June 30, 2011, the result of the if-converted calculation applied to the Notes was antidilutive and as such we did not include the potential conversion of 1.2 million shares under our Notes in our diluted earnings per share calculation in that period.

For the three months ended June 30, 2012, we excluded 1.2 million potential common shares from the computation of diluted earnings per share as their inclusion would have been antidilutive.

As a result of our net loss for the three months ended June 30, 2011, we have excluded 1.0 million potential common shares from the computation of diluted loss per share as their inclusion would have been antidilutive. Had we reported net income for the three months ended June 30, 2011, an additional 17,060 shares of common stock would have been included in the number of shares used to calculate diluted loss per share.

11.   Fair Value
 
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value must maximize the use of observable inputs and minimize the use of unobservable inputs.  There is a fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable, that may be used to measure fair value.  We used the following methods and assumptions to estimate the fair value of our financial assets:
 
                  Level 1 — Quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.  We do not adjust the quoted prices for these investments.
                  Level 2 — Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar

18


assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
                  Level 3 — Discounted cash flow analysis using unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities, as discussed further below.
 
Our policy is to recognize transfers between these levels of the fair value hierarchy as of the beginning of the reporting period.
 
The following table summarizes our financial assets measured at fair value on a recurring basis as of June 30, 2012 (amounts in thousands):
 
Level 1
 
Level 2
 
Level 3
 
Total
Cash equivalents - Money market funds
$
88

 
$

 
$

 
$
88

Other long-term assets, net - Investment in Yuke's
4,506

 

 

 
4,506

Total
$
4,594

 
$

 
$

 
$
4,594

 
The following table summarizes our financial assets measured at fair value on a recurring basis as of March 31, 2012 (amounts in thousands):
 
Level 1
 
Level 2
 
Level 3
 
Total
Cash equivalents - Money market funds
$

 
$

 
$

 
$

Other long-term assets, net - Investment in Yuke's
4,641

 

 

 
4,641

Total
$
4,641

 
$

 
$

 
$
4,641

 
During the three months ended June 30, 2012 we did not hold any Level 3 financial assets.

Financial Instruments
 
The carrying value of certain financial instruments, including cash and cash equivalents, accounts receivable, accounts payable, accrued expenses, and accrued royalties approximate fair value based on their short-term nature. 
 
The book value and fair value of the Notes at June 30, 2012 was $100.0 million and $57.8 million, respectively; the fair value was determined using quoted market prices in active markets.
 
We transact business in many different foreign currencies and are exposed to financial market risk resulting from fluctuations in foreign currency exchange rates, particularly the GBP and the Euro, which may result in a gain or loss of earnings to us. We utilize foreign currency exchange forward contracts to mitigate foreign currency risk associated with foreign currency-denominated assets and liabilities, primarily certain inter-company receivables and payables. Our foreign currency exchange forward contracts are not designated as hedging instruments and are accounted for as derivatives whereby the fair value of the contracts are reported as "Prepaid expenses and other current assets" or "Accrued and other current liabilities" in our condensed consolidated balance sheets, and the associated gains and losses from changes in fair value are reported in "Interest and other income (expense), net" in our condensed consolidated statements of operations.
 
Cash Flow Hedging Activities.  From time to time, we may elect to hedge a portion of our foreign currency risk related to forecasted foreign currency-denominated sales and expense transactions by entering into foreign currency exchange forward contracts that generally have maturities of less than 90 days.  Our hedging programs reduce, but do not entirely eliminate, the impact of currency exchange rate movements in net sales and operating expenses.  During the three months ended June 30, 2012 and 2011, we did not enter into any foreign exchange forward contracts related to cash flow hedging activities.
 
Balance Sheet Hedging Activities.  The foreign currency exchange forward contracts related to balance sheet hedging activities generally have a contractual term of one month or less and are transacted near month-end. Therefore, the fair value of the forward contracts are generally not significant at each month-end.
 
At June 30, 2012, we did not have any outstanding foreign currency exchange forward contracts related to balance sheet hedging activities. At March 31, 2012, we had foreign currency exchange forward contracts related to balance sheet hedging activities in the notional amount of $92.2 million with a fair value that approximates zero at March 31, 2012.  We estimated the fair value of these contracts using Level 1 inputs, specifically, inputs obtained in quoted public markets.  The net loss recognized from these contracts during the three months ended June 30, 2012 was $4.3 million. The net gain recognized from these contracts during

19


three months ended June 30, 2011 was $1.5 million. Net gains and losses recognized from these contracts are included in "Interest and other income (expense), net" in our condensed consolidated statements of operations.

12.   Capital Stock Transactions

On July 31, 2007 and October 30, 2007, our board authorized the repurchase of up to $25.0 million of our common stock from time to time on the open market or in private transactions, for an aggregate of $50.0 million.  As of June 30, 2012 and March 31, 2012 we had $28.6 million, authorized and available for common stock repurchases.  During the three months ended June 30, 2012, we did not repurchase any shares of our common stock.  There is no expiration date for the authorized repurchases. 

13. Segment and Geographic Information

We operate in one reportable segment in which we are a developer, publisher and distributor of interactive entertainment software for video game consoles, handheld devices and PCs, including via the Internet. The following information sets forth geographic information on our net sales and total assets for the three months ended June 30, 2012 and 2011 (amounts in thousands):

 
North
America
 
Europe
 
Asia
Pacific
 
Consolidated
Three months ended June 30, 2012
 
 
 
 
 
 
 
Net sales to unaffiliated customers before changes in deferred net revenue
$
23,325

 
$
12,006

 
$
3,194

 
$
38,525

Changes in deferred net revenue
57,933

 
29,273

 
7,956

 
95,162

Net sales to unaffiliated customers
$
81,258

 
$
41,279

 
$
11,150

 
$
133,687

Total assets
$
119,343

 
$
130,505

 
$
32,967

 
$
282,815

Three months ended June 30, 2011
 
 
 
 
 
 
 
Net sales to unaffiliated customers before changes in deferred net revenue
$
87,743

 
$
35,230

 
$
18,266

 
$
141,239

Changes in deferred net revenue
28,516

 
24,259

 
1,139

 
53,914

Net sales to unaffiliated customers
$
116,259

 
$
59,489

 
$
19,405

 
$
195,153

Total assets
$
446,989

 
$
178,842

 
$
57,874

 
$
683,705


Information about our net sales by platform for the three months ended June 30, 2012 and 2011 is as follows (amounts in thousands):

 
 
Three Months Ended June 30,
Platform
 
2012
 
2011
Consoles
 
 
 
 
Microsoft Xbox 360
 
$
13,980

 
$
51,542

Sony PlayStation 3
 
9,861

 
35,782

Nintendo Wii
 
3,196

 
19,024

Sony PlayStation 2
 
284

 
1,019

 
 
27,321

 
107,367

Handheld
 
 
 
 
Nintendo Dual Screen
 
3,467

 
21,284

Sony PlayStation Portable
 
641

 
2,122

Wireless
 
421

 
736

 
 
4,529

 
24,142

 
 
 
 
 
PC
 
6,675

 
9,730

Net sales before changes in deferred net revenue
 
38,525

 
141,239

Changes in deferred net revenue
 
95,162

 
53,914

Total net sales
 
$
133,687

 
$
195,153


20



Item 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations
 
The statements contained in this Quarterly Report on Form 10-Q ("10-Q") that are not historical facts may be "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements include, but are not limited to, statements regarding industry prospects, our future economic performance including anticipated revenues and expenditures, restructuring activities, results of operations or financial position, and other financial items, our business plans and objectives, including our intended product releases, and may include certain assumptions that underlie the forward-looking statements. We generally use words such as "anticipate," "believe," "could," "estimate," "expect," "forecast," "future," "intend," "may," "plan," "positioned," "potential," "project," "scheduled," "set to," "subject to," "upcoming" and other similar expressions to help identify forward-looking statements. These forward-looking statements are based on current expectations, estimates and projections about the business of THQ Inc. and its subsidiaries and are based upon management's current beliefs and certain assumptions made by management. Our business and such forward-looking statements are subject to risks and uncertainties that may affect our future results. For a discussion of our risk factors, see "Part II, Item 1A. Risk Factors." The forward-looking statements contained herein speak only as of the date on which they were made, and, except as required by law, we disclaim any obligation to update any forward-looking statements to reflect events or circumstances after the date of this 10-Q.

All references to "we," "us," "our," "THQ," or the "Company" in this 10-Q mean THQ Inc. and its subsidiaries. Most of the properties and titles referred to in this 10-Q are subject to trademark protection.

Overview
 
The following is a discussion of our operating results and financial condition, as well as material changes in operating results and financial condition from prior reported periods.  The discussion and analysis herein should be read in conjunction with our consolidated financial statements, notes to the consolidated financial statements, and management's discussion and analysis (which includes additional information about our accounting policies, practices and the transactions that underlie our financial results) contained in our Annual Report on Form 10-K for the fiscal year ended March 31, 2012 (the "2012 10-K").
 
About THQ
We are a leading worldwide developer and publisher of interactive entertainment software for all popular game systems, including:
home video game consoles such as the Microsoft Xbox 360 and Xbox 360 Kinect (collectively referred to as "Xbox 360"), Nintendo Wii ("Wii"), and Sony PlayStation 3 ("PS3");
handheld platforms such as the Nintendo DS, DSi and 3DS (collectively referred to as "DS"), and Sony PlayStation Portable ("PSP");
wireless devices based on the Apple iOS (including the iPhone, iTouch and iPad), Google Android, and Windows Mobile platforms;
personal computers ("PCs"), including games played online; and
the Internet, including on social networking sites such as Facebook.

