Exclusive: Q and A with THQ’s Brian Farrell

thq-logo THQ CEO Brian Farrell recently participated in a Q and A session here at the Pacific Crest Technology Leadership Forum in Vail, Colorado. While most of the focus at this particular conference is on financial performance and investing, Farrell’s session shed light on a few things that might interest gamers.

In particular, Farrell spoke candidly about his company’s recent lackluster performance, a slew of new games coming out between now and next year, and the various challenges of developing for multiple platforms. He also dropped a tiny morsel concerning an upcoming MMO based on the Warhammer series that’s currently in development.

Here’s a transcript of the Q and A session that took place on August 4th, 2008 in Vail, Colorado at the Pacific Crest Technology Leadership Forum.

Q: Investors believe that the video game industry is a recession-resistant industry as a whole. Could you talk about anything you’ve seen so far inside consumer video games and do you think this is something we just grow through or is it something that keeps you up at night?

A: The video game industry is relatively recession-resistant. I think it’s fairly clear that video games offer a great consumer value for the money — you know, hours and hours of gameplay for anything from $20 to $60. So I think that’s what makes the industry somewhat recession-resistant.

The one thing I worry about is the hardware at the higher end of the range of price points. The 360 and the PS3 are still at relatively high price points by historical standards this late in the cycle, so I think we should be a little concerned about the velocity of the hardware at those higher price points.

That being said, the last few months’ NPD data indicate that hardware sales are still fairly robust. In fact, DS and Wii at lower price points are still going very, very strongly and we’re hoping that Nintendo can for the first time actually supply [enough units to meet] full demand.

It’s a bit of a mixed bag, but the takeaway is that from our retail partners we’re really not hearing much concern about the video game sector. In fact, most of our retail partners are actually adding shelf space because this is a growing sector.

Q: You mentioned 360 and PS3. These are two boxes that, relative to our expectations, have underwhelmed in the last two years given the size of the opportunity that we all saw with the PS2 in the last cycle. What do we need to do in order to get [current generation] platforms to a market size that would be as big as something we saw in the previous cycle?

A: Remember that the original PlayStation 2’s launch price was $299. We’re not even close to that yet. So the acceleration ramp has been fairly low by historical standards. Then you’ve got the Wii, which is a tremendous value at $249. That’s really the market leader in every way.

So our very strong view is that as we come down the price curve – and, you know, Microsoft and Sony will come down that price curve. The question is timing. When will they come down they come down the price curve? How aggressively? – but as they come down the price curve, we think you’ll see a huge acceleration in both of those platforms.

We used to always think of this industry as “the cycle” and I think the reality now is that there are several sub-cycles. There’s a sub-cycle with the DS and PSP on the handheld side. There’s a sub-cycle going on with the Wii and there’s a sub-cycle going on with the 360 and PS3. And there’s actually a sub-cycle emerging in digital and online.

So it’s hard now to talk about “the cycle”. I think we have to talk about all the cycles, and the way we think about it at THQ is that we plan our business around each of those platforms, not around “the cycle”.

Q: Given that you’ve got all these mini-cycles building into one big cycle, what’s the cost of addressing all those? It’s clear that the cost of the price of developing for PS3 is up over PS2, but when you add in development costs for all those other opportunities, which are smaller than the one big opportunity in the last cycle, it’s driven up development costs. How do you get efficiency in that environment?

A: You make a great point. We’ve actually been saying from the beginning of this cycle that it’s all about market segmentation because, yes, to your point, what you can’t do – and we all tried to do it initially and paid the price – is take a page from the playbook saying “get a big brand, port it to three platforms, and get the efficiencies.”

Right now with the segments and the sub-cycles, you have to target the consumer where that consumer is playing. On Xbox 360 and PS3, it’s still very much of a core gamer platform. That’s why if you look at our big initiatives there – things like Saints Row 2, Red Faction: Guerilla – a real technology showpiece, Darksiders – a real artistic showpiece – you’ve got to target that high-end gamer on those systems and get the volume with that.

Wii, on the other hand, is much more of a family and kids platform. We started with mostly porting our kids titles over and the lesson we’ve learned is that it’s become much more of a family platform. So things like de Blob, which we launch in just about six weeks, is very much of a family-targeted game. Yes, the kids will want to play it but we think mom and dad will pick up the game and play with the kids.

Going to the handhelds and the sub-markets in there: DS tends to be slightly younger, so that’s more of our licensed content, whereas with PSP, we’ve had great success with our older-skewing content like WWE and our wholly-owned brand MX versus ATV.

So what we have to do – the way you find the efficiencies – is making sure you have the right product on the right platform.

Q: Gross margin question, do you have trouble making money on the Nintendo platforms? Is developing for the Wii going to structurally squeeze your gross margins or can you expand it back to the trajectory you used to be on?