In addition to titles published on the wireless devices noted above, we also develop and publish titles (and supplemental downloadable content) for digital distribution via Sony's PlayStation Network ("PSN") and Microsoft's Xbox LIVE Marketplace ("Xbox LIVE") and Xbox LIVE Arcade ("XBLA"), as well as digitally offer our PC titles through online download stores and services such as Amazon, OnLive, Origin, and Valve.
 
Our titles span multiple categories, including action, adventure, fighting, role-playing, simulation, and strategy.  We have created, licensed and acquired a group of highly recognizable brands, which we market to a variety of consumer demographics ranging from products targeted at core gamers to products targeted to mass market.  Our portfolio of key franchises currently includes:
games based on our owned intellectual properties including Company of Heroes, Darksiders, Homefront, and Saints Row; and new properties in development by Patrice Désilets and Turtle Rock Studios, and
core games based on licensed properties including Games Workshop's Warhammer 40,000 universe, Metro, South Park Digital Studios' South Park, and World Wrestling Entertainment ("WWE").

We develop our products using both internal and external development resources. The internal resources consist of producers, game designers, software engineers, artists, animators and game testers located within our internal development studios and corporate headquarters. The external development resources consist of third-party software developers and other independent resources such as artists, voice-over actors and composers.

Our global sales network includes offices throughout North America, Europe and Australia. In the U.S. and Canada, we market and distribute games directly to mass merchandisers, consumer electronic stores, discount warehouses and other national retail

21


chain stores. Internationally, we market and distribute games on a direct-to-retail basis in the territories where we have a direct sales force and to a lesser extent, in the territories where we do not have a direct sales force, third parties distribute our games. We also globally market and distribute games digitally via the Internet and, to a lesser extent, through high-end wireless devices, such as the iPhone, iTouch and iPad, as well as wireless devices run on the Google Android and Windows Mobile platforms.

Strategic Plan and Product Updates, Business realignments, and Other Updates

Our strategy is focused on creating and marketing high-demand core games with a significant digital component. These connected experiences, in particular, are key to increasing customer engagement, retention, and monetization. A key part of our strategy is to build franchises for the next generation of consoles at or shortly after they are launched. To execute on our strategic plan, on May 25, 2012 we bolstered our management team by appointing a new President and a new Chief Strategy Officer.

In June 2012, in connection with the hiring of our new President, we re-evaluated our games under development and as a result we:
incorporated the development of the standalone expansion Saints Row: The Third – Enter the Dominatrix into production of the next great sequel in the Saints Row franchise; and
cancelled an unreleased title and changed development direction on another unreleased title; these actions resulted in combined non-cash charges of $6.6 million (see "Note 5Restructuring and Other Charges” included in Part I, item 1 for further information).

UFC license. On June 1, 2012, we entered into an agreement to transfer our license to develop future games based on the UFC, which resulted in a cash payment to us. In connection with this action, we wrote-off capitalized software development related to the UFC game that had been under development at the time of the license transfer; these actions resulted in a combined net benefit of $2.3 million. Additionally, we realigned our business through the closure of the studio that had been developing the game. (See "Note 5 — Restructuring and Other Charges” included in Part I, item 1 for further information).

Nasdaq Listing. On January 25, 2012, we received a notification letter from NASDAQ notifying us that we were not in compliance with the $1.00 minimum bid price requirement (NASDAQ Marketplace Rule 5450(a)(1) (the "Rule")) because the bid price for our common stock closed below $1.00 over the prior 30 consecutive business days. To regain compliance with this requirement, we held a special meeting of stockholders on June 29, 2012 to solicit stockholder approval of a proposal to approve an amendment to our certificate of incorporation to effect a reverse stock split ("Reverse Stock Split"). On July 2, 2012, we announced the timing and details regarding stockholder approval of the Reverse Stock Split, which was effected on July 5, 2012 at a ratio of one-for-ten with no change in par value. No fractional shares were issued in connection with the Reverse Stock Split. Stockholders who otherwise were entitled to receive fractional shares were entitled to an amount in cash (without interest or deduction) equal to the fraction of one share to which such stockholder would otherwise be entitled multiplied by $5.75. On July 23, 2012, we received a letter from NASDAQ informing us that we had regained compliance with the Rule.

Business Trends
 
The following trends affect our business:

Increasing Shift to Online Content and Digital Downloads

We provide our products through both the retail channel and through online digital delivery methods. Recently, the interactive entertainment software industry began delivering a growing amount of games, downloadable content and product add-ons by direct digital download through the Internet and gaming consoles. We believe that much of the growth in the industry will come via online distribution methods, including, multi-player online games (both subscription and free-to-play), free-to-play micro-transaction based games, paid downloadable content ("DLC"), and digital downloads of full-games. Conversely, based on industry data, we believe retail sales for the industry will continue to be a decreasing revenue source over the next several years. For the six months ended June 30, 2012, reported retail software sales in the U.S. for the industry decreased 29% compared to the same period in 2011 according to the NPD Group; for the same period, across U.K., Germany, France, Spain and Benelux, aggregated retail software sales decreased 17% compared to the same six-month period in 2011 according to GfK.  However, digital sales for the industry are expected to grow over 24% worldwide in calendar 2012 and almost double, over calendar 2011 levels, in the following five years to $68.5 billion worldwide according to the International Development Group, Inc.'s Forecast Update (April 2012). Accordingly, we plan to emphasize the digital components in our future core game releases. In the event our games are released with increasingly more undelivered elements at the time of sale, such as the online service present within some of our games, more of our revenue may be deferred, which will impact the timing of our revenue recognition but not our cash flow from operations.


22


Sales Concentration of Top Titles

The majority of money spent by consumers on video game software is spent on a few top titles. Because of the demand for “hit” titles and the costs to develop our games, we believe that it is important to focus our development efforts on bringing a select number of high-quality, competitive products to market.
  
Sales of Used Video Games
 
Several retailers, including one of our largest customers, GameStop, continue to focus on selling used video games, which provides higher margins for the retailers than sales of new games. This focus reduces demand for new copies of our games. We believe customer retention through compelling online play and downloadable content offerings may reduce consumers' propensity to trade in games. Additionally, certain of our titles include free access to online content through a code (included in the packaging) for initial purchasers. This structure creates a new revenue stream by offering second-hand buyers of these titles the opportunity to separately purchase the online content.

Shifting Preferences in the Casual and Lifestyle Market

Over the past few years, our industry has seen a shift in preferences in the casual and lifestyle games market away from kids' and movie-based licensed console titles. We believe this shift is due to gameplay with online digital delivery methods, including games played online and on social networking sites such as Facebook, and through wireless devices. As discussed above, in response to this continued shift in preferences, we exited the market for video games based on licensed kids' and movie-based entertainment properties and uDraw. Approximately 17% and 39% of our net sales before the impact of changes in deferred net revenue in the three months ended June 30, 2012 and 2011, respectively, came from these types of games.

Results of Operations — Comparison of the Three Months Ended June 30, 2012 and 2011

For the three months ended June 30, 2012, we reported a net income of $15.4 million, or $2.00 per diluted share, compared with a net loss of $38.4 million, or $5.63 per diluted share, in the same period last fiscal year.

Net Sales
 
Our net sales are principally derived from sales of interactive software games designed for play on video game consoles, handheld devices, and PCs, including via the Internet. The following table presents our net sales before changes in deferred net revenue and adjusts those amounts by the changes in deferred net revenue to arrive at consolidated net sales as presented in our condensed consolidated statements of operations for the three months ended June 30, 2012 and 2011 (amounts in thousands):

 
Three Months Ended June 30,
 
Increase/
(Decrease)
 
% Change
 
2012
 
2011
 
 
Net sales before changes in deferred net revenue
$
38,525

 
28.8
%
 
$
141,239

 
72.4
%
 
$
(102,714
)
 
(72.7
)%
Changes in deferred net revenue
95,162

 
71.2

 
53,914

 
27.6

 
41,248

 
76.5

Consolidated net sales
$
133,687

 
100.0
%
 
$
195,153

 
100.0
%
 
$
(61,466
)
 
(31.5
)%
 
We did not have any major new releases in the three months ended June 30, 2012. Net sales before changes in deferred net revenue in the current quarter were primarily driven by continued sales of Saints Row: The Third, initially released in the third quarter of fiscal 2012, including sales generated from its digital content offerings and full-game digital downloads. Also contributing to net sales before changes in deferred net revenue in the three months ended June 30, 2012 were sales of other catalog titles such as WWE '12.

Included in net sales before changes in deferred net revenue in the three months ended June 30, 2012 was $13.4 million of digital revenue, which was 33% higher than the same period last fiscal year. Digital revenue primarily consists of digital downloads of full-games and paid downloadable content.

Changes in deferred net revenue reflect the deferral and subsequent recognition of net revenue related to undelivered elements at the time of sale, such as online services that are offered in some of our games. The revenue deferrals are recognized as net sales as the undelivered elements are delivered or, over the estimated online service period of generally six months, as applicable. The changes in deferred net revenue are driven by the timing of the release of games that have undelivered elements, and the subsequent timing of the delivery of those undelivered elements. Generally, revenue deferred in the first half of our fiscal year would be

23


recognized by the end of that fiscal year, and revenue deferred in the second half of the fiscal year would be partially recognized in that fiscal year with the remaining amounts of deferred revenue recognized in the following fiscal year.