A: The key to gross margins, like the key to overall success in this business, is making games that sell well. When we have a strong product line, price points maintain for a longer period of time, we show fewer markdowns and allowances to retail for products that don’t sell. The takeaway is to make games that sell.

As we’ve undertaken this very serious commitment to product quality, we’ve not had a strong release slate over the last three quarters. We think that’s about to change with the launch of de Blob, Saints Row 2, WWE, Red Faction: Guerilla, Darksiders, and UFC. So our product slate in front of us, we believe those are all products capable of commanding premium price points, which will drive gross margins.

The gross margins on the Wii, particularly for something like de Blob — $49.99 price point, very moderate development cost – those should be very, very good. Even on the budget side of the Wii, we’ve had terrific success with a product called Big Beach Sports primarily in Europe – budget title, but very low development cost, so those margins are good.

Again, the common theme is that if you make hits, you make money. If you don’t make hits, your margins are compressed.

Q: How important is owned IP versus licensed IP?

A: Our strategy is a balance. We’d love to see around 50-50 owned IP to licensed IP. We love the licensed IP business – predic
table brand, lots of cross-promotion opportunities, relatively stable cash flows – so we like that predictability. Things like WWE and UFC, because they add new fight modes and new characters, you can annualize those and you don’t wear out the brand. We’ve signed recent deals with Marvel and Dreamworks, and the first UFC products are coming. So we’re still going to be very active in that category.

That being said, huge value creation comes from owned IP. You can sequel it, you can extend the brand, you can take it to other media. It is riskier, so that’s why we like the balance. It kind of lowers the overall beta, if you will. We want one to three new IP’s per year, plus sequels and extending some of our other brands. That, going along with our licensed portfolio, we think combines both some sustainability and predictability.

As displeased as I am right now with our recent performance, we have grown for thirteen consecutive years in a very cyclical industry. So I think our strategy is right. Where we’re really focused right now is making sure we execute on the product side because not only will we get the revenue growth, we’ll get the margin growth.

Q: What’s the price point that you think will really ramp console sales? Is $199 still the magic number or is it different now? Because there are so many other platforms that people are playing games on – cell phones, PSP, DS, potentially the iPhone.

A: Really good question. Historically, getting below $199 and even $149 was always crucial to getting to that mass market. I think that price point is probably slightly higher than that right now. I think a sub $200 price point or even sub $249 can be very powerful.

As you know, things like iPhones, PSP’s, and even iPods have had huge success at relatively higher price points. And remember, with the Sony PS3, you get an incredibly powerful gaming machine, plus a Blu-ray playback device at a pretty decent price point.

So, I don’t know exactly what the [magic] price point is, but I can say that acceleration tends to be geometric once you get below those incremental $50 lower price points. So when we look at how the market should progress, you should get a fairly strong ramp as we go from $400 to $249 to $199. Again, the question is when?

You also point out that there has been, in some ways, a proliferation of platforms but our point of view – and I think we’re right on this – is that gamers tend to be very situational. So someone doesn’t buy, say, a PSP or an iPod to play a game on those instead of a PS3 or a 360. PSP’s, DS’s, and iPhones are for portable gaming – much more quick hitting. Consoles like the 360 and PS3 are for much more in-depth gaming. The Wii has been for much more social gaming. That’s another initiative we have – taking advantage of people trying to play games more together. 

So there’s a proliferation of platforms but what you have to do as a marketer is say, “Where is my particular customer on that platform?” And if you target it that well, I think there’s a lot of opportunity. Particularly right now, when you see a lot of those platforms with different consumers on them.

Q: Brian, I’d like to test your confidence on Saints Row 2. In terms of variability, this is probably your biggest product of the year. What do you think as you get closer to launch?

A: Well, let me start by saying that we have a very broad product line and I never want to get anyone – whether it’s retail, investors, or internally – focused on one product.

That being said, Saints Row 2, in my view, is the biggest sandbox game ever built, with the most toys for gamers. It’s got tremendous, over-the-top combat, terrific weapons, a very unique online cooperative play mode that’s been getting a lot of accolades from the press. The character customization, I’ve never seen anything like it. We’ve seen people testing the game, playing for hours just with the customization mode.

So, it is a great product. We think we have a great window for it. We are very pleased with retail’s feedback, but it’s not just about launch day. We think we’ll have a very strong launch, but it’s about driving that brand both here and in Europe and in Asia. So it’s a long-term brand. That’s what we’re looking for with Saints Row 2.

Q: Can you talk about the internal focus on product quality? What should we be focused on with the de Blob release to let us know that the product quality really has improved?

A: Yeah, let’s talk about that product quality initiative that we’ve set out on – I think we announced it last October. It had a couple of prongs to it. One is, we added some people in the corporate office.