Net Sales by New Releases and Catalog Titles
 
The following table presents our net sales of new releases (titles initially released in the respective fiscal year) and catalog titles for the three months ended June 30, 2012 and 2011 (amounts in thousands):

 
 
Three Months Ended June 30,
 
Increase/
 
%
 
2012
 
2011
 
(Decrease)
 
Change
New releases
$
917

 
2.4
%
 
$
89,029

 
63.0
%
 
$
(88,112
)
 
(99.0
)%
Catalog
37,608

 
97.6

 
52,210

 
37.0

 
(14,602
)
 
(28.0
)
Net sales before changes in deferred net revenue
38,525

 
100.0
%
 
141,239

 
100.0
%
 
(102,714
)
 
(72.7
)
Changes in deferred net revenue
95,162

 
 
 
53,914

 
 
 
41,248

 
76.5

Consolidated net sales
$
133,687

 
 
 
$
195,153

 
 
 
$
(61,466
)
 
(31.5
)%

Net sales of our new releases decreased $88.1 million in the three months ended June 30, 2012, compared to the same period last fiscal year, reflecting the fact that we did not have any major new releases in the current quarter. In the same period a year ago, we released several new titles including Red Faction: Armageddon and MX vs. ATV Alive.

Net sales of our catalog titles decreased $14.6 million in the three months ended June 30, 2012, compared to the same period last fiscal year, reflecting fewer catalog units sold.

Net Sales by Territory
 
The following table presents our net sales by territory for the three months ended June 30, 2012 and 2011 (amounts in thousands):

 
Three Months Ended June 30,
 
Increase/
 
%
 
2012
 
2011
 
(Decrease)
 
Change
North America
$
23,325

 
60.5
%
 
$
87,743

 
62.1
%
 
$
(64,418
)
 
(73.4
)%
Europe
12,006

 
31.2

 
35,230

 
25.0

 
(23,224
)
 
(65.9
)
Asia Pacific
3,194

 
8.3

 
18,266

 
12.9

 
(15,072
)
 
(82.5
)
International
15,200

 
39.5

 
53,496

 
37.9

 
(38,296
)
 
(71.6
)
Net sales before changes in deferred net revenue
38,525

 
100.0
%
 
141,239

 
100.0
%
 
(102,714
)
 
(72.7
)
Changes in deferred net revenue
95,162

 
 
 
53,914

 
 
 
41,248

 
76.5

Consolidated net sales
$
133,687

 
 
 
$
195,153

 
 
 
$
(61,466
)
 
(31.5
)%

Net sales in North America in the three months ended June 30, 2012 decreased $64.4 million compared to the same period last fiscal year. This decrease was primarily due to our release schedule as we did not release any new titles in the current quarter whereas in the same period last fiscal year we released several new titles. The decrease in net sales in North America was also due to a decline in the number of catalog units sold in the current quarter compared to the same period last fiscal year.

Net sales in Europe in the three months ended June 30, 2012 decreased $23.2 million compared to the same period last fiscal year. We estimate that changes in foreign currency translation rates during the three months ended June 30, 2012 decreased our reported net sales in this territory by $1.0 million. The decrease in net sales in this territory was primarily due to our release schedule as we did not release any new titles in the current quarter. This decrease was partially offset by an increase in the average selling price of our catalog units sold.

Net sales in the Asia Pacific territory in the three months ended June 30, 2012 decreased $15.1 million, compared to the same period last fiscal year. We estimate that changes in foreign currency translation rates decreased our reported net sales in this territory by $0.2 million during the three months ended June 30, 2012. The decrease in net sales in this territory was primarily due to lower net sales from catalog titles as we sold fewer catalog units and had lower average net selling prices in the current quarter compared to the same period last fiscal year. The decrease in net sales in this territory was also due to our release schedule

24


as we did not release any new titles in the current quarter whereas in the same period last fiscal year we released several new titles.

Cost of Sales
 
Cost of sales decreased $58.5 million, or 41.8%, in the three months ended June 30, 2012 compared to the same period last fiscal year.  As a percent of net sales, cost of sales decreased 10.8 points in the three months ended June 30, 2012 compared to the same period last fiscal year.

Cost of Sales - Product Costs (amounts in thousands)
 
June 30, 2012
 
% of net sales
 
June 30, 2011
 
% of net sales
 
% Change
Three Months Ended
$38,486
 
28.8%
 
$67,063
 
34.4%
 
(42.6)%
 
Product costs primarily consist of direct manufacturing costs, including platform manufacturer license fees, net of manufacturer volume rebates and discounts. In the three months ended June 30, 2012, product costs as a percent of net sales decreased 5.6 points compared to the same period last fiscal year. This decrease was primarily due to the current quarter recognition of net sales and product costs related to Saints Row: The Third. This title was initially released in the third quarter of fiscal 2012 and has had lower product costs relative to its net sales compared to the performance of products recognized in the same period last fiscal year. Additionally, the decrease in product costs as a percent of net sales in the current quarter was also due to an increase in our sales mix of digitally delivered revenue which does not have associated product costs. Digital revenue in the three months ended June 30, 2012 was driven by add-on content associated with Saints Row: The Third.

Cost of Sales - Software Amortization and Royalties (amounts in thousands)
 
June 30, 2012
 
% of net sales
 
June 30, 2011
 
% of net sales
 
% Change
Three Months Ended
$37,353
 
27.9%
 
$64,920
 
33.3%
 
(42.5)%
 
Software amortization and royalties expense consists of amortization of capitalized payments made to third-party software developers and amortization of capitalized internal studio development costs. Commencing upon product release, capitalized software development costs are amortized to software amortization and royalties expense based on the ratio of current gross sales to total projected gross sales. Excluding charges associated with i) the cancellation of an unreleased game and ii) changes in the development direction on another unreleased game, as well as a net benefit associated with the June 2012 transfer of the license we previously had with the UFC and the related game cancellation, (see “Note 3Licenses and Software Development” in the notes to the condensed consolidated financial statements included in Part I, Item 1 for further information), software amortization and royalties expense as a percent of net sales in the three months ended June 30, 2012 decreased 2.1 points compared to the same period last fiscal year. This decrease was primarily due to the current quarter recognition of net sales and software amortization expense related to Saints Row: The Third. This title was initially released in the third quarter of fiscal 2012 and has had lower software amortization expense relative to its net sales compared to the performance of products recognized in the same period last fiscal year.

Cost of Sales - License Amortization and Royalties (amounts in thousands)
 
June 30, 2012
 
% of net sales
 
June 30, 2011
 
% of net sales
 
% Change
Three Months Ended
$5,749
 
4.3%
 
$8,139
 
4.2%
 
(29.4)%
 
License amortization and royalties expense consists of royalty payments due to licensors, which are expensed at the higher of (1) the contractual royalty rate based on actual net product sales for such license, or (2) an effective rate based upon total projected net sales for such license.  Net sales from our licensed properties represented 41% of our total net sales in the three months ended June 30, 2012 compared to 49% of our total net sales in the same period last fiscal year.

License amortization and royalties expense in the three months ended June 30, 2012 included a $2.0 million benefit related to the reduction of a license obligation that was accrued as of March 31, 2012 as a result of negotiations with one of our previous kids' licensors (see "Note 5Restructuring and Other Charges” in the notes to the condensed consolidated financial statements included in Part I, Item 1). Excluding this benefit, license amortization and royalties expense as a percent of net sales in the three months ended June 30, 2012 increased 1.6 points compared to the same period last fiscal year. The primary driver of the increase in the three month comparative periods was higher effective license rates due to the performance of several of our licensed titles in the current quarter compared to their performance in the same period last fiscal year.


25


Operating Expenses

Our operating expenses decreased $57.3 million, or 61.8% in the three months ended June 30, 2012 compared to the same period last fiscal year.

Product Development (amounts in thousands)
 
June 30, 2012
 
% of net sales
 
June 30, 2011
 
% of net sales
 
% Change
Three Months Ended
$9,295
 
7.0%
 
$30,189
 
15.5%
 
(69.2)%
 
Product development expense primarily consists of expenses incurred by internal development studios and payments made to external development studios which are not eligible, or are in a phase of development that is not yet able to be capitalized as part of software development. Product development expense decreased $20.9 million in the three months ended June 30, 2012 compared to the same period last fiscal year.

Included in the three months ended June 30, 2011 was $3.4 million of cash severance charges and other employee-based costs recorded related to our business realignments (see "Note 5Restructuring and Other Charges” in the notes to the condensed consolidated financial statements included in Part I, Item 1).  Excluding these charges, product development expense decreased $17.5 million in the three months ended June 30, 2012 compared to the same period last fiscal year.  This decrease was primarily due to a reduction in expenditures resulting from our studio closures and a reduction in the number of games under development.

Selling and Marketing (amounts in thousands)
 
June 30, 2012
 
% of net sales
 
June 30, 2011
 
% of net sales
 
% Change
Three Months Ended
$14,639
 
11.0%
 
$50,676
 
26.0%
 
(71.1)%
 
Selling and marketing expenses consist of advertising, promotional expenses, and personnel-related costs. Selling and marketing expenses decreased $36.0 million in the three months ended June 30, 2012 compared to the same period last fiscal year. The decrease on a dollar-basis in the three months ended June 30, 2012 was primarily due to our release schedule as we did not release any new titles in the current quarter.

Excluding the impact of changes in deferred net revenue, to arrive at a net sales basis that most closely relates to our selling and marketing activities in a given period, selling and marketing expenses as a percent of net sales increased 2.2 points in the three months ended June 30, 2012 compared to the same period last fiscal year, reflecting the overall lower net sales base in the current quarter.

General and Administrative (amounts in thousands)
 
June 30, 2012
 
% of net sales
 
June 30, 2011
 
% of net sales
 
% Change
Three Months Ended
$10,132
 
7.6%
 
$12,049
 
6.2%
 
(15.9)%
 
General and administrative expenses consist of personnel and related expenses of executive and administrative staff and fees for professional services such as legal and accounting. The decrease of $1.9 million in general and administrative expenses in the three months ended June 30, 2012 was primarily due to lower personnel related costs.

Restructuring
 
Restructuring charges generally include costs such as, severance and other employee-based charges in excess of standard business practices, costs associated with lease abandonments less estimates of sublease income, charges related to long-lived assets, and costs of other non-cancellable contracts.  In the three months ended June 30, 2012, restructuring charges and adjustments were $1.4 million and were primarily due to the closure of a studio that had been developing a game under the UFC license which we transferred on June 4, 2012. In the three months ended June 30, 2011, restructuring charges and adjustments were minimal and reflected facility-related charges and adjustments due to changes in actual and estimated sublease income related to our fiscal 2009 realignment. For further information related to our realignment plans and charges and the events and decisions that gave rise to such charges, see “Note 5Restructuring and Other Charges” in the notes to the condensed consolidated financial statements included in Part I, Item 1.

Interest and Other Income (Expense), net

26


 
Interest and other income (expense), net, consists of interest earned on our investments, gains and losses resulting from exchange rate changes for transactions denominated in currencies other than the functional currency, and interest expense, net of capitalization and amortization of debt issuance costs on our $100.0 million 5% convertible senior notes (“Notes”) and our Credit Agreement and Security Agreement (as amended, collectively, the “Credit Facility”) with Wells Fargo Capital Finance, LLC. For further discussion of the Notes and the Credit Facility, see “Note 6Debt” in the notes to the condensed consolidated financial statements included in Part I, Item 1.

Interest and other income (expense), net in the three months ended June 30, 2012 was expense of $0.8 million and primarily consisted of foreign currency losses. Interest and other income (expense), net in the three months ended June 30, 2011 was income of $0.4 million and primarily consisted of foreign currency gains and interest income.
 
Income Taxes
 
Income tax expense for the three months ended June 30, 2012 was $0.5 million, compared to $1.1 million in the same period last fiscal year.  Income tax expense in both periods relates primarily to income earned in foreign jurisdictions, which is not reduced by carryforward losses in the U.S.  The effective tax rate differs significantly from the federal statutory rate; this difference is primarily due to taxable losses in the U.S. that are fully offset by a valuation allowance.

Liquidity and Capital Resources

Financial Condition
 
At June 30, 2012, we had working capital of $27.6 million, including cash and cash equivalents of $20.9 million. Our working capital was reduced by $20.0 million related to the non-cash deferral of revenue, net of related expenses, as of June 30, 2012.

With our focused product plan, lower cost structure, cash balance, existing credit facility and other sources of external liquidity, we believe we have adequate resources to execute on our plan and deliver on our strong multi-year pipeline of games. Although we believe our current business plan is achievable, should we fail to achieve the net sales, gross margin levels, and maintain the customer payment and vendor credit terms we anticipate, or if we were to incur significant unplanned cash outlays, it would become necessary for us to obtain additional sources of liquidity or make further cost cuts (including future product development) to fund our operations, which could result in additional realignment and impairment charges. However, there is no assurance that we would be able to obtain additional financing on favorable terms, if at all, or to successfully further reduce costs in such a way that would continue to allow us to operate our business. If for any reason our projections do not materialize, we may not be able to comply with the requirements of our credit and debt facilities as further discussed below. Our ability to achieve our business plan and anticipated levels of liquidity could also be affected by various risks and uncertainties described in "Part II, Item 1A. Risk Factors." 

Sources and Uses of Cash
(Amounts in thousands)
June 30,
2012
 
March 31,
2012
 
Change
Cash and cash equivalents
$
20,937

 
$
75,977

 
$
(55,040
)
Percentage of total assets
7
%
 
19
%
 
 


 
 
Three Months Ended June 30,
 
 
(Amounts in thousands)
2012
 
2011
 
Change
Net cash provided by (used in) operating activities
$
(48,067
)
 
$
34,015

 
$
(82,082
)
Net cash used in investing activities
(1,807
)
 
(2,948
)
 
1,141

Net cash provided by financing activities

 
21

 
(21
)
Effect of exchange rate changes on cash
(5,166
)
 
2,345

 
(7,511
)
Net increase (decrease) in cash and cash equivalents
$
(55,040
)
 
$
33,433

 
$
(88,473
)
 
Generally, our primary sources of internal liquidity are cash and cash equivalents. In addition, as further discussed below, we may elect to sell certain of our eligible North American accounts receivable and we have other external sources of liquidity available to us, including our Credit Facility (as described below). Our principal source of cash is from sales of interactive software games designed for play on video game consoles, handheld devices and PCs, including via the Internet. Our principal uses of cash are

27


for product purchases of discs and cartridges along with associated manufacturer's royalties, payments to external developers and licensors, costs of internal software development, and selling and marketing expenses. In the three months ended June 30, 2012 our cash and cash equivalents decreased $55.0 million, from $76.0 million at March 31, 2012 to $20.9 million at June 30, 2012. The decrease in our cash balance was primarily due to investments in software development, payments of accounts payable and other liabilities, and capital expenditures, offset by collection of accounts receivable for released titles and expedited collections from our Walmart Purchase Agreement. For further information regarding the movement in our cash balance during the three months ended June 30, 2012, refer to the Condensed Consolidated Statement of Cash Flows for that period which is included in Part I, Item 1.

Our business is cyclical and thus our working capital needs are impacted by seasonality and the timing of new product releases. Cash used in operations tends to be at its highest during the first part of the third fiscal quarter, as we invest heavily in inventory for the holiday buying season. During the three months ended June 30, 2012, we did not borrow any funds. In addition, in order to expedite collections on our accounts receivable, we have sold, and expect to continue to sell certain of our accounts receivables from Walmart Stores, Inc. ("Walmart") without recourse, to Wells Fargo Bank, N.A. ("Wells") (as discussed below).

Walmart Purchase Agreement.
In November 2010, we entered into a Receivables Purchase Agreement ("Purchase Agreement") with Wells. The Purchase Agreement gives us the option to sell our Walmart receivables to Wells, at our discretion, and significantly expedite our Walmart receivables collections. Wells will pay us the value of any receivables we elect to sell, less LIBOR + 1.25% per annum, and then collect the receivables from Walmart. During the three months ended June 30, 2012, to expedite our receivables collections from Walmart, we sold $1.4 million of accounts receivable under the Purchase Agreement, without recourse, that would have otherwise been collected subsequent to June 30, 2012. The loss related to interest recognized on this transaction for the three months ended June 30, 2012 which is classified in "Interest and other income (expense), net" in our condensed consolidated statements of operations was an immaterial amount. We expect to continue to sell our Walmart accounts receivable pursuant to the Purchase Agreement to further expedite collections.
 
Credit Facility.
On September 23, 2011, we entered into the Credit Facility. The Credit Facility provides for a revolving facility of up to $50.0 million. The Credit Facility allows up to $10.0 million of the total to be used as a letter of credit subfacility.

The Credit Facility has a four-year term; provided, however, it will terminate on June 16, 2014 if any obligations are still outstanding under the Notes. Borrowings under the Credit Facility bear interest at a rate equal to an applicable margin plus, at our option, either a variable base rate or a LIBOR rate. The applicable margin for base rate loans ranges from 2.25% to 2.5% and for LIBOR rate loans ranges from 3.75% to 4.0%, in each case, depending on the level of our borrowings. We will be required to pay other customary fees, including an unused line fee based on usage under the Credit Facility as well as fees with respect to letters of credit.
The Credit Facility provides for certain events of default such as nonpayment of principal and interest when due, breaches of representations and warranties, noncompliance with covenants, acts of insolvency, default on certain agreements related to indebtedness, including the Notes, and entry of certain judgments against us. Upon the occurrence of a continuing event of default and at the option of the required lenders (as defined in the Credit Facility), all of the amounts outstanding under the Credit Facility may be declared to be immediately due and payable and any amount outstanding will bear interest at 2.0% above the interest rate otherwise applicable.  In the event availability on the Credit Facility is below 12.5% (16% beginning January 1, 2013) of the maximum revolver amount, the Credit Facility requires that we maintain certain financial covenants.  As of June 30, 2012, we had availability in excess of 12.5% and therefore we were not subject to the financial covenants.  In the event the financial covenants become applicable, we would be required to have EBITDA, as defined in the Credit Facility, of $9.8 million for the four quarters ended June 30, 2012. Beginning September 30, 2012, the EBITDA requirements are replaced with a requirement that we maintain an annual fixed charge coverage ratio, as defined in the Credit Facility, of at least 1.1 to 1.0.
The Credit Facility is guaranteed by most of our domestic subsidiaries and secured by substantially all of our assets. The Credit Facility contains financial reporting covenant and other customary affirmative and negative covenants, including, among other terms and conditions, limitations (subject to certain permitted actions) on our ability to: create, incur, guarantee or be liable for indebtedness; dispose of assets outside the ordinary course; acquire, merge or consolidate with or into another person or entity; create, incur or allow any lien on any of their respective properties; make investments or capital expenditures; or pay dividends or make distributions.
During the three months ended June 30, 2012, we did not borrow any funds and therefore incurred no related interest expense. In the three months ended June 30, 2012 amortization of debt issuance costs related to the Credit Facility was $0.1 million; these

28


amounts were capitalized as part of in-process software development costs. There were no outstanding borrowings under the Credit Facility as of June 30, 2012. During the three months ended June 30, 2012, we established a letter of credit for $0.6 million under the Credit Facility that is related to a lease we have for one of our studio locations.

As of June 30, 2012, we were in compliance with all applicable covenants and requirements under the Credit Facility.