One, a Vice President of Creative Management. He was an outside hire, some of you may have met him at E3. Many years in the creative development organization at Electronic Arts. Very strong hire. His job is to make sure our production values – story, music, character development – are competing at the highest level. Also, things like graphic quality, in-game cinematics – we think Danny can add tremendous value.

The other guy was promoted internally. He used to run our Rainbow Studios — Roy Tessler. He is a production management professional. It’s all about schedule and budget with Roy. What that’s done is that it’s given myself and my team greater visibility on the tradeoffs between hitting a date and hitting a quality level so that we maximize quality on all of the key drive titles.

One of the reasons we’ve had this dearth of product flow recently is that we’ve moved a number of products out to hit that. What I was very pleased at, really three proof points – starting with a European tour about a month ago, we got great feedback from retail about the strength and quality of our product line.

I was extremely pleased coming out of E3, and now your question, specifically, about de Blob. It won one of the most anticipated games of the show overall. Another press outlet that runs Best of E3 called it the best Wii game of E3. But not just de Blob, a number of our titles won awards at E3, which I think is a proof-point that what we’re doing is working.

Now it’s not like we started last October and we’re finished today. Along the continuum, we’ve made a lot of movement but I won’t be satisfied until every product comes out at the highest level of quality, particularly on the core gamer metrics.

So, yes, E3 was a huge proof-point for us. Now we want to make sure that quality resonates with consumers as well. We’re very pleased. de Blob is a very high-quality game, Saints Row is a very high-quality game. Even something like WWE, which is a licensed brand, we continue to invest in new things just to make sure that brand stays fresh.

If you stay with things like on Red Faction, I’d put that technology that we worked on for four years up against anything in the industry. Lot of shooters out there, nothing has the destruction technology of Red Faction: Guerilla.

So you’ve got to look at each product individually, which is how we do it. The proof-point is going to be “How does it resonate with consumers?” We think that the recent success that we’ve had with the press at E3 gives us a lot of confidence.

Q: On that point of the Wii, we’ve seen other third-party products that have been reasonably well-reviewed but based on new IP, not sell through very well on the Wii for a number of different reasons. What should our expectations be for de Blob? Is this a game that could sell a million or more units in the first couple quarters?

A: You bring up a good point. For the last couple years since the launch o
f the Wii, Nintendo has dominated the Wii with a huge slate of first-party products. We don’t see that many drive titles coming from Nintendo in our market opportunity, so we think we have a great market window coming out this September with de Blob.

What I love about de Blob, I said before. Not a tremendous investment because with the Wii, you can invest a fair amount and get a very high-quality product. So the upside leverage there — if we can create a hit – the upside leverage is very, very strong there. So that’s why we’re confident in de Blob, but also a key objective for us is to make sure we establish the brand.

We want to make sure that we have success so that we can bring it back to the Wii, and to other platforms. And you do that with high quality – drive the brand – and if we do that, there’s leverage and then there’s value creation.

Q: You guys have roughly $300 million in cash. What do you plan to do with it?

A: I’ve been saying the same thing for several years about cash. The highest and best use of cash is investment in intellectual property. That means investing in studios. Both growing ones we already own – we’ve had great success with studios like Volition and Relic, starting with a core team and building out super high quality studios.

We’ve also bought studios. We bought one last year. We had identified role playing games as a huge market opportunity. We bought Big Huge Games and we like what we see there. There’s two products we haven’t announced yet under development there, but a very, very experienced and professional team.

We have an MMO in development in our Austin studio based on our very successful Warhammer 40K franchise. That’s a product — it’s way too early to start talking a lot about it – but if you look at what’s happening in the MMO market and why that product has a great chance of success; it has all the elements of why people like MMO’s. It’s a variability of characters and powers, yet it’s set in a very unique Science Fiction environment. That’s a very large investment.

So we’ve invested in brands and new licenses – it’s all about IP, so that’s the highest and best use of cash.

Q: Where are investors underappreciating THQ?

A: I think it’s in the power of our studios. We’ve been very forthright in saying, you know, “We didn’t execute well last year against our owned IP.” That’s why undertook the product quality initiatives that we’ve done but, frankly, we’ve done it before.

I don’t mean to sound overly optimistic or defensive, but Relic Entertainment created the highest-rated real-time strategy game ever for the PC market. Volition has created – before we even bought them – did the Descent series for those of you old and crusty gamers in the PC market.

The original Saints Row, the original Red Faction – we have a very strong studio system. Yes, we did not have a good flow from them last year but I think you’ll start seeing the benefits of that coming up with de Blob in September and continuing through the launch of UFC in the June quarter of next year.

So, I think it’s the underappreciation of the strong pipeline that we have for the next several quarters.