As of August 1, 2012, we have borrowed $10.0 million under the Credit Facility and we intend to utilize the Credit Facility up to a total amount of approximately $43.0 million to fund working capital needs for our upcoming slate of video games.

At June 30, 2012, approximately 75% of our cash and cash equivalents were domiciled in foreign tax jurisdictions.  We expect to repatriate all or a portion of these funds to the U.S., and we may be required to pay additional taxes (such as foreign withholdings) in certain foreign jurisdictions, which we do not expect to be significant. We do not anticipate that such repatriation, in the short-term, would result in actual cash payments in the U.S., as the taxable event would likely be offset by the utilization of our net operating losses and tax credits. 

Cash Flow from Operating Activities.  Cash used in operating activities was $48.1 million in the three months ended June 30, 2012, compared to cash provided by operating activities of $34.0 million in the same period last fiscal year.  The change in cash flow from operating activities was primarily the result of higher collections of receivables in the three months ended June 30, 2011 which was related to releases that occurred late in the fourth quarter of fiscal 2011.
 
Cash Flow from Investing Activities.  Cash used in investing activities was $1.8 million in the three months ended June 30, 2012, compared to $2.9 million in the same period last fiscal year.  The change in cash flow from investing activities was primarily due to fewer purchases of property and equipment.
 
Cash Flow from Financing Activities.  There were no cash flows from financing activities in the three months ended June 30, 2012 and the financing activities in the same period last fiscal year were insignificant.
 
Effect of exchange rate changes on cash.  Changes in foreign currency translation rates decreased our reported cash balance by $5.2 million.
 
Key Balance Sheet Accounts
 
At June 30, 2012, our total current assets were $179.1 million, down from $290.0 million at March 31, 2012. In addition to cash and cash equivalents, our current assets primarily consisted of:

Accounts Receivable. Accounts receivable decreased $11.9 million, from $16.0 million at March 31, 2012 to $4.1 million at June 30, 2012. The decrease was primarily due to our release schedule as we did not release any major new releases in the three months ended June 30, 2012. Accounts receivable allowances were $47.0 million at June 30, 2012, a $23.4 million decrease from $70.4 million at March 31, 2012. Allowances for price protection and returns as a percentage of trailing nine-month net sales, excluding the impact of changes in deferred net revenue, were 6% and 11% at June 30, 2012 and 2011, respectively. We believe our current allowances are adequate based on historical experience, inventory remaining in the retail channel, and the rate of inventory sell-through in the retail channel.

Inventory. Inventory decreased $3.1 million, from $18.5 million at March 31, 2012 to $15.4 million at June 30, 2012. The decrease in inventory was primarily due to our release schedule as we did not release any major new releases in the three months ended June 30, 2012. Inventory turns, excluding the impact of changes in deferred costs, on a rolling twelve-month basis was 14 at both June 30, 2012 and March 31, 2012.

Licenses. Our investment in licenses, including the long-term portion, decreased $6.8 million, from $64.5 million at March 31, 2012 to $57.7 million at June 30, 2012. The decrease was primarily due to the recognition of previously deferred license amortization and royalties expense.

Software Development. Capitalized software development, including the long-term portion, decreased $13.7 million, from $130.6 million at March 31, 2012 to $116.8 million at June 30, 2012. The decrease was primarily due to the recognition of previously deferred software amortization and royalties expense. Approximately 79% of the software development asset balance at June 30, 2012 is for titles that have expected release dates in the remainder of fiscal 2013 and beyond.

Total current liabilities at June 30, 2012, were $151.5 million, down from $271.3 million at March 31, 2012. Current liabilities

29


primarily consisted of:

Accounts Payable. Accounts payable increased $7.2 million, from $42.9 million at March 31, 2012 to $50.1 million at June 30, 2012. The increase in accounts payable was primarily due to the classification of certain customer credit balances within accounts payable at June 30, 2012.

Accrued and Other Current Liabilities. Accrued and other current liabilities decreased $31.0 million, from $83.7 million at March 31, 2012 to $52.7 million at June 30, 2012. The decrease was primarily due to payments of accrued royalties and timing of developer milestone payments and accruals.

Our liabilities at June 30, 2012 also consisted of:

Other long-term liabilities. Other long-term liabilities decreased $1.7 million, from $53.8 million at March 31, 2012 to $52.1 million at June 30, 2012. The decrease was primarily due to movements of a portion of the settlement payment due to Jakks, from long-term into current liabilities.

Convertible Senior Notes. We issued the Notes on August 4, 2009 and the full principal amount of $100.0 million is outstanding as of June 30, 2012 (see “Note 6Debt” in the notes to the condensed consolidated financial statements in Part I, Item 1).
 
Inflation
 
Our management currently believes that inflation has not had, and does not currently have, a material impact on continuing operations. 

Contractual Obligations
 
Guarantees and Commitments
 
A summary of annual minimum contractual obligations and commercial commitments as of June 30, 2012 is as follows (amounts in thousands):
 
 
 
Contractual Obligations and Commercial Commitments (6)
Fiscal
Years Ending
March 31,
 
License /
Software
Development
Commitments (1)
 
Advertising (2)
 
Leases (3)
 
Debt (4)
 
Other (5)
 
Total
Remainder of 2013
 
$
57,685

 
$
13,020

 
$
11,087

 
$

 
$
3,071

 
$
84,863

2014
 
19,413

 
1,907

 
14,010

 

 
3,624

 
38,954

2015
 
13,600

 
1,163

 
12,413

 
100,000

 
424

 
127,600

2016
 
7,500

 
594

 
7,493

 

 
90

 
15,677

2017
 
7,867

 
513

 
4,610

 

 

 
12,990

Thereafter
 
6,000

 
375

 
11,690

 

 

 
18,065

 
 
$
112,065

 
$
17,572

 
$
61,303

 
$
100,000

 
$
7,209

 
$
298,149

 
(1)
Licenses and Software Development.  We enter into contractual arrangements with third parties for the rights to exploit intellectual property and for the development of products.  Under these agreements, we commit to provide specified payments to an intellectual property holder or developer.  Assuming all contractual provisions are met, the total future minimum contract commitments for such agreements in place as of June 30, 2012 are $112.1 million. License commitments in the table above include $54.1 million of commitments payable to licensors that are included in both "Accrued and other current liabilities" and "Other long-term liabilities" in our June 30, 2012 condensed consolidated balance sheet because the licensors do not have any remaining significant performance obligations.

(2)
Advertising.  We have certain minimum advertising commitments under many of our major license agreements. These minimum commitments are based upon the specific arrangements we have with the respective licensors and range from fixed amounts to specified percentages of projected net sales (ranging from 5%-10%) related to the respective licenses.

(3)
Leases.  We are committed under operating leases with lease termination dates through 2020.  Most of our leases contain rent escalations.  Of these obligations, $2.4 million and $3.0 million are accrued and classified as "Accrued and other current

30


liabilities" and "Other long-term liabilities," respectively, in our June 30, 2012 condensed consolidated balance sheet due to the abandonment of certain lease obligations in connection with our realignment plans (see "Note 5Restructuring and Other Charges"). We expect future sublease rental income under non-cancellable agreements of approximately $2.1 million; this income is not contemplated in the lease commitments shown in the table above.

(4)
Debt.  We issued the Notes on August 4, 2009.  The Notes pay interest semiannually, in arrears on February 15 and August 15 of each year, beginning February 15, 2010, through maturity and are convertible at each holder's option at any time prior to the close of business on the trading day immediately preceding the maturity date.  Absent any conversions or required repurchases of the Notes, we expect to pay $5.0 million in fiscal 2013 and 2014, and $2.5 million in fiscal 2015, for an aggregate of $12.5 million in interest payments over the remaining term of the Notes (see "Note 6Debt").

(5)
Other.  As discussed more fully in "Note 14 — Joint Venture and Settlement Agreements" in the notes to the consolidated financial statements in our 2012 10-K, amounts payable to Jakks totaling $6.0 million are reflected in the table above. The present value of these amounts is included in "Accrued and other current liabilities" and "Other long-term liabilities" in our condensed consolidated balance sheet at June 30, 2012 (see "Note 2Balance Sheet Details"). The remaining other commitments included in the table above are also included as current or long-term liabilities in our June 30, 2012 condensed consolidated balance sheet.

(6)
We have omitted unrecognized tax benefits from this table due to the inherent uncertainty regarding the timing and amount of certain payments related to these unrecognized tax benefits.  The underlying positions have not been fully developed under audit to quantify at this time.  At June 30, 2012, we had $3.9 million of unrecognized tax benefits.  See "Note 9Income Taxes" for further information regarding the unrecognized tax benefits.

Manufacturer Indemnification. We must indemnify the platform manufacturers (Microsoft, Nintendo, Sony) of our games with respect to all loss, liability and expenses resulting from any claim against such manufacturer involving the development, marketing, sale or use of our games, including any claims for copyright or trademark infringement brought against such manufacturer. As a result, we bear a risk that the properties upon which the titles of our games are based, or that the information and technology licensed from others and incorporated into the products, may infringe the rights of third parties. Our agreements with our third-party software developers and property licensors typically provide indemnification rights for us with respect to certain matters. However, if a manufacturer brings a claim against us for indemnification, the developers or licensors may not have sufficient resources to, in turn, indemnify us.

Indemnity Agreements. We have entered into indemnification agreements with the members of our Board of Directors, our Chief Executive Officer and our Chief Financial Officer, to provide a contractual right of indemnification to such persons to the extent permitted by law against any and all liabilities, costs, expenses, amounts paid in settlement and damages incurred by any such person as a result of any lawsuit, or any judicial, administrative or investigative proceeding in which such person is sued as a result of service as a member of our Board of Directors, as Chief Executive Officer or as Chief Financial Officer. The indemnification agreements provide specific procedures and time frames with respect to requests for indemnification and clarify the benefits and remedies available to the indemnitees in the event of an indemnification request.

Critical Accounting Estimates

There have been no material changes to our critical accounting estimates as described in Part II, Item 7 to our 2012 10-K, under the caption “Critical Accounting Estimates.”

Recently Issued Accounting Pronouncements

See “Note 1Basis of Presentation" in the notes to the condensed consolidated financial statements in Part 1, Item 1.



31


Item 3.  Quantitative and Qualitative Disclosures About Market Risk
 
Market Risk

We are exposed to certain market risks arising from transactions in the normal course of business, principally risks associated with interest rate and foreign currency fluctuations. Market risk is the potential loss arising from changes in market rates and market prices. We employ established policies and practices to manage these risks. We use foreign currency exchange option and forward contracts to hedge anticipated exposures or mitigate some existing exposures subject to foreign currency exchange rate risk as discussed below. We do not enter into derivatives or other financial instruments for trading or speculative purposes.

Interest Rate Risk

At June 30, 2012, our $20.9 million of cash and cash equivalents were comprised of cash and time deposits and money market funds; none of our cash equivalents are classified as trading securities.  We generally manage our interest rate risk by maintaining an investment portfolio generally consisting of debt instruments of high credit quality and relatively short maturities.  However, because short-term investments mature relatively quickly and are generally reinvested at the then current market rates, interest income on a portfolio consisting of cash equivalents and short-term investments is more subject to market fluctuations than a portfolio of longer-term investments.  The value of these investments may fluctuate with changes in interest rates; however, the contractual terms of the investments do not permit the issuer to call, prepay or otherwise settle the investments at prices less than the stated par value. Interest income recognized in the three months ended June 30, 2012 was $0.2 million and is included in "Interest and other income (expense), net" in our condensed consolidated statements of operations.

At June 30, 2012, we had no outstanding balances under the Credit Facility.

Foreign Currency Exchange Rate Risk

We transact business in many different foreign currencies and are exposed to financial market risk resulting from fluctuations in foreign currency exchange rates, particularly Australian Dollars ("AUD"), Euros ("EUR"), and Great British Pounds ("GBP), which may result in a gain or loss of earnings to us. Our international business is subject to risks typical of an international business, including, but not limited to, foreign currency exchange rate volatility. Accordingly, our future results could be materially and adversely affected by changes in foreign currency exchange rates. Throughout the year, we frequently monitor the volatility of the AUD, EUR, and GBP (and all other applicable currencies).

Cash Flow Hedging Activities. From time to time, we hedge a portion of our foreign currency risk related to forecasted foreign currency-denominated sales and expense transactions by entering into foreign exchange forward contracts that generally have maturities less than 90 days. Our hedging programs reduce, but do not entirely eliminate, the impact of currency exchange rate movements in net sales and operating expenses. During the three months ended June 30, 2012 and 2011, we did not enter into any foreign exchange forward contracts related to cash flow hedging activities.

Balance Sheet Hedging Activities. We utilize foreign exchange forward contracts to mitigate foreign currency risk associated with foreign currency-denominated assets and liabilities, primarily certain inter-company receivables and payables. Our foreign currency exchange forward contracts are not designated as hedging instruments and are accounted for as derivatives whereby the fair value of the contracts are reported as "Prepaid expenses and other current assets" or "Accrued and other current liabilities" in our condensed consolidated balance sheets, and the associated gains and losses from changes in fair value are reported in "Interest and other income (expense), net" in our condensed consolidated statements of operations. The forward contracts generally have a contractual term of one month or less and are transacted near month-end. Therefore, the fair value of the forward contracts generally is not significant at each month-end.

At June 30, 2012, we did not have any outstanding foreign currency exchange forward contracts related to balance sheet hedging activities. The contracts we did have during the three months ended June 30, 2012, consisted primarily of AUD, CAD, EUR, and GBP; the net loss recognized from these contracts during that period was $4.3 million and is included in "Interest and other income (expense), net" in our condensed consolidated statements of operations.

Foreign currency exchange forward contracts are designed to offset gains and losses on the underlying foreign currency-denominated assets and liabilities. Any movement in foreign currency exchange rates resulting in a gain or loss on our foreign currency exchange forward contracts are offset by an opposing gain or loss in the underlying foreign currency-denominated assets and liabilities that were hedged and would not have a material impact on our financial position.


32


The counterparties to these forward contracts are creditworthy multinational commercial or investment banks. The risks of counterparty non-performance associated with these contracts are not considered to be material. Notwithstanding our efforts to manage foreign currency exchange risks, there can be no assurances that our mitigating or hedging activities will adequately protect us against the risks associated with foreign currency fluctuations.

We do not hedge foreign currency translation risk. A hypothetical 10% adverse change in foreign currency translation rates would result in a reduction of reported net sales of approximately $5.2 million and a reduction in reported income from operations before income taxes of approximately $0.1 million for the three months ended June 30, 2012. A hypothetical 10% adverse change in foreign currency translation rates would result in a reduction of reported total assets of approximately $17.3 million. These estimates assume an adverse shift in all foreign currency exchange rates, which do not always move in the same direction; actual results may differ materially.

Item 4.  Controls and Procedures
 
Definition and limitations of disclosure controls and procedures.  Our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) are controls and other procedures that are designed to ensure that information required to be disclosed in our reports filed under the Exchange Act, such as this report, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms.  Disclosure controls and procedures are also designed to ensure that such information is accumulated and communicated to our management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. 

There are inherent limitations to the effectiveness of any system of disclosure controls and procedures.  These limitations include the possibility of human error, the circumvention or overriding of the controls and procedures and reasonable resource constraints.  In addition, because we have designed our disclosure controls and procedures based on certain assumptions, which we believe are reasonable, about the likelihood of future events, our disclosure controls and procedures may not achieve their desired purpose under all possible future conditions.  Accordingly, our disclosure controls and procedures provide reasonable assurance, but not absolute assurance, of achieving their objectives.

Evaluation of disclosure controls and procedures. Our Chief Executive Officer and Chief Financial Officer, after evaluating the effectiveness of our disclosure controls and procedures, have concluded that as of June 30, 2012, our disclosure controls and procedures were effective in providing the requisite reasonable assurance that information required to be disclosed in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms, and is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

Changes in internal control over financial reporting. There were no changes in our internal control over financial reporting that occurred during our first quarter of fiscal 2013 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.


33


PART II — OTHER INFORMATION

Item 1.  Legal Proceedings

Federal Securities Class Action Case

A purported class action lawsuit on behalf of purchasers of THQ common stock between May 3, 2011 and February 3, 2012 (the "Class Period"), styled Zaghian vs. THQ Inc., et al., was filed against the Company and certain executive officers of the Company on June 15, 2012, in the United States District Court for the Central District of California, Southern Division.  The complaint alleges that the defendants knowingly made materially false and misleading statements regarding the Company's uDraw GameTablet during the Class Period.  The complaint seeks unspecified damages, reasonable attorneys' and experts' fees and costs and other relief.  The Company and the other defendants believe the complaint is without merit and intend to vigorously defend the pending lawsuit.

Additionally, from time to time we are involved in ordinary routine litigation incidental to our business. In the opinion of our management, none of such pending litigation is expected to have a material adverse effect on our financial condition or results of operations.

Item 1A.  Risk Factors

Our business is subject to many risks and uncertainties that may impact our future financial performance. Some of those important risks and uncertainties that may cause our operating results to vary or may materially and adversely impact our net sales, operating results and cash flows are described below. These risks are not presented in order of importance or probability of occurrence.

We have incurred operating losses during the last five fiscal years. We have restructured our business operations in order to adjust our cost structure to better align with our expected future business; however, we may continue to incur losses in the future.

We have had operating losses during the last five fiscal years. In fiscal 2012, we exited development of traditional kids' and movie-based licensed console games and revised our strategy to focus on our premium core franchises and to expand our digital revenues. As part of this business realignment, we implemented initiatives to streamline our organization and reduce our cost structure. We expect these actions to result in annualized reductions in our expenditures that will align with our expected lower levels of future net sales and thus allow us to become profitable; however, in the event our future net sales or required expenditures differ from our expectations for any reason, we may continue to incur losses in the future. In addition, there can be no assurance that we will be able to grow our net sales in future years.

We may require additional capital to fund our planned business operations.

                Development of quality products requires substantial up-front expenditures and thus we expect to utilize a substantial portion of our existing cash and cash equivalents and other working capital to develop our upcoming products.  In addition to our cash and cash equivalents, we have a $50.0 million credit facility that we expect to draw against in order to fund our business operations.  We believe we have adequate resources to execute on our product plan and deliver our multi-year pipeline of games; however, there can be no assurance that we will be able to do so without additional capital.  In the event our future net sales or required expenditures differ from our expectations for any reason, and our external liquidity sources, including our credit facility, customer and vendor payment and credit terms, are not sufficient to meet our operating requirements, we may need to defer and/or curtail currently-planned expenditures, cancel projects currently in development, and/or pursue additional funding or additional external sources of liquidity, which may not be available on financially attractive terms, if at all, to meet our cash needs.

We may not be able to refinance or generate sufficient cash to service and/or pay our convertible senior notes.

On August 4, 2009, we issued the convertible senior notes ("Notes"). The Notes pay interest semiannually, in arrears on February 15 and August 15 of each year and are due August 15, 2014, unless earlier converted, redeemed or repurchased. If we fail to maintain our listing with any U.S. national securities exchange, the holders of the Notes may require us to repay the principal prior to the maturity date. Our ability to make principal and interest payments on the Notes will depend on our financial and operating performance, which is subject to prevailing economic and competitive conditions and to certain financial, business and other factors beyond our control. We may be unable to refinance the Notes or maintain a level of cash flows from operating activities sufficient to permit us to pay the principal or interest on the Notes. In addition, if the Notes are converted to common stock, our current stockholders will suffer dilution in their percentage ownership. The conversion price is $85.13 and depending upon the performance of our stock, it may be unlikely that the notes will be converted and thus will become due and payable on

34


August 15, 2014.

Our operating results may be adversely impacted by worldwide economic uncertainties.

  Our products involve discretionary spending on the part of consumers. Consumers are generally more willing to make discretionary purchases, including purchases of products like ours, during periods in which favorable economic conditions prevail. As a result, our products are sensitive to general economic conditions and economic cycles. In the recent past, general worldwide economic conditions have experienced a downturn due to slower economic activity, concerns about inflation, increased energy costs, decreased consumer confidence, reduced corporate profits and capital spending, and adverse business conditions. Any continuation or worsening of the current global economic and financial conditions could materially adversely affect (i) our ability to raise, or the cost of, needed capital, (ii) our ability to properly budget and forecast for future net sales and expenditures, and (iii) demand for our current and future products. We cannot predict the timing, strength, or duration of any economic slowdown or subsequent economic recovery, worldwide, or in the video game industry.

Our business is "hit" driven. If we do not deliver "hit" games, our net sales, operating results and cash flows could suffer.
 
While many new titles are regularly introduced in our industry, increasingly, only a relatively small number of "hit" titles account for a significant portion of video game sales. It is difficult to produce high-quality products and to predict prior to production and distribution what products will be well received, even if they are well-reviewed, high-quality titles. "Hit" products published by our competitors may take a larger share of consumer spending than anticipated, which could cause our product sales to fall below expectations. Consumers may lose interest in a genre of games we produce. If we fail to develop "hit" titles, or if "hit" products published by our competitors take a larger share of consumer spending than we anticipate, our product sales could fall below our expectations, which could adversely impact our net sales, operating results and cash flows.

We depend on a relatively small number of franchises for a significant portion of our net sales.

Because we no longer develop traditional kids' and movie-based licensed console games and have revised our strategy to focus on our premium core franchises and to expand our digital revenues, we depend on a smaller number of franchises and titles for a significant portion of our net sales in the future. Due to this dependence on a limited number of franchises, the failure to achieve anticipated results by one or more products based on these franchises may significantly impact our business and financial results.

If our products fail to gain market acceptance, we may not have sufficient cash flow to pay our expenditures or to develop a continuous stream of new games.

Our business depends on generating net sales from existing and new products. The market for video game products is subject to continually changing consumer preferences and the frequent introduction of new products. As a result, video game products typically have short market lives, often less than six months. Our products may not achieve and sustain market acceptance sufficient to generate net sales to meet our cash needs and operating requirements.

We may not be able to adequately adjust our cost structure in a timely fashion in response to a sudden decrease in demand.
 
A significant portion of our cost structure is attributable to expenditures for personnel, facilities and external development. In the event of additional declines in our current expected net sales, we may not be able to dispose of facilities, reduce personnel, terminate contracts or make other changes to our cost structure without disruption to our operations or without significant cash termination and exit costs. Management may not be able to implement such actions in a timely manner, if at all, to offset an immediate shortfall in net sales or cash flow. Moreover, reducing costs may hinder our ability to develop a sufficient number of software titles to publish in the future.

Failure to appropriately adapt to rapid technological and consumer preference changes or emerging digital channels may adversely impact our market share and our operating results.
 
Rapid technological and consumer preference changes in our industry require us to anticipate, sometimes years in advance, which technologies we must implement and take advantage of in order to make our products and services competitive and appealing to consumers. Currently, our industry is experiencing an increasing shift to online content and digitally downloaded games. We believe that much of the growth in the industry is coming from online markets and digital distribution of games, paid downloadable content ("DLC"), multi-player online games via services such as Xbox Live Arcade and free-to-play micro-transaction based games. Accordingly, we plan to continue integrating a digital component into all of our key franchises. However, if we fail to

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anticipate and adapt to these and other technological changes or distribution channels, our market share and our operating results may suffer. Our future success in providing online experiences and other digital content will depend upon our ability to adapt to rapidly-changing technologies, develop applications to accommodate evolving industry standards, improve the performance and reliability of our applications, as well as anticipate future consumer preferences.

Connectivity issues related to digital sales and online gameplay could impact our ability to sell and provide online services and content for our games, and could impact our net sales, operating results and cash flows.

We rely upon various third-party providers, such as Microsoft's Xbox Live, Sony's PlayStation Network, and Valve's Steam platform to provide connectivity from the consumer to our digital products and our online services. Connectivity issues could prevent customers from accessing this content and our ability to successfully market and sell our products could be negatively impacted. In addition, we could experience similar issues related to services we host on our internally managed servers. Such issues also could impact our ability to provide online services, and could negatively impact our net sales, cash flows, and operating results.

Our inability to maintain, acquire or create new intellectual property that has a high level of consumer recognition or acceptance could adversely impact our net sales, operating results and cash flows.
 
We generate a portion of our net sales from owned intellectual property and, under our business plan, expect to continue to generate net sales from our owned intellectual property. The success of our internal brands depends upon our ability to create original ideas that appeal to the core gamer. Titles based on owned intellectual property can be expensive to develop and market since they do not have a built-in consumer base or licensor support. Our inability to create new products that find consumer acceptance could negatively impact our net sales, operating results and cash flows.

Some of our products are based on intellectual property rights licensed from third parties. Failure to retain or renew such licenses, or renewals of such licenses on less advantageous terms, could cause our net sales and operating results to decline.
 
Some of our products are based on or incorporate intellectual property and other character or story rights licensed from third parties. For example, we annually release games based on our license with the WWE. These license and distribution agreements are limited in scope and time, and we may not be able to retain the licenses during the entire term or be able to renew key licenses when they expire. The loss of a significant number of intellectual property licenses or relationships with licensors could have an adverse effect on our ability to develop new products and therefore on our net sales and operating results. Additionally, the failure of intellectual property we license to be, or remain, popularly received could impact the market acceptance of those products in which the intellectual property is included. Such lack of market acceptance could result in the write-off of the unrecovered portion of minimum royalty guarantees, which could harm our business and financial results. Furthermore, competition for these licenses may also increase the advances, guarantees, and royalties that must be paid to the licensor.

High development costs for games which do not perform as anticipated and failure of platforms to achieve significant market penetration could result in potential impairments of capitalized software development and/or license costs, which would negatively affect our operating results.
 
Video games played on consoles and certain online-enabled games are expensive to develop. If our games do not achieve significant market penetration, we may not be able to recover our development costs, which could result in the impairment of capitalized software and/or costs, which would negatively affect our operating results.

Video game product development schedules are difficult to predict and can be subject to delays. Postponements in shipments can substantially impact our net sales, cash flows and operating results in any given quarter.
 
Our ability to meet product development schedules is impacted by a number of factors, including the creative processes involved, the coordination of large and sometimes geographically-dispersed development teams required by the complexity of our products, the need to localize certain products for distribution outside of the U.S., the need to refine our products prior to their release, and the time required to manufacture a game once it is submitted to the platform manufacturer. In the past, we have experienced development and manufacturing delays for several of our products. Failure to meet anticipated production schedules may cause a shortfall in our expected net sales and cash flow and thus cause our operating results and cash position in any given quarter to be materially different from expectations given our reduced product line-up.

We rely on external developers for the development of some of our titles.
 

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Some of our games are developed by third-party developers. We do not have direct control over the business, finances and operational practices of these external developers. A delay or failure to complete the work performed by external developers has and may in the future result in delays in, or cancellations of, product releases. Additionally, the future success of externally-developed titles will depend on our continued ability to maintain relationships and secure agreements on favorable terms with skilled external developers. Our competitors may acquire the businesses of key developers or sign them to exclusive development arrangements. In either case, we would not be able to continue to engage such developers' services for our products, except for those that they are contractually obligated to complete for us. We cannot guarantee that we will be able to establish or maintain such relationships with external developers, and failure to do so could result in a negative impact on our business and financial results.
 
Defects in our game software could harm our reputation or decrease the market acceptance of our products.
 
Our game software may contain defects. In addition, because we do not manufacture our games for console platforms, we may not discover defects until after our products are in use by retail customers. Any defects in our software could damage our reputation, cause our customers to terminate relationships with us or to initiate product liability suits against us, divert our engineering resources, delay market acceptance of our products, increase our costs or cause our net sales to decline.

Our business is dependent upon the success and availability of the video game platforms on which consumers play our games.
 
We derive most of our net sales from the sale of products for play on video game platforms manufactured by third parties, such as PS3, Xbox 360, and the Wii and DS. The following factors related to such platforms can adversely impact sales of our video games and our profitability:
 
Popularity of platforms.  Since the typical development cycle for our games is 9 to 36 months, we must make decisions about which games to develop on which platforms based on current expectations of what the consumer preference for the platforms will be when the game is finished. Launching a game on a platform that has declined in popularity, or failure to launch a game on a platform that has grown in popularity, could negatively impact our net sales, cash flows and operating results.
 
Platform pricing.  The cost of the hardware could impact consumer purchases of such hardware, which could in turn negatively impact sales of our products for these platforms since consumers need a platform in order to play most of our games.
 
Success of new platforms. We must make substantial product development and other investments in a particular platform well in advance of introduction of the platform and may be required to realign our product portfolio and development efforts in response to market changes. Furthermore, development costs for new console platforms are greater than such costs for current console platforms if we do not have the ability to re-utilize development engines for new platforms. If any increase in development costs are not offset by higher net sales, operating results will suffer and our financial position will be harmed. If the platforms for which we develop new software products or modify existing products do not attain significant market penetration, we may not be able to recover our development costs, which could be significant, and our business and financial results could be significantly harmed.

Platform shortages.  From time to time, the platforms on which our games are played have experienced shortages. Platform shortages generally negatively impact the sales of video games since consumers do not have consoles on which to play the games.

Transitions in console platforms could adversely affect the market for interactive entertainment software.

In 2005, Microsoft released the Xbox 360 and, in 2006, Sony and Nintendo introduced the PS3 and Wii, respectively. Nintendo has announced that it intends to launch its next-generation console, the Wii U, in all major regions by the 2012 calendar year-end holiday buying season. When new console platforms are announced or introduced into the market, consumers typically reduce their purchases of game console entertainment software products for current console platforms in anticipation of new platforms becoming available. During these periods, sales of game console entertainment software products we publish may slow or even decline until new platforms are introduced and achieve wide consumer acceptance. This decline may not be offset by increased sales of products for the new console platforms. As console hardware moves through its life cycle, hardware manufacturers typically enact price reductions and decreasing prices may put downward pressure on software prices. During platform transitions, we may simultaneously incur costs both in continuing to develop and market new titles for prior-generation video game platforms, which may not sell at premium prices, and also in developing products for current-generation platforms, which will not generate immediate or near-term revenue. As a result, our operating results during platform transitions may be more volatile and more difficult to predict than during other times, and such volatility may cause greater fluctuations in our stock price.


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Our inability to enter into agreements with the manufacturers to develop, publish and distribute titles on their platforms, changes to the royalty rates and fees in such agreements, or delays in manufacturing our products could negatively impact our net sales, cash flow and results of operations.
 
We are dependent on the platform manufacturers (Microsoft, Nintendo and Sony) and our non-exclusive licenses with them, both for the right to publish titles for their platforms and for the manufacture of our products for their platforms. Our existing platform licenses require that we obtain approval for the publication of new games on a title-by-title basis. As a result, the number of titles we are able to publish for these platforms, and our sales from titles for these platforms, may be limited. Should any manufacturer choose not to renew or extend our license agreement at the end of its current term, or if any license were terminated, we would be unable to publish additional titles for that manufacturer's platform, which could negatively impact our operating results.
 
Additionally, we pay a licensing fee to the hardware manufacturers for each copy of a product manufactured for that manufacturer's game platform. The platform licensors have retained the flexibility to change their fee structures and/or pricing for online gameplay and features for their consoles and the manufacturing of products. The control that platform licensors have over the fee structures and/or pricing for their platforms and online access makes it difficult for us to predict our costs in the medium-to-long term. Any increase in fee structures and/or pricing could have a significant negative impact on our business models and operating results.

Further, since each of the manufacturers publishes games for its own platform, and some also manufacture products for all of its other licensees, a manufacturer may give priority to its own products or those of other publishers in the event of insufficient manufacturing capacity. Unanticipated delays in the delivery of products due to delayed manufacturing could also negatively impact our operating results.

We rely on a small number of customers that account for a significant amount of our sales. If these customers reduce their purchases of our products or become unable to pay for them, our business could be harmed.
 
Our largest customers, Best Buy, COKeM, GameStop, Target, and Walmart, in aggregate accounted for approximately 43% of our consolidated gross sales before the impact of changes in deferred gross revenue in fiscal 2012. Sales to these customers are made on a purchase order basis without long-term agreements or other forms of commitments. A substantial reduction or termination of purchases by any of our significant customers could negatively affect our net sales, cash flows and operating results. In addition, if one or more of our significant customers experience deterioration in their business, or become unable to obtain sufficient financing to maintain their operations and pay their outstanding receivables to us, our business and financial results could be harmed.

We may face difficulty obtaining access to retail shelf space necessary to market and sell our products effectively.
 
Retailers typically have a limited amount of shelf space and promotional resources, and there is intense competition among consumer interactive entertainment software products for high quality retail shelf space and promotional support from retailers. To the extent the number of products and platforms increases, competition for shelf space may intensify and may require us to increase our marketing expenditures. Retailers with limited shelf space typically devote the most and highest quality shelf space to those products expected to be best sellers. We cannot be certain that our new products will consistently achieve such "best seller" status. Due to increased competition for limited shelf space, retailers and distributors are in an increasingly better position to negotiate favorable terms of sale, including price discounts, price protection, marketing and display fees, and product return policies. Our products constitute a relatively small percentage of most retailers' sales volume. We cannot be certain that retailers will continue to purchase our products or to provide those products with adequate levels of shelf space and promotional support on acceptable terms which may significantly harm our business and financial results.

Increased sales of used video game products by retailers could reduce demand for new copies of our games.
 
Several retailers, including one of our largest customers, GameStop, continue to focus on selling used video games, which provides higher margins for the retailers than sales of new games. This focus reduces demand for new copies of our games. We believe customer retention through compelling online play and downloadable content offers may reduce consumers' propensity to trade in games; however, retailers' continued sales of used games, rather than new games, may adversely impact our ability to sell new games and could adversely impact our net sales, operating results, and cash flow in any given quarter.

Software pricing and sales allowances may impact our net sales and profitability.
 

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We establish sales allowances based on estimates of future price protection and returns with respect to current period product net sales. While we believe that we can reliably estimate future returns and price protection, if product sell-through does not perform in line with our current expectations, return rates and price protection could exceed our reserves, and our net sales could be negatively impacted in future periods.

If we are unable to sustain premium pricing on current-generation titles, our operating results may suffer.

If we are unable to sustain premium pricing on current-generation titles for the Xbox 360, PS3 and the Wii for as long as those platforms remain current generation, whether due to competitive pressure, retailers electing to price these products at a lower price or otherwise, we may experience a negative effect on our margins and operating results. Additionally, software prices for games sold for play on the PS3 and Xbox 360 are generally higher than prices for games for the Wii, handheld platforms or PC games. As a result, our product mix in any given fiscal quarter or fiscal year may cause our net sales to significantly fluctuate, depending on which platforms we release games on, in that quarter or year. Further, we make provisions for in-channel price reductions based upon certain assumed lowest prices and if competitive pressures force us to lower our prices below those levels, we may experience a negative effect on our margins and operating results.

Development of software by platform manufacturers may lead to reduced sales of our products.
 
The platform manufacturers, Microsoft, Nintendo and Sony, each develop software for their own hardware platforms. As a result of their commanding positions in the industry, the platform manufacturers may have better bargaining positions with respect to retail pricing, shelf space and retailer accommodations than do any of their licensees, including us. Additionally, the platform manufacturers can bundle their software with their hardware, creating less demand for individual sales of our products. Continued or increased dominance of software sales by the platform manufacturers may lead to reduced sales of our products and thus lower net sales.
 
Increased development of software and online games by intellectual property owners and developers may lead to reduced net sales.
 
Some of our games are based upon licensed intellectual properties. In recent years, licensors and independent developers have increased their development of video games in digital and other online distribution channels, which could lead to such licensors not renewing our licenses to publish games based upon their properties that we currently publish, or not granting future licenses to us to develop games based on their other properties. If intellectual property owners continue expanding internal efforts to develop video games based upon properties that they own rather than renewing our licenses or granting us additional licenses, our net sales could be significantly impacted.

Competitive launches may negatively impact the sales of our games.
 
We compete for consumer dollars with several other video game publishers, and consumers must make choices among available games. If we make our games available for sale at the same time as our competitors' games become available, consumers may choose to spend their money on products published by our competitors rather than our products, and retailers may choose to give more shelf space to our competitors' products, leaving less space to sell our products. Since the life cycle of a game is typically short, strong sales of our competitors' games could negatively impact the sales of our games.

Competition with other forms of home-based entertainment may reduce sales of our products.
 
We compete with other forms of entertainment and leisure activities. For example, we believe the overall growth in the use of the Internet, tablets and online services, including social networking, by consumers may pose a competitive threat if customers and potential customers spend less of their available time playing our core, higher-priced video games and more of their time using the Internet, including playing social networking games on the Internet, tablets or mobile devices..
 
Competition for qualified personnel is intense in the interactive entertainment software industry and failure to hire and retain qualified personnel could seriously harm our business.
 
To a substantial extent, we rely on the management, marketing, sales, technical and software development skills of a limited number of employees to formulate and implement our business plan. To a significant extent, our success depends upon our ability to attract and retain key personnel. Competition for employees can be intense and the process of locating key personnel with the right combination of skills is often lengthy. The loss of key personnel could have a material adverse impact on our business.

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A significant portion of our net sales is derived from our international operations, which may subject us to economic, currency, political, regulatory and other risks.
 
In fiscal 2012, excluding the impact of changes in deferred net revenue, we derived 38.3% of our consolidated net sales from outside of North America. Our international operations subject us to many risks, including: different consumer preferences; challenges in doing business with foreign entities caused by distance, language and cultural differences; unexpected changes in regulatory requirements, tariffs and other barriers; difficulties in staffing and managing foreign operations; reduced access to retail sales channels caused by financial stability of retailers; and possible difficulties collecting foreign accounts receivable. These factors or others could have an adverse impact on our future foreign sales or the profits generated from those sales.
 
There are additional risks inherent in doing business in certain international markets, such as China. For example, foreign exchange controls may prevent us from expatriating cash earned in China, and standard business practices in China may increase our risk of violating U.S. laws such as the Foreign Corrupt Practices Act.